Spencer P. Cavalier, CFA, Co-Head Downstream Energy & Convenience Retail Group and John T. Mickelinc, Senior Analyst

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Introduction
In this issue of Capital Markets Perspective©, we explore how certain human psychological tendencies affect business and investing decisions in both confident and uncertain economic times. Behavioral finance is a burgeoning field of study that, over the years, has deepened our collective understanding of why traditional finance is not a completely reliable predictor of asset prices. While the temporary disruption in our economy caused by the COVID-19 pandemic makes this topic very timely, behavioral finance and its influence on business and investing decisions has always been present, as our human tendencies affect rational decision making in all types of economic cycles.

We will apply this analysis of behavioral finance to a question we are sometimes asked by our clients: “What are some of the common leadership behaviors shared by the most successful business owners?” From having advised many highly respected and successful companies for over 30 years, during varied economic cycles, we will share our observations of behavioral traits common among the owners and executives leading these companies.

Behavioral Finance
Arguably the best approach to defining behavioral finance is to contrast it with traditional finance. Traditional finance assumes people are consistently rational and risk-averse and have complete information to make unbiased decisions. These assumptions lead to the belief that markets are efficient and prices constantly reflect fundamental value relative to risk. Thus, by being able to determine the intrinsic value of an investment relative to its risk, investors can compare investments along an “efficient frontier” of options and make an investment decision based on personal objectives of risk and return. Under traditional finance, investors seek to maximize their personal “utility” (i.e. satisfaction relative to risk), without regard to biases, emotions and other subjective matters.

Behavioral finance is the field of study of the influence of psychology on the behavior of investors and attempts to explain why people deviate from traditional finance thinking. Within behavioral finance, it is assumed that investors are not perfectly rational and self-controlled but rather psychologically influenced with somewhat normal and self-controlling tendencies. It helps us understand how human tendencies and biases affect decision making, causing assets to be priced differently than what traditional finance would predict.

Psychologist and behavioral finance expert, Dr. Daniel Crosby, with Brinker Capital, helps investors understand the intersection of the mind and markets. He has written multiple books on behavioral finance, with his most recent titled The Behavioral Investor, which examines sociological, neurological and psychological factors that influence our investment decisions. Dr. Crosby’s research states that all behavioral tendencies and risks can be categorized under four primary behavioral pillars: ego, conservatism, attention and emotion. Each is covered in more detail below:

1. Ego: This is the human tendency to seek information that agrees with our existing preconceptions that support our need to maintain our ego. In short, our egos often do not allow us to challenge our beliefs enough when making decisions. Dr. Crosby provides the example of weighing ourselves each day. If we like what the scale says the first time, we jump off quickly and go about our day. If not, we tend to step off and step back on being careful not to lean too much or put undue pressure on the scale, as our ego struggles to accept what we see.

The following are commonly referenced cognitive error terms that are included under the ego pillar:
a. Conservatism Bias: Investors form an initial opinion but fail to change that view as new information becomes available;
b. Confirmation Bias: Investors seek or distort new information to support an existing view; and,
c. Hindsight Bias: Investors have selective memory of actions or knowledge of past events, resulting in a tendency to view things as more predictable than they really are.

2. Conservatism: This is the tendency to resist change, avoid regret and to esteem things we have as more valuable than those we don’t. This tendency causes us to avoid change, and in an investment context examples include holding on to underperforming assets for too long, failing to make necessary capital improvements and investments, and failing to allocate risk properly. Dr. Crosby states that one of the reasons for this behavior is that “thinking is hard” and most people are too mentally strained to consistently overcome the required cognitive effort, adaptation, and the potential for regret and loss. He cites a study by Dr. Joel Hoomans, professor of Management and Leadership Studies at Roberts Wesleyan College, who found that most people, on average, make as many as 35,000 decisions each day. If you really tried to keep track, you would be surprised by the staggering number we actually make. The point is our brains are taxed, and we do not have the energy to consistently update our beliefs rationally. In order to conserve resources, we default to abbreviated decision making heuristics or not deciding at all and remaining with the status quo.

The following are commonly referenced cognitive error terms that are included under the conservatism pillar:
a. Anchoring Bias: Investors use heuristic (i.e. decision making) experience based on the trial and error rule to incorrectly weigh probabilities of likely outcomes. Changes are made based on the initial view and therefore are inadequate;
b. Endowment Bias: Investors believe an asset is special and more valuable simply because it is already owned;
c. Loss-Aversion Bias: Investors feel more pain from a loss than pleasure from a gain; and,
d. Regret-Aversion Bias: Investors do nothing out of excess fear that actions could be wrong. Action creates feelings of culpability requiring one to take responsibility for uncertain outcomes. A related regret-aversion form is “herding behavior” where investors go with the consensus or popular opinion and tell themselves they are not to blame if others are wrong too.

3. Attention: This is the tendency to make probability judgements based on our reliance on information that is vivid over information that is factually accurate. We have a penchant to rely on salience over math – we think in stories, not percentages. The recent sell-off in the stock market related to COVID-19 fears is a good example. The S&P 500 has generated an average annual total return (dividends and appreciation) of approximately 10% from 1926 to 2019 through all types of economic cycles; however, inevitably, investors (both retail and institutional) cash out of the market during times of fear, because they get mired in the “story” of the daily market volatility and lose focus on the long-term returns and goals. Scary or traumatic stories of market declines tend to linger in the brain longer than good news, which is more quickly released from memory. This struggle is compounded by the glut of media outlets and information available today. We have a difficult time differentiating real risk, which is the risk of permanent loss, from what Dr. Crosby calls, “the bumps and bruises along the way.” Some noise in the markets is necessary to maintain movement and provide liquidity but allowing negative noise to govern our emotions makes it nearly impossible to be a successful investor.

The following are commonly referenced cognitive error terms that are included under the attention pillar:
a. Availability Bias: Investors judge the probability of an event occurring by the ease with which examples and instances come to mind; and,
b. Base Rate Fallacy: Investors have a tendency to erroneously judge the likelihood of a situation by not considering all relevant data. Instead, investors focus more heavily on new information without acknowledging how it impacts original assumptions.

4. Emotion: This is the tendency to view enjoyable activities as less risky (and vice versa), truncate timelines to make decisions and cause us to ignore the future all for immediate gratification. Similar to the “attention pillar” outlined above, emotion leads to greater reliance on short-cut heuristics, which leads to ignoring rules, deemphasizing probability, homogenizing behavior and shifting risk perceptions. Correspondingly, investors who mire themselves in the daily movements in the value of their assets tend to allow emotion to take over.

The following are commonly referenced cognitive error terms that are included under the emotion pillar:
a. Overconfidence Bias: Investors overestimate their own intuitive ability or reasoning. It is often combined with “self-attribution bias”, where people take credit when things go well but blame others or circumstances when they fail;
b. Self-Control Bias: Investors lack self-discipline and favor immediate gratification over long-term goals; and,
c. Mental Accounting Bias: Money is treated differently depending on how it is categorized. Investors make decisions based on a category rather than an overall budget or portfolio. An interesting example of mental accounting is consumers choosing to purchase more expensive premium gasoline when gas prices fall. Instead of viewing the opportunity to save money in the context of their overall budget or having more money for other types of purchases, they choose to continue purchasing the same dollar amount of gasoline by switching to premium.

Behavioral Tendencies of Successful Industry Leaders
Companies today are geographically diverse, vary in ownership structure (private, public and cooperative), operate based on different business models, and are managed by independent entrepreneurs, families and professional executive teams. There are multiple leadership qualities and management styles exhibited by the professionals who continue to invest in and grow their companies. However, some or all of the following behavioral traits seem to be shared by the more successful leaders:
• Very stable, non-emotional demeanor, regardless of the business cycle;
• Independent, intellectually curious thinkers who are not slaves to public opinion or fads;
• Always open to change;
• Extreme ability to focus on the most important issues and ignore the noise;
• Tirelessly diligent and deliberative when making decisions;
• Surround themselves with employees and advisors who challenge their thinking;
• Willing to be aggressive based on calculated risk;
• Not afraid to lose capital on an investment, even if it means admitting to having made a poor decision in the past;
• Open to using different forms of capital (debt, equity, mezzanine, sale-leaseback, etc.) to fuel growth;
• Shares experiences and ideas with other industry leaders and absorbs the information from them to help improve their own business;
• Always strives to be on the frontier of innovation and maximize efficiencies, including analyzing unrelated and/or tangential industries for ideas and best practices;
• Regardless of the economic cycle, makes capital investments, including acquisitions, based on their company’s economic hurdle rates, potential synergies and long-term strategic plans; and,
• Built an industry reputation of being an opportunist but not a mercenary and appreciates and respects the value others have created in their enterprise.

These traits are consistent with executives who have successfully grown their companies and endured multiple economic cycles. No leader is perfect nor able to escape all of the human tendencies and biases discussed above, but most successful leaders are cognizant of the need to fight these natural tendencies in order to consistently make rational decisions. Further, not all decisions need to be unemotional and void of humanity. Leaders can show care and dignity towards employees, as well as other benevolent endeavors, such as retaining certain employees in times of crisis at the expense of the company. These leaders are good at categorizing humanity decisions from the rigor and discipline required for investment decisions.

One of the behavioral models that we discuss at Matrix is the Bailard, Biehl and Kaiser (“BB&K”) five-way model. BB&K categorizes investors into five behavioral types that lie in different quadrants on a set of axes, as depicted below in Exhibit 1. We find most of our clients have traits consistent with the “The Individualist”, but there are traits from each quadrant found in most leaders.

Conclusion
Over the years various industries have enjoyed a history of endurance, profitability and resiliency in all types of economic cycles. It is a tribute to the successful leaders who have been willing to adapt to change, invest and work diligently to build long-term viability in the market. These leaders have made many rational, long-term decisions in periods of both confidence and uncertainty. One could say that these continued successes are attributable to leaders who personify the ability to manage human tendencies described in behavioral finance that can work against successful investment and business decisions.

We look forward to your feedback and questions.

Disclaimer
The contents of this publication are presented for informational purposes only by Matrix Capital Markets Group, Inc. and MCMG Capital Advisors, Inc. (“Matrix”), and nothing contained herein is an offer to sell or a solicitation to purchase any of the securities discussed. While Matrix believes the information presented in this publication is accurate, this publication is provided “AS IS” and without warranty of any kind, either expressed or implied, including, but not limited to, the implied warranty of merchantability, fitness for a particular purpose, or non‐infringement. Matrix assumes no responsibility for errors or omissions in this presentation or other documents which may be contained in, referenced, or linked to this publication. Any recipient of this publication is expressly responsible to seek out its own professional advice with respect to the information contained herein.

About Matrix Capital Markets Group, Inc.
Founded in 1988, Matrix Capital Markets Group, Inc. is an independent, advisory focused, privately-held investment bank headquartered in Richmond, VA, with additional offices in Baltimore, MD and Chicago, IL. Matrix provides merger & acquisition and financial advisory services for privately-held, private-equity owned, and publicly traded companies, including company sales, recapitalizations, corporate carve outs, corporate recovery, management buyouts, capital raises of debt & equity, corporate valuations, fairness opinions and business consulting. Matrix serves clients in a wide range of industries, including automotive, building products, business services, consumer products, convenience retail, downstream energy, and industrial products.

References

Bailard, Thomas E., David L. Biehl, and Ronald W. Kaiser. (1986). Personal Money Management, 5th ed. Chicago: Science Research Associates.

Hastings, Justine S., Jesse M. Shapiro. (2013). Fungibility and Consumer Choice: Evidence from Commodity Price Shocks, Quarterly Journal of Economics, Oxford University Press.

Hoomans, Joel. (March 20, 2015). 35,000 Decisions: The Great Choices of Strategic Leaders, Roberts Wesleyan College Leading Edge Journal.

Kaplan Learning Management System. (2020). CFA Program Curriculum, Modules 7.1 – 9.3, Volume 2.

Snyder, Daniel. (2018). The Behavioral Investor, Harriman House.

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