by Martin Chapman

Created on: February 25, 2009   Last Updated: July 18, 2011

Do you believe that stocks are perfectly priced and include all information available? This belief is known as the Efficient Markets Theory. Yet why then do stock prices move with such incredible volatility, if we know everything. The stock that rose last month, will more than likely fall this month and next month it will rise again. That does not sound very efficient, does it? So there must be some other emotional or psychological factor at work to explain these crazy patterns. 

Over the last two decades a lot of analysis has been conducted which has challenged the view that equities are priced efficiently. Investor behaviour has often been found to be anything but rational, as it was originally assumed in Financial Theory. This has led to the development of "Behavioural Finance" which examines the psychological biases in stock selection. Investors have been found to place too much emphasis on recent events, to suffer from over-confidence and weigh losses more heavily than gains. This article deals with this irrational behaviour and asks what can be done to allow for, or profit from, these biases.

Behavioural finance is just as relevant for the professional fund manager as it is for the amateur. A study in 2005 found that fund managers were losing on average 0.6% of performance every year through inefficient portfolio allocation. Like most humans they tend to pay more attention to things they have and invest little time in the things they do not own. For example, over 70% of the equity portfolios were losing performance on their underweight positions, whereas only 5% of the portfolios were losing performance on their over-weights.

As an equity fund manager myself I have to admit that there is a lot of truth in these findings. Even average fund managers can be very good at picking winners and holding long positions in their portfolios. However, they are weak at choosing what to short in both absolute return and benchmark based portfolios. The explosion in the number of hedge funds over the last five years was always going to lead to much lower returns than the hedge funds of the Soros and Steiner era. It was never going to be possible to turn traditional long-only managers into the shorting experts that the hedge funds needed overnight.

Many fund managers use quantitative screening filters into their investment selection process in order to rank the best investments in their universe. Surveys however indicate that the same problems

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