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Robert Shiller, a professor of economics at Yale University, made a prediction in 2005 that a massive bubble was developing in the housing market, and was proved right just two years later, it seemed a mortal blow for classical finance. Shiller is one of the founders of behavioral finance, a school of economics that believes that the psychological behavior of investors can have a big impact on markets. As he had done with his earlier prescient forecast of “irrational exuberance” in the stock market bubble of the late ’90s, Shiller seemed to be staging a direct attack on the Efficient Market Hypothesis (EMH), which University of Chicago economist Eugene Fama had developed three decades earlier. According to Fama, investors are always rational, and markets accurately reflect all publicly known information. In this utopian world, securities will always be appropriately priced, and no amount of analysis can result in outperformance. Shiller, for his part, vehemently disagrees.

“The Efficient Market Hypothesis is one of the most egregious errors in the history of economic thought,” he says. “It’s a half-truth.”

As Shiller suggests, the financial crisis of 2008–2009 seems to have given a major boost to behavioral finance theory, and its advocates are not shy in declaring victory. “If the argument is that people are perfectly rational, then we have won the argument,” says Dan Ariely, a professor of behavioral economics at Duke University’s Fuqua School of Business.

Yet, when the bubble burst, very few investors actually made any money from the subsequent market crash. Even funds that employ behavioral techniques to influence their investing fell sharply in 2008 along with the rest of the market. It’s true that some hedge funds made huge profits betting against subprime-mortgage-backed securities, but Richard Thaler, a professor at the Booth School of Business at the University of Chicago and a founding theorist of behavioral finance, says it’s almost impossible to earn a living making such investments.

“The world isn’t structured in a way that somebody could create a fund that will bet against bubbles when they appear, because you’d be on the sidelines a lot of the time and you’d go through really hard times,” says Thaler, who works as a principal at Fuller & Thaler Asset Management in San Mateo, California, when he isn’t teaching finance or doing academic research.

Like Thaler, the fund managers employing behavioral finance are not betting against bubbles. Instead, they believe that investors make mistakes because of cognitive and emotional biases — such as a presumption that a stock that has performed well in the past will continue to do so far into the future — that cause equity prices to either overreact or underreact to market news. It is these mispricings that behavioral finance strategies attempt to exploit.

Over the past 15 years, there has been a steady increase in the number of fund managers that are using behavioral finance concepts to select stocks and construct portfolios. One estimate is that half of the 200 listed small-cap value funds use some form of behavioral finance in selecting their portfolios. Such firms as Fuller & Thaler, Chicago-based LSV Asset Management and even fund behemoth J.P. Morgan Asset Management have deployed strategies that use behavioral concepts to select equities for their portfolios. And all of them are beating their market benchmarks over the long term.

In addition, a growing number of investment companies, ranging from Des Moines, Iowa–based Principal Global Investors to Catalpa Capital Advisors, a New York hedge fund firm headed by Joseph McAlinden, a former chief investment officer for Morgan Stanley, are using behavioral finance tools to help shape their portfolios, even if they are not the mainstay of their investment strategy.

Yet critics are dubious of behavioral claims. Ray Ball, a professor of accounting at the University of Chicago, complained recently that behavioral finance is not a theory, but merely a “collection of ideas and results” that depend for their existence on the EMH. Other critics cite the fact that behavioral finance has not produced much data to support its arguments. Fama tells Institutional Investor he still believes behavioral investing is really just another name for choosing value stocks that have a higher cost of capital, which gives them higher expected returns.

“Active managers as a whole can’t beat the market,” he says. “That’s impossible.”

Even Meir Statman, a renowned behavioral finance expert at the Leavey School of Business at Santa Clara University in California, says he doubts you can make any money investing in behavioral finance funds. “Maybe you can make money at the margins, but I doubt it very much,” Statman explains. Even if behavioral investing can earn a few basis points of alpha, he adds, that would be consumed in managers’ fees.

When Russell Fuller and Richard Thaler set up their asset management firm in 1998, Fuller, who had been chairman of the finance department at Washington State University, had already been in business five years. As an academic, Thaler had written a classic paper on why the stock market overreacts to new information, but he says he was still dubious about using behavioral finance actually to invest. He thought Fuller’s results might have been the product of luck as much as skill.

So Fuller produced what his colleague now calls “Thaler’s favorite chart.” The chart shows that, using a small-cap growth strategy, an investor can identify companies that produce consistently positive earnings revisions over a long period of time. The idea is that the market consensus incorrectly interprets positive information about a company’s profitability. That’s because analysts unconsciously make cognitive mistakes in their estimates. Fuller says his firm is able to identify these companies in four out of five cases. “What this says is, it’s working for the reason we think it does,” Thaler explains.

So how does it work? The small-cap growth strategy begins with an earnings surprise. According to Thaler’s research, if you bought every stock that had an earnings surprise, you’d actually make a little money. But Fuller & Thaler takes the strategy one step further. The firm has a portfolio manager go through earnings surprises that are likely to generate an underreaction, which means that the market’s estimates of earnings are biased on the downside and the stocks tend to be underpriced. The trick, according to Thaler, is to determine whether the source of the surprise is permanent. So, for example, if an oil company had an earnings surprise because the price of oil went up, Fuller & Thaler wouldn’t be interested, but if the company had found a more efficient way of refining oil the money manager would be.

Fuller gives this example: Analysts are expecting $1 in earnings, but a company reports $1.50. Many analysts will be slow to revise their estimate to $1.50 because of a behavioral bias, or what academics refer to as a heuristic called anchoring — the attachment to previous information. So, although analysts will eventually catch on, they will catch on slowly, maybe increasing their estimate to $1.30, and there will be a time lag before the estimate goes all the way up to $1.50. It’s that time lag that Fuller & Thaler tries to exploit.

The opposite effect is overreaction. Here, Fuller & Thaler is seeking out companies whose share prices have been beaten down by bad news about their profitability, but where the news is likely to be temporary. If their book value (total assets minus liabilities, preferred stock and intangible assets) remains constant, these equities become low price-to-book stocks, which investors normally term value stocks. Many money managers that have embraced behavioral finance use this value strategy.

Another bias commonly associated with overreaction is representativeness — using past experience to interpret new information. This is based on psychological studies that show when people suffer a long string of losses, their relative risk aversion changes. When the market thinks a stock is a dog, has always been a dog and always will be a dog, that is representativeness. But Thaler and DePaul University finance professor Werner De Bondt showed in an academic paper in 1985 that long-term losers often become future winners. Fuller & Thaler watch for information that indicates that the future earnings of some of these “dog” stocks will make positive changes. That’s when the firm buys them.

Fuller emphasizes that the investing technique is considered “judgmental” because the firm uses three portfolio managers and three analysts to look at events to see if they are correctly reflected in share prices. But they don’t perform fundamental research on the companies in question, because to do so would be to introduce their own behavioral biases. “We don’t try to forecast earnings; we don’t try to be industry experts,” says Fuller, who as president and CIO oversees the 20-person firm’s investment and research activities. “We understand in what circumstances people are likely to make mistakes given a certain type of information event.”

The decision to exclude fundamental analysis is controversial even within the behavioral finance community. Charles Lee, a professor of accounting at Stanford Graduate School of Business and a former adviser to Barclays Global Investors, says that even with a behavioral approach you need to look at fundamentals to determine the difference between price and value. “If you don’t look at fundamentals, you’re looking at market indicators and sentiment indicators,” Lee says. “Behavioral finance is trying to look for the departures and why they are happening, but you have to measure them first before you know they are happening.”

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Related Topics: behavioral finance· asset management· investment strategies· investors· psychology