Practical analysis for investment professionals
13 June 2012

Behavioral Intelligence: Can It Help Managers Generate Alpha?

Posted In: Behavioral Finance

Behavioral finance was a prominent and oft-debated topic at last month’s CFA Institute 65th Annual Conference, which featured Nobel Prize winner and behavioral economist Daniel Kahneman. This burgeoning field of study has its share of critics, including “the father of modern finance,” Eugene Fama. Fama also spoke at this year’s conference and, though he would not extend its validity to entire markets, the developer of the efficient-market hypothesis did concede that behavioral finance is effective in explaining microeconomic, or individual, behavior.

Can a better understanding of behavioral finance, that is, behavioral intelligence, translate into improved investment returns? Opinion may be divided, but research suggests that it can. Professor Christopher Malloy from Harvard Business School and Terry M. Tebbe from Business Intelligence Advisors will make their case at the upcoming Financial Analysts Seminar in Chicago (July 23–27), where Jim Chanos, Emanuel Derman, and Robert Shiller will also take to the podium.

When it comes to the mosaic process that is investment research and analysis, behavioral insights can improve an investment process and help investors make sound analytical judgments. Portfolio managers and analysts often make decisions based on the information conveyed by company management. Corporate scandals like those involving Enron, HealthSouth, and WorldCom demonstrate the critical importance of being able to accurately gauge the honesty and candor of company executives. But what about uncovering less obvious forms of deception? Research indicates that disciplined application of behavioral intelligence, including lie detection techniques, can improve the investment process and generate excess returns.

My colleague Jason Voss, CFA has noted the critical importance of a financial analyst’s ability to separate fact from fiction, and this skill is especially important when it comes to judging corporate management truthfulness. In “Lie Detection: How Can Financial Analysts Improve Their Ability to Discern the Truth?” Voss cited the pioneering work of researchers Maria Hartwig and Charles F. Bond, Jr. Highlighting the challenges of lie detection, Hartwig and Bond found strong evidence that there are only small behavioral differences between truth-tellers and liars. When it comes to uncovering deception, they suggest relying on a preponderance of behavioral cues, including indifference, ambivalence, and a lack of spontaneity, rather any single sign, and to trust your intuition.

Professor Malloy has focused much of his research on the area of behavioral finance. In “The Psychology and Sociology of Investing: Incorporating Behavioral Finance and Network Analysis into Equity Research and Portfolio Management,” Malloy examined investor decision making and behavior through a psychological and sociological lens. He argued that a better understanding of common investor biases can improve the investment process and advocates for, among other things, the adoption of mechanical rules (like “riding winners and dumping losers”) as a means to counteract these behavioral biases.

Malloy’s work meshes nicely with that of BIA, which focuses on measuring the veracity of corporate disclosures. In 2001, BIA’s founders partnered with experts in the field of national intelligence to develop and market their behavior assessment methodology. BIA’s proprietary model analyzes a range of corporate disclosures, including conference call transcripts, press releases, and interviews, in order to identify verbal and nonverbal cues from which it generates a behavioral risk score. Verbal cues include failure to answer a question, protest statements, or qualifying language, while nonverbal cues include stress-induced anchor point shifts (like a sudden forward shift in body weight) or grooming gestures. A back test conducted by Malloy and published as part of a Harvard Business School case study, suggests a correlation between BIA’s risk ratings and subsequent stock performance. Between 2003 and 2008, BIA’s “low concern” stocks outperformed their “high concern” stocks by approximately 32%.

Notwithstanding Fama’s objections, data suggest that a better understanding of the behavioral biases of investors can improve the investment process and stock selection results. Seasoned analysts know not to accept at face value everything coming from company management, but may struggle with identifying what can be charitably called subtle deception. Recognizing and interpreting verbal and nonverbal cues to deception is a learned skill — part science and part art — that has been shown to enhance returns. Active managers looking for an edge should consider incorporating some form of behavioral intelligence into their investment process.

Gears in the human head illustration from Shutterstock.

About the Author(s)
David Larrabee, CFA

David Larrabee, CFA, was director of member and corporate products at CFA Institute and served as the subject matter expert in portfolio management and equity investments. Previously, he spent two decades in the asset management industry as a portfolio manager and analyst. He holds a BA in economics from Colgate University and an MBA in finance from Fordham University. Topical Expertise: Equity Investments · Portfolio Management

3 thoughts on “Behavioral Intelligence: Can It Help Managers Generate Alpha?”

  1. BetaRules says:

    So where is the boundary between behavioural finance and game theory…..

    And should we start looking at micro behavioural finance (as in this article with reference to gestures and verbal cues) and macro behavioural finance (herd mentality).

  2. Urmila Singh says:

    The above blog is amazingly written. I have also written a blog that covers the importance of behavioural finance when it comes to taking investment decisions. DO read and share your comments.

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