Even in severely volatile markets people’s behaviour doesn’t change: Rosevalley’s systematic Behavioural Finance portfolios beat market in March

The Rosevalley Funds are a series of active Australian equity funds managed on the principles of Behavioural Finance. As March unfolded with very volatile financial market movements, we were quietly wondering whether investor behaviour would be different under this severe stress, and lead to poor performance for the portfolios. Quite the opposite turned out to be the case: the portfolios outperformed by 500-600 bps for the month.

Please refer to our website (www.rosevalleyfunds.com) for more details on the portfolios and the approach. We publish a monthly newsletter that discusses the month’s market and macro developments, as well as portfolio performance and attribution. You can subscribe on the website, and access the March report here.

The Behavioural Finance approach

Classical economic theory assumes people (including investors) behave in a rational, utility-maximizing way. One outcome of this assumption is known as the Efficient Markets Hypothesis (i.e., the notion that asset prices at all times incorporate all available information about their value). However, as most market participants will tell you, in reality markets display all kinds of inefficiencies which professional investors attempt to exploit. The field of Behavioural Finance[i] has been gaining increasing support over the last 30 years as an alternative theory to the Efficient Markets Hypothesis, replacing the assumption of rational investors with empirical observations about how people actually behave. Many Investment Managers claim to use elements of Behavioural Finance in their process with no real understanding or grasp of its influence on investment outcomes. The Rosevalley funds explicitly adopts the philosophy in its process with much success.

People are prone to making suboptimal decisions and, most importantly, they do so in consistent and predictable ways. Well-known examples include Anchoring, Availability Heuristic, Loss Aversion, and many more. The result of such behaviour is deviations in asset prices (again, in largely predictable ways) compared to what the Efficient Markets Hypothesis would predict. It is these deviations that the Rosevalley Funds exploit to generate alpha.

Our research shows stock prices in Australia and in other developed financial markets over the past 30 years (the timeframe for which we have back-tested data) have behaved in a manner that is consistent with the academic literature describing Behavioural Finance.

The Rosevalley Funds

The Rosevalley Funds draw on this academic research to understand how investors behave. Rosevalley has created a portfolio construction model and has three portfolios under management that uses these insights to generate alpha in a consistent way. The three portfolios are driven by the same investment process and philosophy; the only difference across the three funds is market exposure: there is a long-only, a long-short 130/30 and a long-short 150/50 fund.

Conclusion

We are not surprised by the performance of our funds as similar results were produced during other periods of extreme market volatility in our back tested research. We believe the principles of Behavioural Finance are well founded and have a strong unwavering influence on investment outcomes. Most importantly, we believe human nature will be the same in the future as it was in the past – meaning that the model should continue to perform regardless of market circumstances.

[i] Behavioural Finance is a subset of Behavioural Economics – the study of how people actually make economic decisions. Behavioural Economics was made famous mainly by the work of Nobel-prize winning economists Richard Thaler, and his book “Nudge”, and Daniel Kahneman, and his book “Thinking, Fast and Slow”. Government units, financial services and the healthcare industry now use insights from Behavioural Economics to deliver better outcomes.