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Michaud vs. behavioral finance

For work, Dick Michaud develops quantitative investing tools at his Boston-based money management consulting shop, New Frontier Advisors.

For work, Dick Michaud develops quantitative investing tools at his Boston-based money management consulting shop, New Frontier Advisors.

By Hal Lux
May 2002
Institutional Investor Magazine

For fun, he wages a one-man crusade against the trendy academic discipline of behavioral finance.

In the past year the veteran quant analyst has inveighed against what he sees as pseudo-science at conferences and meetings from Cape Town to London to San Francisco. Last month he brought his campaign to New York.

In a speech to the New York Society of Security Analysts titled "The Behavioral Finance Hoax," Michaud ridiculed the behavioralists, contention that quirks in the market can be attributed to irrational human psychology. Behavioral finance principles ,including the notion that people irrationally hold on to falling stocks because they are attached to the original price they paid , are now widely cited among investment theorists and practitioners. In recent years such prominent behavioral finance academics as Richard Thaler of the University of Chicago and Josef Lakonishok of the University of Illinois have launched money management operations that attempt to predict market moves in part with behavioral finance insights.

Michaud says it's behavioral finance, not investor psychology, that is nutty: "Behavioral finance is something that has been promoted by a lot of academics. But there's no evidence supporting these hypotheses. I think these ideas are dangerous to investors and detrimental to the investment community."

Like many self-styled debunkers of popular theories, Michaud is a scientist at heart. A former head of equity analytics at Merrill Lynch, with a Ph.D. in mathematics, Michaud spends much of his time adapting the statistical techniques known as Bayes methods, which optimize available data before it is used for analysis. "I,m a Bayesian," Michaud told his lunchtime crowd of analysts last month, referring to 18th-century British parson Thomas Bayes, who developed the techniques. "I,ve always been a Bayesian."

Mixing rigorous finance research with his own flair for hyperbole, Michaud dismisses the idea that any financial behavior is driven by the irrational; furthermore, he suggests that such dramatic claims are often accompanied by a lack of academic rigor.

He argues that ma-ny examples of so-called irrational financial decision making are not irrational at all. For instance, some behavioral finance academics say that investors stay dangerously concentrated in a few stocks because of irrational impulses. In reality, says Michaud, people may not diversify because of their limited knowledge. "Not everyone has a Bloomberg [terminal] on their desk," he says. "Most people only know two or three stocks. Closely examined, many of these ,crazy behaviors, are quite rational."

Not surprisingly, behavioralists don,t take too kindly to Michaud's attacks. "I would like to hear a conversation between him and some employees who lost all their money investing in only their company stock," says University of Chicago professor Thaler, who has heard Michaud speak. "Every economist I know thinks it violates every principle of rational investing to put all of your money into your company's stock , yet people do it. If investors don,t have complete information, wouldn,t the rational strategy be to admit it and invest in readily available index funds?"

Adds University of Illinois professor Lakonishok, who has not heard Michaud's attacks: "So he's saying that investors are not irrational , they,re stupid? You don,t need a whole brain to know to diversify. Just half a brain."

Michaud, meanwhile, objects to behavioral finance on practical as well as philosophical grounds. "These ideas are excuses for poor performance and a way of repackaging investment ideas. Eventually, these strategies won,t work, and the net effect will be a pox on everyone."

Not if Michaud can help it. He's determined to get his message across. He says, "I,m going to give four two-hour talks on the subject in Boston in the fall."