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 IndexUniverse.com 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.

 

 

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.

 

 

John Prestbo, editor and executive director, Dow Jones Indexes

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

John Prestbo, Dow Jones Indexes (Prestbo): It tells us that irrationality and emotionality stand in the way of most people being able to manage their investment portfolios prudently. These people can turn this management over to professionals, except that those professionals are people too, and therefore subject to behavioral quirks. Or, they can place their portfolios in diversified indexed vehicles and reap the benefits of market returns at lower cost.

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

Prestbo: First, they follow the crowd—emphasis on follow—which means they buy high and sell low. Second, they fear loss more than they desire gain, which causes many investors to hang on to both winners and losers too long. Third, they weigh too heavily the implications drawn from small data samples or the recommendation of a single analyst.

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

Prestbo: I think it's more explanation than justification. People in all walks of life must take responsibility for their investments, just as they do their tax returns. We're making considerable progress in this regard—when I started out with The Wall Street Journal 44 years ago, most ''ordinary'' folks were totally mystified and intimidated by investing. Far fewer are bewildered today, though there's still plenty of room for improvement.

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

Prestbo: Obviously the superiority of indexing hasn't been ''proven'' to everyone's satisfaction. Ironically, one of the side effects of more and more people becoming educated about investing is that some of them will eschew indexing and take an active role. And certain people like to try beating the odds. The day that all investors index will never arrive.

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

Prestbo: One would think so, at least in theory, but so far behavioral finance seems to be an academic phenomenon rather than a real-world one. Perhaps a way of putting behavioral finance to work would be an active manager having a robust strategy and the discipline to stick with it through thick and thin.

 

 

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.

 

 

Terrance Odean, Willis H. Booth Professor of Banking and Finance, University of California at Berkeley

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

Terrance Odean, University of California at Berkeley (Odean): Due to a number of behavioral biases, many investors make systematic mistakes when buying and selling stocks. On average, the stocks they sell go on to outperform those they buy. When it comes to mutual funds, most investors focus on past performance and pay too little attention to expenses and other fees. Many investors would be far better off buying broad-based index funds or other low-cost, well-diversified mutual funds.

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

Odean: The most costly mistake made by a large number of investors is under-diversification. Many investors trade too actively. Investors also pay too little attention to trading costs and mutual fund fees. They focus too much on the one thing that they can't control—market outcomes—and too little on important factors over which they do have some control—diversification, costs and taxes.

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

Odean: I'm not sure I understand the question. The advice I give investors is to buy low-cost, well-diversified mutual funds such as index funds. I believe that that is excellent real-life advice. I occasionally suggest, tongue in cheek, that investors do the opposite of their instincts (i.e., buy the stocks they are inclined to sell and vice versa). Of course, this would be an idiotic way to extrapolate from my own research to real life.

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

Odean: I don't know if indexing provides the best odds for long-term success. I do know that it is a very good choice for most investors. People don't choose indexing for a variety of reasons. Some people are overconfident in their ability to beat the market; others are unaware of the advantages—or perhaps even the option—of indexing.

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

Odean: Yes. Individual investor behavior can affect asset prices. Active managers who have insights into that behavior and asset price dynamics could potentially profit from those insights. I doubt that many active managers currently do profit from such insights. Even if some active managers are earning profits from such insights, they may not be passing those profits on to their clients. For example, my co-authors and I found that from 1995 through 1999, institutional investors in Taiwan earned an annual alpha of approximately 1.5 percentage points after trading costs. If, on average, they charged their clients less than 1.5 percentage points in fees, then those clients are benefiting. However, if the fees averaged over 1.5 percentage points, the managers reaped all of the benefits.

 

 

Francis Kinniry, principal and senior member, Vanguard's Investment Strategy Group

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

Francis Kinniry, Vanguard (Kinniry): Behavioral finance has several implications for index investing. At one end of the spectrum, investors in broad market index funds may be more patient, cautious, deliberate and cost-conscious in their decision making, and thus tend to be more immune to the negative behavioral aspects of investing, such as overconfidence, which can manifest itself in return chasing, market timing, wholesale portfolio changes, etc. These investors don't ''follow the herd''—they own the market, invest for the long term, adhere to a buy-and-hold strategy and tend to understand the math and probabilities behind investing. Specifically, these investors understand that commitment to a strategic index asset allocation provides the highest probability for success.

At the other end of the spectrum, investors who follow or participate in a more tactical or aggressive market rotation approach or who actively engage in very narrow indexes may be more risk-tolerant, impatient and overconfident in their investing skills.

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

Kinniry: By far, the biggest mistake investors make is extrapolating recent returns as an indication of future returns. As a result, they fall into the trap of overbuying the current outperforming asset class and underowning the current underperforming asset class. (This statement does not qualify as an endorsement to underweight the winning strategy or overweight the losing strategy as others in the investment community may suggest.)

Another big mistake is investor overconfidence, or believing that you have unique information about future market changes or other advantages that no one else has. Since that is highly unlikely, it could be the reason why professional active managers on average have tended to not outperform indexes over time.

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

Kinniry: It's easy to use the concept of behavioral finance or lack of education to explain investors' decisions. However, we have seen very sophisticated, educated investment professionals fall into some of these situations over time. After all, much, if not most, of the money that trades daily in the markets is under the control of institutional and professional money managers. We must remember that investing is not a science. It is an art that takes on many forms. It is constantly changing; the future attributes that determine outcomes are highly eclectic, dynamic and extremely uncertain. This environment makes predicting or forecasting the future a great challenge.

For the nonprofessional investor, the investment decision process runs counter to most other buying decisions we may make. For example, the concept of ''you get what you pay for'' would suggest that like a good meal, quality and costs are correlated. But, obviously, this is not the case with investing. Similarly, when shopping, we might utilize services that rate the best-performing and highest-rated products. But again, this process does not work nearly as well for investment products. In fact, when comparing funds, index funds are typically rated as average, while the current winning sectors are rated high, and out-of-favor funds rated low. So, some of the concepts of behavioral finance—ill-advised decisions made on the basis of poor information, lack of understanding or the impulsiveness of trying to beat the market—also apply to individual investors.

In the end, behavioral finance is about evaluating the investing habits of people, and people—whether professionals or nonprofessionals—are capable of making rational and irrational decisions.

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

Kinniry: As in many other areas in life, we often overestimate our capabilities (i.e., we are all better-than-average drivers and our kids all have higher-than-average IQs). It is no different when it comes to investing. In many respects, our ego tricks us and limits our ability to consider that we may be average or even below average when compared with the competitive and large playing field of investment professionals. As a result, we tend to ignore proven strategies such as indexing and think that we can do a better job following other strategies.

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

Kinniry: Some managers will outperform the market, whether they use behavioral research, technical research, fundamental research, quantitative research or a combination thereof. However, the challenge facing active managers is being able to outperform the market by having information that is superior to that of all other market participants and by having very low trading friction. These are not impossible hurdles, but high hurdles. Perhaps the best chance for active management to be successful over the long run is to utilize the best of passive management: low costs, low relative friction along with their active management techniques and a talented yet humble team of sophisticated investment professionals.

 

 

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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