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 Neuro-Finance

1. Herding, Groupthink 7. Anticipation vs. Rewards

2. Experts: Articulate Incompetents 8. Selective Perception & Retention
3. Optimism Bias 9. A Species of Dopamine Addicts
4. Confirmation Bias 10. Endowment Effect of Ownership
5. Recency Effect 11. Monkeys Love a Narrative
6. Emotions impact perception 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 It is better for one's reputation to fail
-McKinsey, June 2nd, 2010 conventionally than to succeed
unconventionally.
-John Maynard Kyenes
4. None of the S&P 1500 have a Wall St.
Consensus “Sell” on them
-Robert Powell, Editor, Retirement Weekly, August 2011
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 Don’t You Know About Hedge Fund Investing

What We Don’t 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
public’s 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 1.  Talent Dilution
2012 = $2.04 trillion. 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 – that’s 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% (Total S&P500+Div=17%)
Year 2: +10% (S&P500 = 14%)
Year 3: -5% , (return capital) (S&P500 = 12%)

Earnings (2 + 20%):
Year 1: $20m + $30m
Year 2: $22m + $22m
Year 3: $24m + $0

Total Comp = $118m

 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  Kauffman  
Founda7on  venture  fund  reported  peak  internal  rate  of  return  (IRRs)  and  investment  mul7ples  
early  in  the  fund’s  life.”    
•  “The  cumula7ve  effect  of  fees,  carry,  and  the  uneven  nature  of  venture  inves7ng  ul7mately  le\  us  
with  sixty-­‐nine  funds  (78  percent)  that  did  not  achieve  returns  sufficient  to  reward  us  for  pa7ent,  
expensive,  long-­‐term  inves7ng.”  (hPp://www.kauffman.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  first  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