Want higher returns? Don't take Prozac: James Saft

(James Saft is a Reuters columnist. The opinions expressed are his own)

By James Saft

LONDON (Reuters) - It's no fun at parties, but when it comes to investing being depressed just might help.

Fund managers, like so many of us, consistently think they are smarter than they are and that their ideas are of an unusually high quality. And to keep thinking these reassuring thoughts, they ignore evidence that contradicts their beliefs while paying rapt attention to data or news that confirms their own biases.

But not the depressed, whom multiple research studies have shown to have a more accurate and realistic view of their own abilities and insights, according to James Montier, a strategist at Societe Generale who specializes in behavioral finance, the study of how emotion and thinking patterns influence economics and investment.

"The depressed tend to be less optimistic," said Montier,. "And they certainly would be less prone to the chronic optimism that characterizes pretty much all of the market participants we come across."

Montier thinks that human beings have been hard-wired by evolution to have an optimistic or bullish outlook on things. While that is very useful when you need to leave the cave and hunt saber tooth tigers and the summit of your ambition is to make it to age 20 and pass your genes along, it leaves investors today with some in-built problems in analyzing company or economic prospects.

"All behavioral biases have some evolutionary reasons for existing and it's very tough to overcome those deep-rooted impulses," he said.

A survey of over 500 professional fund managers showed that 74 percent rate themselves as above average at their jobs, according to Montier, a figure that a glance at the performance tables on mutual funds will show to be, well, wildly optimistic. And investors don't just overrate themselves, they think their holdings and the stocks they cover are great too.

Some 91 percent of all stock recommendations are "buys" or "holds," and just nine percent are "sells. Even if you believe that markets tend to go up over time and that most companies are reasonably well run, some have to be preferable to others on a relative basis.

LAKE WOEBEGONE MARKETS

This in part explains a current puzzle in financial markets, which is that while analysts have shaved earnings expectations for 2008 in light of the credit crunch and economic difficulties, they are still expecting stronger growth next year.

Company analysts following S&P 500 companies are in aggregate forecasting 8.6 percent profit growth in 2008, with a sharp recovery in the second half, according to Reuters Research. According to Montier, this is because analysts identify with the companies they follow, and like the parents in Lake Woebegone, think all are above average.

"Everybody thinks their company is going to be OK, and at least half will be wrong," Montier said.

He contrasts this optimism with the mind set of the depressed, who tend to have a more accurate view of their own control. While a funk is not the answer, Montier advocates what he calls evidence based investing, where investors not only use data, but are skeptical in analyzing it and actively seek out things which contradict their beliefs.

Edinburgh-based Standard Life Investments, which controls assets of $275 billion, has adopted techniques from behavioral finance to help guide its money management.

One key concept in behavioral finance is a bias known as "conservatism," which is the natural reluctance to change an opinion even when confronted with data that suggests you should.

Standard Life uses artificial neural networks, which are algorithmic software models, to crunch data on markets and sentiment and produce market indicators and forecasts.

While these indicators can be profitable when used alone, they also act as a reality check against which analysts can benchmark their sometimes biased beliefs about where markets are heading.

"For example, if we interpret the data as negative and the neural networks interpret the same data as positive we should seriously question our own judgment!" Standard Life's global thematic strategist Frances Hudson wrote in a note outlining their efforts.

But of course, while it is easy to denigrate irrational optimism, it has to be said that it has its uses. Gloomy doomsayers have a tough time getting ahead in the world of banking and finance, even if there are some notable exceptions.

And not least, there is lots of research that indicates that optimists are happier, live longer and are more successful by most measures than their pessimistic peers, even if they do tend to overestimate the earnings power of companies when the economy is on the verge of a recession.

Take it from Montier, a well known bear, pessimism is not an easy road, even though it may be a straight one.

"Nobody likes a bear," he said. "As a career move bearishness is not a great idea, in a bull market nobody listens and in a bear market nobody will pay you."

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)