Behavioral Finance


Recent Research: Highlights from August 2012

"Diversification Return and Leveraged Portfolio"
The Journal of Portfolio Management (Summer 2012)
Edward Qian

It is widely accepted that portfolio rebalancing adds diversification return to fixed-weight portfolios, but this is only true for long-only unleveraged portfolios. Qian provides analytical results regarding portfolio rebalancing and the associated diversification returns for different kinds of portfolios including long-only, long-short, and leveraged. He shows that portfolio rebalancing is linked to underlying portfolio dynamics. For long-only unleveraged portfolios, rebalancing amounts to a mean-reverting strategy, and the diversification return is always non-negative. But for short (or inverse) and leveraged portfolios, portfolio rebalancing on the top-down level amounts to a trend-following strategy that detracts from diversification return. Qian analyzes diversification returns of risk parity portfolios and shows that the diversification return of a leveraged long-only portfolio can generally be decomposed into two parts, both of which are related to a scaled unleveraged portfolio. The first part is the positive diversification return from rebalancing among individual assets at the bottom-up level, which is amplified by leverage. The second part is the negative diversification return caused by the leverage of the overall portfolio. His numerical examples show that diversification return is, in general, positive for leveraged risk parity portfolios when the leverage ratio is not too high. In addition, he shows that low correlations between different assets are crucial in achieving positive diversification return and reducing portfolio turnover for risk parity portfolios.

"The Rubber Starts to Meet the Road: Achievable Results in US Housing Finance Reform"
The Journal of Structured Finance (Summer 2012)
Chris DiAngelo

This article begins by noting that the US Congress and the Administration both remain stymied in the area of housing finance reform, notwithstanding numerous “white papers,” “requests for information,” “roundtables,” and the like. After almost four years, Fannie Mae and Freddie Mac remain in conservatorship, with no clear exit plan. Looking past the top level (Congress and the White House), however, one will see that the two government-sponsored enterprises (GSEs) themselves and their regulator/conservator, the Federal Housing Finance Agency, have begun to make real progress in several areas. In early 2012, the FHFA released a strategic plan for the GSEs and followed that up with a “scorecard” that sets forth in some detail a “to do” list of items that the FHFA intends to get done, along with target dates for those items. The article focuses on four items in particular: the REO disposition program, the “new securitization platform” initiative, the “single security” concept, and the possibility of privatizing the multifamily business. The conclusion is that more progress is being made than the public generally believes.

"Kicking the Habit: How Experience Determines Financial Risk Preferences"
The Journal of Wealth Management (Fall 2012)
Joachim Klement and Robin E. Miranda

Conventional explanations for the diversity of risk preferences among individual investors offer only limited insight. Recent research in neuroscience, genetics, and behavioral decision making underscore the importance of experience in financial risk taking. The authors review these findings and argue that not only does individual experience influence risk taking, so do the collective experiences of groups. Additionally, there seems to be a significant genetic component to financial risk taking, suggesting that “evolutionary experience” also needs to be considered when analyzing the risk preferences of individual investors. The authors introduce some simple tools to identify the influence of experience on financial risk preferences. These tools can help financial advisors to accurately assess investors’ risk preferences to help them achieve their goals at an acceptable level of risk.

NYSSA Discount on Journals


Black Swan Events: No Longer a Rarity

Vinny Catalano, president and global investment strategist with Blue Marble Capital Management, is on a mission to heighten investment professionals’ awareness of the impact that black swan events and other hard-to-quantify and predict “big picture” phenomena are likely to have on market behavior in the 21st century. He reports investment analysts need to get comfortable navigating the uncharted waters where the black swan lurks. Catalano will be moderating NYSSA’s upcoming Market Forecast™: Are We There Yet? conference on August 9.

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How Psychological Pitfalls Generated the Global Financial Crisis


The root cause of the financial crisis that erupted in 2008 is psychological. In the events which led up to the crisis, heuristics, biases, and framing effects strongly influenced the judgments and decisions of financial firms, rating agencies, elected officials, government regulators, and institutional investors. Examples involving UBS, Merrill Lynch, Citigroup, Standard & Poor’s, the SEC, and end investors illustrate this point. Among the many lessons to be learned from the crisis is the importance of focusing on the behavioral aspects of organizational process.

Acknowledgments: I thank Mark Lawrence for his insightful comments about UBS; Marc Heerkens from UBS; participants at seminars I gave at the University of Lugano and at the University of California, Los Angeles; and participants in the Executive Master of Science in Risk Management program at the Amsterdam Institute of Finance, a program cosponsored with New York University. I also express my appreciation to Rodney Sullivan and Larry Siegel for their comments on previous drafts.

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BP’s Failure to Debias: Underscoring the Importance of Behavioral Corporate Finance

“BP has a systemic problem with its culture that runs deep.”

Ending the Management Illusion, Shefrin (2008), p. 95.

“In the view of the Commission, these findings highlight the importance of organizational culture and a consistent commitment to safety by industry, from the highest management levels on down.”

Report to the President, National Commission on the BP Deepwater Horizon Oil Spill and Offshore Drilling, (2011), p. ix.


In this paper, we apply key concepts from behavioral finance to document how psychological biases and framing effects impacted corporate culture and management decisions at energy firm BP. On April 20, 2010, an accident drilling BP’s Macondo well in the Gulf of Mexico produced the worst environmental disaster in US history, an event which dominated the daily news during the spring and summer of 2010. In itself, this event makes for the study of BP’s decision making of interest, prompting the question of whether the April 20 accident was simply an unfavorable chance event or instead the result of biased decision making.

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Do Performance-Based Fees Work?

Yesterday's post tackled regulatory matters for performance-based fees. But, how effective are those fees?

Psychologists have determined that the old carrot-or-stick method only works in certain circumstances. In the following video from the Royal Society for the Encouragement of Arts, Manufactures and Commerce, Daniel Pink (author of Drive: The Surprising Truth About What Motivates Us) explains the three factors that improve employee performance. 


Trading on Corporate Earnings News


A study by Roll, Schwartz, and Subrahmanyam (2009) found that options trading around earnings announcements has been steadily increasing every year since 1996. Before we begin with specific trading strategies, it makes sense to get a sense of the general behavior of options around earnings announcement periods.

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Anniversary Special: Top Ten Articles from the FPP

It's been one year since NYSSA launched the FPP, and the readers have spoken: hot topics include career development, landing a job (not surprising!), behavioral finance, emerging markets, and quantitative methods. Here are the ten most popular articles from the previous year in case you missed them the first time around. If you would like to suggest new topics for the FPP to cover, please take a minute to fill out our reader survey. (Everyone who completes the survey is automatically entered in a drawing to win an Amazon Kindle and a selection of e-books from the FT Press.)

1. Five Things NOT to Do if You Want to Pass the CFA Exam
With pass rates lower than 50%, the CFA exams are daunting for even the most seasoned financial professionals. Approach the process strategically and avoid these common mistakes.

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Recent Research: Highlights from March 2011

Capturing Alpha in the Alpha Capture System: Do Trade Ideas Generate Alpha?The Journal of Investing (Spring 2011). Jean W. Thomas.

In the wake of recent failures of such factors as price momentum and estimate revision to generate excess returns to traditional and quantitative strategies, this study explores the potential for using Trade Ideas as a new source of alpha in long-only and hedge strategies.

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Reprogramming the Mind: A Cognitive View of Stress, Performance, and Treatment for Wall Street’s Wounded

Illustration by Mark Andresen The financial industry is an ideal crucible for studying psychological stress and its effects upon performance. Few professions involve such routine exposure to risk and uncertainty; even fewer measure performance success so tangibly. The recent deleveraging and the contraction of the industry have brought a variety of personal and professional stresses to investment professionals.

Consider the following scenarios, each of which is drawn from recent conversations with workers in the finance sector:

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Recent Research: Highlights from February 2011

Policy Portfolios and Rebalancing Behavior.” The Journal of Portfolio Management (Winter 2011). Martin L. Leibowitz and Anthony Bova.

An institutional fund typically has a multi-asset allocation—the policy portfolio—that is maintained over time. When allocations shift, the fund rebalances back to the policy portfolio. The discipline of the policy portfolio has many benefits: simplicity, convenient benchmarking, and a minimum of organizational frictions. Its very routine nature can lead, however, to an overemphasis on relative returns and an insensitivity to fundamental changes in fund status and market structure. In 2003, the late Peter Bernstein questioned whether rigid adherence to the policy portfolio made sense, given frequent market dislocations and high levels of volatility. In this article, Liebowitz and Bova attempt to shed further light on the Bernstein question by analyzing the risk tolerance and return assumptions of a basic two-asset (equity and cash) fund. One key finding is that policy portfolio rebalancing implicitly assumes that the risk tolerance and return premiums remain fixed over time. But few funds have the sponsorship, liquidity, or organizational conviction to keep such a constant risk tolerance in the face of severely adverse markets. One argument for the policy portfolio rebalancing is that assets become “cheaper” after a decline, but this is inconsistent with a constant return premium. Moreover, “cheaper” assets should actually call for rebalancing beyond the original policy portfolio to a more aggressive allocation. One idea for a more pro-active, market-sensitive process is to develop pre-planned contingency actions for various market scenarios.

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Developing Emotional Intelligence Skills to Help Clients in Distress

CFA InstituteMany advisers are moving in the direction of client relationship management, and are therefore managing clients’ financial hopes, dreams, expectations, and fears. Yet very few advisers have degrees in counseling. Emotionally intelligent communication strategies allow an adviser to turn an emotionally charged conversation into one that strengthens the adviser relationship and referral stream.

Click here to read the full article, written by Richard L. Peterson, MD.


Behavioral Finance: Theories and Evidence

CFA Institute That behavioral finance has revolutionized the way we think about investments cannot be denied. But its intellectual appeal may lie in its cross-disciplinary nature, marrying the field of investments with biology and psychology. This literature review discusses the relevant research in each component of what is known collectively as behavioral finance.

Click here to read the full literature review, written by Alistair Byrne, CFA, and Mike Brooks


Hive Mind: Organizational Psychology and the Financial Crisis

Illustration by Mark AndresenEconomists agree about the mechanism for the current financial crisis: a plunge in real estate prices led to widespread mortgage defaults, crushing the value of securities backed by those assets. This caused banks to shut down available credit and sent the global economy into a tailspin. “If there hadn’t been a housing bubble, we wouldn’t be having this tragedy today,” says Hersh Shefrin, PhD, professor of behavioral finance at Santa Clara University and the author of Ending the Management Illusion: How to Drive Business Results Using the Principles of Behavioral Finance (McGraw–Hill 2008).

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Whither Efficient Markets? Efficient Market Theory and Behavioral Finance

The notion of efficient markets has been the subject of rigorous academic research and intense debate for more than a century. As early as 1889, George Rutledge Gibson wrote in The Stock Exchanges of London, Paris, and New York that when “shares become publicly known in an open market, the value which they acquire may be regarded as the judgment of the best intelligence concerning them.” A reference to the concept of efficient markets is also found in French mathematician Louis Bachelier’s 1900 dissertation Théorie de la Spéculation. But it wasn’t until the mid 1960s, through the independent work of MIT economist Paul A. Samuelson and Eugene Fama, then a PhD candidate at the University of Chicago, that the efficient markets hypothesis (EMH) gained widespread acceptance.

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The Three Most Common Biases of Hedge Fund Managers

An upcoming NYSSA forum will be exploring the opportunities, risks, and challenges of investing in emerging hedge fund managers. In the absence of a long track record to review, the field of behavioral finance may offer particularly effective tools, not only for identifying the best emerging talent but also for detecting manager biases that may translate into future blowups.

Cynthia Harrington, a former large-cap value manager who now uses behavioral finance principles to coach hedge fund managers, has observed that their three most common biases are confirmation bias, herding behavior, and overconfidence.

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The Hierarchy of Risk: A New Approach to Risk Management

Risk culture is comprised of those values and behaviors, on the parts of both management and employees, which define an organization’s awareness of and approach to risk. As the financial crisis continues, the most successful firms have been those possessing risk cultures with high awareness, quick escalation, and strategic flexibility. There are echoes of behavioral finance in the way an organization’s view of risk may be skewed by its current investment appetite, its compensation and incentives, and its degree of knowledge of historical risk. Complicating this risk culture is quantitative modeling of limited historical data, decreasing transparency due to financial product innovation, and overreliance on credit ratings.

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Outsiders and Outperformers: Women in Fund Management

The gender gap is a wide one in the world of investment management. Women manage only 3% of the assets in the $1.9 trillion dollar hedge fund industry, and only 10% of mutual fund managers are women (NCRW 2009). While the number of female CFA® charterholders has risen in absolute numbers from 5,719 in 2000 to 15,992 in 2009, the percentage of charterholders who are women has hardly budged—from 18% to 19%—over that period, according to the CFA Institute.

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A Beta for Sentiment?

Standard & Poor'sThe interaction of human emotion and asset pricing has been the focus of much behavioral finance research. Sentiment indicators, which seek to quantify the emotional states of market participants, play an important role in understanding and guiding action based upon this dynamic. In response to the lack of a tradable sentiment index, S&P Indices proposes a frequently-calculated, tradable Sentiment Beta index composed of six metrics of sentiment.

Click here to read the paper. 


Book Review: The Myth of the Rational Market

Myth-Rational-Market-Fox The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street (HarperCollins, 2009) is a history and analysis of the rational market theory which dates back to 1920s economist Irving Fisher which developed with the application of science to traded securities markets. A lot of now famous names made contributions along the way including Harry Markowitz, Franco Modigliani, Merton Miller, Myron Scholes. This academic work moved into the Wall Street mainstream. Much of what is now accepted parts of modern markets—quantitative research, technical analysis, options and derivatives strategies—comes out of the rational and efficient market thesis.

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Research Overview: Cornelia Betsch's Preference for Intuition or Deliberation Scale

Recent work by Cornelia Betsch (Center for Empirical Research in Economics and Behavioral Sciences—CEREB, University of Erfurt, Nordhaeuser Strasse 63, D-99089, Erfurt, Germany) suggests some interesting findings regarding strategies used to make a choice. Several key points of this research are as follows.

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Research Overview: Phantastic Objects and the Financial Market’s Sense of Reality

David Tuckett and Richard Taffler have an interesting paper recently published in the International Journal of Psychoanalysis entitled “Phantastic Objects and the Financial Market’s Sense of Reality: A Psychoanalytic Contribution to the Understanding of Stock Market Instability.” The article suggests that in the context of uncertainty and ambiguity, emotions and states of mind determine the way information about reality is processed. Three questions are posed as follows:

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Most Analysts Miss Data That Affects Their Models—Will You?

First-rainLong-term performers continuously innovate in the research process. In recent years, expert networks and channel checking services have added new data to analysts’ models. Today, the web has emerged as a vast, unmatched investment research database, with:

  • fundamental data on companies––trapped in text form
  • emerging signals of risk in a market or region––before they hit the tape
  • global and local insights on every company––not mentioned in standard analysis
  • comments from experts––outside of the widely used expert networks

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