Applying behavioural finance to value investing

By Mark Noble | April 28, 2009 | Last updated on April 28, 2009
5 min read

(Orlando, FLA) — Being a contrarian is a key piece of successful value investing, but it also runs counter to human nature. Investing, in practice, is much different from what it is in detached theory. A leading value investment strategist believes this is why behavioural science needs to be placed alongside other types of security analyses.

Speaking at the CFA Institute’s Annual Conference in Orlando, Michael J. Mauboussin, chief investment strategist for Legg Mason Capital Management, suggested loss aversion may be keeping a large swath of money on the sidelines, during a time when value investment analysis should be thriving.

Coming from a renowned value investment firm, Mauboussin reiterated value investment guru Benjamin Graham’s belief that irrational cycles will take hold of investors — thereby creating opportunity.

However, investors seem to have eschewed these basic teachings.

Currently, more than US$9 trillion is just sitting in cash and cash instruments such as money market funds — a record amount of capital being withheld from the capital markets during a period where equities are starved for investment. In isolation, this huge amount of money could be symptomatic of dysfunctional capital markets.

Mauboussin doesn’t rule out this possibility. He did outline that the behaviour of investors in recent times seems to reflect the findings of a growing body of work from behavioural science that suggests most humans — including many professional money managers — have a propensity to make investment decisions against their better judgment, often influenced by social factors such as conformity to the majority sentiment rather than actual technical investment analysis.

Investors prefer the herd

Diversity is about as basic as investment teachings go, yet even seasoned professionals tend to succumb to investing in what’s popular rather than let their investment strategy pan out.

“By far the most likely tradition to be violated is diversity. What we know from sociology and social-psychology is that people are inherently social. Time after time, they synchronize their behaviour. Fads in fashion are an example of this,” he says. “When this happens in markets, prices can be driven to extremes in both a positive and negative way.”

Citing studies done at the University of Chicago by Blake LeBaron, Mauboussin showed there are periods in the market that won’t punish investors who abandon diversification; and the upward momentum will sustain itself for awhile. But eventually it crashes.

“Diversity breakdown can have a non-linear impact on prices: It will have no impact for a long period of time and then there’s a ‘woosh’ effect,” he says. “There’s a tipping point where you see the asset prices crash.”

In hindsight, there’s ample evidence of this. Between 1998 and 2007, if you factor out leverage from the market, many investment strategies were actually following a downward trajectory in returns. But rather than alter the strategies, investors used leverage to sustain or magnify returns. The declining margins could be masked by an increase in the use of leverage over the same period.

A social experiment conducted by Solomon E. Asch in the 1950s engendered a theory that investors are influenced by the opinion of others rather than their own judgment.

In his original experiment, Asch had a test group of eight people, seven of whom were aware of the experiment, and one who was not. The task was simple: Each person was shown a group of lines and told to match which ones were the same length. It’s quite obvious, and on their own, subjects had were 100% accurate in picking the matching lines.

Asch added a twist to the experiment. He had the participants who were in on the study deliberately give the wrong answers in front of the unsuspecting eighth participant. He found about a third of the respondents gave the wrong answer.

The experiment has been duplicated in the last decade, with similar results. One theory is that humans will change their answer to what would seem an obvious question because they perceive they are wrong in the face of mounting evidence — whether erroneous or not.

A recent test using MRI scans on the brain during the same experiment has found evidence of this.

“They had an MRI machine so they could literally answer Asch’s question. If you go with the first two possibilities, you expect activity in the forebrain. If it’s perception, activity will show up in the posterior brain where the central lobe is,” he says. “The MRIs found the primary [location] of activity when people just conformed were the areas associated with perception.”

Separating expectation from valuation

Recognizing this propensity to conform, Mauboussin notes value investors need to ensure they separate their fundamental analysis of a security from earnings expectations.

“The single biggest error in the investment business is between a company’s fundamentals and the expectations implied by the price,” he says. “The bottom line is when fundamentals are good, people want to buy. When fundamentals are bad, people want to sell. The key to making money is the difference between price and value.”

Managing expectations also requires managing loss aversion, he adds. Other works by behavioural scientists have found most people will tend to shy away from risk if they have suffered recent loss, even if the odds are in their favour.

Another study compared healthy subjects to a test group of brain-damaged people who still had functioning mathematical and logic abilities, but lacked some basic emotions like fear, outlining how emotions can rule rational analysis.

“Each group had to play 20 rounds of a game. In each round they could either keep their dollar in their pocket and move on to the next round or they could give the dollar to the researcher who would flip a coin and you would get $2.50 if you flipped a coin on this,” Mauboussin says. “The math on this is pretty easy: It ends up being a $1.25 expected value. If you want an expected return you should hand your dollar over to the researcher.”

The brain-damaged people ended up with 13% more money. The reason is they played 45% more rounds then the healthy subjects, who played only 40% of the rounds after they had suffered a loss.

“Brain-damaged people played twice as many times after a loss,” Mauboussin says. He says the study could have larger implications for the mindset of individual investors today.

“Markets are mostly stable but they periodically go through manic-depressive periods. There’s something very elementary to this, and it’s related to human nature. What perhaps is more contemporary is understanding markets as complex adaptive systems,” he says. “What do our recent coin tosses look like? They’re ugly. We now have negative ten-year returns on the markets; they are about -3% — which is the worst result we’ve seen going back to 1812.”

He adds, “In the United States there is $9 trillion held in cash or money markets, which represents nearly 90% of the capitalization of the Wilshire 5000. That is the highest ratio that is ever tracked and it’s nearly twice the average,” he says. “There are a lot of people saying I’m going to sit out this next round even if it all looks good.”


Mark Noble