Putting Prof Thaler’s views into practice

Putting Prof Thaler’s views into practice
article provided by Degroof Petercam AM, a pioneer in behavioral value strategies since 2001

On October 9th, Richard H. Thaler, one of the founders of behavioral economics and behavioral finance, was awarded the 2017 Nobel Prize in Economics for shedding light on how irrational decision making affects the economy and financial markets.

Up until the 1970s, economic thinking was primarily driven by mathematicians. They primarily had a normative view on the world and tried to model the economy as it should be. Typically, it entailed that their economic theories were subject to a set of starting assumptions. The tenet was that economic actors in general and investors in particular think and behave in a rational manner, always aiming for the objective optimum.

As of the late 1970s, this view shifted. A number of behavioral psychologists started to approach economic theory differently. They observed that most investors are unable to comply with the principle of perfectly rational decision-taking. i.e. when confronted with complexity, they tend to fall back upon rules of thumb, of which many are either incorrect or incomplete.

Investment process

Degroof Petercam AM has been a pioneer in behavioral value strategies since 2001. It currently manages over €2.5bn in this specific expertise. The rigorous investment process has been the core of the success.

Indeed, the investment philosophy is deeply rooted into behavioral finance which explains how and why emotion and cognitive errors influence investors. Behavioral finance demonstrates how this leads to mispricing of financial assets and bad investment decisions. Behavioral Finance also demonstrates that investors’ behavior biases are systematic, consistent and predictable.

For those reasons, our process is systematic and very disciplined, a necessary condition to benefit from those errors and protect the manager from making them. The foundation of our investment process is that superior long term returns can be achieved by systematically exploiting the judgmental biases and behavioral weaknesses that influence investors’ decisions.

It concentrates on the value and momentum anomalies which are deeply entrenched into human behavior (overconfidence, representativeness biases, over-reactions, over extrapolation, …).

In practice, the investment universe is first filtering out of potential torpedoes based on EPS revision momentum and some ESG criteria (such as non compliance with United Nation Global Compact or involvement into illegal and controversial weapons)

For each stock of our investment universe, we compute an expected return based on the assumption that market doesn’t value correctly the necessary reversion to “normality”. On the contrary, because of behavioral biases, investors and analysts tend to extrapolate too much and for too long past trends. They overreact to old information which leads to over or under valuation.

The model we used to compute expected return explicitly forces a reversion to the mean and avoids the pitfall of over extrapolation and representativeness biases.

Philippe Denef, CIO Quantitative Equity
Degroof Petercam AM, a pioneer in behavioral value strategies since 2001