Behavioral Finance And Indexing

June 12, 2008

 

 

Ross Miller, finance professor, State University of New York (SUNY) at Albany

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

Ross Miller, SUNY Albany (Miller): I'm not sure it tells us a lot about indexing. People tend to be shortsighted about investing. But there are behavioral anomalies. When people notice these, they tend to go away. Markets can absorb enormous amounts of irrationality. We know individuals can be irrational. And we also know that crowds can actually compensate for individual behavior. The bottom line is that when dealing with liquid securities, it's difficult to beat an index in risk-adjusted terms. In contrast, the analysis of behavioral influences might not be the best measure to explain what happens in illiquid markets. But at least it's something to consider.

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

Miller: No. 1 is timing. People try to time markets. A lot of people who should be investors act like traders. If you have a 20- to 30-year time horizon, you shouldn't be trading your retirement money. There's evidence that people get sucked into bubbles. Mutual funds tend to suck in money while they're going up. Then people bail out when those same funds start going down. People get scared and they have trouble dealing with longer time horizons.

Aside from fear, there's greed. These characteristics do manifest themselves in the markets and they are behavioral in nature.

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

Miller: What's interesting is investor education. It's not so much being inadequate as much as it is a terribly difficult task. The typical person has a big challenge in becoming an educated investor. And there are much more important problems than training individual investors to avoid behavioral anomalies.

It probably doesn't help to have computer programs like Quicken. The front page of Quicken includes a day-by-day breakdown of what people are worth. I don't know if most people really need to know their net worth down to the exact penny at all times, but that's the way the world is these days. You can set it up to update you throughout the day. It's quite amusing, but it's also potentially very dangerous.

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

Miller: Probably because the higher profit alternatives are more aggressively marketed. Even primarily indexing companies such as Vanguard offer a wide array of actively managed products. So you can hear John Bogle preaching the value of passive investing, but at the same time, Vanguard caters to everyone. If they had that strong a belief in indexing, they'd be purely indexing.

That gets back to one of the behavioral aspects marketers play on. Even though active management is statistically a bad bet, marketing plays to individual optimism. In other words, people overestimate their abilities to pick stocks and money managers. If you're in a 401(k) plan that only has active alternatives, then there's no way you're going to be putting money into passive alternatives. And the reason why those 401(k) plans don't have index alternatives is because marketing people have sold the plan's advisors on the attributes of active management.

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

Miller: While there are advisors who operate in that manner to generate alpha, probably highly quantitative hedge fund managers are more efficiently finding the same anomalies. They're finding those anomalies by studying patterns of returns over different time periods. It gives you a broader range of anomalies to draw on. Then, you can use a behavioral aspect to explain those gaps in the market. Computers just provide a more valuable tool to harvest all sorts of data over longer ranges of time.

Perhaps 25 years ago, behavioral approaches were seen as being more effective. In today's market, most hedge funds are populated by quant-based analysts rather than behavioral-based analysts. Increasingly, behavioral analysis is becoming a secondary means to explain market anomalies. Where behavioral science might come more into play with hedge funds these days is less in studying markets and more in psychoanalyzing and monitoring their own traders.

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