Richard
Thaler of The
“Behavioral finance just
entertains the possibility that some ... investors are less than fully
rational”
Sigmund Freud probed the human psyche by interpreting the
trains and tunnels in dreams; Richard Thaler gets
inside investors’ heads by analyzing their trading habits and tunnel vision in
the market. He’s helping investors by exploiting mankind’s behavioral
idiosyncrasies. The
Q. How do you define “behavioral finance”?
A. The idea is pretty simple — it’s a modifier to finance. So
what does “behavioral” mean? Typical economic models of financial markets assume
that everybody is rational. Behavioral finance just entertains the possibility
that some of the investors are less than fully rational some of the time and
then asks, “What happens?”
Q. What are some of the dumbest moves investors make?
A. There’s a long list. Certainly, one of the most common
problems is overconfidence. People think they are better investors than they
are. I think this is particularly a problem over the past decade or so with the
market going up most of the time. The stocks they’ve bought have mostly gone
up, so they think they know something. And obviously just throwing darts at the
stock pages would have been a highly successful strategy over the last 10
years, and the evidence is that individual investors do a little worse than
throwing darts. A related problem is, people trade too
much, and that also stems from overconfidence. They think that the stock
they’re selling is not going to do very well and the stock that they are buying
is going to do better, and there is no evidence to support that.
Q. If the market went through a long period of poor performance,
would that take away some of that overconfidence?
A. It might take away some of it. So it’s a general trait that’s
been exacerbated by a long bull market.
Q. Are there other behavioral defects?
A. Another problem that’s been researched a lot is how people
display loss aversion — they are very sensitive to losing money as opposed to
making money. One manifestation of that is people are reluctant to sell their
losers, because they have to admit they made a mistake if they sell a loser. So
they tend to hold on to losers and sell their winners, and that’s not a
sensible strategy from a tax-minimization perspective.
Q. Does that apply also to institutional investors?
A. I think institutional investors are also overconfident and
also trade too much. We know that on average, mutual fund managers do worse
than the indexes, so it’s the same result. No one is immune from this.
Q. How are the funds you advise exploiting some of those human
weaknesses?
A. What we try to do is understand the biases that most investors
have, try to avoid them ourselves by being aware of
them and try to identify situations in which those biases will cause stock
prices to be mispriced and exploit that. The strategy
we’ve been using the longest, and is present in the growth fund we manage for
Undiscovered Managers, is based on overconfidence and another phenomenon that’s
called “anchoring.”
Q. What’s “anchoring”?
A. The idea behind anchoring is that if I ask you to estimate
something, typically you’ll start with some number and then adjust it, and
typically you don’t adjust it enough. So, for example, how tall are you?
Q. Six feet 1 inch.
A. So let’s suppose I ask you to estimate how tall I am, and you
notice that I’m not as tall as you are. You don’t know how tall I am, but you
know how tall you are, so one thing you might do is start by saying: “Well, I
know I’m 6 feet 1 inch, and Thaler’s smaller than
me,” so you’ll adjust down. The evidence is you won’t adjust down enough, so
you’ll overestimate how tall I am. But let’s suppose I ask you how tall Shaquille O’Neal is, then you’d be
going in the other direction. You’ll adjust up, and inefficiently, so you’ll
guess his height as too short and my height as too tall.
Q. How do you transfer this to evaluating a stock, and which way
it will go?
A. The way that works with the stock market is,
analysts are acting on their own estimates. Let’s say analysts have been
predicting some company is going to make $2 a share, and then it reports $2.50.
Well, the analyst, first of all, is overconfident, so he thinks he’s right and
the company is wrong. He doesn’t want to revise up his assessment of the
company, so in predicting the next quarter he is still going to be anchored
onto the perceptions he had before. What we try to do is we start with firms
that have announced large earning surprises, and among those we look for stocks
where the change seems to be permanent and where the analysts are anchored and
overconfident. Those are the ones we buy.
Q. Give me an example of a past winner.
A. Best Buy is a stock that we bought and ended up holding for
two and a half years because it kept surprising. The way the strategy works is,
we buy the company, and the prediction is that it will surprise the next
quarter, because the analysts will have adjusted up, but not enough, and we
keep holding it until it stops surprising. I believe we held Best Buy for 10
quarters, which is long for us. Typically, it’s more like a year.
Q. Is there a knack for knowing when to get out?
A. Most investment strategies are very well defined for buying
but not for selling. If you talk to portfolio managers about their “sell” criteria,
typically you get a lot of mumbo jumbo. This is one strategy that has a well-defined “sell” criteria which is, if there’s no
earnings surprise, we sell.
Q. Couldn’t you then be blamed for the behavioral fault of
trading too much?
A. Well, this is an active strategy, and it has a turnover of
probably 100% a year. n
Q. Has your strategy helped in a market where no one seems to be
making money?
A. This year it worked best in the value fund. The growth fund is
the one we have the longest track record on, so in some ways we have the most
confidence that that’s a strategy that works. It doesn’t work every year, and
we have been constantly monitoring why the performance this year hasn’t been as
good.
Q. How can financial advisers use those behavioral biases to
their advantage?
A. I think financial advisers should be paying attention to the
biases their clients have and try to push them in the right direction. For
example, we talked about people’s reluctance to sell losers. A good role for an
adviser is to say:“You’ve
got this fund or stock that’s lost money, and you know it’s coming up on the
end of the year. Why don’t we sell that, take the tax credit and buy something
else?” That would be difficult if the adviser recommended that stock, but the
adviser has got to suck it up and say, “You win some, you lose some.”