Stock selection, I believe, can also be improved by the use of behavioral tools. Empirical academic research has highlighted two types of pervasive investor behavior which impact share prices, causing them to diverge from those predicted by the Efficient Markets Hypothesis (EMH); underreaction of stock prices to news and overreaction or anchoring to a stream of good or bad news.
As an example, consider a company that has just reported a positive earnings surprise due to some fundamental improvement in its business. If EMH held, then the stock price should immediately change to the new equilibrium price where all the new information would be reflected.
However, in practice, analysts and investors will take a series of steps to fully reflect the new available information and, therefore, an investor who buys on the announcement of the news can generate a positive excess return. When a company’s fortunes change from negative to positive and vice versa, investors tend to overreact and anchor on the past. As a result, it takes time for the change to be reflected in the share price. Similar to underreaction, an investor can generate excess returns by focusing on those companies where investors anchor.
PORTFOLIO MANAGERS are, like the rest of us, flawed individuals. They tend to make behavioral mistakes despite awareness that investors are not always rational. Allianz Global Investors Capital has been working closely for the past year with Cabot Research to identify and point out inefficient behaviors to our portfolio managers. We then work with them to avoid similar behavior in the future.