Behavioural approach to picking shares

Times change, but history suggests human behaviour does not. Analysts and investors can often make bad decisions when confronted by too much information, or react to newsflow not with the cold eye of rational scrutiny but by learned behaviour or bias.

Understanding in this area can be refined by analysing the academic literature in cognitive psychology, the discipline providing the concepts behind behavioural finance. As with the overwhelming findings of these papers, we believe judgements go awry when they are hijacked by intuition in situations of complexity and uncertainty, with too much information available. Humans are vulnerable to believing misleading information, regardless of its relevance, and to hunt out justifying, supporting information to make ourselves feel more comfortable.

For example, driving patterns in the US shifted significantly after 9/11, as people decided that flying was highly dangerous and that it would be safer to drive. More people took to the road, and as a result driving deaths spiked in the months thereafter. Up to a thousand more lives were lost through driving than normal. When making the decision to fly or drive, people’s judgement was skewed by the more memorable terror of 9/11, as opposed to the dull attritional risk of driving.

The modern world is too complex and the volume of information too great to depend on intuition.

There is plenty of risk in markets, the swings of trauma and excitement, of companies blowing up or growing surprisingly quickly.

One can look for situations where people’s intuitions are likely to be focusing on the wrong kind of information. One job is to gauge the behaviour of three key groups involved in stockmarket investing – company managers, investors, and financial analysts.

Company managers are often prone to excessive risk-taking – their ego-centric personality type and remuneration structures give them a skewed view of risk. Instead of prudently developing their business, company managers, driven by over-confidence, are more likely to take too much risk and cause harm.

One can select companies based on situations where management is either constrained or where the business is too strong to break.

The second group whose biases can be exploited is investors. Investors are prone to overreaction – placing too much weight on a narrow range of information to draw black and white conclusions. One can look for signs that investors are focusing on old traumas that are no longer relevant.

Then there are the analysts. Analysts are prone to ‘under-reaction’ – although intelligent, they are often over-confident about their forecasting ability and are resistant to information that contradicts their views. Investors can look for situations where analysts are struggling to understand a company – often growth companies. Growth companies can attract risky management behaviour, so investors should restrict themselves to businesses that are difficult to break, where management’s natural instincts can’t do too much harm.

Another part of this type of investment strategy is to also look for stocks with unusually high levels of anxiety attached to them. These kinds of businesses offer opportunity when three things happen.

Firstly, managers rail against the stability or perceived ‘dullness’ of the business and chase ego-building growth. They take a difficult-to-break business and try to break it.

Secondly, when disappointment hits, investors get frustrated and confuse recent management behaviour (risky) with the intrinsic nature of the business (not very risky). This creates a potential opportunity, as it is the perfect environment for bias: fixating on the wrong information to form a view.

Thirdly, management behaviour changes, but investors’ perception doesn’t. Now investor anxiety is slowly dissipating, as the business fails to deliver any nasty shocks.

Intuition has been described as “the art of working out the correct answer from data that is, in itself, incomplete or even misleading”.

This underlines the difficulty of depending on intuition when dealing with a complex environment. In the investment world, the sheer volume, breadth and speed of newsflow, all with potential degrees of implied bias, create the opportunities for this type of strategy – it is our job as investors to exploit them.

Gianluca Monaco is partner at Ardevora