Investment Consult: Profit from behavioral biases

September 19, 2003

People are not as logical as we assume when it comes to investing. In fact, our emotions may be costing us.

 

Investment Consult

By Lewis J. Altfest, CFP

Profit from behavioral biases

• To avoid behavioral biases, stick to objective criteria.

• Loss aversion can hurt your financial performance.

We all like to think we take a cool, calculated approach to investing. Generally, though, most people don't. They act illogically when it comes to money, and their emotions often play the biggest role in how successful they are. Unchecked emotions can do much more harm than good.

To see how, we can look to Princeton University professor Daniel Kahneman's Nobel-prize-winning work in behavioral economics, an academic discipline that examines investor behavior. Kahneman's research often describes the same behaviors my clients engage in—behaviors that can drive stock prices. One of them, called "anchoring," refers to the tendency to stick with an initial opinion of an investment for too long. Take AT&T, for instance. It ceased being a blue chip long before many people realized its glory days had passed. Today the telecom giant suffers from declining revenues and shrinking margins as it struggles against fierce competition.

Another common behavior is called "regret," which is when an investor doesn't sell a stock for fear it'll bounce back after the sale. A physician client of mine was filled with regret over the technology stocks he'd bought in the late 1990s. I advised him to keep certain ones and sell the rest. He balked. I agreed with him that most of the stocks would probably rebound in time, but told him that the investments I had chosen would do better in the long run.

I think the doctor respected my opinion but was practicing a related behavior that Kahneman terms "loss aversion." A person feels greater pain after a loss than he does joy after a gain of the same magnitude, Kahneman theorizes. For example, if your portfolio rises 10 percent one year and drops 10 percent the next, you don't break even emotionally; you feel worse because of the loss. That's why you may be tempted to hold onto questionable stocks rather than sell them and reinvest the cash in more promising ones.

To overcome loss aversion and other behavioral biases, you must stick to objective criteria. Don't, for instance, purchase stocks with price-earnings ratios that are more than 20 percent higher than the P-E of the overall market. Better still, take advantage of other peoples' fears and weaknesses by buying sound stocks with below-market-average P-Es, broadly known as "value" stocks.

Moreover, don't give in to short-term impulses. Invest for the long term, and be receptive to things that signify fundamental changes in a company. Lastly, recognize that loss aversion can hurt your performance.

If you'd like to try profiting from the behavioral biases and weaknesses of analysts and other key market participants, you can do so through two domestic mutual funds designed to exploit those foibles: Undiscovered Managers Behavioral Growth Fund and Undiscovered Managers Behavioral Value Fund (888-242-3514 for both). Richard H. Thaler, a subadviser to these funds, has published research with Daniel Kahneman and is a professor of behavioral science and economics at The University of Chicago Graduate School of Business.

The Behavioral Growth Fund seeks mid-cap and small-cap companies whose surprisingly good earnings come into question. The fund's managers then look for some potentially lasting change in the business that would make the company's stock worth acquiring, such as a new revenue stream or novel way of saving money. The strategy has had good results: This year, the fund is going like gangbusters, up 47.5 percent*. And the fund's five-year average annualized return of 9.0 percent is almost 8 percentage points a year better than the S&P 500's return over the same period.

The Behavioral Value Fund's portfolio is a who's who of small companies, including Longview Fibre, Newpark Resources, Stage Stores, and Westar Energy. The fund, which follows the same investment strategy as its counterpart but buys predominantly small-cap and micro-cap stocks, is up 40.7 percent this year and has averaged 8.8 annually over the past three years. (It's still a few months shy of a five-year record.)

Both Undiscovered Managers mutual funds are available only through a financial planner or a funds supermarket like those offered by Fidelity and Charles Schwab. If you believe, like I do, that theories of behavioral science can shape useful investment strategies, either or both of these funds could make rewarding additions to your portfolio.

 

*Unless otherwise noted, all performance figures are through Aug. 31.

 

Lewis Altfest. Investment Consult: Profit from behavioral biases. Medical Economics Sep. 19, 2003;80:18.