Glossary of Terms

Affect Heuristic The over reliance on intuition or gut feelings when making a decision.

Agency Costs The costs associated with less than perfect alignment between the interests of the agent (e.g. company CEO) and the beneficiaries (e.g. stock holders).

Alpha A measure of risk adjusted return. As used with regards to the Cabot Behavioral Analysis, Alpha refers to the results of a four-factor risk model, where the factors include the Fama-French three factors (broad market, growth/value and large/small) plus momentum.

Analysis Period The time interval over which the Cabot Behavioral Analysis is performed.

Anchoring The common tendency for people to rely too heavily, or "anchor," on one trait or piece of information when making a decision. Often once an anchor is set there is a bias toward it as the preferred or desired result. For example, when a stock is purchased for $25 per share it is some times hard to sell it at a lower price because the owner has “anchored” the price at the purchase price.

Availability Heuristic The process of predicting outcomes based upon the vividness and emotional impact of available stimuli rather than on actual probability. For example, “xyz is a great company; their stock price today is a bargain.”

Average Holding Period The average number of months that a position is in the portfolio, as observed during the Analysis Period.

Aversion to a Sure Loss The tendency by many, when confronted with a sure loss, to accept a chance that might (a) result in a break-even or (b) cause them to lose even more.

Basis Point A basis point (bps) equals 1/100th of a percent.

Behavioral Finance The newest branch of finance, Behavioral Finance represents the integration of psychology and finance to better understand how people actually make decisions.

Behavioral Shift A change in a fund manager's investment behavior for the purpose of capturing higher performance. Behavioral Shifts generally reflect actions that are "encouraged" or "discouraged" in order to curb or eliminate non-optimizing behaviors.

Benchmark A group of stocks or portfolios whose performance is used as a reference for evaluating a portfolio’s performance. Examples of benchmarks include: the S&P 500 Index, the Wilshire 600 Index, the Frank Russell 2000 Index, a composite benchmark comprised of several indices weighted together, or the average returns of a relevant peer group of funds.

Bounded Rationality The term bounded rationality is used to designate rational choice that takes into account the cognitive limitations of both knowledge and cognitive capacity. It is concerned with the ways in which the actual decision-making process influences decisions. Regarding the management of equity portfolios, not all decisions are completely profit maximizing; some decisions reflect heuristics and other non-optimizing decision processes.

Buy The establishing or expansion of a Position.

Buy Advantage The pattern of Alpha accretion from Buys, on average. (See discussion of Impact.)

Buy Alpha The Alpha generated from a manager’s actual Buys where the Sells have been removed (i.e. assumes each Position is held for the portfolio Average Holding Period).

Conjunction Fallacy This is a logical fallacy that occurs when it is assumed that specific conditions are more probable than general ones. For example one might believe that it is more likely they will fall (a) this afternoon, getting in to or out of their car while doing errands, versus (b) at some time today.

Counter Factuals The tendency for people to frequently compare actual outcomes in life to mental simulations of what might have been. The more we can identify with the imagined outcome the greater the Counter Factual effect. For example, a passenger who misses a flight by five minutes generally experiences more regret than one who misses a flight by 60 minutes. Among investors, Counter Factuals occur when repurchasing a stock that was previously sold profitably.

Disposition Effect The Disposition Effect is the tendency to sell positions with an unrealized gain more readily than positions with an unrealized loss, all things being equal. This behavior is thought to reflect an individual’s preference to experience the positive feelings associated with winning and to avoid the unpleasant feelings associated with losing. While the academic research generally points to the Disposition Effect as a non-optimizing behavior, Cabot Research takes a different view. Our research across numerous portfolios indicates that persistent patterns of selling gains quicker or slower than losses is not predictive of financial impact. It is always necessary to analyze how the positions performed after their sale to understand if this behavior needs adjustment.

Empathy Gap The Empathy Gap refers to the difference between the way we anticipate we will behave in stressful circumstances (e.g., calm, thoughtful, fearful, anxious) and the way we actually behave when confronted with decisions in these excited states. For instance, it has been observed that some aspects of investment decision-making change radically when the fund performance is either above or below its Benchmark.

Endowment Effect The Endowment Effect is the preference for stability over change. At its roots is the dilemma that the price at which you are willing to purchase an asset is below that at which you are willing to sell. This behavior may lead to holding on to some positions far too long.

Excessive Optimism In general, people tend to overestimate how frequently they will experience favorable results and underestimate how frequently they will experience unfavorable results.

Explicit Theory A concept from Behavioral Science wherein someone’s Explicit Theory (or how they believe they behave) is at odds to their Theory-in-Practice (the way they actually behave). The differences between belief and action are often the result of decisions formed in the unconscious. For example, many managers react to Short-term Volatility, yet believe that this attribute is not part of their decision processes.

Framing This concept suggests that the decision or choice a person will make can be influenced by the way information is presented, separate from the content of the information. Studies have demonstrated that systematic reversals of preference are observed when the same problem is presented in different ways. For example, does a manager choose to sell the same positions when providing liquidity for new investments versus satisfying fund outflows?

Findings The most attractive Opportunities identified during the Cabot Behavioral Analysis are referred to as Findings. Findings are reviewed with clients and from among them specific Behavioral Shifts are chosen.

Fixed Holding Period This involves analyzing some or all positions in a portfolio as if they were all held for the same number of months, or a fixed holding period.

Heuristics These are the rules-of-thumb that we use to guide our decision making. Sometimes Heuristics are intentional, such as a stop loss (e.g. Sell a position when it declines by more than 10% of purchase price). Often, Heuristics are unintended and provoke us into behaviors whose impact is uncertain.

Holding Period The time between when a position is initiated and when it is fully liquidated.

Illusion of Control People overestimate the extent to which they can control events. This bias often leads to Excessive Optimism.

Impact Software Impact is the analytic software underlying the Cabot Behavioral Analysis. This proprietary software analyzes a fund’s Buys and Sells to uncover persistent investment behaviors. These behaviors are evaluated with regards to their positive or negative impact on fund performance. Among its output is a set of Findings which identify Behavioral Shifts which, if implemented, can significantly improve fund return and Alpha.

Impact Bias The gap between the way we expect to feel from a future event or outcome and the way we actually feel when it happens. In general, we tend to overestimate the intensity and the duration of our emotional reactions to future desirable and undesirable outcomes.

Long-term Momentum The change in the price of a stock during the previous 252 market days (one year).

Long-term Volatility The standard deviation in the monthly Volatility of a stock measured for the trailing 12 months.

Loser Within the Cabot Behavioral Analysis, a Loser is a position which on any specific day has a market value less than its cost basis.

Loss Aversion People will often choose a larger potential loss with a low probability, resulting in a higher negative expected value, rather than take a smaller certain loss. This tendency to gamble that a large loss will not happen rather than accept a small certain loss is referred to as Loss Aversion. Within the investing arena Loss Aversion can manifest itself as buying more stock in a loss position in hopes of breaking even or riding a loser down to the bottom rather than selling at a smaller loss.

Momentum The change in price for a stock over a time interval.

Opportunity As it is used within the Cabot Behavioral Analysis, Opportunity indicates the magnitude of potential improvement (basis points) and the statistical confidence that the improvement will remain available over time (P-Value).

Optimism Bias People appear to demonstrate a systematic tendency to be over-optimistic about the outcome of planned actions. Optimism bias arises in relation to estimates of costs and benefits and duration of tasks. Analysts may exhibit some level of Optimism Bias when projecting future performance for certain companies.

Over Confidence The tendency of people to over estimate their knowledge or ability. For example, when a group is asked to rank their individual driving skills most respondents (70%+) indicate they are “above average”.

P-Value This is a form of statistic that measures the likelihood that what is observed is not a random occurrence. In general, the lower the P-Value the more confidence one can have in the finding.

Peak-end Rule People judge their past experiences almost entirely on how they were at their peak (pleasant or unpleasant) and how they ended. Virtually all other information appears to be discarded, including net pleasantness or unpleasantness and how long the experience lasted. Fund managers can develop non-optimizing rules-of-thumb when market cycle evaluations are affected by the Peak-end Rule.

PEG Ratio A firm's PEG Ratio is defined as its P/E ratio divided by its expected earnings growth rate per year (actually 100x expected earnings growth rate). The premise underlying the use of PEG-based valuation is that the stocks of high-growth firms merit higher P/E ratios than the stocks of low-growth firms. Valuation based on the PEG ratio involves the product of three terms, the PEG ratio, an estimate of future earnings per share, and an estimate of expected earnings growth.

Position The total amount of a stock owned on any day.

Prospect Theory Formulated by Daniel Kahneman and Amos Tversky, Prospect Theory explains decision making involving uncertainty in the context of psychology and economics. In part, Prospect Theory offers insights into why people make non-optimizing decisions rather than only those that are profit maximizing. Prospect Theory is central to much of Behavioral Finance and is often contrasted with the more conventional Efficient Market Hypothesis and Expected Utility Theory.

Reference Point The benchmark or price used to measure gains and losses.

Representativeness People often find greater likelihood in something being true if certain descriptive qualities are representative of the desired outcome rather than focusing on the observable probability of the outcome.

Self Attribution The tendency to perceive positive outcomes as “good decisions” and to minimize or rationalize away “poor outcomes”.

Sell The reduction or full liquidation of a Position.

Sell Alpha The difference between the actual Alpha earned by a portfolio and its Buy Alpha. A negative Sell Alpha suggests that had the portfolio positions been sold at the Average Holding Period the results would have exceeded those from the decisions of the manager. In practice, a negative Sell Alpha points to clear opportunities to improve performance through improved selling.

Short-term Momentum The change in the price of a stock during the previous 21 market days (one month).

Short-term Volatility The standard deviation of the price movement of a stock over the trailing month or 21 market days.

Simulation Heuristic This heuristic suggests that people determine the likelihood of an event or outcome based on how easy it is to picture mentally. Therefore, people have greater regret for missing outcomes that had been easier to imagine (such as "… if only I had bought or sold stock xyz …") rather than when the result had been tied to some change in basic approach and, thus, less mentally accessible (such as recalibrating style, strategy or quantitative input).

Status Quo Bias This refers to people's predisposition, all other things being equal, for things to stay the same. The aversion to change appears to be related to Loss Aversion and the Endowment Effect.

Volatility The standard deviation of the price fluctuation for a stock, measured over a specific time period.

Winner Within the Cabot Behavioral Analysis, a Winner is a Position which on any specific day has a market value greater than its cost basis.