The Undoing Project And Your Portfolio

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Includes: SPLV, USMV, XMLV, XSLV
by: Ploutos

Summary

Important portfolio management implications can be gleaned from Michael Lewis' recent best-selling book.

The book is the story two Israeli psychologists with differing personalities who managed to come together to influence how the world makes decisions.

The duo showed repeatedly in experiments that the assumption that investors are rational was deeply flawed, inspiring the new fields of behavioral economics and behavioral finance.

As part of a gift exchange for Christmas, my sister-in-law gave me Michael Lewis' recent best-selling book "The Undoing Project: A Friendship That Changed Our Minds." It was a thoughtful gift. I have read most of Lewis' work - from "Liar's Poker" to "Moneyball" to "The Blind Side" and "The Big Short" and less heralded works in-between. Apart from my affection for Lewis' writing ability and the interesting subject matter, the works of the two subjects of this recent book - Israeli psychologists Daniel Kahneman and Amos Tversky - have influenced my own thoughts around investing.

I must admit it probably took me less time to read this engrossing work than it has taken to write this article on takeaways from the book and their implications on portfolio construction, but I believe that the lessons derived from Kahneman and Tversky can inform management of investment portfolios.

Daniel Kahneman was awarded the Nobel Prize in Economics in 2002, an award that Tversky would have undoubtedly shared if he had not succumbed to cancer in 1996. The book is essentially the tale of how two young Israeli psychologists, with seemingly antithetical personalities, came to influence the world of decision-making, psychology, medicine, economics, and finance. The historical setting, the birth of Israel and the early wars that secured her fate, adds tremendous depth to the story line.

Kahneman was ultimately awarded economics' highest honor for "having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making." Economic and financial models were predicated on the belief that individuals were rational and risk-averse. Time and time again, Kahneman and Tversky were able to show through experiments that individuals were far from rational economic agents under uncertainty. This seminal work ultimately spawned new fields in behavioral economics and behavioral finance.

We are all constrained by cognitive biases that cloud rational judgment. The impacts of three particular cognitive biases have shaped how I think about markets.

Prospect Theory and the Low Volatility Anomaly

The duo coined the term "prospect theory," which describes the way people choose between alternatives that entail risk, where the probability of outcomes are known. The theory explains both why people buy insurance, paying a premium above the expected loss, while also participating in lotteries, with a negative expected value but tremendous payoffs.

This preference for lotteries, society's hunt for asymmetric payoffs, offers a strong link back to the broader capital markets. In any introductory finance class, students are taught that higher risk investments should be compensated with higher expected average returns. This makes intuitive sense, who would enter into a high-risk investment with a higher probability of downside if the same return could be made with much lower risk of loss?

This theory is canonized by the Capital Asset Pricing Model, a mathematical model used to determine an expected return of an asset added to a well-diversified portfolio, given that asset's beta, or non-diversifiable risk. If that sounds like a lot of financial mumbo jumbo, it can be boiled down to the rather simple idea that in this framework high (low) beta assets should be characterized by higher (lower) expected returns.

In the aforementioned Capital Asset Pricing Model (CAPM), one of the underpinning assumptions is that investors are rational and risk averse. Spurred by the insights of Kahneman and Tversky, a new field of study, behavioral economics, has sought to demonstrate how individuals' cognitive biases impact decision-making.

The bias described herein - preference for skewness - is both well documented in finance literature and likely contributes to the demonstrable investor preference for high-volatility stocks that has in turn created the Low Volatility Anomaly, or why lower risk stocks have outperformed across markets and long time intervals. Some participants are in the market buying lottery tickets, and the demand for these asymmetric payoffs may make them overpriced, leading to lower long-run forward returns.

In many articles, I have shown the presence of the low volatility anomaly in small cap stocks (NYSEARCA:XSLV), mid-cap stocks (NYSEARCA:XMLV), large-cap stocks (SPLV, USMV), and high-yield bonds. The low volatility anomaly is present across time and geographies. I believe part of this structural alpha from the low volatility anomaly is a function of individuals misjudging the probability of large gains from riskier assets.

Recency Bias & Momentum

Behaviorists believe that investors are plagued by recency bias, a cognitive bias that makes investors place more weight on recent trends or data than placing their current environment into an appropriate historical context. Nobel laureate Daniel Kahneman noted in Amos Tversky's and his 1974 paper, "Judgement Under Uncertainty: Heuristics and Biases," that test subjects expected that a sequence of events generated by a random process (e.g. short interval stock returns) will represent the essential characteristics of the process even when the sequence is very short.

In past articles, I have shown that momentum exists in various subsets of the stock and bond markets. Securities that have outperformed continue to generate strong short-term returns over the near term. Securities that have underperformed continue to generate poor near-term returns. Strategies that buy portions of the market that have outperformed on a relative basis generate alpha.

Buying strategies that have risen in value to capture the recency bias of investors who heavily weight this recent performance into expectations of future returns is a short-term tactical trade that will require frequent rebalancing as momentum shifts. Value and momentum both are ways to generate structural alpha in financial markets, but their forward-holding horizons are necessarily different. Momentum is short term, and likely driven by recency bias.

Overconfidence Bias: The Plague of Active Management

The overconfidence bias suggests that a person's subjective confidence in their own judgment is reliably greater than the objective accuracy of those judgments. Professional investors have proved similarly overconfident. Active managers implicitly assume that they are capable of beating their benchmark despite long-run evidence demonstrating that the average active manager fails to accomplish this feat on average over time.

The collective overconfidence by the cadre of active managers violates that CAPM assumption of rationality and could be a factor that contributes to the Low Volatility Anomaly. If a manager is truly as skilled as they believe, then participation in higher volatility segments of the market offer the largest return proposition to capitalize on their perceived skill. As described in the previous section on the Low Volatility Anomaly, the highest risk parts of the market have been generated low absolute and risk-adjusted returns over long time intervals.

A more illustrative example on the impacts of the overconfidence bias can be seen in the works of Terrance Odean, a former student of Kahneman's. In a 2000 paper entitled "Trading Is Hazardous to Your Wealth," Odean, and his colleague Brad Barber, showed that over a six-year period that the most active traders had the poorest average results, while those who traded the least earned the highest average returns.

Presumably, active traders were more confident in their abilities, and this overconfidence negatively impacted performance. In another paper published the following year, "Boys Will Be Boys," they reported that men traded 45% more often than women, and when they did trade, generated lower net returns. Maybe the rationality assumption in economic models is gender-specific.

Summary

Michael Lewis' recent book is a great read. Investing is a process of continual decision-making, and the lessons from the works of Kahneman and Tversky can make you a better decision-maker and investor. These works have made me more aware of my own cognitive biases, and enabled me to see situations in markets where opportunities may be created through the behavioral mistakes of others.

Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.

Disclosure: I am/we are long USMV, SPLV, XSLV, XMLV.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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