Behavioral finance specialist Daniel Crosby, founder of newly minted firm Nocturne Capital, can’t help but feel frustrated with the way behavioral finance has been applied to financial planning.

In his view, the process has been limited to “good ideas poorly executed — or not executed at all.”

Crosby has spoken more times than he can count, he said, on the basics of behavioral finance as they relate to financial planning — patience, a long-term view, self-management, humility — only to cede the podium to a speaker whose focus is “chasing returns and reporting on short-term, relative performance.”

To break away from that, Crosby, author of the forthcoming book “The Laws of Wealth: Psychology and the Secret to Investing Success,” designed Nocturne to practice behaviorally informed investing “from top to bottom.” The firm’s products are designed for investors keen on socially responsible and values-based investing.  

He spoke with ThinkAdvisor about the firm’s strategies and approach.

Savita Iyer-Ahrestani: What principles are your strategies are based upon?

David Crosby: At Nocturne, we take what we call “rules-based behavioral investing,” or RBI. We set out to design a process that is resistant to emotion, ego, bad information, misplaced attention and our natural tendency to be loss averse. No small task, but reflecting on what we know about human psychology, we understand that complex problems can have simple but elegant solutions. So we follow a streamlined process that helps mitigate behavior risk and combines the best of both active and passive approaches.

We do so by ensuring that our RBI process exhibits the 4 C’s: consistency (which frees us from the pull of ego, emotion and loss aversion while focusing on uniform execution); clarity (which ensures we prioritize evidence-based factors and are not pulled down the seductive path of worrying about the frightening but unlikely, or the exciting but useless); courageousness (which means we automate the process of contrarianism, doing what the brain knows to be best but the heart and stomach have trouble accomplishing); and conviction (helps us walk the line between hubris and fear by creating portfolios that are diverse enough to be humble and focused enough to offer a shot at long-term outperformance).

Recent research suggests that only about one-fourth of so-called active managers actually differ meaningfully from their benchmarks. We believe in active management, but only when it is truly active and accounts for the most pervasive human errors. 

Iyer-Ahrestani: Please give us a few words about each of your core strategies and how they capitalize on investor misbehavior and mitigate fund manager bias. 

Crosby: Our basic rules-based strategy looks at what we call the 5 P’s:

  1. Price/value: We believe in value investing as a form of risk management and seek to never overpay.
  2. Profit/quality: Looks at gross profitability and 10 different measures of quality of earnings
  3. Pitfalls/Risk: Examines underappreciated sources of risk like manipulation of earnings and inappropriate accounting practices.
  4. People: Includes insider moves, dividends, share buybacks and other sources of shareholder value creation
  5. Push: Momentum

Basically, we are looking for a high-conviction basket of high quality stocks that have a catalyst for future growth. The fact that we create our portfolios using a systematic approach allows us not only to mitigate our own behavioral biases but also to offer them at a discount to most high-conviction active approaches. 

Iyer-Ahrestani: Despite all the buzz around behavioral finance, it feels like there aren’t a whole lot of funds out there that are built on these principles. Why?

Crosby: I think that there are a couple of reasons for this. Firstly, behavioral investing is, of necessity, contrarian and psychologically difficult to stomach. Even knowing what I know, when I looked at what my models were producing early this year, I sort of cringed because none of the stocks look desirable on their face. Instead, you are buying brands that are out of favor in industries that are much maligned, even if they might have long-term staying power.

A second reason has to do with our fascination with studying all things clinical, pathological and negative over more positive applied approaches. When psychology began as a discipline, it started out by studying how people became broken, and it stayed on that trajectory for well over a century. It is only in the last two decades that we have started really researching what is called “positive psychology,” or the study of what makes people great and high-functioning rather than just what makes them sick. Behavioral finance has been very much on this same trajectory. It began largely as a critique of “rational” approaches and has for quite a while now been mired in a lengthy enumeration of how flawed we are, rather than putting forth simple and actionable ideas about how we can be better. I think that the discipline is moving in that direction, and we hope to a big part of that positive shift. 

Iyer-Ahrestani: As much as we hear about investment advisors wanting to help investors overcome or avoid bad behavior, it seems that behavioral funds take advantage of common investor behaviors in order to achieve high performance. Does that mean that you as a fund manager want investors to keep making these mistakes so that those who invest in your fund can do well?

Crosby: That’s a really fantastic point! Independent of my wishes, people have always and will always fall prey to behavioral mistakes. If everyone in the world received comprehensive nutritional counseling, it would do nothing to change the fact that a donut tastes better than asparagus when you are stress eating. Likewise, no amount of my screaming from the rooftops will change the fact that owning glamour stocks, failing to diversify and being excessively active will seem like a good idea in a period of market volatility. That won’t do anything to curb my efforts at educating the investing public, but I’m also realistic about the limits of those efforts. 

Iyer-Ahrestani: You mention client values as being very important to your firm and its funds. These days, more people are keen on ESG and impact investing – how do your offerings fit within that context and how does behavioral finance help match them with client values?

Crosby: The benefits to the world of socially responsible and values-based investing are obvious, but I think that the behavioral benefits are under appreciated. Let’s say the market hits a rough patch and you have two large equity holdings. The first is consistent with your values — let’s say a women’s leadership fund that holds companies that have women with representation on the board or C-suite — and the second is value neutral, say the S&P 500. Which are you more likely to panic sell in a moment of fear? I’d suggest that it’s far more likely to be the value-neutral holding. In an age of information overload, investing can seem more like playing a video game than being part owner in an actual enterprise that has a profound impact on real peoples’ lives. Values-based investing reconnects the investor with what share ownership truly is — an ownership stake in the company — and I believe that it will lead employers and investors to make more calculated decisions as a result.

At Nocturne, our 5P model allows us to create bespoke values-based portfolios based on the unique ethics of the specific client or institution, something that I think is revolutionary in the space. I like to think that we are combining what works with what matters — a simple but powerful proposition. 

— Read What Do Impact Investors Really Want? New Barclays Tool Helps Advisors Find Out on ThinkAdvisor.