The result is Cabot Research, a five-year-old Boston firm whose motto is "behavioral finance, APPLIED." The business is the second that Ervolini, Cabot's CEO, has developed with his partner, Hal Haig, president of the company. Their first enterprise --a software firm that supported CMBS--was purchased by McGraw Hill/Standard & Poor's in 2001.
"My first business was very analytic--fixed income for institutional investors," Ervolini recalled in a recent interview with Wealth Manager. "But then I started thinking, can't we do something to help the managers do better?"
Ervolini had been intrigued by the theory of behavioral finance even before Professor Emeritis Daniel Kahneman of Princeton University's Woodrow Wilson School was awarded the 2002 Nobel Prize in Economics for his work in the field. "The impetus for Cabot was really the amount of research that had been amassed in the area where it was at a point where a practitioner could use it," Ervolini explains. "All the work had been done already. I just had to read! I looked for ways to practically apply behavioral finance and came up with a program that--in a very rigorous way--helps managers to improve their performance, some by 100 basis points or more."
What exactly do you mean by 'rigorous'?
I use rigorous in the sense of careful, thorough, objective. We don't even need to talk to the managers; we get all their history, all their data, and using that information, we are able to look at their buying and selling patterns. Then we have this analytic way to determine how the portfolio would have performed under different behaviors, to see if a particular behavior helps or hurts performance.
The analytics are based on a clear understanding of what the manager really did, not what he or she thinks they did...knowing, for example, where your emotions are telling you to sell too quickly. That's what we do. We can tell them how they'll be much better, and because of the rigor, managers are willing to give it a try.
Is this psychology or science fiction?
The last two decades have been an explosive time of learning how the brain works and using more interesting experiments to find what causes us to act in a certain way; we've made some very big steps.
Behavioral finance is the integration of cognitive psychology with finance, and what it recognizes is that when we make a financial decision, we're using a combination of facts and how we feel about them. Emotions enter into buying and selling stocks whether you're an individual investor or a fund manager. The people we're looking at are looking to improve by 100 basis points a year.
How do you modify behavior when you don't meet with the clients?
We send signals to alert them to their behavior. Knowing what your problem is doesn't solve it. You have to make the solution part of your cortical memory. The model I find resonates with most people is to use a sports metaphor. Let's say you're a pretty good golfer, you hit in the low 90s every time you play, and you play every week. The only feedback you get is your score, and how can you improve your game from that information? That's where fund managers stand with returns.
We break down their "game" into components; show them where they did something that could have been more successful. Just as a golf pro can identify your faults and shave four points off your score. If a manager tends to prematurely sell winners whose price is jumping around, we can make them aware of it. But we can also identify every morning which stocks in the portfolio fall into that category and alert the manager to be extra cautious about selling them.
Once you've succeeded, why would a client stay on board?
There are two reasons why the business will sustain itself: First, people's behavioral tendencies evolve; we can't completely control our subconscious, so there will always be proclivities that will morph. And second, like a good coach, we start with the (client's) strongest opportunity for success, where he/she can improve by 200 to 300 basis points. And then we slowly fine-tune, working our way down to the issues that will improve performance by 100 basis points or even 65 basis points.
Who is your competition?
CBA [CABOT Behavioral Analysis] is pretty pioneering. We're the only firm in the world doing this, but we expect others to do it. We work exclusively with fund managers and for modest size companies. There are a lot of people out there offering to help [managers], but we've analyzed over $400 billion.
Did you encounter much resistance from prospective clients when you started the business?
There was no real resistance, but there was skepticism...so we ran a very extensive beta program to get people to work with us for free. Our first paying customer came from the beta test. You know, fund managers say, "There is no place to run, no place to hide, so I have to try to be better."
Behavioral finance influences the advisor/client relationship, too, but that's person-to-person.
The (principles) go from institutional funds to individual retail investors. And advisors are beginning to realize how important this is when things go awry. One dollar of loss hurts twice as much as a dollar of winnings makes you feel good.
A problem for advisors is defining their clients' risk tolerance. You may test them by asking whether they feel they can withstand losses of 10%? 20%? 30%?...but when that client goes down 30%, the client is crying! Not being able to anticipate how he will behave under circumstances is a very behavioral thing; that's why the interview is so important.
In the last two years, advisors have been telling clients to stick with the strategy; but the client feels let down and the advisors feel like they've let their clients down. This client remorse is what sent a lot of investments into cash. The less experienced advisors and investors were more susceptible to these market swings. What we find is not that behaviors are innate, but that [they are] part of the context. In all the behavioral research, the environment can cause you to make different decisions. Context causes different emotions to come to the surface. An advisor has to change [strategy] when there's a good economic reason.
How did fund managers react to the meltdown? Did they experience the same kind of remorse?
Managers reacted in many different ways: Some rode their financials down and down and down. They just couldn't believe they wouldn't come back. There's an unwillingness to accept the loss, or an over-optimism about the stock coming back.
For some the stress of a 30% to 40% collapse paralyzed them for a brief period of time. These were market conditions they had never felt before; what helps is when you've seen it before. Some of the big quant funds--their models didn't know what to do. It wasn't in the model!
Now there seems to be more resolve. A lot of the managers we're working with are focusing on growth so they'll be prepared when the time comes, so they'll be ready. This self awareness is behavioral finance; this should help. That's one of the reasons the opportunity is so good because it hasn't been part of their process before. They hadn't had the tools to help. They went through surprise and shock; damage and layoffs and unpleasant phone calls from investors. Now they're looking to see how they can make things better. Most managers have made the turn toward optimism.
Nancy R. Mandell (email@example.com) is managing editor of Wealth Manager.