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Behavioural finance: Alpha emotion

Michael Ervolini, chief executive of Cabot Research, a behavioural finance adviser to investors, says that an increasing number of investment managers are beginning to analyse their buying and selling behaviour to increase returns. According to Ervolini, most managers could capture more than 100 basis points more in alpha by better understanding their behavioural tendencies.

"Over the last 10 years, risk models and portfolio optimizers have been adopted to squeeze more and more performance out of strategies. The next frontier is behavioural finance," Ervolini says. He also says institutional investors are starting to realize that selling behaviour can be a weak spot of managers, and are adding behavioural analysis to their selection check lists.

According to behavioural finance, buying and selling are different beasts and produce different emotions in managers. Buying is generally viewed as positive and fun, whereas selling is often viewed as capitulation – the reverse is true for short-sellers. "A good buyer does not necessarily a good seller make, and vice-versa," says Ervolini. "Conceptually it might be better to have the two roles carried out by two separate people."

By simply understanding the emotional patterns of buying and selling, Cabot claims managers will be in a better position to make decisions.

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