January 2, 2012

Behavioral Finance: The Secret Behind Value Investing

Behavioral finance is the core principle behind value investing

Even before she knew what the term meant, Lauren Templeton, founder of Chattanooga, Tenn.-based Lauren Templeton Capital Management, was applying the principles of behavioral finance to her investment philosophy.

It was natural to do so, she says, because behavioral finance is the core principle behind value investing. Value managers have no choice but to conquer their fears and inhibitions vis-à-vis the markets in order to do what they have to do: Make hay when others are not.

“As a value manager, you have to buy whatever other people are selling and when other people are selling it,” Templeton says. “That is a psychologically difficult thing to do, but value mangers have no choice but to do it and to understand their biases. They know they are scared, but they have to also train their brain to buy at very scary moments, because that’s what really allows people to reap maximum rewards.”

No one is born a great value investor, Templeton – whose firm manages about $135 billion in a global long/short hedge fund and in separately management accounts -- says, but the only way to become one is to “force yourself to go in and do it. Once you have done it and you’ve reaped the rewards of buying at these points of what I call maximum pessimism, you’ve actually retrained your brain and it’s anticipating the next big opportunity.”

(Read Outlook 2012: Value Investing--A Glimmer in the Gloom at AdvisorOne.com)

Value investing does become exciting, but taking that first step is extremely tough for all value investors. Even for Templeton -- her great uncle, legendary value investor Sir John Templeton, seeded her first hedge fund when she was only 24 years old – market volatility was extremely nerve-wracking at the outset. Now, though, “I think it’s awesome when we get a good crisis,” she says.

Although a true value investor will quickly realize the benefits of investing when no one else is and, in so doing, overcome those biases that inhibit the majority of investors from taking the plunge into market crises, Templeton believes that even the best value managers cannot succeed alone. To maximize the benefits of value investing, it’s imperative that those who choose to put their money in a value fund go along for the ride, and this means overcoming their own fears and biases.

“I tell my investors that this is a partnership – part me and part them,” Templeton says. “I tell them that they can help me be more successful if they realize that a crisis is a buying opportunity, and that means that they need to actually add more money, not withdraw it, if they want to participate in the returns.”

Of course, this is easier said than done, since most investors cannot help but let their fears guide them and are likely to back away from troubled markets. So the onus of helping people get the better of these fears falls upon investment advisors, Templeton says. Advisors need to manage their clients’ psyches in scary markets, she says, and make them understand that the unique perspective of the bargain hunter works in financial markets, too. A large part of this process entails working with investors on impulse control, she says, and helping them understand that if they are interested in realizing long-term benefits, then it’s important to exercise self-control and to not act impulsively and back away in troubled times. Instead, they need to stay calm, “study the data” and look beyond the short-term, she says.

While this may seem like a huge and onerous undertaking, it is becoming more and more a necessary part of an advisor’s job description, and something that they are just going to have to do, Templeton says.

As behavioral finance becomes more and more mainstream, it will become easier for financial advisors to work on helping their clients overcome biases and fears. A greater number of universities, for example, are now including courses on behavioral finance in their business school curriculums, something that Templeton believes can help in the future. She herself just retired as director of the Finance for the Future Initiative at the University of Tennessee, Chattanooga, a program that focuses on the behavioral and psychological aspects of financial decision making, taking into account factors such as experience, culture and gender, and the impact they have on investment patterns.

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