How to Profit From Behavioral Economics

When people can’t understand what markets are doing, they often turn to psychological phenomena to try and explain it: Think of stock phrases such as “irrational exuberance,” “greed and fear,” and “climbing a wall of worry.” Even economists now widely accept that investors’ mental quirks mess with models of rational decision-making. On Oct. 9, the Nobel prize in economics went to a University of Chicago behavioral economist, Richard Thaler, for exploring the biases and cognitive shortcuts that affect how people absorb and process information.

For an investor, the idea that other people in the markets are making poor decisions is a tantalizing one. If humans are predictably irrational, does that translate into predictable patterns in the stock market that a savvy trader can exploit? As it turns out, Thaler is a principal in a company that tries to do this. San Mateo, Calif.-based Fuller & Thaler Asset Management Inc. runs $6.1 billion in the small-cap Undiscovered Managers Behavioral Value Fund for J.P. Morgan Asset Management Inc. and $261 million in the Fuller & Thaler Behavioral Small-Cap Equity Fund. Both mutual funds have done well, earning an annual average of 15.9 percent and 17.3 percent, respectively, over the past five years. Both have bested more than 90 percent of their competitors.

Thaler arrives at his office in Chicago after winning the 2017 Nobel prize in economics on Oct. 9.
Photographer: Reuters/Kamil Krzaczynski

The funds try to capitalize on the behavioral biases of investors. The Fuller & Thaler fund, for example, focuses on investors’ overreactions and underreactions to events. “In general, people overreact to vivid, emotional stories and underreact to dull information or when they have prior strong expectations,” says lead portfolio manager Raife Giovinazzo. “There’s nothing quite so vivid and emotional as losing money, so when a stock goes down, people overreact.” When he’s looking for evidence of overreaction, his strategy includes screening for patterns of buying and selling by company insiders. If he thinks the market is out of step, he looks at the company’s fundamentals and business model.

The other side of the coin, underreaction, is tied to a cognitive bias called anchoring and adjustment, which was identified by another Nobel laureate, Daniel Kahneman, and fellow behaviorist Amos Tversky. When someone settles on a number—say, an earnings estimate—they get slightly stuck on it. When they get new information, they adjust the number, but their adjustment is based around that initial number, so often it isn’t big enough. “These things persist because people will always make mistakes, because they are human,” says Giovinazzo.

As strong as the Fuller & Thaler funds’ records are, it’s not easy to untangle how much of that performance comes from cutting-edge behavioral insights. “It could be that the behavioral thing has conveniently helped them to uncover some sort of irregularity in the market that isn’t strictly speaking driven by one of the classic tenets of behavioral finance,” says Ben Inker, head of asset allocation at investment firm GMO LLC. For instance, in looking for overreactions, they may be finding some of the same stocks an old-fashioned value manager might have spotted. The challenge isn’t just knowing that other investors can be wrong, but also having a measure that tells you when they’re so wrong that the stock is underpriced. “The difference between good and bad metrics is probably the difference between success and failure,” says Inker. Giovinazzo says it’s true that behavioral investing and value investing are correlated. “That’s the basic idea,” he says. “But we’re coming at it from a different perspective.”

Stephen Wendel, head of behavioral science at investment research company Morningstar Inc., says he wouldn’t take the outperformance of Fuller & Thaler funds “as a lesson to go do your own behavioral fund.” Wendel’s job title is one measure of Thaler’s influence, but he warns against thinking it’s easy to use behavioral ideas to outsmart others. After all, one of our behavioral quirks is that we’re overconfident about our abilities. It’s dangerous to think that because someone else seems to have done it, you can, too.

David Booth, founder of Austin, Texas-based Dimensional Fund Advisors, which has $548 billion in assets under management, agrees that subjective judgment can often lead investors astray. But “it is a leap from saying people behave irrationally sometimes to saying that markets are mispriced,” he says. It’s not that it doesn’t happen, but it’s devilishly hard to tell when it does, and then to take advantage of it. Booth believes some money managers can outperform the market consistently, “but since you never know if you have that person or not, you are best off behaving as though markets were efficient”—that is, that prices reflect the available information well enough that it will be hard to guess their next move. Indeed, for most investors the best use of behavioral insight isn’t as a guide to spotting others’ flaws, but as a reminder to stay humble. “It’s much easier to imagine being successful in stopping yourself from shooting your own foot than turning you into the next great stockpicker,” says Inker.

For example, it’s helpful to know you have a bias toward thinking of investing (incorrectly) as a game you can easily win, says Santa Clara University finance professor Meir Statman, author of . On the surface, deciding to buy a stock often resembles other kinds of purchases where good research and savvy shopping can pay off. You might buy a cheap television at Costco and find that you like it, so you like the store, too. So why not buy Costco stock as well? But stock trading is more brutally competitive than consumer bargain hunting—not everyone wins. “When you buy the stock of this company, someone is selling, and that someone just may be an insider,” says Statman.

Wendel says simply understanding such problems as overconfidence can help investors de-bias their thinking—if they take steps in advance to protect themselves from their instincts. For example, to slow down decision-making in the heat of the moment, individuals can set rules in advance about when they can sell a stock or a fund. “If they find they don’t like those rules, they have to change them and not just make an exception,” says Wendel.

One of the most celebrated examples of a preset system that short-circuits bias comes directly from Thaler’s work. Psychologists have found that people place a high value on saving—when they imagine doing it in the future. In the moment, the temptation to spend is often stronger. And for many everyday investors, the most difficult investment decision is to set aside the money to begin with. Along with behavioral economist Shlomo Benartzi, Thaler developed a retirement savings system called Save More Tomorrow. Participants commit in advance to contributing a higher percentage of their salary to their 401(k)s over time. A majority of large 401(k) plans now have such an auto-escalation option.

The professional investors at Fuller & Thaler also use systems to guard against their biases. They don’t visit companies, says Giovinazzo—because when you meet with people, you judge them more on whether you like them than whether they’re good leaders. To avoid anchoring, he and his colleagues at Fuller & Thaler don’t set price targets for stocks or make quarterly earnings forecasts. It’s good to know that markets can be irrational, but it can only help if you recognize that you’ll be, too.

    BOTTOM LINE – Thanks to psychological biases, markets sometimes overreact or underreact to news. Figuring out which is happening and when is the tricky part.