The Cognitive Alpha™ Approach
- Published: 17 May 2016
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The Next Big Leap After Smart Beta:
For the past 12 years Perth Leadership Institute has been developing a formal model that links individual financial behaviors to financial outcomes including its impact on corporate profitability and valuation outcomes. Although the company has been in existence for a long time, it has only just introduced its research and model to the financial and investment community since for all of its existence it has operated in the executive and leadership development area.
Perth has termed its proprietary approach “Cognitive Alpha™”. The name derives from the cognitive biases that collectively drive financial behaviors. “Cognitive Alpha™” refers to buy-side investment activities that are based on a behavioral finance framework. By “behavioral finance” framework, we refer to a model that is based on the behaviors of management teams that are driven by cognitive biases innate to those leaders and teams. The Perth Leadership Institute has developed a Cognitive Alpha™ model that is based on just two cognitive biases that have been treated in a highly proprietary manner. However this basic model has been published and its broad scope is transparent, even though the techniques and algorithms used to apply it are not.
Perth’s Cognitive Alpha™ model is based on a behavioral finance paradigm but is significantly more advanced than current models. The model allows us to predict actual income statements that will result from a leader’s or a management teams financial behaviors. We can do this since we have developed formal psychometric assessments that provide the right behavioral information and we have models and algorithms that link this behavioral information to financial outcomes. We can derive these results even if an individual or a team does not do the assessments.
Behaviors are leading indicators of performance. This overcomes the insurmountable problem that financial metrics are lagging indicators of performance. Our model results in a revolutionary new way of approaching investment performance. In fact you can use management behaviors as a way of predicting future valuation.
This means that financial behaviors can be used as a new approach to areas such as credit ratings, equity price prediction, asset allocation and portfolio management. Thus Perth’s Cognitive Alpha™ model provides a totally new approach to active management of equities which addresses the loss of confidence in current investing tools which has led to a majority of investment funds now being put into indexes and ETFs. Perth’s Cognitive Alpha™ model aims to revive active investing by using a new and innovative model that addresses the problems in traditional investment approaches.
Who is Perth’s target market?
Our target market for Cognitive Alpha™ is companies who want to revive active investment by using innovative new techniques. This includes pension and mutual funds, hedge funds, rating companies, and companies advising on M&A. In the short-term we are particularly targeted to private equity portfolios in order to conduct custom research on the management of individual companies and on the predicted profitability and valuation portfolios of companies.
What makes Perth different from other firms in the same space?
Of course everyone in a young company says they have no competition. But we can honestly say that there is no-one in the investing space anywhere in the world who has developed anything that is similar to Cognitive Alpha™ – that is, a formal link between financial behaviors and financial and investment outcomes that can be demonstrated in a real income statement, based on a formal psychometric model. We call this particular product a “behavioral ProForma®” (“BeForm”). A BeForm is a predicted income statement for a company where the driving metrics are behavioral rather than financial although industry metrics are used for norming purposes. Globally this product is totally unique. BeForm is a crucial component in Cognitive Alpha™.
There are of course many companies that have psychometric assessments who claim to be able to predict leadership success. However that is not the same as financial and valuation success. And none of these assessments – personality, competency and emotional intelligence assessments was designed from the get-go to predict directly financial and profitability outcomes based on measurable psychometrics that do just that.
There are also some companies that conduct due diligence on CEO candidates. However other than those that are doing criminal background checks (maybe the majority) these use qualitative approaches based on the intuition and knowledge of individual consultants. They have no formal framework either like Cognitive Alpha™ or anything else that results in quantitative predictions of profitability and valuation outcomes. They are probably valuable but not repeatable.