Behavioral Finance And Indexing

June 12, 2008



William Bernstein, author; co-principal, Efficient Frontier Advisors

JoI: What does behavioral finance tell us about investing and indexing?

William Bernstein, Efficient Frontier Advisors (Bernstein): It explains exactly why the average investor underperforms the market, and why the average mutual fund investor underperforms the funds she owns. Human behavior was shaped in the struggle for survival in the savannas of Africa, and the instincts we honed there were of tremendous value in a state of nature. Unfortunately, they are death in the financial markets.

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

Bernstein: The list is so long, and the mistakes so profound, that it's almost impossible to pick just a few. But if I had to, the list would contain these two:

  1. Recency: This relates to the belief that the past five years' return of an asset class predicts its long-term return.
  2. Overconfidence: Most investors don't realize that the fellow on the other side of their trade most likely has the name Goldman Sachs or Warren Buffett on it. It's like playing tennis against an invisible opponent. Unfortunately, more times than not, it's the Williams sisters.

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

Bernstein: No, I don't worry about that. It is being misused as a marketing gimmick by unscrupulous money managers, if you'll allow me to use a redundant modified noun.

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

Bernstein: See my answers to the second question. The real mystery is just why both professionals and small investors think that asset management—active or passive—is so easy. No one in his right mind would walk into the cockpit of an airplane and try to fly it, or into an operating theater and open a belly. And yet they think nothing of managing their retirement assets. I've done all three, and I'm here to tell you that managing money is, in its most critical aspects (the quota of emotional discipline and quantitative ability required) even more demanding than the first two. I think that the reason for this is that unlike flying or surgery, investing seems easy—tap a few keystrokes, and hey presto, instant portfolio. It's almost as easy as turning on a chainsaw, but far more dangerous.

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

Bernstein: It all depends upon what you call ''behavioral.'' I'm a strong believer in the value premium, and I think that most, but not all of it, is behavioral. So to that extent, it does provide the active manager with tools. (Of course, it's even better to value-tilt passively.) The return kicker you get from rebalancing is also behavioral in origin.

But even if an active manager is able to generate alpha, she still has to deal with the behavioral flaws of her clients and shareholders. The generation of alpha by definition involves tilting away from the market portfolio, and that's a very noisy process. Even the most skilled active managers underperform for quite a while, and during those periods, they're likely to lose most of their investors. So even if she can overcome her own behavioral demons, she'll still get nailed by those of the folks in the backseat.

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