Why even Warren Buffett is at risk of behavioural biases

CEO explains how his systematic approach can mitigate gut instinct errors but why emotion can be used positively

Why even Warren Buffett is at risk of behavioural biases

Everybody’s investment decisions are afflicted, to varying degrees, by behaviour biases – even Warren Buffett.

That’s according to Dr Richard Smith, founder and CEO of TradeStops, a web-based stock tracking and alerting programme that provides access to his algorithms and research tools. With a PhD in Math and Systems Science, Smith spent 10 years developing ways to help investors apply a systemic approach to deploying their money into stocks.

From his early days of getting his “butt kicked” by the markets, he realized that making investment calls based on gut instinct was simply not producing the results he wanted.

While retail investors are widely regarded to be most risk of irrational decision-making, Smith said that professional money managers also succumb to biases based on past returns and loss aversion.

He told WP: “We’re seeing that message resonate with all kinds of individual investors and IRAs, and also just seeing how quantitative tools and techniques can mitigate that.

“So it isn’t a surprise to see how that is also prevalent in the professional community. The evidence is so overwhelming today that we have so many built-in behavioural biases to our decision-making, it’s hard to believe anybody makes any money in the market!”

Having helped more than 50,000 clients steward more than $20 billion, Smith does not discount emotion from professional investing because he is adamant that it simply is not possible. Instead, he prefers an 80% system, 20% discretionary approach, with the latter focusing on the right emotions that benefit portfolios long term.

Smith added: “Why are you investing? What’s the goal? What’s really meaningful to you? So when those short-term fear and greed impulses arise you actually have a longer-term plan. It just can’t be a quantitative anchor. If you can really connect to more deeper enduring emotions like providing for your family or helping to drive intelligent capital allocation in the economy, those can really change the way you make decisions.”

Smith believes professional money managers can benefit from quantitative strategies to overcome behavioural biases without becoming totally systems-based investors. Apply these to past decision-making and its results, and he backs sophisticated investors to come up with their own valuable hybrid of the systems-discretionary approach.

He explained: “Sometimes you have to overrule the system and there is a big opportunity in that. But 80% of the time if you can keep your known behavioural biases out of your decision-making, you’ll be light years ahead of most of the market participants.”

Smith’s own work includes a Volatility Quotient, which asks investors how much noise you should be ok with and how much stock market randomness you can cope with?

For example, it could be 12% in Johnson & Johnson and Walmart, 33% in Tesla and Twitter, 50% on some junior goldmining stocks and maybe 80% on some biotech start-ups. It means that if you pump $10,000 into Tesla stocks you should be ok with it falling $3,500 because of the noise in the market.

He said: “[It’s about] the ability to help people assess risk in a simple way. Money managers know what the Sharpe Ratio is and they know what beta is etc. But for most people, even a lot of very educated people, they need a simple measure to help us understand what’s signal and what’s noise over different time horizons.

“I think that can be really helpful to a more behaviourally sane approach to successful investing so that you have a better idea of what you need to pay attention to and what you can ignore.”

TradeStops’ own website promotes its algorithm’s ability to determine when to get into a stock and when to get out, using hedge fund guru Dan Ackman’s infamous decision to hold on to his Valeant losses too long, eventually getting out at under $12 when it had hit highs above $250. Tradestop believes its system would have told him that the stock hit volatility exit point at $205.67.

Smith said: “We applied this to a dozen of the world’s well-known investors and found that just applying this kind of system strategy to their own publicly traded investments would have improved the performance of 10 out of 12 of them. The average improvement was above 50%.

“It was pretty close with Warren Buffett, we didn’t dramatically improve his performance but to even match his performance with a systems-based approach [is good].

“Most of us aren’t able to invest like Buffett because he gets to talk to all the top insiders at a company and is committed to holding for decades. Most professional money managers aren’t in a position to invest that way.

“Most people need a hybrid approach where they can have a three-to-five year holding period and not have to live through 80-90% drawdowns like even Buffett did during the 2008 crisis.”

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