How do people invest? The difference between group and individual decision taking – with a small side-step to the credit crisis

By Erik L. van Dijk

In our previous entry on Fund Manager Selection we noticed what the typical flaws of private investors and their advisors are. Now, before turning to decision taking by the so-called specialists in part 2 of the series on Fund Manager Selection, it is good to take into account resulst from a great paper by Barber, Heath and Odean from the Haas Business School at the University of California Berkeley. In their paper Good Reasons Sell; Barber, Heath and Odean, published in Management Science in 2003 they point out that individual investors take different decisions when being part of an investment club. 

A lot of the research focusing on differences between private and institutional investors incorporates agency-related factors in one form or another. The Agency Theory, going back to the original work of Mike Jensen and Bill Meckling in the mid-70s, indicates that situations in which a principal / decision taker is working in his own self-interest can lead to different outcomes when – for example because of the decision framework or company structure getting too large – he/she outsources part of the decision taking to an agent. Supposedly the agent is required to act totally in the interest of the principal / decision taker, but one can never exclude that the agent will incorporate his/her own agenda with goals/targets in the overall decision framework. Consequence: the end result can easily be less good than what the principal expected.

Before turning to investment decisions by institutions in a future post on Fund Manager Selection (part 2 of the series started yesterday), it is good to re-analyze the Barber et al. paper. In their paper they publish results from tests in which they distinguished between individual investors who took their investment decisions alone, and those who worked together in a group. Now with investors in an investment group still being the sole owner of their share of the overall group portfolio, the agency aspects don’t apply. Any difference in investment style of people in groups versus people on their own is therefore the sole result of behavioral factors.

The results are astonishing. People do decide differently when in groups. And not just that: people in general use decision processes in which ”good reasons” are guiding them more than conscious cost-benefit-analysis-based decision taking! Both the individual investors and the clubs in the Barber et al. study underperformed the benchmark, both on a net and gross basis. In other words: professional investors as a group do outperform. And that implies that the fun, anecdotes about King Kong beating the specialists with stocks picked by throwing darts are demagogic. The tests of monkey versus specialist do always incorporate 5 or less stocks and one ot the key characteristics of a good specialist portfolio is diversification. Taking away the diversification from the specialist, is like taking away bananas from the monkey. If you don’t give him his yellow, curvy food, he won’t be able to pick any stocks, let alone outperform.  

But the differences between the good, bad and ugly in both investor categories can be substantial. And that holds for both the professionals and the amateurs.

One standard mistake made by private investors is that they forget to diversify. Research has indicated that it is best to diversify a portfolio over 15-20 different, if possible not too-correlated holdings. In case your portfolio is too small: stick to funds and avoid individual stocks or other securities. The average investor club or individual diversified his/her portfolio over 5-10 holdings. The excess risk that results from this is one reason for the relatively meagre performance. Diversification was a bit better in the groups, but there diversification did not follow the lines of correlation reduction. It was more a way to ensure that everyone in the group had something funny and interesting to do, with others being able to mingle in the discussions. I.e. we diversify the research, but please make sure that the group discussions in the meetings that decide on portfolio changes are ‘fun’ with all respected members being able to show how knowledgeable they are.

This phenomenon can explain why securitized portfolios that were so instrumental in explaining the credit crisis were not diversified enough. A good group process would be one in which bottom-up specialists prepare things, bring their research into a meeting with eachother and with top-down specialists, with the latter than deciding ultimately about allocations. That is not what is happening in the case of investment clubs I am afraid. Actually, it is not even true for most institutional decision processes either. As top-down specialists, we believe that our cooperation with Noble Prize laureate dr Harry Markowitz (mr Diversification if you like) has helped us to take an objective stand by using a helicopter view in which we give credit to the bottom-up specialists that we categorized as best-of-breed.

No, decision taking in investment clubs follows a different path. Barber et al. show that ‘good reasons’ are the dominating factors explaining buy decisions. ‘Good reasons’ are labels and categorizations providing a seal of approval / quality stamp to individual stocks, albeit that the same could apply to mutual funds. Factors that fall under the ‘good reason’ definition could be; i) incorporation in a most-admired list (e.g. the one by Fortune); ii) strong sales growth of a firm over the last 5 years; or iii) strong stock returns over the last 3 years. With respect to the incorporation in most-admired lists: compare what we wrote in our previous contribution about advertising by mutual funds! And the 3-year return track record is of course one-on-one in line with what we wrote about raw returns in our previous post. ‘Good reasons’ are useful quality stamps, but not necessarily so for achieving above-average investment results: you have to pay for them. ‘Good reasons’ firms are more expensive, so that net results on ‘good reasons’ portfolios can be lower than on a contrarian one. That is how markets work: if something is more desirable, more people want it. And this higher demand translates into a higher price.

The fascinating thing is that people in an investment club are not agents, but principals! So, why do they decide the way they do? In our contribution on Fund Manager Selection by institutional investors we will show that the old adage ‘No one ever got fired for buying IBM’ is an important explanation in an agency setting. But the Barber et al. research indicates that there is more at stake. Group decision taking incorporates innate behavioral problems that can lead to sub-optimal investment decisions with or without agency complications. Investment portfolios should – in the end – lead to diversified mixes of individual holdings or mutual funds that are sufficiently different. Selection of different things involves different qualities. Different qualities require different type of people/specialists. Group processes with different people might lack the ‘social fun’ or a group process in which all like each other, respect each other, have fun working together. And that is where things go wrong. It is most likely that this problem plays a bigger role, the bigger the organization is. Investment clubs are normally limited to just 10-15 people, and already with those small numbers, the problems are tantamount.

Interestingly enough, it is not true that this problem arises solely in groups. Be they institutional (with agency problems included) or private (principal-only). Barber et al. show that the ‘good reasons’ problem is also bothering most individuals on a stand-alone basis when selecting stocks, albeit to a lesser extent. We can extrapolate this behavioral finding into another plea for making sure that boutique, smaller asset management firms in which a charismatic set of key personnel plays a leading role are not forgotten within a diversified portfolio of funds.

Bottom line: taking the right investment decisions – be they the selection of fund managers or the buying or selling of individual stocks, bonds or other securities – is a complicated thing. Too often, do we show weakness to quality-related factors, or non-investment-related agency factors, or do we fall prey to naive extrapolation of historical results. The ‘good reasons’ work by Barber et al. confirms this.

Conclusion: good investing requires a complicated skill set, that is unfortunately less readily availabe than we would like. It is not very helpful that the average marketing or business development executive of big financial institutions tries to make us believe that they are big because they are the best in everything they provide. The same holds for investor relations personnel (or the CFO or even CEO) of stock-market-listed firms trying to convince investors to buy their shares and hold them longer. The difference between ‘the good’, ‘the bad’ and ‘the ugly’ is complicated when it comes to finding the best investment portfolio. Avoiding ‘bads’ and ‘uglies’ alltogether will lead to underpermance. Buying the bads is not an option either. The best strategy should lead to a diversified mix of ‘goods’ (‘quality’) and ‘uglies’ (contrarian strategy components), but as a decision taker you need a strong stomache to defend the latter category, especially in harsh times.

POSTSCRIPTUM

Application example 1; Emerging Markets 2008

The fact that Emerging Markets – even the ones with strong fundamentals – lost more in the credit crisis than struggling but bigger (‘good reasons’) developed markets gives you an idea about what we mean here.

We at Lodewijk Meijer continue to believe that only a robust, cost-benefit-based approach in which all pluses and minuses are made transparant to the final decision taker (‘principal’) can lead to structural outperformance. That is why we combine ‘best-of-breed’ specialist products of a mix of large firms and boutiques in a framework in which we only play the top-down, objective outsider role based on a framework that we developed together with Noble Prize laureate dr Markowitz. Humble when necessary, bold when based on something and boring when it comes to risk: that is the right way to go for investors in this new era. Unfortunately too many decision takers didn’t come to that conclusion yet.

Application example 2; Will our leader be capable of getting us out of the current crisis?

And that does also seem to hold for the ones that are trying to lead us out of this credit crisis. Initially the G7 leaders and ministers of Finance tried to do it themselves. With the smaller developed nations playing copy-cat in their own country. But hey guys, if you let liquidity first flow towards the Chinese and Arabs through the acquisition of products, oil or direct investments, don’t be surprised that – when suffering a problem – liquidity is somewhere else. The receivers of liquidity in the aforementioned nations did not automatically send it back to Wall Street or London. Sure, sooner or later it will come, but at their convenience. Only now, months down the road do we see markets slightly improve and leaders change talk from G7 to G20. Finally! The initial money spent was printed money of future tax payers. If we want it or not, cost-benefit-based thinking would imply direct talks with the Chinese, the Arabs and other sovereign wealth investors. Our leaders have to be bold and humble at the same time when doing so. Difficult, but possible.