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Irrational mistakes in market creates buying opportunities

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JPMorgan is one of the big brokerages actively trying to make the tenets of behavioral finance applicable in its investment strategies. The U.S. behavioral group, part of the equity group, manages portfolios for retail clients, mutual funds, institutions and 401(k)s. It's part of a global effort that has similar products in Europe and Asia as well.

We recently spoke with Dennis Ruhl, chief investment officer of U.S. Behavioral Finance, to get his insights. Here is an edited version of that discussion.

Bank Investment Consultant: How do you apply behavioral finance to investment decisions?
Dennis Ruhl: We start with the idea that any active manager should have a reason that the market is inefficient and why it's beatable. And if you don’t have that reason, you shouldn't be an active manager. For us, that reason is behavioral finance….Partially irrational and illogical decisions that investors and management teams make create the raw source for alpha over time.

The research we've done has led us to focus on value, quality and momentum. We think there are behavioral anomalies underlying each one of those…Behavioral finance is the why for everything we do.

BIC: You could use P/E ratios and other data to find undervalued stocks, how do you use the psychological ideas behind behavioral finance to help make your decisions.
DR: When it comes to the valuation aspect, we think the reason for anomalies lies in something called representativeness bias. This says that when you have two similar ideas, people tend to use the simpler one. For instance, people tend to think that a good company will be a good stock… and a bad company will be a bad stock. But we think that a good company can be a terrible stock if it's overvalued, and a bad company can bet a great stock if it's cheap enough. Sometimes, people will say, 'Yeah this stock is cheap,' and then give a reason why you shouldn't like it. Or, 'Yes, this stock is expensive,' and then give a reason why it's a good stock. This investor bias creates valuation anomalies in the market.

BIC: So if a company is a good company, and the stock is highly valued, will you ever consider it, or would you just avoid it?
DR: We look at three legs to our process: value, quality and momentum. If a stock was a bit highly valued but outstanding on quality and momentum, we still may buy it. But valuation is the core of what we do and the most heavily weighted. So if it's extremely expensive, it would be hard for us to buy it, but the decision is a combination of all three.

An active manager should have a reason that the market is inefficient and why it's beatable. If you don’t have that reason, you shouldn't be an active manager. For us, that reason is behavioral finance.

BIC: Do you feel your approach works best in weak markets or at least in markets characterized with high volatility? Or can you use it in strong markets too?
DR: We found that our approach works well over time in up and down markets, and even in flat markets. Where we have the biggest challenge are in the sharp shifts from up to down markets, or vice versa, the inflection points. This comes out of the momentum part of our analysis, but we think this is challenging for a lot of active managers.

BIC: Walk me through your day. What's the most important thing you do when you get into the office?
DR: We look through all the news and look for stocks in our universe that are moving up or down. Usually that's a signal that news or information is coming out … and we know there are anomalies in the way people process news and information so when we see that happening, we'll look to see if there are any opportunities for us. After that, we spend time on a mixture of quantitative and fundamental research. We think quantitative research really gets you away from the emotional biases and the lack of disciple that a subjective approach can allow. We use quantitative and fundamental research, but in such a way as to keep the behavioral biases from creeping into the fundamental research.

BIC: With the idea of loss aversion in mind, do you tend to go conservative with investments?
DR: We think about loss aversion in two ways. When you look at investor returns versus average market returns over the long term, you often see that investor returns are worse because there is a tendency to buy at the top and sell at the bottom because of loss aversion. So we try to design products to be as consistent as possible, whether it’s consistency to a benchmark or in terms of absolute returns. If you have products where the highs are not be as high as possible, but the lows are not as low, even if investors follow the classic patterns of selling on the lows and buying on the highs, they won’t hurt themselves as much if the products are less volatile.

Unconnected to that, but still related to loss aversion, is the continued outperformance of low-volatility stocks, or what we call bond proxies. This is rooted quite deeply, in terms of loss aversion, to the scarring of the 2001 and 2008 downturns. We think even though they've made their money back, provided they stayed in the markets, the pain of losing it was greater than the pleasure of making it back.

Abraham Lincoln used to write a letter and then put it in a drawer and decide the next day whether to send it. I think making financial decisions that same way could really help investors.

BIC: I'm surprised, the 2008 crash hit bottom and bounced back after just a few months, compared to the 1929 crash when it took an entire generation to hit pre-crash levels.
DR: It did come back fast, but it was so violent it has stayed in people's minds. There is a "saliency bias" that says when people think about a concept like the markets, they don’t think rationally about all the experiences people have had. Instead, they draw the salient point from their mind and that’s what they focus on. This is why people are more afraid of plane crashes than car crashes even though they are more statistically likely to get hurt in a car crash … When people are going about their business and their daily lives, when they do think about investments, they'll think of what’s salient, and that's the crash of 2008, or the downturn of 2000.

BIC: What's the most useful lesson from behavioral finance for investors and advisers.
DR: The most important lesson is to slow down and examine our decisions and engage in the logic part of our brains. Daniel Kahneman talks a lot about this in his book "Thinking, Fast and Slow." When we’re confronted with a situation, especially a stressful one, what takes over is the fight-or-flight part of the brain, and quick-thinking, emotional shortcuts. For someone facing a lion in the Stone Ages, that’s probably a good thing, but in today’s financial world, not so much.

Any trick you can use to slow down will be a huge help over time, and there are a number of ways to do that. Try to decide on your response to crises ahead of time. Things like investment plans, rules and policy statements can help because it’s easier to stick to your decisions if you make them ahead of time instead of on the fly … Plus, just making decisions slower and “sleeping on it” can help the emotions drain off …A story about Abraham Lincoln says he would write a letter and then put it in a drawer and decide the next day whether to send it. I think making financial decisions that same way could really help investors.

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