Tag: process

Essays

Counterfactual Investing

Behavioral Matters: Insights from the application of Behavioral Finance | Issue 14

Written by Michael A. Ervolini

Counterfactual Investing

“So we have the paradox of a man shamed to death because he is only the second pugilist or the second oarsman in the world. That he is able to beat the whole population of the globe minus one is nothing; he has “pitted” himself to beat that one; and as long as he doesn’t do that nothing else counts.”

– William James

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INTRODUCTION

Imagination and creativity help turn good ideas into winning strategies and great picks if they are calibrated to ensure favorable results. Imagination also can push investors toward unproductive decisions — ones that feel right while lowering performance. Known as Counterfactual Thinking, this type of deliberation can affect your interpretation of results and can shape the buys and sells you make.

DARN, I JUST MISSED IT

Emotional responses to outcomes often are influenced by what might have been. Counterfactual Thinking, as such thoughts are known, often ends in regret. The emotional response to an event depends on how easily one can conjure up alternate outcomes that are either better or worse. An often cited example regards missing a flight by five minutes or 45 minutes. People that just miss their flight tend to kick themselves more than those who missed their plane by a mile. The closer you were to making the flight, the easier it is to construct an alternative outcome or counterfactual that triggers regret.

WHEN WORSE IS BETTER

Who should be happier, the person that wins the silver medal or the bronze? The silver medal winner is objectively better off — he or she is closer to gold than the bronze medal winner. Yet, that is precisely why a silver medalist enjoys second place far less than the bronze medalist enjoys coming in third.

In analyzing medal winners from both the Olympics and the Empire State Games, researchers Thomas Gilovich, Victoria Husted Medzec and Scott Madey found that silver medalists were less happy with their accomplishment than bronze winners. The silver medalists created a counterfactual based on not having won gold, focusing upward and ruminating about how close they came to first place. This thinking induced feelings of regret and frustration… the, if-only-I-hads. The bronze medalist, in contrast, focused downwards and formulated a more positive counterfactual. Rather than being among the others hitting the showers, they were at least up on the awards pedestal and very happy to be there. Counterfactual Thinking does more than color how we feel about past events; it can also trigger surprising actions.

PHANTOM GAINS AND LOSSES

Investors sometimes generate counterfactuals when they consider repurchasing previously owned stocks. In their paper “Once Burned, Twice Shy” Terrance Odean, Michal Strahilevitz and Brad Barber observed that investors are more likely to repurchase a stock when its current price is below that at which it was sold, and less likely to repurchase it when the current price is higher. The counterfactuals motivating these choices are explained as: “Investors who buy a stock at a lower price than they previously sold it experience the pleasure of knowing they are better off than if they had never sold that stock. Investors who buy a stock at a higher price than they previously sold it are painfully aware that they are worse off than if they had simply never sold that stock.” The terms “knowing” and “being aware“ express the feelings investors have about these purchases based on their if-only-I-hads.

The more relevant question for these investors is whether any stock they previously owned is likely to outperform alternate stocks going forward. For example, repurchasing a stock at a price higher than at what it was sold might be a good investment decision — even though it might feel bad. The counterfactuals make the investor feel a loss or gain based on price movement when the stock wasn’t even owned. This distracts from focusing on today’s thesis and how the stock will perform going forward. The result can be murky judgment — where emotions emanating from if-only’s override objective analysis.

CAN’T WIN FOR LOSING

Counterfactuals also shape the choices made when adding to current positions, according to Odean et al. Investors tend to add less frequently to holdings whose price has gone up, since being purchased (“winners”) and add more frequently to those whose price has dropped (“losers”). The counterfactual created for winners is, “I should have purchased more when it was cheap.” Investors prefer to avoid feeling the regret that this counterfactual brings, so they tend to avoid these buys. The counterfactual for buying losers seems to be associated with avoiding the pain of losing, as in, “If I buy more now and the price moves up, I can regain my current losses.” This counterfactual is consistent with Prospect Theory and resetting one’s reference point. The team’s research demonstrates, however, that the investors were no better off preferentially adding to losers over winners. Feeding their counterfactuals did not enhance their returns.

CONCLUSION

Counterfactual Thinking can hurt performance. It has the power to make silver medalist feel worse than those taking bronze. It can drive investors to make decisions based on if-only’s rather than facts. Counterfactuals can cause you to consider repurchasing stocks based more on price movement since being last sold than on current thesis. They can also cause you to refrain from adding to current portfolio winners… perhaps missing a huge run-up in the bargain. Selfawareness counters such ineffective thinking — keeping decisions factual.

ENDNOTES

“When Less Is More: Counterfactual Thinking and Satisfaction Among Olympic Medalist”, Thomas Gilovich, Victoria Husted Medzec and Scott F. Madey, Journal of Personal and Social Psychology, Volume 69, 1995.
“Once Burned, Twice Shy: How Naïve Learning and Counterfactuals Affect the Repurchase of Stocks Previously Sold”, Terrance Odean, Michal Strahilevitz and Brad M. Barber, Working Paper, September 2004.

MICHAEL A. ERVOLINI, AUTHOR

The ideas expressed on this website are developed and/or curated by Michael Ervolini. Mike has spent his entire 35 year + career leading efforts to improve and strengthen active management.

FROM THE SKILL LIBRARY

Endowing Success

ESSAY

Behavioral Matters: Insights from the application of Behavioral Finance | Issue 13

Written by Michael A. Ervolini

8 min read

Endowing Success

“The salesman knows nothing of what he is selling save that he is charging a great deal too much for it.”

– Oscar Wilde

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INTRODUCTION

Holding winners well past their alpha generation is a tendency recently identified among professional investors. These once highly productive buys inevitably devolve towards reversion to the mean, yet they seem to hold a special place in the minds (or is it hearts) of the managers. One explanation for holding winners too long is the Endowment Effect — valuing items higher when we possess them, making it more difficult to find a clearing price. This essay takes a look at the Endowment Effect and how it can impact the management of portfolio positions.

TRIALS OF BEING WELL ENDOWED

The Endowment Effect stifles selling. That is what Richard Thaler first suggested in 1980. The reasoning behind this theory goes like this: once a person possesses an item they then value that item more than prior to such possession. The item, it is believed, becomes part of the individual’s endowment and grows in value or importance for that reason alone. In other words, you would refuse to pay the same price for an item that you would want to sell it for. At first blush this might sound like simple horse-trading — buy low and sell high. But the roots of the Endowment Effect go deeper into our psyche.

Motivating this behavior is Loss Aversion. Taking a loss is an emotionally expensive experience. Studies suggest that the displeasure of losing $1 is two to three times greater than the pleasure of winning the same dollar. This asymmetry between winning and losing results in our avoiding losses in order to avoid the associated pain. Selling, it turns out, is perceived as a loss while buying tends to feel more like a gain. An implication of this asymmetry is that Loss Aversion will, on average, induce a higher dollar value for owners than for potential buyers, reducing the set of mutually acceptable trades.

NO MONKEYING AROUND

The sense of attachment we feel for possessions appears to be primal. Studies conducted by Keith Chen of Yale University involving Capuchin monkeys and Owen Jones at Vanderbilt University involving chimpanzees both support the notion that the Endowment Effect emanates from deep within our DNA.

The Capuchin monkeys were taught to trade coin-like tokens for food. They were offered similar amounts of food simultaneously at two windows in a specially designed pen. In any experiment, choosing one window would yield exactly the food offered, while choosing the other window would yield a 50/50 random chance of what was offered or a different amount. In one set of experiments the surprise amount was more than what was offered. In another set of experiments the surprise amount was less. After many trials, the monkeys showed a preference for choices where surprises were presented as bonuses rather than losses. They would choose the certain pay-out when they concluded the surprise was a loss; and choose the 50/50 pay-out when they concluded it provided a random gain. They exhibited classic Loss Aversion.

In a separate study chimpanzees were given a choice between peanut butter and frozen juice bars — both requiring time to fully ingest. Peanut butter was preferred by 60% of chimps when both treats were offered simultaneously. But when offered one at a time, only 20% of chimpanzees would trade. So while 40% preferred frozen juice bars, only 20% traded away their peanut butter when it was provided. Even more interestingly, while 60% showed a preference for peanut butter just 20% traded away frozen juice when it was provided. Their preferences apparently changed based on which treat they were given or possessed — a sure indication of the Endowment Effect.

THINKING IS ENDOWING

The sense of possession can be heightened merely by thinking about an item. In his 2008 paper, James Wolf discusses how exposure to an item (physical and mental) can increase feelings of ownership. He states “…that is, examining an item for longer periods of time resulted in greater attachment to the item and thus higher valuations.” Does the act of reviewing portfolio positions enhance their endowment?

It certainly is possible. Research suggests that analysis can promote enhanced feelings of ownership, which then inflates the value assigned to an item, in this case an equity position. Add to this scenario a position that has hit its current price peak and the stage is set for hesitancy in selling winners. Unfortunately, learning from our mistakes is a poor approach for overcoming the Endowment Effect. Studies indicate that market exposure — that is repeated attempts at essentially the same choice — does not result in eliminating the desire to over-value possessions. In other words, being a professional is no guaranteed defense against our unconscious motivations.

CONCLUSION

Managing positions is tough business and managing winners is no less so. The bias towards selling winners quickly has received tremendous attention in academic literature. The tendency to hold winners past their ability to generate alpha is less discussed, but has been shown to produce similar negative impacts on performance.

One explanation for holding winners too long is the Endowment Effect. We become fond of what we own… to a level where our selling price floats above what reasonable buyers are willing to pay. And the more we evaluate our winners the more difficult it may become to sell them without a sense of loss. Discipline, analysis and thesis confirmation may excite that monkey inside all of us and we… well… just go bananas.

ENDNOTES

“How Basic Are Behavioral Biases: Evidence From Capuchin Monkey Trading Behavior”, Journal of Political Economy, 2006, by Keith Chen, Venkat lakshminarayanan and Lauri R. Santos.
“Experimental Tests of the Endowment Effect and the Coase Theorem”, The Journal of Political Economy, Vol. 98, No. 6, December 1990, by Daniel Kahneman, Jack L. Knetsch, and Richard H. Thaler.
“The Power of Touch: An Examination of the Effect of Duration of Physical Contact on the Valuation of Objects”, Judgment and Decision Making, Vol. 3, No. 6, August 2008, pp. 476-482, by James R. Wolf, Hal R. Arkes and Waleed A. Muhanna.
“Law, Biology, and Property: A New Theory of the Endowment Effect”, William and Mary Law Review, Vol. 49 No. 6, 2008, by Owen D. Jones and Sarah F. Brosnan.

MICHAEL A. ERVOLINI, AUTHOR

The ideas expressed on this website are developed and/or curated by Michael Ervolini. Mike has spent his entire 35 year + career leading efforts to improve and strengthen active management.

Tags active management, equity management, process

Essays

Thesis, Narrative, or Just Another Disappointing Story

Post author By Kyra Spradlin
Post date May 29, 2024

ESSAY

Behavioral Matters: Insights from the application of Behavioral Finance | Issue 9

Written by Michael A. Ervolini

8 min read

Thesis, Narrative, or Just Another Disappointing Story

“What is most important is not dispelling particular erroneous beliefs, but creating an understanding of how we form erroneous beliefs.”

– Thomas Gilovich

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INTRODUCTION

Stocks are often managed on the basis of a thesis. This has come to mean that the manager has a clear expectation of how a stock will add alpha to the portfolio and she can express it in a tight sentence or two. The mere existence of a thesis suggests purpose, conviction and discipline. On the other hand, the dictionary defines thesis as an unproved statement or argument put forward as a premise. Too often the tentative nature of a stock’s thesis is lost, inviting behaviorally motivated decisions that undermine performance. In this essay we examine the nature of the investment thesis and how, lacking sufficient self-awareness, it can be just another disappointing story.

MIND YOUR THESIS

Our unconscious brain plays a dominant role in the decisions we make. Many scientists now believe that the role of our conscious brain, to a large extent, is to create a narrative so that we can understand what our unconscious brain has already decided.

A thesis can, therefore, as easily be the end result of intense research and process or the verbal expression of one or more instinctive judgments. Consequently, the thesis for stock A may be fact based and built entirely from your process while the thesis for stock B might feel comparably formulated but reflect much less discipline. Understanding the veracity of each thesis in your portfolio can help you strengthen your process and improve performance.

SELLING YOUR THESIS

Buying stocks often is a highly disciplined and process driven activity. Not so with selling. Rigorous investigation points to selling as being underdeveloped with regards to research, analysts’ recommendations, capital expenditure and overall industry investment. The short shrift being given to selling, suggested by these signs of inattention, is underscored by the uneasiness exhibited as most managers explain that they are not as confident in their sells as their buys.

Selling is, therefore, more judgmental and thus prone to behavioral influences. One way this can be observed is through thesis drift. For example, a stock might initially be purchased based upon growth at a reasonable price (GARP) but as the price continues to fall it is reclassified and held as a value stock. This change in thesis might in fact be a case of nimble and responsive portfolio management or just another instance of the Disposition Effect.

The Disposition Effect is perhaps the most studied behavior affecting professional equity managers. It states that when choosing positions in the portfolio to sell managers are behaviorally more inclined to sell winners over losers. This behavior can lead to a relatively high turnover of gains in the portfolio and a commensurate longer holding period for losers. Redefining the thesis for a stock, as in the example above, can reflect the unconscious desire to avoid realizing a loss and formulating a narrative to help make that happen.

PAINFUL AVOIDANCE

Thesis drift can also result from cognitive dissonance. A term coined by the social psychologist Leon Festinger in the 1950’s, cognitive dissonance refers to the discomfort we feel when holding on to mutually inconsistent beliefs. In finance, cognitive dissonance commonly involves our sense of self efficacy. We are, after all, smart, trained and capable investors yet we often find ourselves owning a notorious loser. Our unconscious wants desperately for us to feel capable yet there is the not so small matter of this unfortunate position stinking up the portfolio. How we manage this dilemma can impact performance both today and tomorrow.

The self-aware professional confronts such situations by examining his process. His goal is to learn, improve and reduce the chance that the same misadventure will occur again. Others might formulate a narrative for why riding this stock down to the bottom was a reasonable decision. In such instances the self protective mandate of our brain may be initiated before we have even had a moment to think about what happened consciously. Knowing that our unconscious can override introspection is knowledge that can help us learn from the decisions made in 2008 rather than put them behind us too quickly.

CONCLUSION

The thesis under which you hold a stock is only as good as the process under which it was developed. Self-aware investors with rigorous process can rely on thesis to guide as well as explain their buys. When it comes to selling, however, the lack of discipline and process make formulating a sound thesis more challenging. Learning to question the thesis of each position held as thoroughly as that of a new buy is how many managers are preparing for the rebound. The alternative may have you generating a narrative that your clients won’t be happy with.

ENDNOTES

How We Know What Isn’t So: The Fallibility of Human Reason in Everyday Life, by Thomas Gilovich, 1993, Simon and Schuster.
“The Origins of Cognitive Dissonance: Evidence from Children and Monkeys”, by Louisa C. Egan, Laurie R. Santos, and Paul Bloom, Psychological Science, November, 2007.

MICHAEL A. ERVOLINI, AUTHOR

The ideas expressed on this website are developed and/or curated by Michael Ervolini. Mike has spent his entire 35 year + career leading efforts to improve and strengthen active management.

Tags active management, equity management, process

Essays

Stressing Performance

ESSAY

Behavioral Matters: Insights from the application of Behavioral Finance | Issue 8

Written by Michael A. Ervolini

8 min read

Stressing Performance

“Nothing is more difficult, and therefore more precious, than to be able to decide.”

– Napoleon Bonaparte

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INTRODUCTION

No one has to tell you what stress feels like. It is your job to make the tough decisions about which names stay in the portfolio and which go. A burdensome responsibility, even in the best of times. But these are not the best of times. Your normal processes are being wracked by a market slump well outside your career experience combined with outflows that can be unnerving. If you are sensing in yourself a few raw nerve endings, that is only natural. It is one thing to survive stressful times – quite another to excel during them – ask any jet fighter pilot. In this essay we examine the nature of stress, its impact on critical thinking and what top professionals are doing to harness its effects rather than be overwhelmed by them.

FEELING IS BELIEVING

Stress isn’t always a bad thing. After all it is simply a state of heightened emotional and physiological awareness. Athletes, actors, public speakers and others use positive stress to strengthen their performance. Eustress, a term coined by researcher Richard Lazarus, is felt when the demands being placed upon us seem within our ability to handle. Coping with these stresses is exciting and actually heightens our abilities. In other words “getting pumped up” to perform involves harnessing positive stress.

Negative stress or distress, on the other hand, is felt when we are overwhelmed. Fears of failure or feeling out of control are powerful stressors that can severely limit our thinking and actions. During such experiences we are heavily driven by emotions that, while instinctive, are not the instincts that propel us to do our best. Learning what stresses you, and how to better manage these stressors, is all part of professional self awareness.

DR. JEKYLL, MR. HYDE

Stress can change who you are … or at least how you think. A diminished ability to consciously make good decisions is a common reaction to stress. Stress elicits our brain’s primitive protective responses, that old “fight or flight” feeling. These ancient instincts worked well when we needed protection from a marauding Woolly Mammoth, but are generally less helpful when managing modern sources of stress like market volatility or unhappy investors. This instinctive over-ride of conscious decision making limits us to only part of our brain, the part that doesn’t want to think. It prefers action.

Here are a few ways that stress can impede your decision-making.

Narrow framing: Distress causes us to curtail research and investigation prematurely. This rush to be done results in limiting the number of options we consider; emphasizing simplicity and expediency.

Shortened time horizon: Negative stress can push us towards a quick fix, even when that fix may cost us in the future. We just want the pain to stop.

Heuristics: Stress can result in an over reliance on simple rules-of-thumb. When succumbing to the desire to “do something” we might repeatedly apply ineffective solutions rather than reassess.

Negativity: Stressors can weaken our self confidence, lower our creativity and tilt our viewpoint so that more alternatives seem to possess negative outcomes. This “glass mostly empty” approach to decision making often becomes self fulfilling.

STRESS THIS

So how can you benefit from the current market chaos? We recommend building upon your self awareness, discipline and process. In general, good coping skills help us negotiate stressful times. They enable us to increase our sense of self-efficacy and perception of control. According to Dr. Albert Bandura self-efficacy is our sense of competence, our belief in our own abilities. The more capable we feel in any given situation, the less distress. Our sense of control also helps determine if we experience eustress or distress. According to Harry Mills, Ph.D “The perception of being in control (rather than the reality of being in or out of control) is an important buffer of negative stress”. Our sense of competency and control, therefore, act together in determining our personal reactions to stressors.

Self awareness, discipline and process are the tools you possess to strengthen your feelings of self-efficacy and control. The more you understand and believe in what you do at each decision point, the better you can manage stressors. As you learn to harness stress the more your portfolio decisions will reflect your strategy and analytic thinking rather than those unexamined rules-of-thumb hiding in your unconscious.

CONCLUSION

Stress is part of life. Minimizing negative stress is a skill that can be developed. The further you develop self awareness, discipline and process the better you will handle stress and the better the decisions you will be placing in your portfolio.

Managing stress and thinking clearly as markets gyrate around you can have an obvious impact on return. They can also mean the difference between having your portfolio, strategy and processes well positioned for the eventual market rebound or being caught flat-footed while others garner assets.

ENDNOTES

“Judgment and Decision Making Under Stress: An Overview For Emergency Managers”, Journal of Emergency Management, 2008, by Kathleen M. Kowalski-Trakofler.
Making Decisions Under Stress: Implications for Individual and Team Training, American Psychological Association, 2000, edited By Janis A. Cannon-Bowers and Eduardo Salas.
Sitting in the Hot Seat: Leaders and teams for Critical Incident Management, John Wiley & Sons, 1997, by Rhona Flin.
Sources of Power: How People Make Decisions, MIT Press, 1998, by Gary Klein.

MICHAEL A. ERVOLINI, AUTHOR

The ideas expressed on this website are developed and/or curated by Michael Ervolini. Mike has spent his entire 35 year + career leading efforts to improve and strengthen active management.

Tags active management, equity management, process

Articles

Active Management – Take Down The White Flag

Post author By Kyra Spradlin
Post date February 26, 2024

ARTICLE

Behavioral Published in Pensions & Investment | February 2024

Written by Michael A. Ervolini

2 min read

Active Management – Take Down The White Flag

Article Abstract

This article discusses several of the challenges facing active equity management including: the shift from active to passive equities, the emergence of active ETFs, and the downward pressure on active fees. It also offers hope from the potential to improve equity results with the help of stronger feedback. The new analytics described enable asset owners and allocators to have greater conviction in their decisions, while also allowing managers to become more self-aware and improve. For the full text click on the link below.

Three Key Takeaways:

It’s time for equity managers to fight back by generating stronger results more consistently.

Newer analytics now enable managers to become more self-aware and to improve deliberately. These newer analytics quantify skills and analytically describe investment processes, allowing managers to replace guessing with rigorous feedback.

Managers using these analytics are already benefiting – by delivering their best results and maintaining assets and winning new allocations.

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MICHAEL A. ERVOLINI, AUTHOR

The ideas expressed on this website are developed and/or curated by Michael Ervolini. Mike has spent his entire 35+ year career leading efforts to improve and strengthen active management.

RESOURCES

Weak Feedback And Denial Are Killing Active Management

Post author By Kyra Spradlin
Post date February 16, 2024

ARTICLE

The Journal of Portfolio Management | February 2024

Written by Michael A. Ervolini

2 min read

Weak Feedback And Denial Are Killing Active Management: A Slow Death Perhaps But One That Is Avoidable

Article Abstract

It’s been over a decade since the introduction of analytics that effectively quantify manager skill. Yet there is little evidence that these enhanced metrics are being used by active equity managers, based on the general results of funds versus their benchmarks. Initially it was believed that most managers would eagerly adopt these enhanced analytics and learn to be more self-aware and improve. This belief proved to be overly optimistic. Hundreds of interviews with equity professionals indicates a second roadblock to the much needed turnaround across active management – this one being denial. And while resistance to change is perfectly understandable it is undermining the active management industry. The paper argues that both weak feedback and individual denial are co-contributors to the industry’s lackluster results.

Three Key Takeaways:

Weak feedback long has been a significant impediment to equity managers learning and improving. Newer analytics introduced over the past decade have vastly improved the quality of information now available to managers.

Nevertheless, active equities as a whole continue to struggle. It’s now clear that in addition to the once analytic shortcomings holding back manager success there is also the issue of widespread denial.

One new analytic that can help managers improve is the analytic

assessment of their information advantage. This analytic provides a clear quantification of the alpha generating capacity of the fund’s average new buy.

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MICHAEL A. ERVOLINI, AUTHOR

The ideas expressed on this website are developed and/or curated by Michael Ervolini. Mike has spent his entire 35+ year career leading efforts to improve and strengthen active management.

RESOURCES