We also incorporate an in-depth qualitative process to further analyze companies using data that are hard to quantify, or that are company and sector specific. Our expertise in behavioral finance gives us a unique competitive advantage during this qualitative fundamental analysis. Analysts also often succumb to behavioral errors such as: falling in love with certain stocks, aversion to selling losing positions and style creep. We have developed processes and methodologies to avoid these behavioral flaws.
In constructing portfolios, we avoid behavioral flaws by using current information, not past statistical relationships, i.e., portfolio optimizers. Hillcrest neutralizes non-alpha factors by only taking significant deviations relative to the benchmark on stock-specific factors like value, growth and, most important, sentiment. Our strategy and methodology we believe create numerous advantages over our competition.
Hortz: What are you seeing as to trends on applying behavioral finance as an investment methodology? Do you have any concerns?
Bruce: Every year more people express interest in adding a behavioral component to their investment process. I’ve heard recently from two mutual fund firms who want to add a behavioral manager to their platform.
Our main concern is that many active managers now mention behavior as part of their process, however there are only a handful that utilize behavior in all parts of their investment process like we do. Behavioral insights should not just be given lip service or applied casually or one dimensionally. They are not just a series of models but an approach to investing that starts with philosophy, permeates stock selection and continues all the way through portfolio construction. A true behavioral finance firm follows the philosophy of behavior in every part of the investment process.
Hortz: Any final comments or recommendations you want to share with readers on furthering their inquiry of behavioral finance as an investment methodology?
Bruce: Behavior is important because it will last longer than investment fads or trends. It’s based on cognitive biases that never change. It is programmed into our brains from thousands of years of evolution that drives our actions. Investment performance we feel is anchored in the ultimate inseparability of investor (mis)behavior that our process captures from the market itself, serving to ensure the process we utilize will not permanently lose efficacy.
These are biases a good behavioral investment manager is fully aware of and can take advantage of. We firmly believe that a consistent combination of value, growth and sentiment is the key to good investment results. Behavioral investment methodologies formalize and chart a course of systematic, repeatable, model-driven, non-emotional action that takes advantage of this built-in irrationality in the markets to create alpha and protect against risk.
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