Romancing Alpha

Forsaking Beta
How Cognitive Biases Lead to Performance Chasing & Investing Failures. The High Cost of Neuro-Financial Errors

Presentation by Barry Ritholtz Vancouver Symposium, July 24, 2013

Our Three Goals Today
1. Your Brain: Give you an understanding of your own Wetware – its development, strengths & weaknesses. 2. Its Cognitive Issues: Show how your wiring affects your ability to make decisions in the realm of investments. 3. Make You a Better Investor: Give you a check list of errors to avoid to

This is Your Brain. This is Your Brain on Drugs
1987 PSA

This is your brain

Your brain weighs 3 pounds, and is 100,000 years old. It is a “dynamic, opportunistic, self-organizing system of systems.” MRIs have revealed to Neurologists what our brains looks like when making decisions . We can observe it 1) in real time; 2) under actual conditions, and 3) in reaction to financial risk/reward stimuli. Once we begin trading stocks, however, our brains begin to undergo subtle physical change that we can actually see in the MRIs of Traders . . .

This is your brain on stocks

A brief intro to

Behavioral Economics & NeuroFinance

What Has Your Brain Evolved To Do?

1. Food 2. Flight 3. Fight 4. . . .

What Has Your Brain Evolved To Do?

1. Food 2. Flight 3. Fight 4. Procreation

How Does Your Brain Interfere With Your Investing?

Behavioral Economics
1. Herding, Groupthink 2. Experts: Articulate Incompetents 3. Optimism Bias 4. Confirmation Bias 5. Recency Effect 6. Emotions impact perception

7. Anticipation vs. Rewards 8. Selective Perception & Retention 9. A Species of Dopamine Addicts 10. Endowment Effect of Ownership 11. Monkeys Love a Narrative 12. Cognitive Errors Impact Processes


Mutual of Omaha “Lone Gazelle”

Source: Kal, Economist

Wall St. Groupthink: Buy Buy Buy!
1.  Only 5% of Wall Street Recommendations Are “SELLS”
-NYT, May 15, 2008


Why Analysts Keep Telling Investors to Buy
-NYT, February 8, 2009


Equity Analysts Too Bullish and Bearish at the Exact Wrong Times
-McKinsey, June 2nd, 2010


None of the S&P 1500 have a Wall St. Consensus “Sell” on them
-Robert Powell, Editor, Retirement Weekly, August 2011

It is better for one's reputation to fail conventionally than to succeed unconventionally. -John Maynard Kyenes

Sources:, NYT, McKinsey, Marketwatch

Optimism Bias
“Here, Kitty, Kitty, Kitty”

Dunning Kruger Effect: DK is a cognitive bias in which unskilled people make poor decisions and reach erroneous conclusions, but their incompetence denies them the metacognitive ability to recognize these mistakes. Metacognition: The less competent you are at a task, the more likely you are to over-estimate your ability to accomplish it well. Competence in a given field actually weakens self-confidence. This has devastating consequences in the investment world.

Paradox of Over Confidence
“Here, Tweetie”

How much information is required to make informed financial decisions?

“Expert” Forecasting versus Ambiguous Uncertainty
Bennett Goodspeed, The Tao Jones (1984) discussed “The articulate incompetents:” • Expert forecasters do no better than the average member of the public; • The more confident an expert sounds, the more likely he is to be believed by TV viewers • Experts who acknowledge that the future is inherently unknowable are perceived as being uncertain – and therefore less trustworthy. (Isaiah Berlin: Hedgehog vs Fox) • The more self-confident an expert appears, the worse their track record is likely to be. • Forecasters who get a single big outlier correct are more likely to underperform the rest of the time.
Source: Zweig, Your Money & Your Brain; Grants Interest Rate Observer,

Confirmation Bias Selective Perception & Retention  
1. We tend to read that which we agree with; We avoid that which disagrees with our preconceived biases, notions or ideologies; 2. Our biases change the way we perceive objects – literally, the way we see the world. 3. The same biases affect our memories – we retain less of what we disagree with . . . 4. Expectations Affect Perception

Recency Effects Impact Your Thinking
WSJ: 2007 WSJ: 2010

Source:, WSJ

If u cn rd ths

When it absolutely positively has to deceive your eyes overnight

Stroop Effect: Language vs. Color
As fast as you can: 1.  Read each word in order 2.  Say the color of each word

This animation . . .  

. . . is not an animation  

Applying Behavioral Finance To Alternative Investing

Romancing Alpha, Forsaking Beta

Alpha α:   is a risk-adjusted measure of active return on investment in excess of the assumed risks taken versus a benchmark. It is commonly used to assess active managers' performance. Beta β: of a stock or portfolio is the correlated volatility of an asset in relation to the volatility of its benchmark.

5 Things Not Often Discussed About Alternative Investing
You may not know . . . 1. Hedge Funds manage a small percentage of total financial assets 2. PE/VC/HF Fees are excessively high 3. Performance for the class is unusually bad 4. Picking emerging managers is exceedingly difficult 5. Your own biases and emotions make the process even harder

HFRX Global Hedge Fund Index Performance Data
How Have Hedge Funds Done? 2012 = Returns equaled 3.5% versus S&P 500-stock index 16% 2007-12 = Lost 13.6% vs. S&P 500-stock +8.6% 2013 = Gained 5.4% vs. S&P 500-stock +15.4% As a source of comparison, the average mutual fund is up 14.8% in 2013

Source: WSJ, HFRX

Confirmation Bias in Action

56% said they invested in hedge funds for diversification purposes Hedge funds correlated with other vehicles, falling in crisis Is Your Original Investing theme valid? 81% of investors said Yes (as of 2009)

Hedge Fund Manager Profit Capture
Managers Capture Investment Profits Mostly For Themselves
• From 1998-2010 hedge fund managers earned $379 billion in fees. The investors in their funds earned only $70 billion in investing gains. • Managers kept 84% of investment profits, investors netted 16%. • As many as 1/3 of hedge funds use feeder and/or fund of funds. This brings the industry fee total to $440 billion – that’s 98% of capture. Investors are left with $9 billion dollars – merely 2%.
Source: Simon Lack, The Hedge Fund Mirage

Hedge Fund Manager Profit Capture

Does not include Survivorship Bias, self reporting. Assume +3%

Media Buzz Hedge Funds = 1.1% All Fin Assets
The global hedge fund industry manages ~$2.13 trillion dollars Given what a relatively small asset class this is, they receive an excess of media attention. Perhaps because so many hedge fund managers have become billionaires, they have captured the investing public’s imaginations

Hedge Fund Growth
1997 = $118 billion 2012 = $2.04 trillion.

Selecting Active Management
The Daunting Math of Manager Selection (Mutual fund data)
1.  Only 20% of active managers (1 in 5) can outperform their benchmarks in any given year; 2.  Within that quintile, less than half (1 in 10) outperform in 2 out of the next 3 years; 3.  Only 3% stayed in the top 20% over 5 years (1 in 33) 4.  Once we include costs and fees, less than 1% (1 in 100) manage to outperform (net). 5.  What are the odds you can pick that 1 in 100 manager?
Sources: Morningstar, Vanguard

Paulson Hedge Fund
Manager Selection is Much Harder Than Most People Believe John Paulson launched his hedge fund in 1994 Hires Paulo Pellgrini in 2004 Raised $147 million in 2006 for Subprime Bet “Greatest Trade Ever” in 2006-07 Assets under management had swelled to $36 billion. Subsequent losses were 52% in one fund, 35% in another.

Pellegrini PSQR Hedge Fund
Manager Selection is Much Harder Than Most People Believe Paulson gave Pellegrini a $175 million bonus . . . Response: “F#$% you, I quit” Formed PSQR in 2008 Returns: 2008 = 40% 2009 = 61.6% 2010 = -11% August 2010, Pellegrini returned all outside investor capital
Sources: Greg Zuckerman, The Greatest Trade, WSJ

Comparable Compensation

Source: Forbes

Top Hedge Fund Manager Compensation

It takes the average family 18.5 years to make what these hedge fund managers make in 1 hour

Source: Forbes

Two Smart Guys
2 smart guys leave Goldman Sachs to set up a hedge fund; They raise $1 billion dollars: Performance: Year 1: +15% Year 2: +10% Year 3: -5% , (return capital) Earnings (2 + 20%): Year 1: $20m + $30m Year 2: $22m + $22m Year 3: $24m + $0 Total Comp = $118m (Total S&P500+Div=17%) (S&P500 = 14%) (S&P500 = 12%)

“We have met the enemy, and he is us.” -Walt Kelly, Pogo, 1971


Last Vancouver Event

Top 10 Cognitive Investor Errors
How to Overcome Your Own Wetware 1. Understand Your Own Cognitive Errors 2. Avoid the Narrative (stick with data) 3. Passive Investing avoids emotional decisions (Unlike Active) 4. High Fees Are a Huge Drag on Returns 5. Avoid Forecasts: The Future is Inherently Uncertain 6. Your Asset Allocation Decisions Matter More than Stock Picking 7. Be aware of Randomness 8. Never Confuse Past Performance with Future Returns 9. Allow Compounding to work for you 10. You Are Your Own Worst Enemy

Focus on What Matters

Sentiment Cycle


Understand the Long Cycle  
100 Years of Secular Markets, P/E Expansion & Contraction

Source:, Crestmont Research

Composite  19  Secular  Bear  Markets  

Source:, Morgan Stanley Europe

Earnings versus Equities Since 2009 Lows

for more information, please contact

Barry L. Ritholtz  
CEO, Director of Equity Research Fusion IQ 535 Fifth Avenue, 25th floor New York, NY 10017 516-669-0369

My favorite books on these subjects can be found at  

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