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Ross Miller, finance professor, State University of New York (SUNY) at Albany JoI: What does behavioral finance tell us about investing and indexing? Ross Miller, SUNY Albany (Miller): I’m not sure it tells us a lot about indexing. People tend to be shortsighted about investing. But there are behavioral anomalies. When people notice these, they tend to go away. Markets can absorb enormous amounts of irrationality. We know individuals can be irrational. And we also know that crowds can actually compensate for individual behavior. The bottom line is that when dealing with liquid securities, it’s difficult to beat an index in risk-adjusted terms. In contrast, the analysis of behavioral influences might not be the best measure to explain what happens in illiquid markets. But at least it’s something to consider. Miller: Probably because the higher profit alternatives are more aggressively marketed. Even primarily indexing companies such as Vanguard offer a wide array of actively managed products. So you can hear John Bogle preaching the value of passive investing, but at the same time, Vanguard caters to everyone. If they had that strong a belief in indexing, they’d be purely indexing. That gets back to one of the behavioral aspects marketers play on. Even though active management is statistically a bad bet, marketing plays to individual optimism. In other words, people overestimate their abilities to pick stocks and money managers. If you’re in a 401(k) plan that only has active alternatives, then there’s no way you’re going to be putting money into passive alternatives. And the reason why those 401(k) plans don’t have index alternatives is because marketing people have sold the plan’s advisors on the attributes of active management. JoI: Can active managers use behavioral insights to outperform the market? Being comfortable and following the crowd is rarely profitable over the long term. JoI: What are the biggest mistakes investors make from a behavioral standpoint? Miller: No. 1 is timing. People try to time markets. A lot of people who should be investors act like traders. If you have a 20- to 30-year time horizon, you shouldn’t be trading your retirement money. There’s evidence that people get sucked into bubbles. Mutual funds tend to suck in money while they’re going up. Then people bail out when those same funds start going down. People get scared and they have trouble dealing with longer time horizons. Aside from fear, there’s greed. These characteristics do manifest themselves in the markets and they are behavioral in nature. JoI: Is behavioral finance being used to justify poor investment decisions and a lack of education? Miller: What’s interesting is investor education. It’s not so much being inadequate as much as it is a terribly difficult task. The typical person has a big challenge in becoming an educated investor. And there are much more important problems than training individual investors to avoid behavioral anomalies. It probably doesn’t help to have computer programs like Quicken. The front page of Quicken includes a day-by-day breakdown of what people are worth. I don’t know if most people really need to know their net worth down to the exact penny at all times, but that’s the way the world is these days. You can set it up to update you throughout the day. It’s quite amusing, but it’s also potentially very dangerous. JoI: If indexing is proven to provide the best odds for long-term success, why don’t more investors index? Miller: While there are advisors who operate in that manner to generate alpha, probably highly quantitative hedge fund managers are more efficiently finding the same anomalies. They’re finding those anomalies by studying patterns of returns over different time periods. It gives you a broader range of anomalies to draw on. Then, you can use a behavioral aspect to explain those gaps in the market. Computers just provide a more valuable tool to harvest all sorts of data over longer ranges of time. Perhaps 25 years ago, behavioral approaches were seen as being more effective. In today’s market, most hedge funds are populated by quant-based analysts rather than behavioralbased analysts. Increasingly, behavioral analysis is becoming a secondary means to explain market anomalies. Where behavioral science might come more into play with hedge funds these days is less in studying markets and more in psychoanalyzing and monitoring their own traders. Terrance Odean, Willis H. Booth Professor of Banking and Finance, University of California at Berkeley JoI: What does behavioral finance tell us about investing and indexing? Terrance Odean, University of California at Berkeley (Odean): Due to a number of behavioral biases, many investors make systematic mistakes when buying and selling stocks. On average, the stocks they sell go on to outperform those they buy. When it comes to mutual funds, most investors focus on past performance and pay too little attention to expenses and other fees. Many investors would be far better off buying broad-based index funds or other low-cost, welldiversified mutual funds. 24 July/August 2008
JoI: What are the biggest mistakes investors make from a behavioral standpoint? Odean: The most costly mistake made by a large number of investors is under-diversification. Many investors trade too actively. Investors also pay too little attention to trading costs and mutual fund fees. They focus too much on the one thing that they can’t control—market outcomes—and too little on important factors over which they do have some control— diversification, costs and taxes. JoI: Is behavioral finance being used to justify poor investment decisions and a lack of education? Odean: I’m not sure I understand the question. The advice I give investors is to buy low-cost, well-diversified mutual funds such as index funds. I believe that that is excellent real-life advice. I occasionally suggest, tongue in cheek, that investors do the opposite of their instincts (i.e., buy the stocks they are inclined to sell and vice versa). Of course, this would be an idiotic way to extrapolate from my own research to real life. JoI: If indexing is proven to provide the best odds for long-term success, why don’t more investors index? Odean: I don’t know if indexing provides the best odds for long-term success. I do know that it is a very good choice for most investors. People don’t choose indexing for a variety of reasons. Some people are overconfident in their ability to beat the market; others are unaware of the advantages—or perhaps even the option—of indexing. JoI: Can active managers use behavioral insights to outperform the market? Odean: Yes. Individual investor behavior can affect asset prices. Active managers who have insights into that behavior and asset price dynamics could potentially profit from those insights. I doubt that many active managers currently do profit from such insights. Even if some active managers are earning profits from such insights, they may not be passing those profits on to their clients. For example, my co-authors and I found that from 1995 through 1999, institutional investors in Taiwan earned an annual alpha of approximately 1.5 percentage points after trading costs. If, on average, they charged their clients less than 1.5 percentage points in fees, then those clients are benefiting. However, if the fees averaged over 1.5 percentage points, the managers reaped all of the benefits. Francis Kinniry, principal and senior member, Vanguard’s Investment Strategy Group JoI: What does behavioral finance tell us about investing and indexing? Francis Kinniry, Vanguard (Kinniry): Behavioral finance has several implications for index investing. At one end of the spectrum, investors in broad market index funds may be more patient, cautious, deliberate and cost-conscious in their decision making, and thus tend to be more immune to the negative behavioral aspects of investing, such as overconfidence, which can manifest itself in return chasing, market timing, wholesale portfolio changes, etc. These investors don’t “follow the herd”—they own the market, invest for the long term, adhere to a buy-and-hold strategy and tend to understand the math and probabilities behind investing. Specifically, these investors understand that commitment to a strategic index asset allocation provides the highest probability for success. At the other end of the spectrum, investors who follow or participate in a more tactical or aggressive market rotation approach or who actively engage in very narrow indexes may be more risk-tolerant, impatient and overconfident in their investing skills. JoI: What are the biggest mistakes investors make from a behavioral standpoint? Kinniry: By far, the biggest mistake investors make is extrapolating recent returns as an indication of future returns. As a result, they fall into the trap of overbuying the current outperforming asset class and underowning the current underperforming asset class. (This statement does not qualify as an endorsement to underweight the winning strategy or overweight the losing strategy as others in the investment community may suggest.) Another big mistake is investor overconfidence, or believing that you have unique information about future market changes or other advantages that no one else has. Since that is highly unlikely, it could be the reason why professional active managers on average have tended to not outperform indexes over time. JoI: Is behavioral finance being used to justify poor investment decisions and a lack of education? Kinniry: It’s easy to use the concept of behavioral finance or lack of education to explain investors’ decisions. However, we have seen very sophisticated, educated investment professionals fall into some of these situations over time. After all, much, if not most, of the money that trades daily in the markets is under the control of institutional and professional money managers. We must remember that investing is not a science. It is an art that takes on many forms. It is constantly changing; the future attributes that determine outcomes are highly eclectic, dynamic and extremely uncertain. This environment makes predicting or forecasting the future a great challenge. For the nonprofessional investor, the investment decision process runs counter to most other buying decisions we may make. For example, the concept of “you get what you pay for” would suggest that like a good meal, quality and costs are correlated. But, obviously, this is not the case with investing. Similarly, when shopping, we might utilize services that rate Continued on page 45 www.journalofindexes.com July/August 2008 25
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Page 3 and 4: Contributors David Blitzer Matt Hou
Page 5 and 6: David Smith Publisher dsmith@fa-mag
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