[Behavioral finance in the financial services industry has been very widely discussed, seriously explored, and finally, starting to be implemented into financial advisor business models and client engagement practices. But less mainstream industry awareness and traction exists in its application to financial analysts, asset managers and the investment process itself — behavioral finance as the basis of an investment methodology.

The study of the influence of psychology on the behavior of financial analysts and investment managers demonstrates that they are also influenced by their own biases. Substantial research further proves their behavior can have subsequent effects and influence market reactions.  

This area of behavioral research and disciplined implementation has been the realm of new Institute member Brian Bruce, CEO of Hillcrest Asset Management, with his decades of research work spawning the Journal of Behavioral Finance, a vibrant investment professional community and a full-fledged behavioral investment methodology embodied in a series of Hillcrest Small Cap and Mid Cap strategies. To get a better understanding of this area and its growing recognition and place in the investment landscape, the Institute reached out to discuss this topic further. Come explore this area with us.]

Bill Hortz: What is the basis and core philosophy behind a behavioral finance methodology to investing?

Brian Bruce: Behavior is important because it is the reason that active management works. The accepted theory on asset pricing is the efficient market hypothesis. It says all information is in the price of a stock. It’s why so many people index. What the theory neglects is the mechanism that the information takes to get into the price. Information comes from the company or news outlets and goes to analysts and investors. They then have to make a buy, sell or hold decision about the stock based on that information. The buying and selling are what moves the price. The key from a behavioral standpoint is that a decision must occur. That means the price is not only based on the information but also on the behavioral and cognitive biases that occur when that decision is made.

Our investment philosophy at Hillcrest is firmly rooted in our expertise in behavioral finance. We believe stocks deviate from their fair value due to behavioral biases that occur among market participants. Deviations from fair value follow a systematic pattern we call the behavioral cycle. Understanding this cycle and the behavioral pricing dynamic associated with it allows us to capture pricing inefficiencies created by market biases.  We believe that a consistent and repeatable pattern of outperformance is achieved by combining the techniques and insights of traditional analysis with sentiment indicators we specifically developed that isolate these behavioral finance issues. Biases such as expert overconfidence, recency effect, framing and the base-rate effect, as examples, are common traps for active managers and behavioral approaches can offer a better way to determine stock valuations and future growth prospects.

Besides just acknowledging behavioral factors, a behavioral finance investment methodology works to systematically uncover and take advantage of or defend from these pricing effects to maximize alpha and reduce risk. Two of our portfolio managers, Douglas Stark and myself, built the first global behavioral model in 1991 when we worked together at an institutional money manager to determine analyst sentiment. We continue to be thought leaders in the development of behavioral sentiment models. We feel the accurate analysis of sentiment can make or break an investment strategy.

Hortz: You co-authored back in 2004 Analysts, Lies & Statistics: Cutting through the Hype in Corporate Earnings Announcements — the first book on analyst behavior and a comprehensive guide to interpreting corporate earnings announcements, revisions and surprises. What have you been uncovering in your research?

Bruce: Analysts, Lies & Statistics (ALS) explored the cycle of information flow between companies, analysts and investors to more deeply understand earnings revision and earnings surprises. The research uncovered that financial managers and analysts mediate corporate earnings announcements and the conflicts of interests that can affect the release of corporate information. Our research showed that company management changed their behavior when they realized that institutional investors were comparing theirforecasts to actual results. Management went from overstating the future earnings to understating them in order to create a positive earnings surprise. These were the first behavioral concepts applied in money management. ALS became required reading from institutional researchers to mainstream investors on how to better interpret and use earnings estimate data.

Since then, we developed a proprietary analysis process to determine the sentiment of the management team of each company we review. Determining the sentiment of investors outside the company is an important challenge, but just as important is the more elusive sentiment within the company. That led us to study earnings call transcripts creating a proprietary scoring system to compare the number of positive phrases to negative phases. Companies where the executives are nervous, apprehensive or concerned, or trending so, have increasingly used more negative phrases.

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