Despite the large and growing body of research on behavioral finance and its role in the investment process, convincing most investment professionals of the merits of behavioral finance is still an uphill battle, according to Ralf Scherschmidt, portfolio manager of the $100 million Oberweis International Opportunities Fund.
"In the conversations we have with investment advisors, pension consultants and the like, there is still a resistance toward behavioral finance," says Scherschmidt.
That's because most investment professionals still hold tight to the efficient market theory. To them, the notion of human psychology and the idea that "humans actually behave like humans" remains a moot point, Scherschmidt says.
Scherschmidt, though, is a strong proponent of behavioral finance, despite the resistance he continues to face in convincing investment advisors and others of its importance, and his investment decisions rely in large part on insights gained from the discipline. He strongly believes that understanding human psychology is key to finding good investment opportunities, and the first stage of his investment process is based on the principles of behavioral finance, focusing specifically on the delayed reaction of the market to sudden changes in a company's fundamentals.
"One of the strongest traits of the human brain is to stick with established beliefs," Scherschmidt says. "Humans do not like change and they don't like to change their beliefs. We take advantage of this in our investment process.
Scherschmidt has seen it happen time and time again that when a company's fundamentals improve suddenly and significantly, leading to an increase in earnings that surprise the market, investors often struggle to immediately accept the change as they are biased by their previous estimates. His investment approach takes advantage of this "delayed reaction" behavior by buying the company's stock before other investors adjust their prior expectations to reflect the new fundamentals, which then usually leads to higher stock prices.
"There is almost always a delayed share price reaction to an increase in earnings because people tend not to believe that the company is earning more and they need a number of data points to overcome the hurdle and change their beliefs," he says. "By the time people have the confirmatory evidence they need to understand the change that's resulted in an earnings increase and change their belief about the company, we are already ahead."
