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Behavioral Finance Roundtable continued from page 25
the best-performing and highest-rated products. But again,
this process does not work nearly as well for investment
products. In fact, when comparing funds, index funds are
typically rated as average, while the current winning sectors
are rated high, and out-of-favor funds rated low. So, some
of the concepts of behavioral finance—ill-advised decisions
made on the basis of poor information, lack of understanding
or the impulsiveness of trying to beat the market—also apply
to individual investors.
In the end, behavioral finance is about evaluating the
investing habits of people, and people—whether professionals
or nonprofessionals—are capable of making rational and
irrational decisions.
JoI: If indexing is proven to provide the best odds for long-term
success, why don’t more investors index?
Kinniry: As in many other areas in life, we often overestimate
our capabilities (i.e., we are all better-than-average drivers and
our kids all have higher-than-average IQs). It is no different when
it comes to investing. In many respects, our ego tricks us and
limits our ability to consider that we may be average or even
below average when compared with the competitive and large
playing field of investment professionals. As a result, we tend to
ignore proven strategies such as indexing and think that we can
do a better job following other strategies.
JoI: Can active managers use behavioral insights to outperform
the market?
Kinniry: Some managers will outperform the market, whether
they use behavioral research, technical research, fundamental
research, quantitative research or a combination thereof.
However, the challenge facing active managers is being able to
outperform the market by having information that is superior to
that of all other market participants and by having very low trading
friction. These are not impossible hurdles, but high hurdles.
Perhaps the best chance for active management to be successful
over the long run is to utilize the best of passive management:
low costs, low relative friction along with their active management
techniques and a talented yet humble team of sophisticated
investment professionals.
David Blitzer, managing director and
chairman of the Index Committee,
Standard & Poor’s
JoI: What does behavioral finance tell us about
investing and indexing?
David Blitzer, Standard & Poor’s (Blitzer): One of the key factors
determining whether stock prices rise or fall are investors’
buy/hold/sell decisions. Investors don’t know the future and their
decisions usually depend on a mix of rational analysis, opinions,
fears, greed and wishful thinking. Behavioral finance warns us
that our decisions aren’t always rational and at times will reduce
our profits or increase our losses. One way to reduce the impact
of our irrational or emotional decisions is to invest with a simple
rule: Index. This way, investors can avoid falling in love with
stocks, selling winners too soon or denying the losers’ existence
by refusing to sell them to cut the losses. Indexing is not the only
rules-based emotionless way to invest; however, it is one of the
simplest ways and it does have a proven track record.
JoI: What are the biggest mistakes investors make from a
behavioral standpoint?
Blitzer: Letting any successful investment convince them
that they can beat the market consistently. Someone buys
a stock, it rises 10 percent and they’re a winner—and a
stock market genius. First, they forget that three other
stocks in the same industry rose 15 percent at the same
time. Then they think they can time the market for their
next move. Finally, they read that indices outperform
active managers two out of three times and are absolutely
sure they will consistently be in that top third who always
beat the market. There are some people who escape this—
but they are often the ones who believe that even though
they can’t pick stocks, they have found a money manager
who can pick stocks.
JoI: Is behavioral finance being used to justify poor investment
decisions and a lack of education?
Blitzer: While behavioral finance may explain some poor
investment decisions, it doesn’t justify them. An investor who
says his education is complete and that he fully understands
the markets is an investor who can’t or won’t compare his
results to the markets over the long run.
JoI: If indexing is proven to provide the best odds for long-term
success, why don’t more investors index?
Blitzer: People see indexing as settling for the average result
and no one wants to be “just average.” Further, no one wants
to admit he paid too much, so when they understand that the
key reason indexing outperforms active management is lower
costs, they are even less likely to embrace indexing. Finally,
stock markets are very complex and indexing is simple, so
how could it possibly work?
JoI: Can active managers use behavioral insights to outperform
the market?
Blitzer: Active managers, like any other investors, can use
insights from behavioral finance to improve their results. In
the last 10 years we have seen two massive bubbles; one in
dot-com stocks and the second in housing. Understanding
either requires recognizing the importance of human behavior
and emotions in investing and markets. That said, simply
having read or even understanding much of the behavioral
finance literature would not have guaranteed selling at the
peak of either bubble. Moreover, no managers always outperform
the market; some do it occasionally, others do it more
often; but no one does it all the time.
July/August 2008
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