Decoding Behavioral Finance: An interview with Herman Brodie

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Cold OPEN: … “We don't perceive losses to the same extent that we perceive gains. In fact, it's estimated that we perceive a loss with more than double the intensity than we perceive a gain, for the same monetary amount”

Justin Thomson
Welcome to The Angle from T. Rowe Price, a podcast for curious investors. Sharper insights on the forces shaping financial markets begin here.
Thank you for joining me today. I'm Justin Thomson, head of the T. Rowe Price Investment Institute. Today's it’s my great pleasure to welcome Herman Brodie – erstwhile trader, speaker, I think you're a TED talk specialist, an educator. Herman has run his own business, Prospecta Limited, since 2013, which was formed with the goal of bringing together academia and finance professionals.
He is also an author, and his book, “The Trust Mandate: The behavioral science behind how asset managers really win and keep clients”, looks to find the answers as to why investors choose one asset manager over another to manage their money.
Herman - it's a great pleasure to welcome you to T. Rowe Price. Tell us why behavioral finance is so important.

Herman Brodie
It's because we are human beings. And as a result, whenever we make decisions, it's really, really difficult to take our humanness out of the picture. I know as financial professionals we like to think that we can sort of hang our humanness at the door when we go into work, but in reality it's a lot tougher than that. And it's remarkable how easy it is to be influenced by psychological factors that allow us simply to take our eye off the ball when we're looking to optimize economic outcomes.

Justin Thomson
So Herman, can we have a little bit of your back story? I know you ran a book at an investment bank. I think it was an FX book. I also think you were an algorithmic trader, which is interesting because theoretically, algorithms take the biases out of trade decisions.

Herman Brodie
Yeah, and it was algorithms that got me interested in behavioral finance at the outset, in fact. So, I was working at an investment bank. We ran a portfolio of algorithms, a variety of asset classes, equities, fixed income, currencies as well. And the goal was to, well, separate the individual from the transaction. Oh, it’s the algorithm that wants to buy here, not me. So, we put our best ideas into these algorithms and off they went. And they actually did very, very well. But despite this there were two occasions in my career where the human being got involved, not my finger on the on/off button, but my bosses at the time. One of them was, this is a period after some very, very good performance and the boss had the idea that we should double up the volumes going through these models because they're doing so well. And this is what we did. But that corresponded within a week or so of the peak of the performance and subsequently we experienced some drawdowns.

And there was another period, a couple of years later, where after a relatively short period of weak performance, they decided they want to switch the machines off altogether. I wasn't really in agreement with this, but we did it anyway. And this corresponded, I promise you, to the day, of the worst point of the performance. Thereafter the performance skyrocketed, and I thought this could not be just by chance, there had to be some, something systematic in these poor decisions. Right at the worst possible moment.

And at that time, of course, we didn't have anything to do. So we were just sitting there twiddling our thumbs, and we had a trainee on the desk who showed me some– an academic paper, which proved to be a revelation for me. It showed that some of our preferences were systematic in nature. And the conclusion that I drew from this was that, we were not the only ones experiencing, outperformance at that time, or underperformance at that particular time. Everybody else was doing exactly the same thing that we were doing. Perhaps we were doing a little bit more slowly than they were, so our timing was even worse. But we were doing the same thing as everybody else, and it was precisely this which gave rise to our behaviors. And also, had an impact on the aggregate market as well. And so, I used that free time that I have, to become familiar with behavioral finance.

Justin Thomson
Fascinating story. And actually reminds me of more apocryphal stories of whole investment banks that have been blown up by the interventions of the big boss, should we say? Yeah, not naming names, but there are some great stories around it. Do you recognize your own behavioral biases? And were you able to have the opportunity to apply those in your own investing career?

Herman Brodie
Oh, for sure, for sure. I mean, I’ll give you an example. This is one of the things I read all those years ago. Imagine, let's say there is, there's a lottery. Okay. And I tell you that there are 100 tickets only in this lottery, this prize draw. And the winner will get a prize of 100 pounds. You say okay, there’s 100 tickets, hundred pounds. Each one of those tickets is worth a pound. Let's say I give you the opportunity to buy one for 90p. Now as a serious investor you say, 10% discount. Yeah, I have one of those tickets for 90p. But then I tell you that the owner of the other 99 tickets is me. Do you still want to buy that one ticket for 90p? Probably through gritted teeth, you'd say, yeah. I’ll buy it anyway. And now I tell you, that well I've only paid 70p for all of my other tickets. Do you still want to buy that one for 90p?
 
Now, as an investor, you would say, yeah, you know what the right answer because it's obvious what you have to do. All the other information I've just provided with you is completely irrelevant to the decision. But still, suddenly we don't like to buy that ticket any longer. It's just unattractive and the reasons for it start to become evident. It’s to do with the focus of our attention, for example. When we're only talking about your ticket, the focus of attention is you, and being the most likely winner. You knew there were 99 other tickets, but you were not thinking about them, didn't have your focus. But as soon as I mention it, suddenly it seems less likely that you're the winner.

And if you hear that I only paid 70p and you have to pay 90, it just seems sort of unfair and as human beings, we don't like unfairness. All of these things are completely irrelevant. So even if you do buy the ticket, you don't enjoy it any longer, this lottery. So, you see, it's impossible to separate out our humanness from our economic choices. And this is the problem with sort of, you know, an efficient markets approach; is that it treats all non-monetary consequences of our decision as negligible. So, things like, like fairness or, or, or things like, regret. And anybody who's ever felt the sting of regret will tell you this is not negligible.

Justin Thomson
Takes me on to ask, what are the most common investment mistakes you encounter, and what's the psychology behind those mistakes?

Herman Brodie
There is one characteristic of human decision making in situations of risk, and it's called the disposition effect. It is probably the most robust characteristics of human decision making in situations of risk. And this is the tendency, is when people are winning to want to take those profits very quickly, but when they are losing, to want to adopt, you know, a much more generous attitude to risk, and to allow those losses to run. And this, the idea of taking profits early and letting losses run, in my opinion, is probably responsible for some of the greatest disasters of all financial history. So robust is the characteristic.
If we do nothing else, if we learn nothing else from behavioral finance, this must be the thing. And in much the same way as this example I gave you with the lottery, even if you wind up able to do the right thing, you still don't enjoy it. And it's really, really difficult. And the knowledge of it does not help. The only thing that one can do is to structure one's decision-making process so that we are no longer hurt by these things. So, it's not something that we can learn not to do or learn not to feel or perceive. The only thing we have to do is to put guardrails in place to make sure that we are no longer able to do it.

Justin Thomson
And why are people's attitude to risk different with their losses than with their gains?

Herman Brodie
It has to do with the way that we perceive losses, you see. We don't perceive losses to the same extent that we perceive gains. In fact, it's estimated that we perceive a loss with more than double the intensity than we perceive a gain, for the same monetary amount. So, we win a pound that feels like a pound, we lose a pound, it feels like two. And because we don't like that loss of two, we are motivated to do something to try and get it back. And that usually involves some sort of gambling and sometimes doing nothing, holding on to the losing position is also a means of gambling, in order to get out of that losing position. And I say the average is around 2 to 1. We call this the coefficient of loss aversion. But it varies from individual to individual. So I'm somebody who has had an incredibly high coefficient of loss aversion, probably 5 to 1 or 10 to 1. So, again, I hardly perceive it, but a loss and I will torture myself for days and weeks about this single loss. And this then causes, you know, my ability to respond appropriately to opportunities out in the market, effectively.
 
Justin Thomson
When I look at the attribution from my own career, and I've got over 20 plus years of performance attribution, it wasn't so much stocks that went bad, it were the ones that were going bad and you defended. That's what really hurts. And we have a great saying that, it's okay to be wrong, it's not okay to stay wrong. There is a lot of empirical evidence to show that most investors are better buyers than sellers. That was certainly the case with me. What makes selling so hard?

Herman Brodie
The short answer is that selling does not hold our attention. So, when we investigated the difference between buying and selling, and yes, you're correct about the empirical evidence, a lot of evidence over decades that shows that investment managers are quite good at buying. They are rigorous. Their analysis robust. They base their decisions on their strongly held beliefs about the drivers of investment returns. And it works. So we have evidence showing that purchases will outperform a naïve counterfactual. Usually in the 12 months following the purchase.

But when it comes to sales, it seems that those decisions are not based on their beliefs about what is going to underperform. Rather, they use some sort of simple rules of thumb, some sort of decision-making heuristics to, to simplify the decision rather than to optimize it. And it's this that gives rise to an underperformance relative to, a naïve selling strategy. And so it's because sales decisions don't really have the fund manager’s attention, and therefore they don't apply the skill. So the, the skill to buy and sell, of course– buying and selling requires the same, you know, cognitive abilities, the same intellectual skills. But the problem is they don't apply those skills to the sales. They apply them only to the buys, and they base their selling decisions on some simple heuristics.

Justin Thomson
I want to branch out and do justice to your book because it's an extension of how you started this journey. But in the “Trust Mandate”, you make the case that empathy is more important than competence or capabilities in establishing trust. How should our investors go about establishing trust?

Herman Brodie
Yeah. Well, empathy is not exactly the right word. The more correct word would be benevolence. So it's what we call benevolence. So there are two judgments that we make when we evaluate somebody else. One is called benevolence, and one is called competence. Competence of course is the skills. Does this person, we will ask ourselves have the the training, the education, the experience, the resources, etc. in order to make good things happen? But we also ask a second question is, is this person motivated to make those good things happen for me?

So does this person genuinely have my best interests at heart, or are they going to use that competence to pursue their own selfish interests? Unless we believe that they have benevolent intentions towards us, that they have our best interests at heart, the competence does not really matter. I mean, even the smartest people in the world are only useful to us if they are on our side. If they're working against us, of course, that competence, it's of no value whatsoever. I mean, we prefer, our enemies to be dumb, right? And so the first judgment we always make is, does this person have my best interests at heart?

And this is the benevolence judgment. And what was curious, what motivated us to produce the book, is that in the financial services industry, we are not very good at conveying our benevolent intentions to others. We are very good at conveying our competence. And we– It's not that we don't have benevolent intentions, we do, but we're just not very good at conveying it. We try as much as possible to push our competence, whereas the – and the missing ingredient, therefore, is these benevolent intentions. And so the goal of the book was to show people specifically in the financial services industry, the importance of being able to convey your benevolent intentions to others, and also how you can do it, scientifically. And in this way you can win trust.

Justin Thomson
But logically, if you're responding to benevolence rather than competency, does that not lead to the wrong investment outcomes?

Herman Brodie
Well, basically if you don't have any clients, so if your clients don't trust you, then you don't really have a business. Ultimately, it comes down to this. Now you can, you can survive on just competence alone. So, let's say that you are perceived as being, you know, highly, highly competent, but not particularly benevolent. So, you know, clients are a little bit wary of you.

If, let's say you're only managing a tiny part of the client's wealth. They say, well, show me some good numbers, and you get a little part. Or you are involved in very low risk sort of business. So, you're managing, you know, developed market index fund. You can find– just show me some cheap prices and you know how to, you know, build a portfolio and control your risk, etc. But you're never going to get the opportunity to manage the fund for that client, and you're not going to get the opportunity to get involved in some very high risk, complex business, and which are usually higher margin business with that client.

And so, it is possible to survive on competence alone, but the client is never going to– they don't fully trust you. Then there's always going to be a certain distance between you and the client. It's going to become a little bit more transactional that relationship. And of course, as soon as that performance falls off, you're fired by the client. Whereas if you have a genuinely trusting relationship, meaning that the benevolence is high and the perception of competence is still high, you can hold onto the business even, you know, during the more difficult phases in the cycle.

Justin Thomson
So, if markets are the sum of emotions of all the participants in that market, and that fact is exploitable, why has active management struggled so much?

Herman Brodie
Because somebody has to be the one who does the exploiting, and the one who does the exploiting cannot be prone to the same thing that's making the markets exploitable. Which means go back to the example with the with the lottery. If you say, well, I don't want to buy a ticket that's worth a pound for 90p, we must find somebody who is ready to buy it. And that means that that individual cannot be prone to the same bias that creates the inefficiency in the first place. And that is something that's actually quite difficult. Now, in that example, you knew the correct answer, and so you’ll power on through. But would you be able to do it if it was less obvious? Let's say it was a little bit more subtle that discrepancy. Would you be able to notice it? Would you be able to do it in every single security in the portfolio? Would you be able to do it today and tomorrow, this year, next year, etc.?
So to have this consistent laser focus, which will allow you to overcome those obstacles, and there will be many, along the way is very, very difficult. And this is precisely the problem. As long as we human beings are the one who are trying to exploit the weaknesses of other human beings, you can see it's going to be quite a challenge.

Justin Thomson
What do you think makes the best investors? What characteristics, what absence of bias has defined them as investors?

Herman Brodie
Well, I'm very often asked about, especially in the context of this disposition effect. You know, is there a certain trait that makes one investor better than another? And the truth is I've not really been able to find one. Certainly, we have each individual, we have certain traits that make us prone to certain biases more than others. So, some investors are more prone to the disposition effect than others. But all that one needs to really do is to operate in a decision process and perhaps in the market as well, which is compatible with your personal preferences.
So, it's not that you'll be a better investor than me if you have a lower disposition effect, it's just that if I have a much higher disposition effect than you, then I need to be in a market where, or have a decision process, which is not going to leave me more vulnerable. So how do I adapt my investing style to my own personal characteristics.

In terms of career growth and development, I think it's important to be able to, you know, learn from our own experiences and from the experience of others. So, we can grow as an investor and improve over time, if we have some good feedback about our own decision-making processes, and we have the possibility to learn as well from those around us.

Justin Thomson
So I'm going to, I'm going to summarize that, Herman, by saying we should strive to be the best version of the investor we are.

Herman Brodie
Yeah, I would endorse that 100%.

Justin Thomson
So final question, I know you have a top ten ways in which you can improve your investment decision making, but I'd like you to to finish this podcast to narrow that down to just three.

Herman Brodie
Okay. Certainly, we need to have some good feedback about how well, or not, we are making our decisions. Nobody can learn anything without feedback. So, from learning a language, for example, or learning to walk as a toddler, we get feedback because you know, we say the wrong thing, or we fall on our bums, and we get to do this a little bit better. And as investors, very often we deny ourselves that feedback. And I find it sometimes tragic when you have some very good investors who are not really able to tell you, you know, what that characteristic of their decision-making process or, you know, their thought processes. They just need to, you know, have written down what they are thinking. What were the reasons they bought X, Y or Z security? How much weight did they give to various elements of the input in that decision process? They know this, and if they write this down at the time, they can go back and refer to that information later on to see, you know, what are the things which I can see genuinely contributing to good outcomes, and which ones are not. And then not only would they be able to, you know, double up on the good stuff and play, downplay the bad stuff, but they're also in a unique position to teach other people, and that is incredibly valuable for an organization.

Justin Thomson
So, I'm going to divide that into two things. One is to take feedback. Second is to create some sort of investment log, which over time will give you information that can make you a better investor. What would be the third and final one?

Herman Brodie
You can't learn not to be human, so it doesn't; if you have to just learn about behavioral finance to be a better investor, then I would be the world's best investor because I've been doing nothing more other than this for the last 25 years. You cannot, you know, unlearn your humanness. The only way that you can draw some advantage out of this is by building it in systematically into your decision process. Identify the things which do you the most harm. The kind of behavioral traits that you've identified as being the most damaging for you. And then build into your process something which is going to prevent that thing from hurting you. So, for example, if you are just prone to hanging on to your losers, you have to build in some process where you have some sort of stop-loss rule, where if something is triggered, something that you have yourself have identified, if certain conditions are met, then, I mean, I don't have to turf it out into the market disposition, but at least I need the permission of somebody else, or the responsibility goes to somebody else. So, I have to have something in my process to prevent it from happening.

Justin Thomson
I think that's a very nice qualifier for your own science, Herman, that this is not a panacea, but it is a tool. And given we win by degrees in this business, it is a tool that can help us all get better. So, thank you.

Herman Brodie
Welcome.
And thank you for listening to The Angle. We look forward to your company on future episodes. You can find more information about this, and other topics on our website. Please rate and subscribe wherever you get your podcasts. 
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