Sunday, April 22, 2012

Applied Behavioral Finance - Using Insights From Behavioral Finance in Practice

Cabot Behavioral Analysis (CBA)
Four-step methodology  that helps guide fund managers towards more profitable investment behaviors.

1. Portfolio Analyses

Insight you can act on

Cabot Behavioral Analysis (CBA) begins by analyzing the buy/sell decisions within a portfolio. The analyses then uncover persistent patterns or behaviors amongst the buys and sells. For example: Is your selling sometimes unintentionally affected by erratic price movement or changes in consensus forecasts? Do you regularly sell winners differently than losers?

CBA then computes the potential for enhanced performance associated with altering each of the behaviors identified. Can changing one or more of these behaviors add 50 bps, 100 bps, 150 bps or more to annual alpha and return? Finally, CBA computes the statistical significance and predictiveness (e.g., In Sample and Out-of-Sample testing) associated with shifting each behavior.

2. Shift Selection

Honing decisions

Cabot Behavioral Analysis then selects that group of shifts, from among all potential shifts, that provides the greatest combined expected benefit (basis points) and predictiveness (likelihood the benefit will last). The process or algorithm used begins with the very best finding or shift and then selectively adds shifts that both increase benefits and improve predictiveness. For some clients this means implementing 4 or 5 shifts at once. For others it might mean focusing on 1 or 2 shifts. The outcome is always to identify that small number of shifts that deliver the greatest benefit with the strongest statistical significance. The final shifts enable managers to address aspects of their decision-making which, when honed, will provide substantial and lasting improvement.

3. Implementation & Support

Where insight and decisions become results

You begin to capture incremental performance the first day you implement your Behavioral Shifts. And, the dividends compound every day thereafter.

Cabot Behavioral Analysis supports the implementation of your shifts with 3 daily indicators. 1. Discouraged Buys helps you improve by avoiding those buys which are shown to have persistently underperformed; this allows you to focus more energy and capital on what really works. 2. Discouraged Sells assists you in selecting which positions to let run. Capturing all the performance in your buys requires knowing where your advantage runs long and allowing those positions to deliver their full performance. 3. Favored Sells represent positions that tend to stay in your portfolio beyond their usefulness and are ready for recycling. Favored Sells point you to positions that are excellent sources of liquidity to support new buys or fund outflows.

4. Review & Improvement

Learning never ends

Cabot Behavioral Analysis (CBA) helps you manage your success with a variety of concise, intuitive reports. You can start with portfolio level measures of behavioral improvement and then drill all the way down to asset-by-asset information. You learn what you want when you want it. That way every decision you make can be well informed – putting maximum power behind your judgments.

CBA keeps you up-to-date on how daily decisions align with chosen behavioral shifts. You learn how well you are doing and how performance is improving. CBA also guides you to new shifts as the opportunities from current shifts are fully captured. You have better insight, you make better decisions, you deliver better results. 

About Cabot

Cabot helps equity fund managers improve portfolio performance. We do this through the rigorous application of Behavioral Finance. The results include a better understanding of your investment behaviors, small but decisive changes you implement to make better investment decisions, with opportunity to deliver better alpha, return an asset growth.  


Michael A. Ervolini, Chief Executive Officer

Mike has over 27 years of experience in institutional investment management and software development. Cabot Research reflects his dedication to assist investors in improving performance by enhancing decision-making with solutions that deliver impact through clarity and greater control.

Hal Haig, President

Hal is committed to providing institutional investors with effective, practical and innovative tools and techniques to drive performance. He leads Cabot Research’s development and sales

Behavioral Finance - Basic Theory
Behavioral Finance recognizes that people often make choices that "feel right" but may not be financially optimal. Research has identified broadly observable mental traps that often lead to non-optimal financial decisions. The most commonly observed traps are: heuristics (rules-of-thumb that often are untested), biases (preferences independent from facts), over confidence (learning without analytic support) and framing (choices influenced by presentation over facts).
The academic literature categorizes non-optimal decisions into specific financial behaviors. The Disposition Effect (selling winners in preference to losers), Anchoring (the tendency to hold on to previously established ideas or opinions – such as the target price for selling a stock), Contra-positive Investing (allowing previous experience with a stock to influence reinvestment) and Hindsight Bias (using memory rather than analytics to evaluate past judgments) are examples of well documented investor behaviors reflecting the mental traps above.

Suggested Readings (By Cabot)


All that Glitters: The Effect of Attention and News on the Buying Behavior of Individual and Institutional Investors
Barber, Brad M., and Terrance Odean
EFA 2005 Moscow Meetings Paper
November 2006

Boys will be boys: gender, overconfidence, and common stock investment
Barber, Brad M., and Terrance Odean
Quarterly Journal of Economics
116.1 (2001): 261-92

Once Burned, Twice Shy: How Naïve Learning and Counterfactuals Affect the Repurchase of Stocks Previously Sold
Odean, Terrance, Michel Strahilevitz, and Brad M. Barber
September 2004

Do Day Traders Make Money? Evidence from Taiwan
Barber, Brad M., Yi-Tsung Lee, and Terrence Odean
May 2004

The Disposition Effect and Momentum
Grinblatt, Mark, and Bing Han
NBER Working Paper No. W8734
January 2002

The Tyranny of Choice
Schwartz, Barry
The Chronicle of Higher Education
January 23, 2004: B6

Just How Much Do Individual Investors Lose by Trading?
Barber, Brad M., Yi-Tsung Lee, Yu-Jane Liu and Terrance Odean
AFA 2006 Boston Meetings Paper
October 2006

The Role of Social Context in Investing
Mauboussin, Mike
CSFB Research Paper
January 13, 2004

Individual Preferences, Monetary Gambles, and Stock Market Participation: A Case for Narrow Framing
Barberis, Nicholas, Ming Huang, and Richard H Thaler
American Economic Review
September 2006

A Survey of Behavioral Finance
Barberis, Nicholas, and Richard H. Thaler
September 2002


Mind over money: Behavioral research may explain why people spend and save the way they do
Gavin, Robert
Boston Globe
December 19, 2005
Story describes purpose and vision of the newly created behavioral economics center, at the Boston Federal Reserve Bank.

Mind Games: What neuroeconomics tells us about money and the brain.
Cassidy, John
New Yorker
September 18, 2006

Lessons From The Brain-Damaged Investor
Spencer, Jane
Wall Street Journal
July 21, 2005

The Testosterone Factor in Mutual Funds
Hulbert, Mark
New York Times
January 29, 2006, late ed., sec 3: 5

The Futile Pursuit of Happiness
Gertner, Jon
New York Times
September 7, 2003

Thought for thinkers: 'Follow your gut'
Cook, Gareth
Boston Globe
February 17, 2006


Advances in Behavioral Economics
Camerer, Colin F., George Loewenstein, and Matthew Rabin, eds.
New Jersey: Princeton UP, 2003

Advances in Behavioral Finance, Vol. 2
Thaler, Richard H., ed.
New York: Russell Sage, 2005

Choice, Values, and Frames
Kahneman, Daniel, and Amos Tversky, eds.
New York: Cambridge UP, 2000

Famous First Bubbles: The Fundamentals of Early Manias
Garber, Peter M.
Cambridge: MIT, 2000

Judgment Under Uncertainty: Heuristics and Biases
Kahneman, Daniel, Paul Slovic, and Amos Tversky, eds.
New York: Cambridge UP, 1982

How Customers Think: Essential Insights into the Mind of the Market
Zaltman, Gerald
Boston: Harvard Business School, 2003

Heuristics and Biases: The Psychology of Intuitive Judgment
Gilovich, Thomas, Dale Griffin, and Daniel Kahneman, eds.
New York: Cambridge UP, 2002

Rational Choice in an Uncertain World: The Psychology of Judgment and Decision Making
Hastie, Reid, and Robyn M. Dawes
Thousand Oaks, California: Sage, 2001

Social Psychology and Economics, 1st ed.
Cremer, David D., Marcel Zeelenberg, and J. Keith Murnighan, eds.
Mahwah, New Jersey: Lawrence Erlbaum, 2006



Contact Address

Cabot Research, LLC
11 Beacon Street, 10th Floor
Boston, MA 02108

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