Portfolio Managers Are Victims of Bias, Too

One firm is using behavioral portfolio management to build unbiased portfolios

C. Thomas Howard, CEO and director of research at AthenaInvest, caps off the number of holdings in the portfolios he manages at 10. More remarkably, though, Howard swears that “I forget the names of the stocks I buy, as well as the price I paid for them.”

Sound iffy?

“Sure,” says Howard, a former finance professor at the University of Denver and the author of the upcoming book “Behavioral Portfolio Management.” “People do get nervous when they hear me say this.”

But he firmly believes that forgetting what he owns once he’s bought it is the only way to completely remove individual emotions from investing. And this, Howard says, is vital for behavioral portfolio management, a method he converted to about a decade ago and that he believes is far more fruitful a way to get the best out of the markets.

Human behaviors and biases are well-documented and everyone, including the portfolio manager, exhibits certain traits when it comes to investing. Behavioral portfolio management calls for an investment manager to completely distance himself or herself from those emotions, Howard says, but it also means “harnessing” those same emotions on a broader, societal level to maximize portfolio returns.

“In short, we take out emotions on an individual level but we follow the emotional crowds around, watch their behavior – which is a proxy for price distortions in the stock market – and then we build a portfolio,” Howard says.

For AthenaInvest, the investment outcomes derived from behavioral portfolio management are far greater than those that result from modern portfolio management theory. The firm’s Athena Pure portfolio, which has been in existence for 12 years and picks stocks based on five behavioral factors, has doubled the market in five years, Howard says.

Most of the investment management community still follows modern portfolio management theory, which is based on the idea that although there are many irrational investors, the universe of rational investors dominate the financial marketplace and they quickly arbitrage away any price distortions.

Behavioral portfolio management, on the other hand, posits that it’s the irrational investors who dominate the market, and that portfolios based on the price distortions their emotions and biases create result in returns that are superior to corresponding indexes. The theory divides financial market participants into emotional masses on the one hand; on the other are investors like Howard, who “ruthlessly drive the emotions out of investing” and seek to harness the distortions created by social validation, short-term loss aversion and all the other emotional reactions and behavioral biases.

Of course, Howard and his team also pay careful attention when researching and selecting their stocks, and though they’re behavioral portfolio managers, their analysis is highly quantitative.

“We look for dividend paying stocks,” he says, “because if management commits to dividends, you know they’re putting their money where their mouth is, and we’re interested in commitment to an action because that’s very relevant.”

Howard also looks at analysts’ projections for future earnings and whether they will support and justify the current price of a particular stock.

Beyond that, though, his approach is radically different from most other investors. “I look for the worst balance sheets among a group of stocks, and that’s where I lose everyone.”

But, he says, balance sheets really have nothing to do with a company’s performance, and because most people take them into consideration, therein lies an emotional pitfall that he as an investor can take advantage of.

“We also look for companies that have as much debt as possible–because most people think debt is bad, and that’s a measureable proxy of their vision that we can find and build a portfolio on,” he says.

Although specific events that trigger crowd responses may be short lived, the emotions they result in are long-lasting and give way to distortions that are both measurable and persistent.

All the same, it’s not easy to build a portfolio based on behaviors, Howard says. It calls for an investor to really go against the grain, which is very difficult to do since even investors are affected by the need for social validation. Of course, it goes without saying that convincing investors of the validity of AthenaInvest’s approach is extremely tough and a constant work in progress. 

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