Amadeo Alentorn, lead investment manager, Jupiter systematic, reflects on the importance of head and heart in understanding investor behaviour and markets.
The head and the heart both play a role in all areas of human decision making, including investment. While some people may be led by their intellects, and others more by their emotions, it is important to give both their due.
It can be limiting to be led by intellect only. For example, the efficient market hypothesis (EMH), which claims that all new information is immediately reflected in prices (making it impossible to generate excess returns) is an apparently simple theory that offers a neat intellectual solution and appeals to the heads of many. The EMH flatters the intellect by fitting in with neo-classical economic theories about rational decision makers who maximise utility and cause prices to be in equilibrium. The EMH has done much to drive growth in passive investing.
We have always felt the EMH to be a little too neat to be plausible. Over recent decades, some academics have argued that markets are inefficient, for example because of investor behaviour, which is not always rational 1. In the real world, prices stray far from equilibrium — think about bubbles and crashes.
One reason why markets may be inefficient is greed and fear, those twin monsters of the heart. Ruled by greed, investors may cash in winning stocks; and they may cling onto losing stocks for fear of realising a loss. The behaviour of cashing in winners may, if widespread, delay the upward move of stocks that have had good news. Conversely, widespread holding onto losers may delay the downward move of stocks that have had bad news. This may explain why momentum strategies (buying stocks that have performed well and selling those that have performed badly) have often worked 2.
There are many possible causes of market inefficiencies, including: calendar effects, which could be caused by investors rebalancing; stocks followed by fewer analysts trading less in line with fundamentals; market illiquidity, market frictions, and slow or imperfect diffusion of information. Some of these causes can be blamed on the vagaries of the human heart. Anchoring, framing, loss aversion, overconfidence bias, confirmation bias, and overreaction are examples of behavioural biases that can skew investor behaviour and so markets.
One behavioural tendency we have noticed is for investors to remain wedded to one style (such as value or growth) that has worked well in the past. But markets change, and a style that served in one market environment may flounder in a new regime. Instead, we believe in being flexible as to investment style. Our investment process dynamically flexes between different styles, based on our analysis of the market environment.
In recent months, rotations between the value and growth investment styles have been pronounced. Style rotation may be going on under the surface of the index: a flat market can be turbulent as to style. At times, investors are willing to take on more risk and a value style may suit those conditions. At other times (such as after the banking crisis of March 2023), value investors may pull in their horns, setting the stage for a rally in the growth style (recently inspired by the promise of artificial intelligence).
Although behavioural tendencies based on greed and fear can hurt investors, economic intuition is a good thing and is often supported by empirical analysis. By economic intuition we mean common sense views about prices and choices in a marketplace. And we mean any marketplace during the last five thousand years or so. (Markets are, after all, as old as civilisation.) It is common sense that, faced with a choice between buying, let us say, sheep A and sheep B, and if A is much cheaper than B, but they are otherwise roughly the same, you should buy A. (If you don’t know that, you will never be promoted to shepherd.) This common-sense intuition is the basis of the value style of investing (not greed, but a prudent emphasis on price).
It is also common sense that, if sheep A has especially fine wool, it is worth more beads (or money) than sheep B. This is the basis of the quality style of investing, where highly rated and reliable companies are sensibly selected. If buying for mutton, a sheep that grows more quickly will be more prized: this is the germ of the growth style of investing, more familiar in its modern application to fast-growing tech companies. Common sense economic intuition is partly a matter of the heart and partly a matter of the head, but unlike fear and greed it is prudent, sensible, and clear-sighted.
Most investors try to sort their sheep manually. They scrutinise company accounts, share price charts, and meet company management. We do not criticise this long-established form of investing, we applaud it. But in today’s world it is possible, we believe, to give the head a little electronic assistance. Our process is systematic, based on crunching data and analysing thousands of stocks in a morning.
Although our process is systematic, we select individual stocks based on the same common-sense selection criteria that have served for centuries in financial markets (and for millennia in agricultural ones). It’s a misunderstanding to think that a systematic process cannot pick stocks based on their fundamentals. We apply the same intuitive, common-sense reasons for selecting stocks that many discretionary investors do (such as that a stock is good value, good quality or has strong growth). The difference is that we apply fundamental analysis in a rigorously systematic way over very large universe of stocks. It would be impossible to analyse thousands of stocks by hand, but this can be done by harnessing the power of computers. What about company meetings and conference calls? Again, it would be impossible to attend thousands in person, but it is possible to analyse meeting transcripts using a computer technique called Natural Language Processing (NLP), and we do this as part of our process. NLP is an active area of research for us: we are continually working to actively improve our investment process over time.
Does common sense investment come from the head or from the heart? Perhaps it can be seen as a combination of the two: head and heart acting in harmony.
1 Werner F. M. De Bondt; Richard Thaler, Does the Stock Market Overreact? Journal of Finance, 40-3, 1984.
2 Jegadeesh and Titman, Returns to Buying Winners and Selling Losers: Implications for Stock Market efficiency, Journal of Finance, 48-1, 1993.