Investors’ behavior can be sooo predictable

If you give some gamblers cards and allow others to pick their own, do they value them differently? You bet. Not only are the gamblers who picked their cards twice as likely not to sell, but those who would sell would require a premium of more than four times what gamblers who were simply handed cards would require.

“This is why we do not visit with management teams of companies,” says Arnie Wood, a principal with Martingale Asset Management LP in Boston. “When you do this, there is an illusion of knowledge. Once you touch something, you tend to assign a lot more value to it.”

This is just one example of how some money managers and investors are using findings from the heretofore-nascent field of behavioral finance to run money. Although behavioral finance has been studied since the 1930s, it gained momentum after Daniel Kahneman, a psychology professor from Princeton University, won a 2002 Nobel prize for his work in economics. According to The Nobel Foundation in Sweden, “Kahneman’s findings concern decision-making under uncertainty, where he has demonstrated how human decisions may systematically depart from those predicted by standard economic theory.”

Such statements are anathema to economists. If emotion and the psychological makeup of individuals play a significant role in the outcome of markets, then economic models built on rational behavior cannot be entirely correct. Perhaps this explains the lengthy gestation period for behavioral finance: Every economist in the western world has a stake in its failure.

4 Pillars of Wisdom

Given its academic heritage, behavioral finance is not a neat, easy-to-understand body of knowledge. Mr. Wood says, however, that its practical applications can be parsed into the following four general areas: predictions and overconfidence, group behavior, risk preferences and agency theory.

For instance, regarding the first area, “investors will often make the faulty extrapolation that the future will be very much like the past, and their overconfidence in this prediction will cause them to miss obvious signs they are wrong,” according to Russ Fuller, an unapologetic behavioralist who is a principal with Fuller & Thaler Asset Management Inc. in San Mateo, Calif.

Along with other behavioral-finance precepts, Mr. Fuller and partner Richard Thaler have made hay with the tendency of other investors to be overconfident in their predictions. Net of fees, Fuller & Thaler’s small-/mid-cap-growth portfolio returned 16% to investors over the 10 years through June 30, representing an excess return of 9.4% over its benchmark, the Russell 2500 Growth Index, which returned 6.6%. The firm’s Behavioral Growth Fund, a mutual fund with $58.4 million in assets delivered an average annual return of 1.47% between yearend 1997 and midyear 2003, versus a return of -3.43% for the Russell 2500 Growth Index over the same period

For instance, Mr. Fuller notes, the firm in April 1999 started buying RARE Hospitality International Inc. (RARE), which operates steakhouses, because “the markets were going crazy, and RARE was going down in relative and absolute terms, making the stock look like a real loser.”

Investors, he says, had an incorrect bias that the Atlanta company’s stock would continue to fall. “They were so confident the future would repeat the past, they ignored information that would tell them otherwise.” Insiders were buying stock for their own account. Customer surveys were indicating that an increase in repeat visits was in the offing. Same-store sales, reported monthly, were inching up. “We bought the stock at $9 and sold in 2001 at $27,” says Mr. Fuller, adding that his firm is now completely out of RARE.

It’s Everywhere

“All value strategies are implicitly based on a simple model of investor overreaction,” says Mr. Thaler, a widely published author who teaches at the University of Chicago. But, he adds, “most value investors do not put any weight on behavioral findings.” The best example, according to Mr. Thaler, is Santa Monica, Calif.-based Dimensional Fund Advisors, which offers a small-cap-value index “but does not make any attribution about why the stocks it buys will do well.”

Parenthetically, short investors relying on behavioral finance would be putting their faith on the phenomenon of investors’ underreaction to news. As a classic example, consider investors who continued to buy the stock of Amazon.com Inc. even as quarterly losses mounted for the Seattle-based online bookseller.

Behavioral finance has its detractors. Perhaps most vocal among them is Richard Michaud, founder and principal with New Frontier Advisors LLC, a Boston firm offering portfolio optimization and asset allocation technology. Mr. Michaud, who has a doctorate in mathematics, says he also has an advanced degree in psychology, which he feels gives him an advantage over “all those people in finance who are talking about psychology.”

In short, he feels that behavioral finance is nothing more than a catch-all for things that financial professionals, academic or practicing, cannot understand. “Anything we do not understand is behavioral finance. But what a good scientist would do is spend more time trying to understand the behaviors.”

Martingale’s Mr. Wood, whose market-neutral portfolio has beaten its benchmark of cash by 10% per year over the last three years, says that behavioral finance is intellectually rigorous but simply lacks the unifying physical laws of the hard sciences. “It’s soft, and that takes time to gain acceptance.” Hard or soft, he says, there is one universal: “While markets are unpredictable, people are not. They will continue to behave the same way, and this can be exploited.”