How to apply behavioral finance to renew and improve investment management.

Emotional behavior and biases run throughout financial markets. The is the diagnosis of behavioral finance.

But it is not enough to know that investors make biased decisions. What do we do about it? How do we move beyond diagnosis, to prescription?

By C. Thomas Howard, PhD and Jason Apollo Voss, CFA

The widely accepted style grid of market capitalization and price-to-earnings ratios was largely arbitrary in design, lacking substantial research or academic foundation. An alternative framework based on how managers actually manage their portfolios and organizing around those investment strategies provides a superior alternative for organizing and comparing funds.

Examining investment strategy can be useful when evaluating mutual funds, but what information is contained in fund holdings? Do they reveal stock-picking skill?

We are witnessing a dramatic flow of money out of active equity mutual funds and a similarly sized flow into index funds. A large portion of these outflows are from so-called closet indexers, funds that claim to be active equity managers but, upon closer inspection, closely track an index while charging active fees. Investors have wised up to this and are heading for the exits, moving into much lower-fee passive funds that provide the same underlying equity return.

Rather surprisingly, the equity strategy framework can provide an estimate of current expected stock market returns. This is accomplished by measuring the recent investor response to each strategy, which, it turns out, captures the deep behavioral currents driving market returns. The resulting information is useful when managing equity market exposure.

High return dispersion and volatility are a stock picker’s nirvana.