Behavioral Investment Management Overview Beating the market –Are markets efficient? –What are the sources of alpha? –Is your alpha reliable? Behavioral
Overview Beating the market Are markets efficient? What are the
sources of alpha? Is your alpha reliable? Behavioral approach to
asset management Investors are biased Biases often persist Biases
are not always arbitraged away Example of implementing a behavioral
approach 2
Slide 4
Are Markets Efficient?
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4
Slide 6
Real Life Orange Juice Example: Royal Dutch / Shell formed in
1907 Royal Dutch trades on the NYSE Shell trades on the Financial
Times Stock Exchange Index 1 Royal Dutch = 1.5 Shell 5 Source:
Froot and Dabora (1999)
Slide 7
Do These Two Stocks Trade At A Price Ratio Of 1.5? 6 Source:
Thaler (2008)
Slide 8
Another Orange Juice Example 3Com sold 5% of Palm, the rest
still belonged to 3Com stockholders Each 3Com holder owned 1.5
shares of Palm At the end of 3/2/2000 Palm was at $95 3Com holders
owned $142.50 worth of Palm 7 Source: Lamont and Thaler,
(2002)
Slide 9
What Was 3Com Worth At The Close of 3/2/2000? 8 Source: Lamont
and Thaler, (2002) $242? $197? $142.50? $102? $81?
Slide 10
What Are The Sources Of Alpha?
Slide 11
Fundamental Managers 1.Better information Analysts outperform
on stock recommendations when they have school ties to senior
officers of the firm being evaluated 2.Better processing Warren
Buffett has a net worth of $62 billion Berkshire Hathaway averages
~27% annual returns 10 Sources: Frazzini, et al (2008),
http://moneycentral.msn.com/content/investing/findhotstocks/p90537.asp
Slide 12
Market Average Vs. Buffett Returns 11 Source: CRSP
Database
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Quantitative Managers 12 3.Finding statistical relationships
Momentum Short and long term returns negatively predict returns but
intermediate returns predict continuation Reversal Stocks doing
well tend to do worse than average over the long term Sources:
Jegadeesh and Titman (1993, 1999), Debondt and Thaler (1985)
Slide 14
Quantitative Managers 13 Post Earnings Announcement Drift A
stock's price jumps after an earnings surprise and tends to
continue in the same direction over the following months The
January Effect Small stocks give excellent returns from the end of
December through January Sources: Ball & Brown (1968), Rozeff
& Kinney (1976)
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Is Your Alpha Reliable?
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By The Time We Know Buffett Has Alpha, Hes Ready To Retire 15
Source: CRSP Database
Slide 17
Daily Returns Before And After Anomalies Were First Published
16 Sources: Marquering et al (2006)
Slide 18
Behavioral Approach To Asset Management
Slide 19
Investors Are Biased
Slide 20
Roulette Anyone? 19 Roulette is a casino game where a wheel and
a ball are spun in opposite directions and eventually, the ball
falls into a space. Bets can be placed on whether the ball will
fall into a red, black, or green space. There are 18 red spaces, 18
black, and 1 green
Slide 21
Question: Youre in Vegas and walk up to roulette tables with
the 5 previous spins posted as: Which table would you feel more
comfortable placing a bet on black? 20 Table 1Table 2 29 2736 317
265 129
Slide 22
Representativeness Heuristic Belief that even small samples
should be representative of the population People also think that
the recent past is indicative of the future The Gamblers Fallacy
says: 5 reds in a row in a fair gameblack is due! 21
Slide 23
Question: (1) Write down the last 4 digits of your SSN (2) Do
you think that a Gronitz PCM-5 CC Tuba costs more or less than this
number? (3) What is your best estimate of the cost of a Gronitz
PCM-5 CC Tuba? 22
Slide 24
Anchoring The tuba costs ~$12,000 according to
www.tubaexchange.com Any arbitrary number can influence your guess
by anchoring you to that number 23
Slide 25
What Is Your 90% Confidence Interval For These Questions? Lower
Upper 1.Length of the Nile River (miles) ____ ____ 2.Diameter of
the Moon (miles) ____ ____ 3.Weight of an empty Boeing 747 (lbs)
____ ____ 4.Year in which Mozart was born ____ ____ 5.Number of
countries in OPEC ____ ____ 24 Source: Fuller (2008)
Slide 26
Answers: 1.Length of the Nile River (miles) 4,187 2.Diameter of
the Moon (miles) 2,160 3.Weight of an empty Boeing 747 (lbs)
390,000 4.Year in which Mozart was born 1756 5.Number of countries
in OPEC 13 Were these answers within your range? 25 Source: Fuller
(2008)
Slide 27
Biases Often Persist
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Immediate Gratification 27
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Is there learning? 28
Slide 30
Biases Are Not Always Arbitraged Away
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Arbitrage Concentrates In Only A Few Markets What would you get
if you converted: Arbitrage is concentrated in bonds and exchanges
and little in stocks There is low cost and risk There is high
leverage 30 $1$ Source: Shliefer and Vishny (1997)
Slide 32
Arbitrage Doesnt Necessarily Correct Mispricing Professionals
made big profits off the internet bubble buying and selling at the
right time Everyone believed the prices were too high but
forecasted even higher prices in the future 31 Source:
Brunnermeier, and Nagel (2004)
Slide 33
Behavioral Effects Can Be Hard To Arbitrage Stocks have
outperformed bonds over the last century by too high a margin
Myopic loss aversion Investors are very sensitive to losses, and
even long-term investors focus on short-term losses, hence
demanding a very high equity premium How would you arbitrage myopic
loss aversion? 32 Source: Benartzi and Thaler (1995)
Slide 34
Long Term Capital Management 33 Source: Lowenstein (2001)
Arbitraged similar bonds (30 yr & 29.5 yr) and figured they
would converge in the long run Annual returns were > 40%! Lost
$4.6B over 4 mos in 1998 Eventually, the bond prices did converge
but LTCM went bankrupt waiting
Slide 35
Example Of Implementing A Behavioral Approach
Slide 36
Mental Mistakes Made By Investors Under-reaction to new
information Foundation of the growth process Over-reaction to old
information Foundation of the value process 35 Source: Fuller
(2008)
Slide 37
Causes Of Under-Reaction Anchoring Individuals are tied to
their previous opinions, causing under-reaction to new information,
resulting in biased expectations Overconfidence Individuals place
too much confidence in existing knowledge, causing under-reaction
to new information 36 Source: Fuller (2008)
Slide 38
Analysts Under-React to Earnings Surprises Analysts are
surprised again and again when growing companies outperform
forecasts Surprises are greater when earnings increases are
permanent (i.e., success of a new product) versus temporary (i.e.,
change in exchange rate) 37
Slide 39
Analysts Revisions For Fiscal Year 1 Earnings 38 Source: Fuller
& Thaler (2008)
Slide 40
Causes Of Over-Reaction Representativeness People tend to infer
that a single observation represents the entire population
(stereotyping) Saliency People tend to over-estimate the
probability of a low frequency event (earthquakes) Prospect Theory
Investors may be irrationally risk averse in the domain of losses
39 Source: Fuller (2008)
Slide 41
Fuller and Thaler Asset Management Fund Performance 40 Source:
Fuller & Thaler (2008); See important disclosure on last page
of presentation
Slide 42
Disclosure Statement 41 Fuller & Thaler Asset Management,
Inc. claims compliance with the Global Investment Performance
Standards (GIPS). Fuller & Thaler has been verified for the
period from January 1, 1992 through March 31, 2008 by Beacon
Verification Services, LLC. A copy of the verification report is
available upon request. This information is provided solely for
general informational purposes and does not constitute an offer to
sell or a solicitation of an offer to buy or sell any product or
service to any person or in any jurisdiction where such offer or
solicitation would be unlawful. Fuller & Thaler is an
independent investment management firm registered with the U.S.
Securities and Exchange Commission that manages primarily equity
assets for primarily institutional investors. Fuller & Thaler
seeks to identify mis-priced securities by exploiting insights from
the field of behavioral finance. The firm changed its name from RJF
Asset Management, Inc. to Fuller & Thaler on December 14, 1998.
The firm was called RJF Asset Management, Inc. as of April 5, 1993
to December 13, 1998. The investment philosophy has remained
constant throughout the firms history. *Assets in a composite may
exclude accounts in a strategy that do not comply with the
composites account inclusion criteria. Market Neutral Composite is
primarily invested in the equities of the top 1,500 U.S. companies
ranked by market capitalization and liquidity. The composite has a
$10 million account minimum and was created in February 2000. The
composite is an un-levered version of the market neutral strategy
which employs a long/short strategy managed with minimal net dollar
exposure and minimal net beta exposure and is measured against the
Citigroup BIG Treasury Bill (3 M) (LOC) Index. The standard
advisory fee is a 1.0% per annum management fee and a performance
fee of 20% of the profits in excess of a T-Bill hurdle subject to a
high water mark. For the period February 1, 2000 through April 30,
2000 the composite returns represent the performance for the long
and short equities carved-out of a market neutral account passively
equitized with S&P 500 futures (S&P 500 futures were
purchased and "rolled" on a quarterly basis to maintain a passive
exposure to the S&P 500 index). The composite returns were
derived by excluding the futures positions from this equitized
market neutral account. The carve-out received a 100% cash
allocation.