Behavioral Finance And Indexing

June 12, 2008



David Blitzer, managing director and chairman of the Index Committee, Standard & Poor's

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

David Blitzer, Standard & Poor's (Blitzer): One of the key factors determining whether stock prices rise or fall are investors' buy/hold/sell decisions. Investors don't know the future and their decisions usually depend on a mix of rational analysis, opinions, fears, greed and wishful thinking. Behavioral finance warns us that our decisions aren't always rational and at times will reduce our profits or increase our losses. One way to reduce the impact of our irrational or emotional decisions is to invest with a simple rule: Index. This way, investors can avoid falling in love with stocks, selling winners too soon or denying the losers' existence by refusing to sell them to cut the losses. Indexing is not the only rules-based emotionless way to invest; however, it is one of the simplest ways and it does have a proven track record.

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

Blitzer: Letting any successful investment convince them that they can beat the market consistently. Someone buys a stock, it rises 10 percent and they're a winner—and a stock market genius. First, they forget that three other stocks in the same industry rose 15 percent at the same time. Then they think they can time the market for their next move. Finally, they read that indices outperform active managers two out of three times and are absolutely sure they will consistently be in that top third who always beat the market. There are some people who escape this—but they are often the ones who believe that even though they can't pick stocks, they have found a money manager who can pick stocks.

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

Blitzer: While behavioral finance may explain some poor investment decisions, it doesn't justify them. An investor who says his education is complete and that he fully understands the markets is an investor who can't or won't compare his results to the markets over the long run.

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

Blitzer: People see indexing as settling for the average result and no one wants to be ''just average.'' Further, no one wants to admit he paid too much, so when they understand that the key reason indexing outperforms active management is lower costs, they are even less likely to embrace indexing. Finally, stock markets are very complex and indexing is simple, so how could it possibly work?

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

Blitzer: Active managers, like any other investors, can use insights from behavioral finance to improve their results. In the last 10 years we have seen two massive bubbles; one in dot-com stocks and the second in housing. Understanding either requires recognizing the importance of human behavior and emotions in investing and markets. That said, simply having read or even understanding much of the behavioral finance literature would not have guaranteed selling at the peak of either bubble. Moreover, no managers always outperform the market; some do it occasionally, others do it more often; but no one does it all the time.

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