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Two weeks ago, I introduced the concept of behavioral portfolio management (BPM) as a way to build superior portfolios.

Last week, I discussed the first basic principle underlying BPM: Emotional crowds dominate market pricing and volatility. In this article, the third in a series of five, I will discuss the second basic principle.

What is BPM?

BPM posits that there are two categories of financial market participants: emotional crowds and behavioral-data investors (BDIs). Emotional crowds are made up of investors who base decisions on anecdotal evidence and emotional reactions to unfolding events. Human evolution hardwires us for short-term loss aversion and social validation, which are the underlying drivers of today’s emotional crowds. On the other hand, BDIs thoroughly and extensively analyze behaviorally driven price distortions and build portfolios based on these distortions.

Basic principle II: Behavioral-data investors earn superior returns

Emotional crowds dominate pricing; that was the first basic principle, which I demonstrated last week. This would seem to indicate that BDIs earn superior returns by taking positions opposite the crowds. But this is not necessarily the case. Though there is little doubt emotions increase volatility, the resulting distortions might be random and unpredictable, making it difficult, if not impossible, to take advantage of them. So beyond proving the fact that emotions drive prices, it is necessary to show that the resulting distortions are measurable and persistent.

The behavioral finance literature is full of examples of measurable stock price distortions.1 It would seem easy to build superior performing portfolios, but doing so would mean taking positions that are opposite the crowd. The powerful need for social validation acts as a strong deterrent for many investors, discouraging them from pursuing such an approach. It is tough to leave the emotional crowd and become a BDI. Thus, though we find price distortions to be measurable and persistent, building a portfolio benefiting from them is emotionally challenging.

In order to demonstrate that it is possible to earn superior returns, I turn to the active equity mutual fund research. This group of investors is one of the most studied in finance because of the availability of extensive data over long time periods. One stream within this large body of research reveals that active equity funds are managed by successful stock pickers.2 These studies examined individual fund characteristics and holdings and confirmed that a significant number of funds outperformed, as did their top stock picks.

1. See the behavioral finance summaries in Shefrin (2010), Hirshleifer (2008), Barberis and Thaler (2003), Baker et al. (2007) and Subrahmanyam (2007).

2. See Jones and Wermers (2011) and Howard (2013) for summaries of the active equity mutual fund research.