Chapter 2: The Strange Paradox of Behavioral Finance: “Neoclassical Theory Is a Theory of Sharks”
Ø Behavioral Finance argues that most investors make decisions and choices based upon an inability, or unwillingness, to analyze situations in the cool, detached and fully informed manner of the investors in the CAPM or EMH.
Ø Black: “Noise traders buy and sell on what they would like to believe is informed opinion and analysis, but in most instances they act on what is in fact misinformation – in the broadest sense of the word.”
Ø As a matter of fact, many investors will be beating the market at any given moment – “the market”, after all, is the average result of what everybody is doing – so some people will be performing better than the market and others will be performing more poorly.
Ø This is not the same thing as outperforming after adjustment for risk, with consistency year after year.
Ø The record suggests that only a handful of investors are outperforming the markets with any degree of consistency (in which, what these investors do, although seemed simple, are remarkably hard to emulate).
Ø Studies of institutional investing continue to show that most active managers underperform in both equities and fixed-income markets.
Ø Although many mutual funds show a tendency to outperform the market before fees and expenses, they then display a propensity to give that margin away in the turnover costs, taxes, and management fees that cut into the returns accruing to their shareholders.
Ø Even is the evidence suggests that most mutual funds do underperform, are there any funds with some identifiably consistent ability to outperform – and if so, do we have any way to identifying them in advance?
Ø Two studies provide some basis for both the likelihood that such skills exist and the likelihood that those skills can be identified in advance:
n A sizable minority of managers pick stocks well enough to more than cover their costs. Moreover, the superior alphas of these managers persist.
n The tests consistently indicate that the large positive alphas of the top 10% of funds, net of costs, are extremely unlikely to arise solely due to sampling variability (luck).
n Harlow and Brown find a number of factors explaining past superior performance especially costs and turnover rates, as well as past alpha, tends to predict future alpha.
n We have no knowledge of how these managers would perform after they were identified by investors using the Harlow-Brown paradigm (if identification of superior managers becomes simple, those managers will be buried under an avalanche of new money to a point which they can’t deliver the superior performance).
Ø By definition, most investors cannot outperform the market because they are the market.
Ø On the other hand, the available evidence suggests that fewer investors are able to win out over the others than would be the case if the markets were not so competitive. What the crowd knows is already in the price, but it is not easy to think outside the crowd.
Ø Jack Treynor (one of the pioneer of CAPM) believes that systematic errors provide many opportunities to earn excess returns:
n His favorite approach is to tell people about the stocks that look especially attractive to him. If they agree right away that he is on to something, he figures the price of the stock already reflects this idea, and he goes on to something else.
n “Slow ideas” – ideas that will take time to bear fruit and therefore have no attraction for most investors.
n Comment: this is why Fuller and Thaler seek opportunity in the smaller capitalizations. Pickings are easier and the gains are surer, while the huge composite of large growth mutual funds can barely squeak through with something resembling outperformance before taxes and fees.
Ø Under no-arbitrage, the debate between the doctrines of Capital Ideas and Behavioral Finance vanishes.
n Stephen Ross (one of the most distinguished scholars of Capital Ideas): “I never thought people are all that rational. But that was never the point of financial theory. Neoclassical theory is a theory of sharks and not a theory of rational homo economicus and that is the principal distinction between finance and traditional economics. Well-financed arbitrageurs spot these opportunities (resulting from behavioral errors), pile on, and by their actions close aberrant price differentials [emphasis added]”
n Andrei Shleifer and Robert Vishny counter argue that: “There are limitations to arbitrage. There are possibilities that arbitrage becomes ineffective in extreme circumstances when prices diverge far from fundamental values. The model also suggests where anomalies in financial markets are likely to appear, and why arbitrage fails to eliminate them.”
n Well aware of the risks involved, these arbitrageurs may stand aside or, on occasion, actually join in the fun and drive values even farther apart.
n The greatest risk to arbitrageurs is momentum risk (“Don’t fight the tape!” is an old saw on Wall Street that can still ring true from time to time).
n As a result, price discrepancies in special cases (particularly securities with narrow market that are difficult or costly to borrow) can persist for long periods of time, and failure of the EMH is there for all to see.
Ø Entertaining as these anomalies may be, that very feature reveals that violations of the non-arbitrage condition are not typical of the vast majority of situations in the market. These promising opportunities sound tempting, but we rarely encounter them.
Ø Evidence supporting the case for market inefficiency:
n Irrational pricing in the market as a whole in contrast (namely, gross inefficiency).
n Mispricing of individual securities.
n Rational bubble à rational investors pick off the mispricings provided for them by the noise traders – follow the crowd into a bubble on the assumption that this irrational exuberance is an opportunity to make money and that they will be so smart they will know how to get out in time.
Ø Merton Miller: “What can the poor kids (Behavioral Finance) do? The filed of finance is kind of a mature field now.”
Ø Eugene Fama: “Consistent with the EMH that anomalies are chance results, apparent overreaction of stock prices to information is about as common as underreaction. And post-event continuation of pre-event abnormal returns is just about as frequent as post-event reversal. Most important, the LT anomalies are fragile… The evidence does not suggest that market efficiency should be abandoned.”
Ø I would argue there is more to Behavioral Finance than its critics are willing to admit.
Ø The issue is not whether the markets perform precisely as Capital Ideas prescribes. Rather, the issue is how wel Capital Ideas have survived the attack from the behavioral side.
Ø The whole lesson embedded in Modern Portfolio Theory is that financial management is a risky business, and the contribution of Behavioral Finance has deepened our understanding of how investors reach decisions and how they interact with one another under conditions of uncertainty.
Ø Kahneman: “I think behavioral models can be very important to institutional design, but it isn’t as clear that in the end they are going to have dramatic explanatory power for asset prices”
Ø Ultimately, however, all mispricings arise from the heuristics investors employ in the daunting task of valuing financial assets.
Ø More precisely, behavioral anomalies are where alpha is born.
Ø Jeffrey Gould: “In order to protect returns, we don’t show anyone else what we do or don’t do. It would give people a leg up. We want them to keep doing what doesn’t work, because it lets us capture more alpha.”
Ø Behavioral Finance is planting the seeds of its own destruction. The ultimate result is a market in the real world that bears a closer resemblance to the theoretical models.
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