Mind over matter: behavioral finance and quality investing

The early part of a new year is often when we look to take stock, re-assess, and change the way we behave. However, new year’s resolutions are not the only triggers for behavioral changes – it’s been shown that the right investment approach can tame our behavioral flaws.

From inspiring confidence to encouraging discipline, the investment style – and specifically, we believe, quality investing – can have positive effects on investor behavior and help investors to sleep better during roller-coaster days at the financial markets.

What is Quality Investing?

The aim of quality investing is to pick stocks (or other assets such as bonds) that are high quality. The question is: what really defines the quality of an asset? The characteristics that are usually used to define the quality of an asset fall into several categories such as profitability, earnings stability, capital structure, accounting quality, payout/dilution and investment level.^1&2

Investors see high quality firms as companies that have high profitability, stable earnings growth, a relatively low leverage in the capital structure (i.e. are financially stable and do not carry a lot of debt), high accounting quality, pay out more and do not issue a lot of equity and debt, and invest conservatively but steadily.

When assessing complex characteristics such as the quality of a company's financial reporting or its investment decisions, which can vary widely from sector to sector, an active approach using analyst judgements can help to add value when selecting high-quality stocks. With such characteristics it is not surprising that, particularly during negative times in the business cycle, i.e. during slowdowns and contractions, high quality stocks usually outperform stocks that are not of high quality . High quality stocks can provide drawdown protection and, historically, exhibit a lower volatility in returns compared to other investment styles.³

So, lets see how quality characteristics help investors to alleviate or at least dampen certain behavioral biases that the typical investor has, and which are well documented in a vast array of scientific empirical studies.⁴

Understanding behavioral finance

Behavioral finance involves the study of behavioral biases as they relate to investing. Behavioral biases are systematic patterns of deviation from rationality in judgment and decision-making. These biases can lead investors to make decisions that are influenced by emotions, cognitive errors, and social influences rather than purely rational analysis. And this applies to both sides of the coin, clients of funds and fund managers. Clients tend to pull out of the market at lows while fund managers sometimes losing their discipline and are overwhelmed by their own behavioral biases. So, applying a structured investment approach via quality investing can help mitigating behavioral biases.

How quality investing can help overcome behavioral biases

The quality investing process has a rigor and discipline that promotes and modifies behaviors in ways that can be beneficial to investors:

The benefits of quality

I believe that the rigor of quality investing can help investors make more rational, disciplined decisions. Think of the emotional rollercoaster that everyone who has invested in stock markets has experienced at some time:

The quality investing approach can help dampen the negative effects that the typical emotional rollercoaster has on our investment behavior. By applying a disciplined investment process based on fundamental qualitative characteristics, it helps us not to sell with the herd when the market is tanking but rather to adapt our portfolio in a continuous screening process: replacing stocks that have lost their quality characteristics with the ones that newly gained it (thereby avoiding herding behavior and loss aversion bias). This could also help to avoid becoming overconfident (next bias avoided) about stocks that performed well in the past but are lacking in certain quality characteristics and, hence, should be divested from the portfolio.

Secondly, by applying quality measures, we know that the underlying company is solidly financed, profitable and has more stable earnings than lower quality stocks, which may help to sleep well even during market downturns. This may also help to stay invested, even in harsh times, and not to engage in the typical rollercoaster behavior of selling when the market has already reached the bottom and to stay away from the market even if it is about to recover, in other words it could help to reduce recency bias.

And lastly, you do not fall prey to the lottery effect when the financial markets are turning from a sell-off into a booming period when many investors try to make-up for their former losses and put their money into high risk and high reward assets. Quality measures could keep your feet on the ground in those periods (and another bias is avoided).

The characteristics of quality investing – where stable earnings and strong fundamentals instill confidence and encourage a long-term perspective – could help investors to stay disciplined and avoid reactionary behavior. This is true for both the clients and fund managers. We believe that these disciplines are critical factors in building any successful portfolio.