Behavioral Finance And Indexing

June 12, 2008


 Behavioral finance has been making headlines lately, and with such attention comes a renewed focus on indexing.
How so?

Because if investors were rational, they'd index. And we know that the majority of investors don't index.

As William Bernstein wrote in his classic book, The Four Pillars of Investing: ''The major premise of economics is that investors are rational and will always behave in their own self-interest. There's only one problem. It isn't true.''

Murray Coleman, managing editor of and director of research for Index Publications LLC, spoke with seven leading academics and practitioners to find out what the latest research into behavioral finance can tell us about investors and indexing.

Ed McRedmond, executive vice president of portfolio strategies, Invesco PowerShares

Journal of Indexes (JoI): What does behavioral finance tell us about investing and indexing?

Ed McRedmond, Invesco PowerShares (McRedmond): I discussed this topic with my colleagues here at Invesco PowerShares, along with John West at Research Affiliates, and it's our collective opinion that behavioral finance may explain the collective lack of rationality and consistency with which we reach our investment decisions.

Much of modern finance theory rests upon the assumption that investors make rational, well-informed decisions based solely upon a consistent view of risk and reward. However, inconsistencies and irrational behavior are embedded into human economic behavior—consider buying a lottery ticket and an insurance policy with the same paycheck! Behavioral finance experiments and research have confirmed many cognitive errors—behaviors that contradict the standard assumptions of rationality but are part of human nature. These lead to errors in the pricing of assets.

JoI: What are the biggest mistakes investors make from a behavioral standpoint?

McRedmond: Some common cognitive errors appear to be:

  1. Loss Aversion: Most investors are loss-averse; that is, the pain they feel from a 10 percent loss is much greater than the rush and excitement received over a 10 percent gain. Because of this asymmetrical relationship, investors tend to change their risk tolerances. As a result, their asset allocations and portfolio structures move to more-conservative postures during down periods and volatile market sell-offs, while sustained or dramatic up markets produce more-aggressive portfolio adjustments. Reversion to the mean typically implies that such moves produce disappointing results. This may explain why some of the world's most successful investors are contrarians—being comfortable and following the crowd is rarely profitable over the long term.
  2. Herd Mentality: Underperforming managers find it far easier to review top holdings in exciting and recently successful growth companies than underperforming stocks with their host of negative publicity. There's an old saying among portfolio managers that ''you never get fired for holding IBM.'' Many clients and advisors seem to agree and find it far more palatable to fail conventionally while following the crowd than striving to exceed unconventionally. This dynamic tends to overprice stocks that have done well recently and are expected to continue doing so in the future. This often leads popular stocks to become overvalued and distressed names to be undervalued, thus explaining the value effect.
  3. Law of Small Numbers: A short performance stretch, such as a quarter or year, by itself, reveals little about a manager's skill or the attractiveness of a sector or industry. However, investors place a large emphasis on the recent past and tend to extrapolate it well into the future in forming investment decisions. This often explains why mutual fund investors dramatically underperform mutual funds. The recent past causes ''returns-chasing'' behavior—investing by looking in the rearview mirror—a game that can be very costly when the latest investing fad inevitably reverses.

JoI: Is behavioral finance being used to justify poor investment decisions and a lack of education?

McRedmond: Behavioral finance helps to explain, not justify, poor investment decision making. We would like to believe that humans are all rational and optimize solely on risk and reward, but this simple assumption gets very cloudy when you add in fear, greed, overconfidence, career risk and different measures of investment success. A lack of education may be a source, but in all likelihood our collective irrational and poor decision making is more likely the result of evolution, not education. Our caveman ancestors had to be loss-averse! A big gain wasn't worth the potential of a big loss when that ''loss'' might mean death.

JoI: If indexing is proven to provide the best odds for long-term success, why don't more investors index?

McRedmond: Index funds comprise roughly 20 percent of the U.S. stock market. Surprisingly, this figure hasn't really budged much in recent years despite overwhelming evidence of their long-term outperformance in many categories. The relatively small adoption of index funds seems to confirm that investors don't make rational decisions.

Overconfidence, greed and large fund company marketing budgets convince most investors that they can beat the market (hence the often-heard statement that most investments are ''sold not bought.'') After all, who among us doesn't believe that we are above average, either in terms of our athletic abilities or our investment abilities?

JoI: Can active managers use behavioral insights to outperform the market?

McRedmond: We believe so. The last 10 years have seen a variety of firms whose whole philosophy of outperformance is based upon behavioral finance, and these managers have shown some success. The historical outperformance of value managers versus growth managers would also seem to support this.

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