The High Cost of Neuro-Financial Errors: How Cognitive Bias and Performance Chasing leads to Investing Failures:
Presentation by Barry Ritholtz Trustee Leadership Forum for Retirement Security Kennedy School, Harvard University June 10 - 11
This is Your Brain. This is Your Brain on Drugs
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
Behavioral Economics & NeuroFinance
A brief intro to Behavioral Economics & NeuroFinance
How Does Your Brain Interfere With Your Investing?
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
Groupthink on Wall Street: 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: Ritholtz.com, NYT, McKinsey, Marketwatch
Analysts: Over-Optimistic GroupThink
“Analysts have been persistently overoptimistic for the past 25 years, with [earnings] estimates ranging from 10 to 12 percent a year, compared with actual earnings growth of 6 percent… On average, analysts’ forecasts have been almost 100 percent too high” -McKinsey study
Source: Ritholtz.com, McKinsey
“Here, Kitty, Kitty, Kitty”
How much information is required to make informed financial decisions?
“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.
“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 self-confident an expert appears, the more likely he is to be believed by TV viewers, but 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. • Experts who acknowledge that the future is inherently unknowable and unpredictable are perceived as being uncertain – and therefore less trustworthy. (Isaiah Berlin: Hedgehog vs Fox)
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
How What Already Happened Affects Your Thinking
WSJ: 2007 WSJ: 2010
Source: Ritholtz.com, WSJ
Emotions & the Sentiment Cycle
If u cn rd ths
This animation . . .
. . . is not an animation
When it absolutely positively has to deceive your eyes overnight
Applying Behavioral Economics To Alternative Investments
What Don’t You Know About Hedge Fund Investing
What We Don’t Discuss When We Discuss Hedge Funds 1. Hedge Funds manage a very small % of total financial assets, yet capture an unusual amount of media & mindshare. 2. 2&20% fees are an enormous drag on returns 3. Total Alpha generated by tiny % of managers (Non Gaussian Dispersion = Fat head/Long tail) 4. Funds can create Alpha but most morph into fee capture business 5. Picking new & emerging managers is exceedingly difficult; your own biases make the process even harder
Hedge Funds = 1.1% All Financial 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
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
Hedge Fund Growth
1997 = $118 billion 2012 = $2.04 trillion. 1. Talent Dilution 2. Excess Size 3. Correlation / Indexers
Diminishing Hedge Fund Returns
Alpha has diminishing returns to scale because many strategies only apply to smaller stocks and/or prices move against managers if they try to execute trades that are too large.
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)
Optimism Bias at Work
The Daunting Math of Mutual Fund Manager Selection
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 two out of the next three years; 3. Only 3% stayed in the top 20% over five 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
Is This Rational Investing?
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%
Top Hedge Fund Manager Compensation (Hourly)
It takes the average family 18.5 years to make what these hedge fund managers make in 1 hour
Paulson Hedge Fund
Manager Selection is Much Harder Than 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 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
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%)
Hedge Fund Attrition
– – – – – – – – Fund
• • • • • •
“We have met the enemy, and he is us.” -Walt Kelly, Pogo, 1971
What Can Pension Plans/Foundations Do ?
Understand What You Can and Cannot Do Well As Managers -How overweight in alt (PE/HF/VC) investments are you? -Focus on Asset Allocation (15 distinct classes) -Use Core & Satellite Approach to Reduce “Temptations” -Take Advantage of Mean Reversion via class rebalancing -Lower Your expectations until the next 1982 comes along -Think longer term -Get Unsexy!
Outperformance: • Bain & Co. in their 2013 Global Private Equity Report claim that, despite falling returns (above) and increased volatility (top right), buyout funds still outperformed the S&P 500 (right).
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 RitholtzCapital@optonline.net
My favorite books on these subjects can be found at http://www.ritholtz.com/blog/behavioral-books