J.P. Morgan has mutual funds that seek to exploit behavioral biases. In this case study you will first read more about this fund and another one, and then answer questions that appear at the end.
“JP Morgan’s behavioral finance process began in 1992 in London. Even in 2006, two thirds of the $76 billion AUM in behavioral finance products was in non-U.S. stocks. Jonathan Golub took the lead CPM role for U.S. retail products, including the behavioral finance funds. At investment conferences and in conference calls, Golub offered his views on broad capital market trends and gave detailed information on the investment process at JP Morgan.
Investment Philosophy: Traditional finance theory held that investors were rational, or if they were not, that sophisticated investors would trade aggressively and force stocks to be accurately priced. Eugene Fama made this argument persuasively in the 1960s and, by the late 1970s, it had become academic orthodoxy.8 The early 1980s marked a turning point. Anomalies in stock prices and a new behavioral finance theory emerged, built on the psychology of Daniel Kahneman and Amos Tversy, whose collaborative work earned the 2002 Nobel Prize. Early contributions by Robert Shiller and Richard Thaler cast doubt on Fama’s efficient markets hypothesis.
1 Early contributions to behavioral finance included: Robert Shiller, who argued that stock prices were too volatile given realizations of fundamentals; and Werner DeBondt and Richard Thaler showed that individual stocks tended to mean revert.
2 Bradford De Long, Andrei Shleifer, Lawrence Summers, and Robert Waldmann developed early models of the limits to arbitrage, which helped to explain why sophisticated investors had a limited appetite for correcting mispricing. Unlike in traditional finance models, real arbitrage involved costs and risks that rational investors were sometimes unwilling to bear.
3 Prominent contributions to academic research on efficient market anomalies included: Rolf Banz showed that small stocks tend to outperform large stocks; Sanjoy Basu found that stocks with low valuation ratios, like the ratio of price to earnings, also tended to outperform; Victor Bernard and Jacob Thomas extended early work by Ray Ball showing that the prices of stocks with earnings surprises were likely to continue to drift upward; and Narasimhan Jegadeesh and Sheridan Titman showed the profitability of momentum strategies. The meaning of these empirical findings was still hotly debated. Some argued that these characteristics were proxies for firm risk and others maintained that they reflected mispricing, and hence underlying behavioral biases.
Golub commented: These anomalies are glaring. Analysis shows that this outperformance cannot be explained by risk, so something else must be at work. We believe that that something is the collective impact of human psychological biases on markets.
Drawing on academic research in psychology and behavioral finance, JP Morgan emphasized two behavioral biases: overconfidence and loss aversion. Complin and Silvio Tarca, the lead portfolio manager of the Intrepid funds, believed both were pervasive and persistent in influencing investing decisions and key to explaining the existence of value and momentum anomalies. Each bias was grounded in psychology, with an application to financial decisions and an implication for stock prices. Of course, there were other biases relevant to financial decisions, and at times Chambers had used a broader set in marketing the Intrepid funds. (See Exhibit 7 and Exhibit 8 for one-page summaries of recency and anchoring.) But, Complin and Tarca argued that overconfidence and loss aversion were the most powerful effects on stock prices.
Chambers defined overconfidence, in his marketing materials, as the tendency of individuals to overestimate their own ability. He pointed to surveys of drivers, for example, where more than 80% believed they were “better than average.”
Complin elaborated: When it comes to investing, people believe that each decision they make will be better than it actually is. This leads to more decisions (and hence trading) and a tendency to pursue winning stocks for short term outperformance. This is the antithesis of a long-term, slow-burn strategy like value investing. Overconfident people have great difficulty being systematic value investors, particularly when value looks like it isn’t working. This in turn means that they miss out on the persistent tendency of value stocks to undergo massive mean reversions and outperform for extended periods.
Our approach, which forces our funds to systematically overweight value stocks, means that our investment behavior is changed. We are forced to focus on out of fashion stocks that we wouldn’t naturally have bothered with and that means that we cannot fall into the same overconfidence trap.
Chambers defined loss aversion as the tendency of individuals to seek pride and avoid regret in their decisions. He pointed to a study that illustrated the disposition effect: in a large sample, individual investors were twice as likely to sell winning positions – stocks that had gone up – as losers.
When you buy a stock and it goes up, it’s easy to make the decision to sell that stock because you’re just taking profits – an easy thing to do psychologically. If your stock goes
More specifically, a JP Morgan study showed that a consistent strategy of the cheapest stocks (defined as the bottom 10% of a universe of 3000 stocks sorted on the ratio of price to sales) at the beginning of each year and holding them in equal proportions for a one year period produced an average annual return of 15.8% over the 55-year period ending in 2005. A strategy of buying the most expensive stocks in the same way produced an average annual return of only 2.8%. Likewise, buying the best performers over the previous year returned 15.2%; and buying the worst performers returned only 3.4%.
Data cover the period from 1951-2005. These results were equally weighted across stocks within each decile portfolio and did not take into account costs of trading.
When you buy a stock and it goes up, it’s easy to make the decision to sell that stock because you’re just taking profits – an easy thing to do psychologically. If your stock goes down, however, selling it represents the final, irrevocable admission that you’ve made a mistake. For markets, the consequence of the disposition effect is that the movement of stocks in either direction is slowed down. Stocks don’t immediately reach a new price warranted by the information that they have just released – as efficient market theory would have you believe. They take time to get there. That’s why momentum investing works. Our approach requires a systematic tilt to momentum, forcing us to run our winners and cut our losers. It also forces our investors to re-evaluate stocks which have done well for a long time but are now starting to disappoint.
Built on both data and insights from psychology, JP Morgan’s investment philosophy held that these long term market effects were the direct result of the collective impact of human behavioral biases on the markets. Complin summarized:
We think that nothing other than human behavioral biases can explain why value and momentum stocks have outperformed for 55 years, and probably longer if we only had the data. Human behavior at this deep psychological level doesn’t change. The basic tendency to be overconfident, to seek pride and avoid regret was there 50 years ago and it will be there in another 50 years. In theory this means that, provided we don’t change our investment process, we will still be outperforming in 50 years time.
In the three years since a 2003 launch in the United States, JP Morgan’s behavioral finance products had attracted new assets at a rapid pace. The Asset Management unit at JP Morgan had been a pioneer in what it termed “Behavioral Investing.” It had over a decade of experience since 1992 when it offered an initial retail product in the United Kingdom.2 In the late 1990s, JP Morgan offered a wider range of mutual funds in the U.K. and Europe, and began to focus its efforts on the larger U.S. market.
On the investment side, Chris Complin, chief investment officer (CIO) for behavioral finance products globally, had all five new products in the top 20% of their Lipper categories.3 This provided confirmation for a concept that been successfully applied internationally. On the business side of the Asset Management unit, Richard Chambers, the head of U.S. and European marketing, had given investor psychology a central role in the branding of the new funds. The idea that well documented behavioral biases could create opportunities for JP Morgan’s investment managers seemed to resonate with retail investors.”
We now move on to a newspaper article published in the Wall Street Journal.
His J.P. Morgan Intrepid Value Fund (trading symbol JIVAX) uses a mix of quantitative and behavioral strategies to sort out undervalued stocks that investors shun because they act irrational or overlook opportunities for short-term gains.
Mr. Blum is chief investment officer of the U.S. behavioral-finance group at J.P. Morgan Funds and manages a group of funds that aim to leave Wall Street’s herd mentality behind.
Markets aren’t rational and investors’ decisions follow emotions rather than facts, he said. “When it comes to risk, that irrational tendency becomes exaggerated,” Mr. Blum said.
Take Macy’s, said J.P. Morgan Funds client portfolio manager Theodore Dimig: “I have heard it all: department stores don’t have a reason to exist, they go out of business; the management is terrible; they made horrible acquisitions.”
“The bears may be right” in the long run, but now Macy’s market value “is absurd,” Mr. Dimig said. “That’s how you make money.”
Mr. Blum said financial stocks offer a rich picking, but he warned that the sector is “a bit of a minefield.” His fund is particularly fond of Capital One Financial and Goldman Sachs Group.
With Capital One, the market remains concerned that delinquent credit-card holders will continue to hurt profits. But the credit-card lender turned bank has substantial leverage to an economic recovery, Mr. Blum said. “The consumer doesn’t have to get back to normal for us to make a nice profit,” he said.
For Goldman Sachs, “the momentum has been fantastic,” Mr. Blum said, particularly since the fund bought the shares at around $70—they now trade at around $170.
Goldman “got hammered with the rest of the financial-services industry” but is well-managed, he said.
Overall, Mr. Blum said investors haven’t caught on to the improving economy.
“Leading economic indicators are changing to the better,” but investors still worry about unemployemt—a lagging indicator. Case in point: Nearly 80% of companies that are components of the Standard & Poor’s 500 were able to beat the average analyst earnings estimates in the third quarter because Wall Street’s earnings predictions were too timid.
As of Tuesday, J.P. Morgan Intrepid Value Fund was up 22.4% so far this year and down 7.6% over the last three years; its benchmark, the Russell 1000 Value Index, had risen 18.5% this year. The J.P. Morgan fund has a two-star Morningstar rating, mainly because of its relatively short track record since its 2005 inception.
Behavioral funds are somewhat of a niche; the LSV Value Equity Fund (LSVEX) also uses a mix of quantitative and behavioral strategies. It has three stars and is up 23% this year and down 9.4% over the last three years.
The Intrepid Value fund has $320 million under management, and the minimum investment is $1,000. Its assets have been flat this year. “To us, that’s behavioral finance at its best: People got burned on equities and they shun risk at exactly the wrong time,” Mr. Blum said. When the sentiment changes, “chances are, we may be bearish.”
Read the case study. Then answer the following questions:
1) Briefly describe the money management business of JPM.
2) Identify 3 behavioral biases that JPM hopes to exploit, and how they can be exploited to obtain superior returns?
3) The fund created by JPM to exploit these biases is described on their website.
The ticker symbol for the fund is JIVAX.
The fund was launched in 2005. What has been the return to the fund from Jan 31, 2005 to the current date? (Provide the starting price, ending price and return over the time period.)
What has been the return to the S&P 500 over the same time period? (Provide the starting price, ending price and return over the time period. S&P is an appropriate comparison as it is comprised of mid and large sized firms.)
4) What could be the reasons for the difference is performance for JIVAX and S&P 500? What suggestions would you make for improving the performance of JIVAX?
 Behavioral Finance at JP Morgan, Harvard Business School, 9 -207 -084, FEBRUARY 28 , 2007
 Bad companies can be good investments, says Christopher Blum