Rationalising the irrational: An introduction to Behavioural Finance
Traditional finance is based on the assumption that the investment markets are efficient, and that investors process information in a rational and unbiased way.
Behavioural finance is an alternative view based on the principle that in fact markets are inefficient, and that this is the inevitable result of irrational, unpredictable or biased human behaviour. Investment decisions are driven by sentiment and emotion, such as fear and greed, and so tend to ignore market and stock fundamentals.
At J.P. Morgan Asset Management, we have used the principles of behavioural finance to build an investment process that defines and measures specific behaviours, and exploits the investment opportunities that arise from irrational decisions taken by others. We look in particular for three types of stocks that can help us benefit from market inefficiencies created by behavioural bias: value, quality and momentum.
The types of value stocks that we look for have both attractive valuations and strong fundamentals. Investors are prone to “anchoring”, or focusing on outdated or irrelevant information. As a result, they may remain pessimistic about value companies, which can drive a gap between price and fair value, and create buying opportunities. An example is the UK housebuilder sector, which suffered particularly badly in 2008-09, when investors sold out, causing prices to plunge 50% or more of the underlying book value. Though shares were trading at less than 1x net asset value, the fundamentals had remained strong and over 2012-13, shares rose more than 50% (see chart).
Source: J.P. Morgan Asset Management, Bloomberg, 31 December 2015. The companies/securities above are shown for illustrative purposes only. Their inclusion should not be interpreted as a recommendation to buy or sell. J.P. Morgan Asset Management may or may not hold a position on behalf of its clients in any or all of the aforementioned securities. Past performance is not a guarantee of future performance.
We look for quality companies that have high earnings and disciplined management teams. Corporate management is prone to overconfidence and empire building, to the detriment of shareholder value. The principles of behavioural finance require investors to look for companies with sustainable high returns and management teams that exert greater discipline with shareholder capital. Long term, such companies would be expected to outperform the market.
For us, momentum means capturing persistent business trends, to which the market may be slow to react. Sell-side analysts tend to herd close to the consensus, or focus on prior views, leading to short-term trends in earnings forecasts at variance with the stock’s value. Collectively these instincts lead to price and earnings momentum. One famous example is the dotcom bubble, when analysts’ consensus view on the valuations of internet-related companies was pushed to levels far in excess of the dotcom companies’ fundamentals. Such behavioural traits illustrate the value of an analysis of market fundamentals that can help to identify a stock’s potential value and invest in those with lasting momentum, not just short-term performers.
The key to behavioural finance is to capitalise on behavioural bias by identifying pricing anomalies in value, quality and momentum stocks. By maintaining exposure to such stocks, investors can build more efficient portfolios for long-term growth.
Blake Crawford is co-manager of the JPM UK Dynamic Fund. Read more:
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