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Undertanding market psychology and behavioral finance helps us build better investment portfolios... and cut through the market hype!

Portfolio Construction

For Psychonomics, the construction of stock portfolios - or specialized funds - begins by applying knowledge from behavioral finance and investment psychology, in conjunction with standard methods from financial economics. In other words, we use a hybrid approach. Portfolios formed in this way, we believe, are more robust because they better mirror the way in which markets function and the way in which real investors operate and make financial decisions.

In actual fact, the way we work is to advise clients on how to build a portfolio, as we are not investment advisors but rather specialists in the application of psychological knowledge to financial markets. Institutional clients come to us to help them build and tailor a behaviorally based portfolio that suits their requirements in the investment sector or market that they want to be in.

So what kind of elements go into constructing a portfolio or fund using this approach? At Psychonomics we would look at several factors starting with the financial data of a universe of stocks - although to a large extent, it depends on client requirements and the risk profile of the portfolio to be developed. Nevertheless, good companies are, of course, those that are well run and have good earnings, and in many cases the model that runs the portfolio is initially constructed to allow a universe of stocks to be whittled down with financial criteria such as this. Other related factors, in the same vein, cover assets, financial multiples (such as price to earnings ratios and price to book ratios), and historical data on a number of dimensions. From this perspective, the portfolio formed allows stocks to be selected that are financially sound and have good potential. This, though, only represnts a primary filter.

Often, the next step in these types of portfolios, is where the distinction is made between value and glamor stocks. Portfolios constructed with a behavioral element should allow value stocks to be sought out. These are stocks that while good are overlooked by the market. If they are financially sound the reason they have so far been missed is not important, only that they can be bought at a reasonable price. The idea is that the manager tucks away these stocks for the long term in the portfolio, or until such time as the market realises it has made a mistake and revalues them. At this point our client would then be able to reassess the constituent stocks' importance to the portfolio and either hold or sell.

The construction of a value based portfolio makes use of investor psychology by exploiting investor dealing anomalies (or lack of dealing) and is a useful approach on its own. However, at Psychonomics we go much further in applying psychological knowledge. The third step in our approach is highly predictive in nature and considers: trend psychology, statistical phenomena based on investor behavior, market anomalies such as those related to earnings surprises, behavioral biases, overreaction to news and information, sentiment, overconfidence, and much else. These are all measured and integrated into our model.

A fourth step of our portfolio construction is the application of decision science. Decision analysis is a way of deciding how much of a factor we want to keep in the model we apply. Hence, for something like overconfidence, we can find out an appropriate threshold value. The importance of this is that it limits dealing orders - so called churning - to more rational levels.

The ideal portfolio is made up of stocks that provide a return greater than can be achieved in the stockmarket as a whole. Generally speaking the benchmark is taken to be an index fund based on one of the stockmarket indices. So if the S&P500 (the Standard and Poors Five-Hundred index) was used, and a fund of this index produced a return in the region of 9%, behaviorally based portfolios would be looking to achieve a return for clients in excess of this.

The end result of our work is a multi-factor model for a tailored portfolio, based on the latest financial and behavioral research, that institutional clients can then use and market to their own clients.

 

Find out more about portfolio construction strategies >>
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