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How Fear, Greed and Ego Create Value

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A few years ago, Robert Bridges, executive director and co-head of Sterling Capital Management’s behavioral finance equity group, took a long look at the airline sector. Bridges had never been totally convinced of the sector’s merits, and ultimately, after much deliberation, he decided to pass.

That wasn’t the best investment decision at the time, he admits.

“I didn’t go into airlines because I had a bias against the sector, but it became clear that there was still value left there,” he says.

That’s why Bridges and his team at Sterling make as conscious an effort as possible to steer away from their own cognitive biases to make sure they don’t get in the way of potential value in any sector or stock. However, their behavior-focused funds capitalize on the biases of other investors — biases that, regardless of investors’ financial sophistication, unwittingly condition their investment decisions.

These biases — and Sterling believes that fear, greed and ego are the most important — create irregularities in the market, Bridges says, which in turn create value and momentum.

“We’re trying to capitalize on fear, greed and ego at all points in the cycle,” he says, “and the key to that process is a framework that identifies and captures valuation and momentum anomalies.”

Investors’ fear of “bad” stocks, Bridges says, creates value. Their greed drives them to “chase what works,” and that means holding onto losers longer than necessary in order to avoid realizing losses while selling winners too soon, a dynamic that creates momentum. Finally, financial analysts tend to be overconfident in their ability to forecast the future, he says, even as they’re slow to react to new information; then they’re quick to play catch-up once they realize their mistake, their ego resulting in earnings revisions.

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The Stock Selection Process

The themes driving these three key behaviors complement each other well. Sterling has based a strategy on them that allows the company’s three behavior-focused funds to focus on the best stocks that blend behavior-based value and momentum factors, Bridges says.

“We take price momentum that captures positive sentiment and we marry that with value, which comes from people being skeptical, so we’re getting opposites together,” he says. “Then, ego is a huge part of who we are as human beings. Wall Street analysts are paid a lot of money to do one thing, which is to divine future earnings, but there’s a huge amount of error that occurs, particularly at the extremes, where companies are either breaking to the upside or the downside. We know that human beings are slow to incorporate new information if it differs from their personal view, and we believe that we can get around that.”

Sterling’s stock selection process seeks to identify stocks from the MSCI EAFE index that have been mispriced by irrational investor behavior. These stocks are then ranked relative to each other in the investment universe and selected for their behavior-based value and momentum factors. Sterling aims to hold the best quintile of blended behavior-based value and momentum factors; these stocks are sold when they become expensive in the value framework, when they lose their long-term price momentum or when they receive negative price revisions.

“Many firms will use a lot of factors and be very dynamic, often changing factors and factor weight, but we made the business decision that based on our lens, human psychology doesn’t really change,” Bridges says. “Ours is a rules-based process that operates on the basis that investment biases are evident in every asset class [and] across market size and geographies. Not deviating from our disciplined value and behaviorally driven momentum process allows us to systematically score high.”

Sterling’s Small-Cap Value Diversified Fund (SPSAX ), which in February was renamed the Sterling Capital Behavioral Small-Cap Value Equity Fund, was the first of the firm’s three actively managed behavioral funds and was launched in 2010 at Bridges’ behest. Since that time, the firm has launched two other funds: the Behavioral Large-Cap Value Equity Fund (BBTGX), which picks the best 150 large-cap stocks that meet the firm’s value and momentum proxies as they’re rooted in investor behavior; and the Behavioral International Equity Fund (SBIAX), which was launched in December 2014 and focuses on developed markets outside the U.S. and Canada.

— Read Analysts Are Victims of Behavioral Biases, Too on ThinkAdvisor.