Behavioural Finance is at an exciting juncture. There is no single unified theory, no integration with conventional economics, but some real, practical application is now emerging. This is happening as the early behavioural focus on biases is questioned, as is the over-simplified distinction between emotion and thinking. However, classical economic theory - resting on its pillar of equilibrium to make the maths work - still survives and is taught as the core from which presumably irrational behaviour departs.
Behavioural finance is growing in relevance as some of the softer factors in investment get attention; ESG, incentives, corporate behaviour and the best way to integrate investment professionals and artificial intelligence. There are positives and negatives in our biases, but psychology helps us understand human strengths.
For many, the starting point in behavioural finance is set out here by its best known exponent, Daniel Kahneman. It draws distinctions between the unconscious and knowing, heuristics and hard thinking, automatic and thoughtful. I will pick-up later on his reference to stories.
But this sharp distinction does not fully cover all the aspects of psychology that are relevant to investment – we can learn much more. Quite apart from cognitive dissonance, there are also differences in beliefs – not just emotion but hard-wired differences in people’s view of how the world works, the logic of it. And, with most firms making decisions in groups, social behaviour matters too. An issue I will focus on particularly here, is the role of incentives – we expect them to shape behaviour and outcomes, yet fail to understand just how precisely they can be gamed by humans. There are often unintended consequences
The starting point is that biases are usually helpful. We draw on experience and context to make sense of the new. In the Ebbinghaus illusion, thinking harder does not necessarily fix this. Our judgement of shapes and even numbers seems to be altered by what surrounds them. For perspectives and most day-to-day activity, this is helpful. But for understanding company accounts or the narratives that management deliver, it can be unhelpful. The pareidolia slide is an example of where we try to create a pattern or narrative out of randomness.
We bring a lot of previous experience and modelling to this, and these patterns are quite difficult to unsee.
Added to this challenge - interpreting what is new without drawing on unhelpful previous experience - is the difficulty of investment itself. Even the best managers find it difficult to pick a single stock and a specific timeframe, as the Sohn London investment conference stock pitch performance shows.
It is a noisy environment in which we are ill-equipped to understand what is statistically valid. And company management is difficult, too. We pay attention to the social validation of reputation, but it may not be relevant, as we saw with Luke Johnson’s position as Executive Chair of Patisserie Valerie. And a lot of the numbers that we have to work with as analysts are not what they seem. Even things that look precise, like earnings per share or organic growth. These may not be comparable between companies, or even in the same company from year-to-year. Research points to the impact this has on pay, despite the lack of correlation with actual share price performance. And, while we might unpick the adjusted numbers, it is difficult to unsee the nice images and trends that appear in annual reports. Even if we only take away the impression that this is a good business or is a growth company, the graphs frame our subsequent analysis.
This is, of course, intended by company management and boards. These images often come early in presentations or at the start of annual reports, and appear more salient. Images and the patterns we make of them appear vivid – we can more easily construct a narrative from them, although companies usually provide that anyway.
Compounding this problem is the fact that it takes many years (22) for investment performance to be meaningful, and predictive. And even then, what it indicates is the likely longer term results, not the sort of variability we actually see from good managers. Some of the expense in the investment system, and cost to investors, results from the chopping and changing after periods of underperformance by managers. Managers who were thought good enough to invest with in the first place.
Amidst this noise and confusion, the search for meaning often focuses on narratives. This is not new, as we can see from the Ponzi coverage.
Inevitably, the managers with periods of underperformance must construct stories and there is good research on manager behaviour with underperformance. For some, it will mean cutting risk until a record is rebuilt. In other cases, as the slides show, some high profile managers wish to demonstrate that their confidence is undiminished and that they will actually make bigger bets after a tough period.
Whilst intended to support a narrative of confidence and consistency, this signalling can be in itself a style shift. There are often patterns in how managers change their engagement with colleagues and clients, or parse different periods to help clients frame what is happening. A manager might say “the decade plus long record clearly shows I am an exceptional manager. The last three years do not negate that, and were atypical. That’s not me. The latest three months demonstrates the beginning of a turnaround and is evidence of my true ability, as you previously recognised”. Written down, this seems a bizarre mix of selective periods, but sadly is common. It is a heroic narrative, and many investment managers struggling with performance problems do indeed describe their battle against adversity in this way. Imagined foes are short sellers, consensus, and myopic investors. The embattled manager is visionary and contrarian. Managers know the emotional appeal of epic tales.
Kahneman notes that stories tend to be judged by our perception of coherence rather than the quality of evidence. The world – and investment, in particular – is less coherent and more ambiguous than we believe. As Kahneman notes, “the world makes less sense than you think”. “We are too easily convinced by simple vivid stories, rather than admitting our discomfort with complex abstract and often random reality”. The investment profession needs people who can be comfortable with that ambiguity, but it may not be the way we train analysts. The intake for the profession tends to be quite deterministic and numerate in mindset.
Academic research in psychology is going through an upheaval. Already the result is an improvement in methodology that should benefit other disciplines, too. Too many early psychology studies have not been replicated, or were underpowered. Experiments in incentives were often questionable – what a student might be influenced to do for $5 does not obviously translate into a trading environment or the sort of sums involved in investment and executive bonuses. Viewed from the outside, research in psychology seemed simply to be a growing pile of increasingly specific biases. Many of these appear to contradict – which matters more; priming or recency? It seems too much has been expected of biases – many are likely to have small effects and be very context or culture dependent. It is little wonder that this has not built a coherent substantial economic theory.
But for the biases that do seem persistent, some solutions have emerged. On hiring, for example, or manager selection, it is now considered good practice to have a process that involves different stages of systematic screening and data collection with separate people handling interviews. Equity analysis typically also works best in a systematic process, although it can be challenging to gather comparative company data and to be disciplined in rejecting the spurious idiosyncratic numbers that management often push out; alternative facts.
In recent years, much effort and legislation has been directed to company incentives and metrics. I will not deal here with the absolute level of executive reward, but bonuses and other incentives, and consequent behaviour. Unfortunately, most companies are still obsessed with growth, despite the low growth in the economy in general and the difficulty of measurement. And it is too easy to focus on adjusted numbers, which can become an exercise for CEOs to mark their own homework. Now, much of the focus on audit is on cost rather than quality. And auditors are responsible only to shareholders( as a body) despite the broader obligations of company boards. I will pick out a few company examples to illustrate the impact of some very specific incentives. Financial incentives can over time have a very big impact on shareholder value, often negative. We should remember that value creation is usually driven by more than the few executives at the top, and question how deeply and well-aligned incentives are within a business. And, it is also worth remembering that many public and not-for-profit organisations are driven very successfully by mission-driven individuals motivated largely non-financially.
Incentives are usually taken very seriously by management and do direct behaviour. Perhaps this is to be expected when bonus can be twice salary, even small components of the bonus mix get attention. Patisserie Valerie is one example of a company focused on measures that could be easily met given flexibility on adjustments. Of course, what is not included here are objective, easily-verified metrics, such as cash.
While there is evidence, noted in the earlier research cited from Bob Pozen et al, that US earnings adjustments are increasing, it appears less dramatic in the UK.
The extent to which bonuses can be driven by adjusted numbers seems to be the main factor, rather than earnings smoothing.
With a tailwind from easy money, perhaps there has been little need to. However, that has not stopped individual companies from making increasing use of adjustments. Marks & Spencer, for example, has seen a decline in earnings over the past decade, but we can see here just how much the statutory earnings have been flattered by adjustments.
Interestingly, its CEO total remuneration has averaged £2.1m per year over the last 10 years (various CEOs), varying between £1.4m and £4.4m, with little sign that any particular level or composition of bonus has made much difference to the company’s performance. Since I prepared this slide, the company’s cut in dividend and capital raise has supported my thoughts about the relevance of the statutory number with respect to cash.
Perhaps analysts do not realise how reported numbers can be adjusted. IMImobile plc operating profit fell 43% but is adjusted to +15%. Pre-tax fell 48% but is adjusted to +12%. Profit after tax, which fell 79% still managed to be adjusted up to +4%. The end result is a statutory diluted EPS down 86% that becomes +1% as adjusted.
While adjustments are often presented as an add back of non-cash items such as depreciation and goodwill amortisation, I would contend that collapsing statutory earnings may often be a better guide to cash and the need for capital. Behavioural finance points to a number of issues here. In terms of groupthink, it is clear that a collection of talented individuals on a board and management, often deliver a poorer result collectively than they might as individuals. And it is clear that individuals are ill-equipped to score their own work. Financial incentives do not help this.
Incentives can work for a while, and we can see with lender, Provident Financial, that they delivered a steadily increasing share price in the middle of this decade. But incentives and the reported numbers were all re-set with the change of CEO in 2017 after a share price and earnings collapse. The first and last parts are two different CEOs, and two largely disconnected narratives. But the point is that shareholders own the bit in the middle as the only group that has to join-up these two different reward packages and two different CEOs. The trend for claw-back provisions now goes only in a very small way to bringing accountability back into a bonus package.
Incidentally, where an organisation is so dependent on quality – such as the quality of lending – would you really want the CEO focused on growth? Generally the metrics for bonuses used by most companies do not address quality of earnings or service, risk, or the capital consumed by the strategy.
Moving onto an apparently social rather than financial example. With Metro Bank we can see how incentives and conflicts can drive behaviour. Most challenger banks are focused on avoiding the branch network legacy of the older incumbents. Metro instead has a business model built around new branches called “uniquely branded state of the art stores”. These are grand, impressive and stylishly fitted out. The need for these always puzzled me, but some of the press coverage perhaps addresses this.
It helps to underline a further point. Incentives not only drive executive behaviour in a very precise way, but they will also tend to drive corporate structure. Companies may not readily demerge subsidiaries that support group earnings, even if of lower margin or earnings quality. Think how long it has taken for GSK to find a solution for its consumer products division. But investors are beginning to catch-on to the importance of margin and the realism of the growth focus. This is not helped by the behavioural problem of money illusion. There are reasons for thinking that is worse now, and more subtle.
As Yale’s Robert Schiller has commented recently, an obsession with growth frames our thinking and seems to derive from central bank policy. Monetary authorities have targets above zero but inflation has been so low we have forgotten to adjust for it. With bigger numbers for everything, it is easy to believe that we live in an exceptional age. Bigger GDP, larger daily swings in stockmarket indices etc.
Just as we have trouble in bringing these back to real and per capita measures – such as the lack in the West of real per capita wage growth – it stops us getting to the root of growth. Analysts might decide that rolling out new units in a business like Patisserie Valerie is not organic growth. (This is the source of a lot of our misunderstanding of consumer businesses as unit economics tend to flatten out after 18 months and subsequently there is little inherently organic in growth of those units.) But is raising prices of say, iPhones but selling far fewer really sustainable organic growth? I think we would agree that it is not quite as good as finding more customers or actually getting those customers to buy more goods and services. We might think much the same of shrinkflation as it now hits the long established consumer staples businesses. I sense that stockmarkets are beginning to work out what true growth is, but there is an urgent need for boards, remuneration committees and CEOs to get the message.
In summary, the market is thinking more about margin and true growth rates. For some technology growth companies organic profits growth can be low single digits on unadjusted numbers. The framing of results reporting often makes it difficult to pull this number out from all the noise.
While there are signs of improvement in the way that remuneration committees are looking at this, there are still widespread weaknesses in incentive packages. Investors should put in more thought to giving feedback and voting on this. It makes a strong case for ESG. My own observation is that many of the weakest incentive packages are aligned with weakness in governance structure and both should be areas of focus for ESG investors. AIM companies, for example, do not need to publish an audit committee report. And investors should spend more time looking at auditors’ comments or thinking about the judgement involved in the numbers. Increasingly, as more goodwill piles up on balance sheets and we move to a knowledge-based economy, management projections will underpin inventory valuation, goodwill valuation/impairment and other assets that lie on the balance sheet. Any change in trading or even outlook can quickly trigger a cascade of write-downs and covenant breaches - taking a red pen through a balance sheet.
The problems with growth don’t end in the listed sector. Regulation and presumed efficiency on public markets has moved the longer term investors on to alternatives, and private equity in particular.
However, for those entering the profession, I think it is interesting to see how investment firms are evolving. Already, many investment management firms are finding that younger analysts are bringing with them new sources of information and search tools. This has the potential to help create alpha and bring an edge back into active management.
But this data is prone to error, sometimes systematic and occasionally manipulated or deliberate. Essentially the problem with company information is one of fake news. Investment firms should look at how social media and new sources are trying to deal with this. There is a focus now on automated factchecking to systematically clean this, but that is proving difficult. Pressure to deliver this is being put on social media companies to allow rapid takedown of contentious or malicious material. But there are limitations and it still looks like human judgement must be somehow brought in. This is encouraging for investment professionals – integration of human effort and AI will be more subtle than simply separating out what are considered to be low level tasks. We can expect more interaction between humans and technology rather than processes that simply grade the level of judgement needed and farm some out to machines. Augmented intelligence rather than machine-assisted. Indeed, technology is bringing tools to help correct unhelpful human behaviours, identifying subtle biases. And it can help optimise human work by integrating it with AI in a more effective process.
Finally, I think behavioural finance often overlooks the importance of beliefs. And by this I do not just mean emotion or affect. There can be differences between the rational decisions of smart or thoughtful individuals when presented with the same information. Not everyone expects the same outcomes from the same actions; rationality is a difficult concept to define. YouGov produces surveys almost every day that are interesting vox pop exercises. It does show how different perceptions can be, even with the same information. We may not readily be able to change our own beliefs, but it does point to the value of cultural diversity in investment teams.