Always Trying To Behave Better

When I started learning about the world of investments many years ago, I was a young(ish) computer programmer. At that time, I fully expected investing to be a problem that could be “solved” with analytics and rationality. That led me to learn about economic theory and read several books about the science of investing.

I was learning these things in the late 90s as the stock markets went wild with the beginning of the internet. We were seeing stock prices rocketing on “dot com” companies, and companies like America Online, Cisco Systems, and Pets.com were trading at prices many times higher than analytics and rationality would suggest. The tech-heavy NASDAQ Index averaged 55% (a year!) between April 1998 and March 2000. It became clear to me that there was something else going on here. It took years, but most of these highfliers came back to earth (with many going out of business), with the NASDAQ dropping 75% from its highs.

“I can calculate the motion of heavenly bodies,
but not the madness of people.” - Isaac Newton

These events led me to behavioral finance, where researchers have studied where and how we consistently make irrational financial decisions. Books like Your Money and Your Brain, Predictably Irrational, and Irrational Exuberance discuss our “behavioral biases,” areas where our brains lead us astray. I quickly fell in love with this area of finance. Recent books like Nudge, Thinking Fast and Slow, and The Psychology of Money continue to advance the discussion.

In a nutshell, behavioral finance shows we are not all-knowing, all-rational investors. When it comes to investing, we have biases that lead us to periods of over-reaction (panic to bad news) and under-reaction (ignoring boring news or news that does not fit our beliefs).

Researchers have identified over 100 different behavioral biases; I’ll share just a few:

Loss Aversion – Losses feel about twice as painful as equivalent gains, leading investors to make bad selling decisions. Example: An investor refuses to sell a losing stock because realizing the loss feels worse than the relief of avoiding further decline.
Anchoring – We rely too heavily on prior information (like past price) to make decisions, resulting in underreacting to new information or clinging to outdated numbers. Example: A homeowner insists their house is worth last year’s peak price, ignoring new listings that show values have fallen.
Overconfidence – We believe our judgments are more accurate than they are, allowing people to ignore contradictory evidence. Example: A day trader believes their intuition can beat the market, trading frequently despite evidence showing the vast majority of active traders underperform.
Availability Bias – Vivid and recent news stories crowd out other information, causing investors to chase (or run from) investments based on headlines. Example: After seeing constant headlines about AI stocks, investors rush to buy them, assuming they must be good investments.
Herding – We tend to follow the crowd, instead of making independent choices, leading to buying at peaks and selling at bottoms. Example: During a bull market, people invest heavily in the same popular investments simply because “everyone else is making money there.”
Endowment Effect – We value things we own more than we would if we did not own them, causing investors to hold onto investments when they would not be buying them. Example: An investor keeps holding a losing mutual fund, telling themselves it will rebound, but they would never buy it fresh today at the same price.

There is a well-known “behavior gap” where investors underperform basic portfolios strictly because of their decisions. Minimizing this gap is one of the most impactful things an advisor can provide clients. (See the Vanguard Group’s article on this if you are more interested.)

We all have these biases to some extent. The more I know about these biases, the better I can work to minimize their impact on my financial decisions and recommendations. This is similar to learning about optical illusions – we will always see them, but if we know about them, we can adjust our behavior accordingly.

Can we take advantage of these biases to make more money? The folks at Fuller &Thaler Asset Management think so. Professors Russell Fuller and Richard Thaler (a Nobel Prize winner) are leaders in behavioral economics. They have created an investment firm whose main focus is to make money for investors by exploiting various behavioral biases.

As you probably know, I’m not a fan of active management for equities. The evidence is clear: beating the stock market is very hard. It’s so difficult that more than 90% of active managers underperform basic index funds over any longer period. This is the main reason the equity piece of client portfolios is mostly index funds.

Despite the odds against active fund outperformance, I’ve used the Fuller & Thaler Behavioral Small Cap Equity Fund (an actively managed equity fund) in client portfolios for over seven years. Why? Most active fund managers try to pick stocks they believe will grow faster than the markets predict (growth investing) or with prices lower than the fundamentals indicate (value investing).

Fuller & Thaler’s team takes a very different approach. They look for hints where a stock might be in a behavioral overreaction or underreaction period. Specifically, fund managers look for events that often signal mispricing; they do not look at things like suppliers, competition, balance sheets, earnings power, valuation metrics, or stories. Instead, they look for insider buying and buybacks after bad news, in hopes the markets have overreacted (taking advantage of loss aversion, availability bias, and herding biases). They also look for positive earnings surprises and upward revisions, expecting that these are often temporarily ignored, and pricing will eventually follow (taking advantage of anchoring and overconfidence biases).

The stats for the Fuller & Thaler Small Cap fund have been impressive:

Since the fund’s inception in September 2011, the fund has averaged annual growth of 14.5% a year, outperforming the Russell 2000 Small Cap Index by a very impressive 3.6% a year. Over the last five years, the fund has grown annually by 18.1%, outperforming its index by 7.1% annually.
The fund’s upside/downside capture has been “96/80” over the last 10 years. This ratio tells us the fund has historically received 96% of the market’s gains while only receiving 80% of the market’s losses.
The fund’s “batting average” has been excellent at 91%. This calculation shows how consistently a fund has outperformed its index. This fund has beaten its index in 91% of all three-year periods.
Fuller & Thaler closed the fund to new investors in 2022 so it would not grow too big to manage effectively. Fortunately, MILE Wealth clients are “grandfathered,” so we can all continue to use this solid fund.

This young programmer has come a long way. I now appreciate that the markets will have their crazy times that come from decisions we make with our flawed brains. While we cannot predict when or how long these periods will run, a better understanding of behavioral finance can help us avoid getting caught up in the craziness and keep more of what the stock and bond markets offer.