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Behavioral Investment Management

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Overview Beating the market Are markets efficient? What are the sources of alpha? Is your alpha reliable? Behavioral approach to asset management Investors are biased Biases often persist Biases are not always arbitraged away Example of implementing a behavioral approach 2

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Are Markets Efficient?

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Real Life Orange Juice Example: Royal Dutch / Shell formed in 1907 Royal Dutch trades on the NYSE Shell trades on the Financial Times Stock Exchange Index 1 Royal Dutch = 1.5 Shell 5 Source: Froot and Dabora (1999)

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Do These Two Stocks Trade At A Price Ratio Of 1.5? 6 Source: Thaler (2008)

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Another Orange Juice Example 3Com sold 5% of Palm, the rest still belonged to 3Com stockholders Each 3Com holder owned 1.5 shares of Palm At the end of 3/2/2000 Palm was at $95 3Com holders owned $142.50 worth of Palm 7 Source: Lamont and Thaler, (2002)

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What Was 3Com Worth At The Close of 3/2/2000? 8 Source: Lamont and Thaler, (2002) $242? $197? $142.50? $102? $81?

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What Are The Sources Of Alpha?

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Fundamental Managers 1.Better information Analysts outperform on stock recommendations when they have school ties to senior officers of the firm being evaluated 2.Better processing Warren Buffett has a net worth of $62 billion Berkshire Hathaway averages ~27% annual returns 10 Sources: Frazzini, et al (2008), http://moneycentral.msn.com/content/investing/findhotstocks/p90537.asp

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Market Average Vs. Buffett Returns 11 Source: CRSP Database

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Quantitative Managers 12 3.Finding statistical relationships Momentum Short and long term returns negatively predict returns but intermediate returns predict continuation Reversal Stocks doing well tend to do worse than average over the long term Sources: Jegadeesh and Titman (1993, 1999), Debondt and Thaler (1985)

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Quantitative Managers 13 Post Earnings Announcement Drift A stock's price jumps after an earnings surprise and tends to continue in the same direction over the following months The January Effect Small stocks give excellent returns from the end of December through January Sources: Ball & Brown (1968), Rozeff & Kinney (1976)

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Is Your Alpha Reliable?

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By The Time We Know Buffett Has Alpha, Hes Ready To Retire 15 Source: CRSP Database

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Daily Returns Before And After Anomalies Were First Published 16 Sources: Marquering et al (2006)

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Behavioral Approach To Asset Management

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Investors Are Biased

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Roulette Anyone? 19 Roulette is a casino game where a wheel and a ball are spun in opposite directions and eventually, the ball falls into a space. Bets can be placed on whether the ball will fall into a red, black, or green space. There are 18 red spaces, 18 black, and 1 green

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Question: Youre in Vegas and walk up to roulette tables with the 5 previous spins posted as: Which table would you feel more comfortable placing a bet on black? 20 Table 1Table 2 29 2736 317 265 129

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Representativeness Heuristic Belief that even small samples should be representative of the population People also think that the recent past is indicative of the future The Gamblers Fallacy says: 5 reds in a row in a fair gameblack is due! 21

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Question: (1) Write down the last 4 digits of your SSN (2) Do you think that a Gronitz PCM-5 CC Tuba costs more or less than this number? (3) What is your best estimate of the cost of a Gronitz PCM-5 CC Tuba? 22

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Anchoring The tuba costs ~$12,000 according to www.tubaexchange.com Any arbitrary number can influence your guess by anchoring you to that number 23

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What Is Your 90% Confidence Interval For These Questions? Lower Upper 1.Length of the Nile River (miles) ____ ____ 2.Diameter of the Moon (miles) ____ ____ 3.Weight of an empty Boeing 747 (lbs) ____ ____ 4.Year in which Mozart was born ____ ____ 5.Number of countries in OPEC ____ ____ 24 Source: Fuller (2008)

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Answers: 1.Length of the Nile River (miles) 4,187 2.Diameter of the Moon (miles) 2,160 3.Weight of an empty Boeing 747 (lbs) 390,000 4.Year in which Mozart was born 1756 5.Number of countries in OPEC 13 Were these answers within your range? 25 Source: Fuller (2008)

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Biases Often Persist

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Immediate Gratification 27

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Is there learning? 28

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Biases Are Not Always Arbitraged Away

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Arbitrage Concentrates In Only A Few Markets What would you get if you converted: Arbitrage is concentrated in bonds and exchanges and little in stocks There is low cost and risk There is high leverage 30 $1$ Source: Shliefer and Vishny (1997)

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Arbitrage Doesnt Necessarily Correct Mispricing Professionals made big profits off the internet bubble buying and selling at the right time Everyone believed the prices were too high but forecasted even higher prices in the future 31 Source: Brunnermeier, and Nagel (2004)

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Behavioral Effects Can Be Hard To Arbitrage Stocks have outperformed bonds over the last century by too high a margin Myopic loss aversion Investors are very sensitive to losses, and even long-term investors focus on short-term losses, hence demanding a very high equity premium How would you arbitrage myopic loss aversion? 32 Source: Benartzi and Thaler (1995)

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Long Term Capital Management 33 Source: Lowenstein (2001) Arbitraged similar bonds (30 yr & 29.5 yr) and figured they would converge in the long run Annual returns were > 40%! Lost $4.6B over 4 mos in 1998 Eventually, the bond prices did converge but LTCM went bankrupt waiting

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Example Of Implementing A Behavioral Approach

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Mental Mistakes Made By Investors Under-reaction to new information Foundation of the growth process Over-reaction to old information Foundation of the value process 35 Source: Fuller (2008)

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Causes Of Under-Reaction Anchoring Individuals are tied to their previous opinions, causing under-reaction to new information, resulting in biased expectations Overconfidence Individuals place too much confidence in existing knowledge, causing under-reaction to new information 36 Source: Fuller (2008)

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Analysts Under-React to Earnings Surprises Analysts are surprised again and again when growing companies outperform forecasts Surprises are greater when earnings increases are permanent (i.e., success of a new product) versus temporary (i.e., change in exchange rate) 37

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Analysts Revisions For Fiscal Year 1 Earnings 38 Source: Fuller & Thaler (2008)

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Causes Of Over-Reaction Representativeness People tend to infer that a single observation represents the entire population (stereotyping) Saliency People tend to over-estimate the probability of a low frequency event (earthquakes) Prospect Theory Investors may be irrationally risk averse in the domain of losses 39 Source: Fuller (2008)

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Fuller and Thaler Asset Management Fund Performance 40 Source: Fuller & Thaler (2008); See important disclosure on last page of presentation

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Disclosure Statement 41 Fuller & Thaler Asset Management, Inc. claims compliance with the Global Investment Performance Standards (GIPS). Fuller & Thaler has been verified for the period from January 1, 1992 through March 31, 2008 by Beacon Verification Services, LLC. A copy of the verification report is available upon request. This information is provided solely for general informational purposes and does not constitute an offer to sell or a solicitation of an offer to buy or sell any product or service to any person or in any jurisdiction where such offer or solicitation would be unlawful. Fuller & Thaler is an independent investment management firm registered with the U.S. Securities and Exchange Commission that manages primarily equity assets for primarily institutional investors. Fuller & Thaler seeks to identify mis-priced securities by exploiting insights from the field of behavioral finance. The firm changed its name from RJF Asset Management, Inc. to Fuller & Thaler on December 14, 1998. The firm was called RJF Asset Management, Inc. as of April 5, 1993 to December 13, 1998. The investment philosophy has remained constant throughout the firms history. *Assets in a composite may exclude accounts in a strategy that do not comply with the composites account inclusion criteria. Market Neutral Composite is primarily invested in the equities of the top 1,500 U.S. companies ranked by market capitalization and liquidity. The composite has a $10 million account minimum and was created in February 2000. The composite is an un-levered version of the market neutral strategy which employs a long/short strategy managed with minimal net dollar exposure and minimal net beta exposure and is measured against the Citigroup BIG Treasury Bill (3 M) (LOC) Index. The standard advisory fee is a 1.0% per annum management fee and a performance fee of 20% of the profits in excess of a T-Bill hurdle subject to a high water mark. For the period February 1, 2000 through April 30, 2000 the composite returns represent the performance for the long and short equities carved-out of a market neutral account passively equitized with S&P 500 futures (S&P 500 futures were purchased and "rolled" on a quarterly basis to maintain a passive exposure to the S&P 500 index). The composite returns were derived by excluding the futures positions from this equitized market neutral account. The carve-out received a 100% cash allocation.