Case Study: J.P. Morgan Behavioral Funds
Order ID 53563633773 Type Essay Writer Level Masters Style APA Sources/References 4 Perfect Number of Pages to Order 5-10 Pages
J.P. Morgan offers mutual funds that aim to take advantage of behavioral biases. In this case study, you’ll first learn more about one and another fund before answering questions at the end.
The behavioral finance approach at JP Morgan began in London in 1992. Even in 2006, non-U.S. behavioral finance products accounted for two-thirds of the $76 billion AUM. stocks. Jonathan Golub has been named the lead CPM for retail products in the United States, including behavioral finance funds. Golub presented his thoughts on broad capital market trends and comprehensive details on JP Morgan’s investment procedure at investment conferences and conference calls.
Traditional finance theory assumed that investors were rational, or that if they weren’t, knowledgeable investors would trade aggressively, forcing stocks to be valued appropriately. In the 1960s, Eugene Fama made a compelling argument, and by the late 1970s, it had established academic orthodoxy.8 The early 1980s marked a turning point. Anomalies in stock prices and a new behavioral finance theory evolved, based on Daniel Kahneman and Amos Tversy’s psychology, for which they shared the Nobel Prize in Economics in 2002. Robert Shiller and Richard Thaler’s early contributions threw doubt on Fama’s efficient markets hypothesis.
1 Behavioral finance pioneers included Robert Shiller, who argued that stock prices were overly volatile given fundamental realizations, and Werner DeBondt and Richard Thaler, who demonstrated that individual equities tended to mean revert.
2 Early models of the limits of arbitrage were established by Bradford De Long, Andrei Shleifer, Lawrence Summers, and Robert Waldmann, which served to explain why educated investors had a limited appetite for correcting mispricing. Real arbitrage, unlike traditional finance models, had costs and dangers that rational investors were not always prepared to endure.
Rolf Banz demonstrated that small stocks tend to outperform large stocks; Sanjoy Basu discovered that stocks with low valuation ratios, such as the price-to-earnings ratio, also tended to outperform; and Victor Bernard and Jacob Thomas extended early work by Ray Ball showing that the prices of stocks with earnings surprises tend to outperform. The significance of these empirical findings is still a point of contention. Some claimed that these traits represented mispricing and so underlying behavioral biases, while others claimed that they were proxies for corporate risk.
These inconsistencies are obvious, according to Golub. Risk cannot explain this outperformance, thus something else must be at play, according to the analysis. That something, we believe, is the market’s combined impact of human psychological biases.
JP Morgan emphasized two behavioral biases: overconfidence and loss aversion, based on academic studies in psychology and behavioral finance. Both were ubiquitous and persistent in affecting investing decisions, according to Complin and Silvio Tarca, the primary portfolio manager of the Intrepid funds, and important to explaining the occurrence of value and momentum anomalies. Each bias was based on psychological principles, with implications for financial decisions and stock prices. Of course, other biases play a role in financial decisions, and Chambers had employed a broader set of them in promoting the Intrepid funds at times. (For one-page descriptions of recency and anchoring, see Exhibits 7 and 8.) However, Complin and Tarca claimed that overconfidence and loss aversion were the most powerful effects on stock prices.
In his marketing materials, Chambers defined overconfidence as the tendency for people to overestimate their own abilities. He cited poll results showing that more than 80% of drivers believe they are better than average.
When it comes to investing, people assume that each move they make will be better than it actually is, according to Complin. This results in more decisions (and thus trading) and a predisposition to chase winning stocks for short-term gains. This is the polar opposite of value investing, which is a long-term, slow-burn strategy. Overconfident people have a hard time being systematic value investors, especially when value appears to be failing. As a result, they miss out on value stocks’ long-term tendency to undergo significant mean reversions and outperform for protracted periods.
Our strategy, which drives our funds to overweight value equities routinely, has transformed our investment habit. We’re forced to concentrate on out-of-favor stocks that we wouldn’t normally consider, which means we can’t fall into the same overconfidence trap.
Loss aversion, according to Chambers, is the inclination for people to seek pride and avoid regret in their decisions. He cited a research that demonstrated the disposition effect: individual investors were twice as likely to sell winning positions stocks that had increased in value as losers in a big sample.
Complin continued, ”
When you acquire a stock and it rises in value, it’s easy to sell it since you’re simply taking profits a psychologically simple decision. If your stock plummets,
In particular, a JP Morgan study found that buying the cheapest stocks (defined as the bottom 10% of a universe of 3000 stocks sorted by price-to-sales ratio) at the start of each year and holding them in equal proportions for a year produced an average annual return of 15.8 percent over the 55-year period ending in 2005. The average annual return on a strategy of buying the most costly equities in the same way was only 2.8 percent. Similarly, investing in the best performers over the previous year returned 15.2 percent, while investing in the worst performers only returned 3.4 percent.
The data spans the years 1951 through 2005. The findings were weighted evenly across stocks within each decile portfolio and did not account for trading costs.
When you acquire a stock and it rises in value, it’s easy to sell it since you’re simply taking profits a psychologically simple decision. If your stock falls in value, however, selling it is an irreversible admission that you made a mistake. The disposition effect has the effect of slowing the movement of stocks in either direction in markets. As the efficient market theory would have you think, stocks do not immediately establish a new price justified by the information they have just released. It takes time for them to arrive. That is why momentum investing is effective. Our strategy necessitates a systematic shift in momentum, which forces us to keep our wins and cut our losers. It also forces our investors to reconsider stocks that have performed well in the past but are now beginning to disappoint.
JP Morgan’s investment theory, based on both facts and psychological insights, held that these long-term market effects were the direct outcome of the collective impact of human behavioral biases on the markets. Complin summed up:
Nothing but human behavioral biases, we believe, can explain why value and momentum stocks have outperformed for the past 55 years, and certainly longer if we had the data. At this level of psychology, human conduct does not change. The basic propensity to be overconfident, to seek pride, and to avoid regret existed 50 years ago and will continue to exist in the future. In theory, this indicates that we will continue to outperform in 50 years if we do not change our investment methodology.
JP Morgan’s behavioral finance products had drawn new assets at a quick rate in the three years from its launch in the United States in 2003. Since 1992, when it provided an early retail product in the United Kingdom, JP Morgan’s Asset Management unit had been a pioneer in what it called “Behavioral Investing.”2 In the late 1990s, JP Morgan offered a wider choice of mutual funds in the United Kingdom. It began to concentrate its efforts on the larger U.S. market after exiting Asia and Europe.
On the investing side, Chris Complin, global chief investment officer (CIO) for behavioral finance products, had all five new products in the top 20% of their Lipper categories.3 This validated a concept that had been successfully implemented internationally. Richard Chambers, the chief of U.S. and European marketing for the Asset Management unit, had given investor psychology a prominent role in the branding of the new funds. The idea that JP Morgan’s investment managers may profit from well-documented behavioral biases seemed to appeal with retail investors.
Now we’ll look at a newspaper item from the Wall Street Journal.
His J.P. Morgan Intrepid Value Fund (ticker: JIVAX) employs a combination of quantitative and behavioral methodologies to identify undervalued stocks that investors avoid because they act irrationally or ignore opportunities for short-term gains.
Mr. Blum is the chief investment officer of J.P. Morgan’s behavioral finance department in the United States. Morgan manages a collection of funds that try to break out from Wall Street’s herd mentality.
According to him, markets aren’t rational, and investors’ judgments are based on emotions rather than facts. “That illogical propensity becomes magnified when it comes to danger,” Mr. Blum added.
Take Macy’s, for example, said J.P. “I’ve heard it all: department shops don’t have a reason to exist, they go out of business; the management is poor; they made disastrous purchases,” says Morgan Funds client portfolio manager Theodore Dimig.
“The bears may be right in the long term,” Mr. Dimig added, but Macy’s current market valuation is “absurd.” “That’s how you make money,” says the narrator.
Mr. Blum said banking companies have a lot of potential, but he cautioned that the sector is “a little risky.
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