However, when emotional crowds make cognitive errors, they impact the market as a whole and the resulting price distortions are measurable and persistent. The key is objective measurement rather than survey data. One must understand what investors are doing, not what they are saying.

We have three such measures. Two are based on investor preferences for strategies using recent relative strategy return rankings compared with long-term rankings of investment pools based on strategy peer groups. The third is based on Baker and Wurgler’s sentiment index, which uses behavioral factors such as closed-end fund discounts, M&A activity and trade volume. Using these measures, U.S. large stock, U.S small stock and international equity markets can be evaluated as strong, normal or weak by deriving expected market returns from the behavioral data. See Forecasting Market Returns.

Investing in the best markets with a single ETF rotation generates a 7.5% advantage versus the MSCI AC World Index (16.9% versus 9.4% from March of 2003 to March 2013). The magnitude of expected returns can be used to determine leverage, generating additional returns. The model withdraws from weak markets, is fully invested in normal markets and is leveraged in strong markets. The 10-year results are reported in Figure 3. The result is a 17.4% annual return advantage over the MSCI AC World Index return (26.8% versus 9.4%) due largely from investing in cash for most of 2007-2009 and the timely use of leverage.



Trades into a 100% single-long or double-long exchange-traded fund for the S&P 500, Russell 2000 or MSCI EAFE or Treasury bills based on beginning-of-the-month U.S. and international strategy market barometers and modified sentiment index. Returns since September 2010 are GIPS-compliant actuals, with prior returns back-tested using the same month-beginning methodology as for the actual results. Data sources: AthenaInvest, Thomson Reuters Financial and Lipper.

Summary
Summary results are presented in Figure 4 for April 2003 through March 2013. Staying invested in the S&P 500 provides a return advantage of 6.9% annually versus investing in Treasury bills. Investing in best-idea stocks adds 8.4% annually above the S&P 500, and investing in the best markets using leverage results in another 9.9% annually above best-idea stocks.


See footnotes in previous figures for more information on how each return is calculated. April 2003 - March 2013.
Data sources: AthenaInvest, Thomson Reuters Financial and Lipper

Conclusion
Each of these return improvements is based on currently available data that measures predictive and persistent behavioral factors such as endowment allocation, equity manager consistency and conviction and investor behavior. They are compelling and demonstrate the advantage of focusing on behavioral factors when constructing long-term portfolios. Behavioral Portfolio Management is a departure from modern portfolio theory, which assumes investors are rational and markets are efficient. Instead, Behavioral Portfolio Management asserts that emotions and behavior are central to markets. We welcome inquiries and collaboration from anyone interested in this exciting new research. 

C. Thomas Howard is Professor Emeritus, Reiman School of Finance, Daniels College of Business, University of Denver
CEO, Director of Research, Portfolio Manager, AthenaInvest 
PSN Top Guns Manager1 2010, 2011, 2012, 2013 - Barron's SMA Winner2 Q1, Q2 - 2013
Portfolio Manager Advisor Shares Athena International Bear ETF (HDGI)
Contact information: [email protected]; (877) 430-5675 x100.

 

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