The Persistence of Behavioural Alpha

– David Wanis, October 2020

If you discovered a new truth that was inconsistent with your existing beliefs, would you change your belief or ignore the new information?

One form of behavioural alpha exists when new evidence conflicts with strongly held but incorrect beliefs, but the beliefs remain unchanged. If asset prices ultimately reflect reality, then alpha can reside in the widespread persistence of incorrect beliefs.

We observe shared articles of faith across the market that are so entrenched they are rarely questioned. Agreed knowledge feels safe but doesn’t guarantee reality. How many forecasts do market experts have to get completely wrong before we conclude their models are an unreasonable version of reality?

“What important truth do very few people agree with you on? This question sounds easy because it’s straightforward. Actually, it’s very hard to answer. It’s intellectually difficult because the knowledge that everyone is taught in school is by definition agreed upon. And it’s psychologically difficult because anyone trying to answer must say something she knows to be unpopular. Brilliant thinking is rare, but courage is in even shorter supply than genius.”

Peter Thiel, Zero to One (book) 2014

Behavioural biases in small caps

We continue to observe behavioural biases in how investors approach small caps – and some are so powerful that this behaviour is unlikely to change even when presented with compelling evidence. There are a couple of reasons for this. As mentioned above, there is a strong bias to hold onto existing beliefs, but there are other reasons. Investors are inundated with so many contrary views, blurring the lines between opinion, analysis and facts, which makes it difficult to justify updating their beliefs given so much uncertainty. In addition, as we have seen in recent US elections, reason alone can be a much weaker influencer compared to emotion when it comes to changing an existing and embedded belief.

Three examples below evoke embedded beliefs for many small cap investors;

  • Lottery stocks (belief: ten baggers)
  • Index inclusion and exclusion effects (belief: agreed source of alpha)
  • Analyst coverage in small caps (belief: agreed source of alpha)

Take for example lottery stocks. A lottery stock shares the same expected payoff as playing the lottery – a small probability of exceptional returns. Over time the expected return for repeated play of the lottery and lottery stocks is negative.

Research across time and across markets concludes that investing in listed companies with lottery like characteristics produces significantly below market returns at higher risk. Even knowing this, investors (including professionals) continue to believe that their lottery stocks are going to be the exceptions, the ten baggers. Not surprisingly these companies also elicit a strong emotional response. The greatest expected value decision to make here is not to play.

Small cap index inclusion and exclusion, as well as analyst coverage effects on stock returns are well known and often quoted, but have many investors done this research themselves? Have they critically reviewed the research done by others? Is it possible reality is also not consistent with these agreed beliefs?

Research from first principles

Doing first principles research (more than reading an article or listening to a podcast) helps to understand where beliefs come from, how robust they are and when changes in the world may challenge or render those beliefs obsolete. It can also highlight why beliefs in a particular domain (eg: large caps / macro economics / American culture) are not automatically transferrable to another (eg: small caps / micro economics / Australian culture).

There are so many narratives flying around markets that many investors are mentally fatigued from compelling cases for and against everything. One mental defense against this is to hold onto existing beliefs despite the risk of these being wrong. First principles research is desirable not for some sort of Protestant work ethic, rather as a buffer against opinion overload. Doing original research, or at least a critical and objective assessment of the issues, helps determine when beliefs should be updated.

Original research provides inoculation against noise.

An interesting test for whether your investment beliefs are truly original comes from venture capitalist Paul Graham (Y Combinator), who asked 15 years ago when searching for original start up ideas; Do you have any opinions that you would be reluctant to express in front of a group of your peers? If so, these heretical views may just contain the beginnings of enduring behavioural alpha.

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