In the conclusion to this two-part series, Nick Dewhirst continues to look at the strengths and weaknesses of behavioural finance, and what can split the interests of the investor, their agent and the fund manager
Last month, portfolio strategies examined the differences between efficient market thesis compared to behavioural finance. Many academics support market thesis, believing the market's performance is random because everything known is immediately reflected in share prices by players acting rationally, while those in favour of behavioural finance argue that share prices are predictable because players often act irrationally.
This month, the rationale behind investing will be examined starting with what organisational effects create a divergence of interests between investors and their agents and the professional fund manager.
don't Follow the crowd
The first effect is herding, (see graph below). This shows the distribution of five-year performance by bands. Normally one would expect such a graph to be in the shape of a bell curve, with the largest proportion of funds producing results in the middle of the range, and ever decreasing proportions of funds diverging by larger amounts.
Therefore, there should be very few geniuses or dunces but large numbers of managers with results close to the average. However, this particular bell curve possesses some unusual features.
Firstly, the extent of concentration differs between the different types of investment packaging. As they all share the same investment objective, one would expect the distribution to be similar.
However, the results of balanced managed life, balanced managed unit trusts and managed pension funds are highly concentrated whereas those for multi-manager unit trusts and fund of funds unit trusts are much more widely dispersed.
This suggests that the pressure to conform is much greater among the first group than among the latter. If herding were a performance neutral effect, this would be of merely theoretical interest, but it is not.
The two types of fund with less conformists performed better than any of the three types with more conformists. Furthermore, the difference is significant, amounting to 10% over five years or 2% per annum between best and worst, meaning the cost to investors of their agents' herding effect lies in the order of several percentage points a year.
Secondly, the bell curve is skewed. There are significantly more outperformers than under-performers. Indeed, except for multi-manager units, there are virtually none.
The existence of outperformers suggests there are some managers whose interests are aligned with those of their investors. However, the lack of underperformers suggests they are air-brushed out of the statistics, typically by merger, closure or re-classification. In any event, the consequences for the individual fund managers are clear - career risk.
Therefore, the reason for herding, otherwise known as closet linking, becomes clear. The loss aversion syndrome identified by behavioural finance for investors applies equally to their agents and fund managers. Bonuses and praise are all very well for good performance, but irrelevant if one is no longer given the opportunity to perform.
The next organisational effect is short term, as fund managers are obsessed with their own quarterly performance figures. It may be obvious to them that a particular market is outrageously overvalued on a long-term basis, yet they do not sell, because it may become even more overvalued in the short term.
BEnefit vs risk
Given a choice between a short-term benefit and a long-term risk, or vice versa, managers tend to pay greater attention to the short term. This is often also irrespective of the relative importance of short and long-term factors. The reasons are that the short-term factor is an immediate career risk/opportunity, whereas the long-term factor can be explained away.
It may never happen because anything in the future can change. One may have been promoted out of the line of fire by then. If it does happen, it may be forgotten. If not forgotten, it may be deniable, if there is no record of it.
The third organisational effect is the business of free money-losing advice. Professionals apply their particular professional discipline to making balanced judgments about the information available to them.
So, the most effective means for influencing a professional's judgment is to tip the scales by overloading one side with the weight of information favourable to one's cause.
New issues are a classic problem, because commission is paid by the issuer, rather than the investment fund.
Because brokers are paid higher commissions for selling new issues, rather than secondary trading, their salesforces will devote a disproportionate effort to new issues.
These are made at times and prices convenient to their issuers and thus professional managers making balanced judgments of the information presented to them are likely to purchase at least some issues. Anyone foolish enough not to flip their allocations immediately typically suffers inferior performance.
A similar effect applies to investment research. If free sell-side research is bullish on 75% of all shares, there is a 75% chance that the average manager will buy. Such research is free to fund management companies because its cost is bundled into commissions, which can be charged against a fund-holder's performance.
By contrast, independent research is often ignored, even though there is no shortage of surveys that show it is usually more balanced in its recommendations. This is because such subscriptions are charged against the firm's profit and loss account.
Independent research is therefore used more sparingly and so accounted a lower weight, despite its superior performance.
Those who understand organisational finance, realise it is the most powerful means for achieving superior investment performance.
Loss aversion syndrome is responsible for herding, which affects investors, agents and fund managers alike
Given the choice between short-term benefit and long-term risk, managers tend to lean towards the former
Use independent research. Although often ignored, it is the most balanced in its recommendations
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Investment trust savings scheme