Romancing Alpha,

F o r s a k i ng B e t a
How Cognitive Biases Lead to Performance Chasing & Investing Failures. The High Cost of Neuro-Financial Errors

Presentation by Barry Ritholtz New York Spring Conference St. Regis Hotel May 23, 2013

This is Your Brain. This is Your Brain on Drugs

1987 PSA

T his is your brain

Yourbrainweighs3pounds,andis100,000yearsold.Itisadyna mi c , oppor tunist i c , se l f -organizing syst em of syst ems.MRIshaverevealedtoNeurologistswhatourbrainslookslikewhenmakingdecisions.Wecan observe it 1) in real time; 2) under actual conditions, and 3) in reaction to financial risk/reward stimuli. Once we begin trading stocks, however, our brains begin to undergo subtle physical change that we can actually see in the MRIs of Traders . . .

T his is your brain on stoc k s

A bri e f int ro to

Behavioral Economics & NeuroFinance

How Does Your Brain Interfere With Your Investing?

B e havioral E conomi cs
1. Herding, Groupthink 2. Experts: Articulate Incompetents 3. Optimism Bias 4. Confirmation Bias

N e uro-F inan ce
7. Anticipation vs. Rewards

8. Selective Perception & Retention

9. A Species of Dopamine Addicts

5. Recency Effect
6. Emotions impact perception

10. Endowment Effect of Ownership

11. Monkeys Love a Narrative

12. Cognitive Errors Impact Processes

Herding

Mutual of Omaha LoneGazelle

Source: Kal, Economist

Wall St. Groupthink: Buy Buy Buy!

1. Only 5% of Wall Street RecommendationsAreSELLS
-NYT, May 15, 2008

2.

Why Analysts Keep Telling Investors to Buy

-NYT, February 8, 2009

3.

Equity Analysts Too Bullish and Bearish at the Exact Wrong Times
-McKinsey, June 2nd, 2010

4.

None of the S&P 1500 have a Wall St. ConsensusSellonthem

-Robert Powell, Editor, Retirement Weekly, August 2011

I t is be tt e r for one's reput a t ion to f ail convent ionally than to succeed unconvent ionally. -John Maynard Kyenes

Sources: Ritholtz.com, NYT, McKinsey, Marketwatch

Optimism Bias
Here,Kitty,Kitty,Kitty

Dunning K ruge r E ff ec t : DK is a cognitive bias in which unskilled people make poor decisions and reach erroneous conclusions, but their incompetence denies them the me t a cogni t ive ability to recognize these mistakes. M e ta cognition : The less competent you are at a task, the more likely you are to over-estimate your ability to accomplish it well. Compe t ence in a given field actually weakens se l f-conf idence. This has devastating consequences in the investment world.

Over Confidence
Here,Kitty,Kitty,Kitty

How much information is required to make informed financial decisions?

ExpertForecastingversusAmbiguousUncertainty
Bennett Goodspeed, The Tao Jones (1984) discussed The articulate incompetents:

Expertforecastersdonobetterthantheaverage member of the public;

Themoreconfidentanexpertsounds,themorelikely he is to be believed by TV viewers Expertswhoacknowledgethatthefutureisinherently unknowable are perceived as being uncertain and therefore less trustworthy. (Isaiah Berlin: Hedgehog vs Fox) Themoreself-confident an expert appears, the worse the ir t ra ck record is li ke ly to be . Forecasterswhogetasinglebigoutliercorrectare more likely to underperform the rest of the time.
Source: Zweig, Your Money & Your Brain; Grants Interest Rate Observer,

Analysts: Over-Optimistic GroupThink

Analystshavebeenpersistentlyoveroptimisticforthe past 25 years, with [earnings] estimates ranging from 10 to 12 percent a year, compared with actual earnings growth of 6percentOnaverage,analystsforecastshavebeen almost100percenttoohigh -McKinsey study

Source: Ritholtz.com, McKinsey

Confirmation Bias

Se l ec t ive P e rcept ion & Re t ent ion

1. We tend to read that which we agree with; We avoid that which disagrees with our preconceived biases, notions or ideologies;
2. Our biases change the way we perceive objects literally, the way we see the world. 3. The same biases affect our memories we retain l ess of what we disagree with . . . 4. Expec t a t ions A ff ec t P e rcept ion

Recency Effects Impact Your Thinking

WSJ: 2007 WSJ: 2010

Source: Ritholtz.com, WSJ

Sentiment Cycle

ustin mames called 908-754-2308

Source: Ritholtz.com

If u cn rd ths

When it absolutely positively has to deceive your eyes overnight

This animation . . .

. . . is not an animation

Applying B ehavioral E conomi cs To Hedge Fund Investing

WhatDontYouKnowAboutHedgeFundInvesting
5 T hings Not O ft e n Disc usse d A bout H e dge F unds 1. Hedge Funds manage a small percentage of total financial assets

2. Fees are unusually high

3. Performance is unusually bad 4. Picking emerging managers is exceedingly difficult 5. Your own biases and emotions make the process even harder

Confirmation Bias in Action

56% said they invested in hedge funds for diversification purposes Hedge funds correlated with other vehicles, falling in crisis Is Your Original Investing theme valid? 81% of investors said Yes (as of 2009)

Hedge Funds = 1.1% All Financial Assets

The global hedge fund industry manages ~$2.13 trillion dollars Given what a relatively small asset class this is, they receive an excess of media attention. Perhaps because so many hedge fund managers have become billionaires, they have captured the investing publicsimaginations

HFRX Global Hedge Fund Index Performance Data

How Have Hedge Funds Done? 2012 = Returns equaled 3.5% versus S&P 500-stock index 16% 2007-12 = Lost 13.6% vs. S&P 500-stock +8.6%

2013 = Gained 5.4% vs. S&P 500-stock +15.4%

As a source of comparison, the average mutual fund is up 14.8% in 2013

Source: WSJ, HFRX

Hedge Fund Growth

1997 = $118 billion 2012 = $2.04 trillion.

Hedge Fund Manager Profit Capture

Managers Capture Investment Profits Most ly For Themselves
From1998-2010 hedge fund managers earned $379 billion in fees. The investors in their funds earned only $70 billion in investing gains. Managerskept84%ofinvestmentprofits,investorsnetted16%. Asmanyas1/3ofhedgefundsusefeederand/orfundoffunds.Thisbrings the industry fee total to $440 billion thats98%ofcapture. Investors are left with $9 billion dollars merely 2%.
Source: Simon Lack, The Hedge Fund Mirage

Hedge Fund Manager Profit Capture

Does not include Survivorship Bias, self reporting. Assume +3%

Selecting Active Management

The Daunting Math of Manager Selection
1.Only 20% of active managers (1 in 5) can outperform their benchmarks in any given year; 2.Within that quintile, less than half (1 in 10) outperform in 2 out of the next 3 years; 3.Only 3% stayed in the top 20% over 5 years (1 in 33)

4.Once we include costs and fees, less than 1% (1 in 100) manage to outperform (net).
5.What are the odds you can pick that 1 in 100 manager?
Sources: Morningstar, Vanguard

Paulson Hedge Fund

Manager Selection is Much Harder Than Most People Believe John Paulson launched his hedge fund in 1994 Hires Paulo Pellgrini in 2004

Raised $147 million in 2006 for Subprime Bet

GreatestTradeEverin2006-07 Assets under management had swelled to $36 billion. Subsequent losses were 52% in one fund, 35% in another.

Pellegrini PSQR Hedge Fund

Manager Selection is Much Harder Than Most People Believe Paulson gave Pellegrini a $175 million bonus . . . Response: F#$% you, I qui t

Formed PSQR in 2008

Returns: 2008 = 40% 2009 = 61.6% 2010 = -11%

August 2010, Pellegrini returned all outside investor capital

Sources: Greg Zuckerman, The Greatest Trade, WSJ

Comparable Compensation

Source: Forbes

Top Hedge Fund Manager Compensation

It takes the average family 18.5 years to make what these hedge fund managers make in 1 hour

Source: Forbes

Two Smart Guys

2 smart guys leave Goldman Sachs to set up a hedge fund; They raise $1 billion dollars: Performance: Year 1: +15% Year 2: +10% Year 3: -5% , (return capital) Earnings (2 + 20%): Year 1: $20m + $30m Year 2: $22m + $22m Year 3: $24m + $0 (Total S&P500+Div=17%) (S&P500 = 14%) (S&P500 = 12%)

Total Comp = $118m

Wehavemetthe enemy,andheisus. -Walt Kelly, Pogo, 1971

for more information, please contact

Barry L. Ritholtz
CEO, Director of Equity Research Fusion IQ 535 Fifth Avenue, 25th floor New York, NY 10017 516-669-0369 RitholtzCapital@optonline.net

My f avori t e books on these subj ec ts c an be found a t http://www.ritholtz.com/blog/behavioral-books