Richard Thaler, a professor of behavioral science and economics at the University of Chicago Booth School of Business, is widely considered one of behavioral finance’s founding fathers (along with Daniel Kahneman and Amos Tversky). His excellent new book, “Misbehaving,” is partly a history of how the field of behavioral finance originated and developed, despite hurdles created by the financial establishment.
Don’t Dismiss EMH
Thaler also discusses some of the more common investment mistakes arising from behavioral biases, as well as a behavioral explanation for the equity risk premium puzzle. Today however, we’ll take on Thaler’s thoughts in “Misbehaving” regarding two key issues related to the efficient markets hypothesis (EMH).
First, as a descriptive model of asset markets, Thaler gives the EMH a mixed report card. Regarding the “no free lunch” component of EMH, he writes: “It’s mostly true. There are definitely anomalies … But it remains the case that most active managers fail to beat the market. Even when investors can know for sure prices are wrong, these prices can still stay wrong, or even get more wrong. This should rightly scare investors who think they are smart and want to exploit apparent mispricing. It’s possible to make money, but it’s not easy.” Thaler then concludes: “Investors who accept the EMH gospel and invest in low-cost index funds cannot be faulted for that choice.”
Second, regarding the “price is right” component of the EMH, Thaler has a much lower opinion. A basic hypothesis of behavioral finance is that, due to behavioral biases, markets make persistent mistakes in pricing securities. An example of a persistent mistake is that the market underreacts to news. In other words, both good and bad news is only slowly incorporated into prices.
A Business Built On Others’ Errors
Fuller and Thaler Asset Management was formed in 1993 to exploit such errors. In his book, Thaler states: “The fact that the firm is still in business suggests that we have either been successful at using behavioral finance to beat the market, or have been lucky, or both.” We can test that statement.
Fuller and Thaler originally offered two publicly available mutual funds based on behavioral theories: Undiscovered Managers Behavioral Growth Fund and Undiscovered Managers Behavioral Value Fund. To test Thaler’s assertion, we will compare the performance of these funds to the performance of the Dimensional Fund Advisors (DFA) U.S. Small Cap Fund and U.S. Small Cap Value Fund, respectively. (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.)
The DFA funds are managed based on the belief that markets are efficient, so stock-selection and market-timing efforts are eschewed. Thus, we have a real live test of the behavioral theory versus the efficiency of the markets. Note that J.P. Morgan acquired the behavioral-finance funds in January 2004. However, Fuller and Thaler continued on as subadvisors.
