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Rekenthaler Report

The Savior That Wasn't

Why behavioral economics hasn't helped active management.

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False Hope
Behavioral economics should have been a boon for active investment management. The argument for stock market efficiency and, therefore, for the superiority of index funds came from traditional economics, which treated each investor as a fully rational party. When behavioral economics showed that rationality assumption to be a fiction, with investors subject to a variety of decision-making biases, the claim for active management should have been vindicated. In a marketplace of blind participants, one-eyed professionals figured to be king.

The early research supported that notion. To the astonishment of efficient-market theorists--Eugene Fama was so surprised that he had a graduate student double-check the numbers because he doubted their accuracy--Werner De Bondt and Richard Thaler discovered in 1985 that a very simple plan of buying the stocks with the worst 36-month returns and then holding them for the next 36 months had generated outsized gains over the previous six decades. Such results could not be explained by the efficient-market hypothesis. But they could come from irrational investor overreaction, as predicted by the behavioral economists.

The opportunity for professional managers, it seemed, was immense. If the mindless tactic of buying a basket of losers could comfortably beat the S&P 500, then surely a mindful tactic, informed by a brilliant, trained expert, could absolutely thrash the overall market. Reliably. Consistently. Again and again.

We all know how that has played out. As behavioral economics has grown in popularity, becoming a mainstream academic pursuit and earning Daniel Kahneman a Nobel Prize (an award he would have shared with co-author Amos Tversky, had Tversky been alive), the performance of active portfolio managers has declined. Meanwhile, once-tiny Vanguard has become by far the largest fund company on the globe, mostly courtesy of its index funds. The behavioral-economics boost was no boost at all.

Three Problems
There were three reasons why the hope didn’t translate into reality.

One is that trained expertise isn’t all that. In Kahneman’s Thinking, Fast and Slow (my vacation reading, and an inspiration for this column), he discusses how one of the big shocks of early behavioral research was learning that experts are, by and large, no better at thinking than are the unwashed masses. Experts quickly spot relevant data, which permits them to quickly solve routine problems that stump civilians. But when the problems are not routine, and thus require fresh analysis, experts are as bumbling as the rest of us.

One of the biggest problems is the refusal to confront failure because it is easier and more pleasant to remember one’s successes, forget one’s mistakes, and carry on. As an example, Kahneman tells of his work in the Israeli army, where he and a fellow psychologist were charged with evaluating officer candidates. The duo observed the candidates as they were put through several tests, designed by the psychologists to measure leadership skills. The conclusions, writes Kahneman, seemed obvious. “Under the stress of the event, we felt, each man’s true nature revealed itself. Our impression of each candidate’s character was as direct and compelling as the color of the sky.”

Direct and compelling, perhaps, but not particularly accurate. The psychologists’ predictions bore little correlation with subsequent performance. (“Our forecasts were better than blind guesses, but not by much.”) Yet the duo proceeded blithely onward. When another batch of candidates arrived, the duo once again “saw [the candidates’] true natures revealed, as clearly as before.” The experts “knew as a general fact that [their] predictions were little better than random guesses, but [they] continued to feel and act as if each of our specific predictions was valid.”

A second problem has been increased competition. With all the leading MBA programs now offering behaviorally influenced management classes, more and more portfolio managers are equipped with strong decision-making tools. Admittedly, knowing what is the right decision to make is different from following through and doing it, but, nonetheless, today’s investment managers appear to be better trained than those of the past and thus operate in a fiercer competitive environment. And indeed, both academic articles and institutional investors have made that claim.

Finally, there are the limits of arbitrage. Even if market prices are in error and a portfolio manager does make the correct trade to capitalize on the opportunity, that’s no guarantee of success. The market might remain crazy longer than the manager remains solvent--or at least, longer than the manager can retain clients. This problem was memorably illustrated in Adam Smith’s classic The Money Game, which related the harrowing tale of a money manager who shorted Caesar’s Palace in the early 1970s. By the time that bubble collapsed, so had the manager’s will power; he had covered his position at a huge loss.

New Hopes
All that said, I think that behavioral research does suggest a couple of fruitful investment paths.

One is to use mechanical approaches. According to Kahneman, using a simple algorithm often yields better results than relying on the individual judgment of subject-matter experts. He cites as an example the Apgar test for judging a newborn baby’s health--a simple checklist, capable of being used by various medical staff, that replaced a doctor’s personal evaluation. The adoption of the test proved “an important contribution to reducing infant mortality” because the gain in consistency from using an universal system outweighed the loss of losing personal insights.

The obvious candidates are strategic-beta funds, which mechanize active management’s strategies. Value, momentum, low volatility ... if an attribute appears to offer investment merit and is used as a screen or input by active managers, then it can be converted into a rule (or set of rules) that governs a strategic-beta fund. As with the Apgar test, much complexity is shed when moving from the experts to a rules system. But perhaps the benefit of consistency is worth the trade-off--particularly as strategic-beta funds usually have lower expense ratios.

The other opportunity lies in opting out of the game. Let others pummel each other over the gains to be made from short- to intermediate-term decisions. Whether won by the savviest of the active managers or via smart beta, those prizes will be difficult to obtain, with so many people chasing the same trades. Instead, stand and wait. Buy securities that for some reason--liquidity is one possibility, but there are others--are unattractive to those with shorter horizons but that may deliver above-market returns over the long haul.

This, of course, is the approach followed by the world’s most successful investment fund: Berkshire Hathaway (BRK.A). Its disciple,  Sequoia Fund (SEQUX), has also fared well, beating just about every single one of its mutual fund peers over the past several decades. Both securities thrive by buying when others are disinterested. Behavioral researchers point out that most people who are making decisions don’t think much about what others are doing, with the result that they unwittingly land in a crowd when they arrive at the same conclusions as the rest of the mob. Berkshire and Sequoia don’t have that problem. They recognize what others have done, and they step the other way.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.