Behavioral Finance and the Sources of Alpha
Introduction (Via RJF )
Behavioral finance is a new field in economics that has recently become a subject of significant interest to investors. This article provides a general discussion of behavioral finance and presents some insights from this field that apply to the problems plan sponsors face when evaluating and selecting active equity managers.
Excerpts (Via RJF)
Of course there is overlap between all three types of managers. For example, many traditional managers who primarily focus on generating, say, better earnings estimates may also try to develop better ways for processing such information. Similarly, many traditional and quantitative managers may also try to exploit behavioral biases.
The types of behavioral biases we do observe in securities markets fall into two broad categories:
1. Non Wealth-Maximizing Behavior: The economist’s view of rational behavior assumes that investors act only to maximize the expected value of their portfolios. In fact, investors may maximize other things that are more important to them than their wealth.
2. Heuristic Biases and Systematic Mental Mistakes: Heuristic biases cause investors to make systematic mental mistakes and as a result incorrectly process available information. Before the fact investors believe they are correctly processing information and acting in a manner which maximizes their expected wealth. After the fact they may discover the mental mistake, but frequently they are not even aware of the error.
Favorite Paragraphs (Via RJF)
Because expectations are formed by processing an information set, two potential sources of alpha are: 1) Generating a better information set by obtaining information that the market does not have, i.e., private information; 2) Processing information better than the market. A third potential source of alpha is: 3) Exploiting behavioral factors that cause the market’s expectations to be biased.
One of the first questions to ask a prospective manager is: “What is the source of your alpha?” If the manager cannot describe the source of his alpha, you may want to politely end the interview. Most managers, of course, will have an answer to this question, but the answer should fall into one or more of the three sources of alpha noted above