Thursday, August 06, 2015

Behavioral economics

Behavioral economics should have been a boon for active investment management. The argument for stock market efficiency and, therefore, for the superiority of index funds came from traditional economics, which treated each investor as a fully rational party. When behavioral economics showed that rationality assumption to be a fiction, with investors subject to a variety of decision-making biases, the claim for active management should have been vindicated. In a marketplace of blind participants, one-eyed professionals figured to be king.

The early research supported that notion. To the astonishment of efficient-market theorists--Eugene Fama was so surprised that he had a graduate student double-check the numbers because he doubted their accuracy--Werner De Bondt and Richard Thaler discovered in 1985 that a very simple plan of buying the stocks with the worst 36-month returns and then holding them for the next 36 months had generated outsized gains over the previous six decades. Such results could not be explained by the efficient-market hypothesis. But they could come from irrational investor overreaction, as predicted by the behavioral economists.

The opportunity for professional managers, it seemed, was immense. If the mindless tactic of buying a basket of losers could comfortably beat the S&P 500, then surely a mindful tactic, informed by a brilliant, trained expert, could absolutely thrash the overall market. Reliably. Consistently. Again and again.

We all know how that has played out. As behavioral economics has grown in popularity, becoming a mainstream academic pursuit and earning Daniel Kahneman a Nobel Prize (an award he would have shared with co-author Amos Tversky, had Tversky been alive), the performance of active portfolio managers has declined. Meanwhile, once-tiny Vanguard has become by far the largest fund company on the globe, mostly courtesy of its index funds. The behavioral-economics boost was no boost at all.

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All that said, I think that behavioral research does suggest a couple of fruitful investment paths.

One is to use mechanical approaches. According to Kahneman, using a simple algorithm often yields better results than relying on the individual judgment of subject-matter experts. He cites as an example the Apgar test for judging a newborn baby’s health--a simple checklist, capable of being used by various medical staff, that replaced a doctor’s personal evaluation. The adoption of the test proved “an important contribution to reducing infant mortality” because the gain in consistency from using an universal system outweighed the loss of losing personal insights.

The obvious candidates are strategic-beta funds, which mechanize active management’s strategies. Value, momentum, low volatility ... if an attribute appears to offer investment merit and is used as a screen or input by active managers, then it can be converted into a rule (or set of rules) that governs a strategic-beta fund. As with the Apgar test, much complexity is shed when moving from the experts to a rules system. But perhaps the benefit of consistency is worth the trade-off--particularly as strategic-beta funds usually have lower expense ratios.

The other opportunity lies in opting out of the game. Let others pummel each other over the gains to be made from short- to intermediate-term decisions. Whether won by the savviest of the active managers or via smart beta, those prizes will be difficult to obtain, with so many people chasing the same trades. Instead, stand and wait. Buy securities that for some reason--liquidity is one possibility, but there are others--are unattractive to those with shorter horizons but that may deliver above-market returns over the long haul.

This, of course, is the approach followed by the world’s most successful investment fund: Berkshire Hathaway (BRK.A). Its disciple, Sequoia Fund (SEQUX), has also fared well, beating just about every single one of its mutual fund peers over the past several decades. Both securities thrive by buying when others are disinterested. Behavioral researchers point out that most people who are making decisions don’t think much about what others are doing, with the result that they unwittingly land in a crowd when they arrive at the same conclusions as the rest of the mob. Berkshire and Sequoia don’t have that problem. They recognize what others have done, and they step the other way.

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