If there is one investment strategy that financial professionals agree on, it may be…objectivity.
Relying purely on your emotions when making financial decisions can seriously damage your investment strategy.
Dr. C. Thomas Howard, co-founder of AthenaInvest, talks about why objectivity should be an important component of your investment strategy. He describes the five emotional triggers that cause the most damage, and why he thinks Modern Portfolio Theory may lead to emotional investing.
However, don’t be discouraged if you do make a wrong investment decision. You can always learn from your mistakes.
This is also an important lesson to teach your children. Find out why it’s a good idea to let your children make financial mistakes… and learn the best way to help them understand the importance of financial responsibility.
Follow Dr. C. Thomas Howard at: http://www.athenainvest.com/
Read the Transcript
Interview with Dr. Thomas Howard
Dr. Thomas Howard, co-founder of Athena Invest, discusses the role that emotions sometimes play in investment decisions. Should you “follow your gut” when making decisions about your money?
Douglas Goldstein: I’m talking today to Dr. Thomas Howard, who is the co-founder of Athena Invest. He serves there as the CEO and Director of Research, as well as the Chief Investment Officer. I found Tom because of a speech he delivered at the CFA Institute annual conference called, Behavioral Finance: Reject the Model, Not the Real World.
In your talk, you spoke about the interplay of uncertainty and how emotions drive us to make sub-optimal decisions, which is just a fancy way of saying when your head is spinning, you make bad choices. Is that what you were saying there?
Don’t Go By Your Emotions
Thomas Howard: That's right. There are two things here. One is that people make decisions based on emotions. That's our fallback way of making decisions, and it's hardwired into us. It's allowed us to survive and thrive as humans and so we fall back on that particular approach. We make decisions based on how we feel about something.
Two is that people are not good at estimating probabilities. They tend to overestimate the probability of significant events that may have actually a low probability but have devastating results. We have all kinds of examples where people have a very difficult time estimating probability. You put those things together and you end up with some very poor financial decisions.
Douglas Goldstein: How about going with your gut? A lot of coaches and the business consultants say that. Why does that not apply in investment?
Don’t Go By Your Gut
Thomas Howard: In many situations it does, but in investing, it doesn't. Almost everything is counter-intuitive when you're making investing decisions, and this is also true of many economic decisions. Going with your gut is generally a very poor way to make decisions. We talk about the five big triggers, emotional triggers, and so if the investment you're looking at or the financial decision you make has something like that in it, you'll tend to make a decision to move away from that investment. You may do that even though it may generate tremendous returns over the long run.
We don't use any emotions in making decisions in what investments we're going to go into. We do take advantage of what we call behavioral price distortions because many individuals make emotional decisions. But when we actually manage money, we remove emotions from the process.
Douglas Goldstein: I'm sure you remember that not so long ago, the market had a big meltdown in 2008. People like you and me, who are on the financial advising or money management side, were talking to clients and people about the importance of staying the course. We advised them not to get all tied up in emotions and sell into the crash. We tried to talk to people about planning and not dealing emotionally.
The problem is that not only does the market overall seem emotional, but also how the government was making decisions. If you looked at the Ben Bernankes and the Tim Geithners of the world, in a weekend they would be opening and closing multi-billion dollar businesses. This couldn't have all been well thought out. If the market's so emotional, shouldn't we be dealing with that?
Thomas Howard: There were a lot of emotional decisions made then. We found that if you step back and remove the emotions, you've got to have some kind of objective measure that tells you whether this is a good investment or not. Whether it's an individual stock or a market or a particular fund manager, you should use those particular objective, measurable, persistent measures for making those decisions. Even when everybody around you is losing their head, you use those and make decisions.
In our global tactical portfolio, which is a top performing tactical portfolio here in the U.S., we went double long in the Russell 2000 in early 2009 in March and April. Everybody looked at that and said, "That just doesn't make any sense." We had just gone through the emotion of the 2008 meltdown, but our measure said that's what you should do, and so we did it. It turned out extraordinarily well. Those are the opportunities that can allow individuals to build significant long-term wealth if they focus on those measures versus the emotions.
Douglas Goldstein: When you said “double long,” what did you mean, and what tools do you use to do that?
What Does The Term “Double Long” Mean?
Thomas Howard: In this particular portfolio, which is our global tactical, we have what we call “deep behavioral currents.” These help us to know which markets are the best and have the highest expected returns. We move among several different markets based on these criteria. If the signals are strong enough, we leverage the portfolio, which means if the market goes up by 5%, this portfolio goes up by 10%. We use leveraged ETFs to implement that particular strategy, so when we're talking about a “double long,” we're talking about a leveraged portfolio. It's very much like buying a stock on 50% margin; very similar sort of behavior.
Douglas Goldstein: Would you recommend that type of tool to individual investors, or is too hot to handle for the average guy?
Thomas Howard: You've got to have a reliable signal. We have a very large database over a long period of time. We’ve researched this particular portfolio back to 1980, and so you've got to have a reliable signal, something that is tested out over a long period of time. You must have a large database before you make these kinds of decisions. Otherwise you're just using your gut. If your gut is, we should go double long, then that's not a good decision at all. Our emotions tend to lead us in the wrong directions in these kinds of situations.
Douglas Goldstein: There are a lot of different strategies for handling portfolios. We had Nobel Prize winner Dr. Harry Markowitz here on the show about a month ago. He spoke to us about modern portfolio theory, and you talk a lot about behavioral portfolio management. Do these two work in concert, or are they totally different approaches to managing money?
Modern Portfolio Theory and Behavioral Portfolio Management
Thomas Howard: They are totally different. When I started out my career in the late 70s and got my PhD, I was a strong believer in modern portfolio theory. I'm very much a quantitative person, and the evidence just kept getting worse and worse against it. As I began to develop and evolve my own particular approaches, I began to move into the behavioral area and the role emotions play.
It dawned on me that modern portfolio theory enforces emotional decision making. It is the underpinning of the markets and of the industry these days, and unfortunately it encourages emotional decision-making. Harry Markowitz started this with his mean variance optimization. It's largely based on volatility as measured by standard deviation. Volatility is all emotion. There are very few fundamentals in there and if you build your portfolio based on that, you are making a return emotion decision, and you end up with under-performing portfolios as a result.
Douglas Goldstein: What are the areas that someone should focus on if they want to develop skills in behavioral portfolio management?
Thomas Howard: There's three parts to it. Investors will always experience emotions, but they've got to get to the point where they're not making their decisions based upon their emotions. We're hard-wired to react emotionally to things, but we don't have to make a decision based on that.
Emotions are the most important determiner of long-term wealth in an investment portfolio. An investor that can do that is going to add hundreds of thousands, if not millions of dollars to their portfolio just by that step alone.
The next step is building a portfolio based on behavioral price distortions. Most investors don't manage or control their emotions. They end up making what we call “cognitive errors” and since we tend to move in crowds, we end up distorting prices. You can build portfolios, and that's what we do at Athena, based on those price distortions. We're harnessing those particular distortions. You've got to have an objective measurable way of detecting those particular distortions, and they have to be persistent. That requires a fair amount of effort.
Douglas Goldstein: How would you do that? Before 2008, when the prices of homes were going up and real estate was really shooting up, some people called it a “bubble.” Other people said the market was hitting its true value because that was the free hand of the market. How can you step back and see that there’s a mistake going on there and that people are investing emotionally?
Tom Howard: We need to go back to our global tactical portfolio where we look at markets. We have a measure of deep behavioral currents in those markets. We again tested it very thoroughly over a 30-year time period. We looked at the deep behavioral currents and we were able to tell which markets were the strongest. We don't have real estate in there. We just have equity markets and treasury bills.
When those signals come through based upon our extensive research, we make a decision. We decide whether we should move into a particular market or leverage that market, or whether we're in cash or treasury bills. This particular indicator told us to be in cash during 2008. There may be that same opportunity in real estate, but I haven't studied it. I haven't looked at it carefully. That requires a considerable amount of effort.
Douglas Goldstein: People also shouldn’t invest in things that they don't understand or don't have time to manage. That is why you should work with a money manager. How can people learn more about you and the work that you're doing?
Tom Howard: They can visit our website, Athenainvest.com.
Douglas Goldstein: Tom Howard, thanks so much for your time.