Romancing Alpha,

Forsaking Beta
The High Cost of Neuro-Financial Errors: How Cognitive Bias and Performance Chasing leads to Investing Failures:

Presentation by Barry Ritholtz Trustee Leadership Forum for Retirement Security Kennedy School, Harvard University June 10 - 11

This is Your Brain. This is Your Brain on Drugs

1987 PSA

This is your brain

Your brain weighs 3 pounds, and is 100,000 years old. It is a dynamic, opportunistic, self-organizing system of systems. MRIs have revealed to Neurologists what our brains looks like when making decisions . We can 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 . . .

This is your brain on stocks

Behavioral Economics & NeuroFinance

A brief intro to Behavioral Economics & NeuroFinance

How Does Your Brain Interfere With Your Investing?

Behavioral Economics
1. Herding, Groupthink 2. Experts: Articulate Incompetents 3. Optimism Bias 4. Confirmation Bias 5. Recency Effect 6. Emotions impact perception

Neuro-Finance
7. Anticipation vs. Rewards 8. Selective Perception & Retention 9. A Species of Dopamine Addicts 10. Endowment Effect of Ownership 11. Monkeys Love a Narrative 12. Cognitive Errors Impact Processes

Herding

Mutual of Omaha Lone Gazelle

Source: Kal, Economist

Groupthink on Wall Street: Buy Buy Buy!

1. Only 5% of Wall Street Recommendations Are SELLS
-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. Consensus Sell on them
-Robert Powell, Editor, Retirement Weekly, August 2011

It is better for one's reputation to fail conventionally than to succeed unconventionally. -John Maynard Kyenes

Sources: Ritholtz.com, NYT, McKinsey, Marketwatch

Analysts: Over-Optimistic GroupThink

Analysts have been persistently overoptimistic for the past 25 years, with [earnings] estimates ranging from 10 to 12 percent a year, compared with actual earnings growth of 6 percent On average, analysts forecasts have been almost 100 percent too high -McKinsey study

Source: Ritholtz.com, McKinsey

Over Confidence
Here, Kitty, Kitty, Kitty

How much information is required to make informed financial decisions?

Optimism Bias
Here, Kitty, Kitty, Kitty

Dunning Kruger Effect: DK is a cognitive bias in which unskilled people make poor decisions and reach erroneous conclusions, but their incompetence denies them the metacognitive ability to recognize these mistakes. Metacognition: The less competent you are at a task, the more likely you are to over-estimate your ability to accomplish it well. Competence in a given field actually weakens self-confidence. This has devastating consequences in the investment world.

Expert Forecasting versus Ambiguous Uncertainty

Bennett Goodspeed, (The Tao Jones, 1984) discussed The articulate incompetents Expert forecasters do no better than the average member of the public; The more self-confident an expert appears, the more likely he is to be believed by TV viewers, but the worse their track record is likely to be. Forecasters who get a single big outlier correct are more likely to underperform the rest of the time. Experts who acknowledge that the future is inherently unknowable and unpredictable are perceived as being uncertain and therefore less trustworthy. (Isaiah Berlin: Hedgehog vs Fox)
Source: Zweig, Your Money & Your Brain; Grants Interest Rate Observer,

Confirmation Bias Selective Perception & Retention

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 less of what we disagree with . . . 4. Expectations Affect Perception

How What Already Happened Affects Your Thinking

WSJ: 2007 WSJ: 2010

Source: Ritholtz.com, WSJ

Emotions & the Sentiment Cycle

Source: Ritholtz.com

If u cn rd ths

This animation . . .

. . . is not an animation

When it absolutely positively has to deceive your eyes overnight

Applying Behavioral Economics To Alternative Investments

What Dont You Know About Hedge Fund Investing

What We Dont Discuss When We Discuss Hedge Funds 1. Hedge Funds manage a very small % of total financial assets, yet capture an unusual amount of media & mindshare. 2. 2&20% fees are an enormous drag on returns 3. Total Alpha generated by tiny % of managers (Non Gaussian Dispersion = Fat head/Long tail) 4. Funds can create Alpha but most morph into fee capture business 5. Picking new & emerging managers is exceedingly difficult; your own biases make the process even harder

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 publics imaginations

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. 1. Talent Dilution 2. Excess Size 3. Correlation / Indexers

Diminishing Hedge Fund Returns

Alpha has diminishing returns to scale because many strategies only apply to smaller stocks and/or prices move against managers if they try to execute trades that are too large.
Source: WSJ

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)

Optimism Bias at Work

The Daunting Math of Mutual Fund 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 two out of the next three years; 3. Only 3% stayed in the top 20% over five 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

Is This Rational Investing?

Managers Capture Investment Profits Mostly For Themselves
From 1998-2010 hedge fund managers earned $379 billion in fees. The investors in their funds earned only $70 billion in investing gains. Managers kept 84% of investment profits, investors netted 16%. As many as 1/3 of hedge funds use feeder and/or fund of funds. This brings the industry fee total to $440 billion thats 98% of capture. 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%

Comparable Compensation

Source: Forbes

Top Hedge Fund Manager Compensation (Hourly)

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

Source: Forbes

Paulson Hedge Fund

Manager Selection is Much Harder Than People Believe -John Paulson launched his hedge fund in 1994 -Hires Paulo Pellgrini in 2004 -Raised $147 million in 2006 for Subprime Bet -Greatest Trade Ever in 2006-07 -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 People Believe
Paulson gave Pellegrini a $175 million bonus . . . Response: F#$% you, I quit 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

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 Comp = $118m (Total S&P500+Div=17%) (S&P500 = 14%) (S&P500 = 12%)

Hedge Fund Attrition

When a fund leaves the Lipper TASS database or stops repor7ng, the database lists one of the following as the possible reason:
Fund closed to new investment. Fund dormant. Fund has merged into another en7ty. Fund liquidated. Fund no longer repor7ng. Program closed. Unable to contact fund. Unknown.

92% of funds that leave the database are assigned to just three of the 8 reasons: fund liquidated (36%), fund no longer repor7ng (38%), and unable to contact fund(18%) If a fund leaves the database because it liquidated, it is safe to assume that the decision was based largely on poor performance The aPri7on for funds that reported returns for the month of December 2006 (which covers the 24 months through 2008) is alarmingly high- 29% to 63% of the funds seem to have disappeared Based on these aPri7on rates, one can expect anywhere from 20% to 60% of the funds repor7ng at any given 7me not to last through the next 24 months Such high aPri7on rates can have serious consequences for long-term investors Vanguard also reports the average annualized excess returns of the funds that disappear. The excess return is calculated with respect to the peers in the hedge fund categories

Source: hPps://www.vanguardinvestments.se/content/documents/Ar7cles/Insights/alt-vs-indexing.pdf

We have met the enemy, and he is us. -Walt Kelly, Pogo, 1971

What Can Pension Plans/Foundations Do ?

Understand What You Can and Cannot Do Well As Managers -How overweight in alt (PE/HF/VC) investments are you? -Focus on Asset Allocation (15 distinct classes) -Use Core & Satellite Approach to Reduce Temptations -Take Advantage of Mean Reversion via class rebalancing -Lower Your expectations until the next 1982 comes along -Think longer term -Get Unsexy!

Underperformance: The majority of funds sixty-two out of 100 failed to exceed returns available from the public markets, a\er fees and carry were paid. There is not consistent evidence of a J-curve in venture inves7ng since 1997; the typical Kauman Founda7on venture fund reported peak internal rate of return (IRRs) and investment mul7ples early in the funds life. The cumula7ve eect of fees, carry, and the uneven nature of venture inves7ng ul7mately le\ us with sixty-nine funds (78 percent) that did not achieve returns sucient to reward us for pa7ent, expensive, long-term inves7ng. (hPp://www.kauman.org/uploadedFiles/vc-enemy-is-us-report.pdf) A report by the Na7onal Venture Capital Associa7on (NVCA) states that, It is interes7ng to note that 2012 is the rst post-bubble year in which venture funds collec7vely distributed more cash to limited partners than they brought in. (hPp://www.prweb.com/releases/2013/5/prweb10770077.htm)

(http://smullaney.com/wp-content/uploads/2010/12/VC-Performance1.jpg)

Outperformance: Bain & Co. in their 2013 Global Private Equity Report claim that, despite falling returns (above) and increased volatility (top right), buyout funds still outperformed the S&P 500 (right).

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 favorite books on these subjects can be found at http://www.ritholtz.com/blog/behavioral-books