Behavioral Investment Management

1. Behavioral Investment Management

2. 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

3. Are Markets Efficient?

4. Are Markets Efficient?

5. Real Life “Orange Juice” Example: Source: Froot and Dabora (1999) 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

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

7. Another “Orange Juice” Example Source: Lamont and Thaler, (2002) 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

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

9. What Are The Sources Of Alpha?

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

11. Market Average Vs. Buffett Returns Source: CRSP Database

12. Quantitative Managers Sources: Jegadeesh and Titman (1993, 1999), Debondt and Thaler (1985) • 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

13. Quantitative Managers Sources: Ball & Brown (1968), Rozeff & Kinney (1976) • 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

14. Is Your Alpha Reliable?

15. By The Time We Know Buffett Has Alpha, He’s Ready To Retire Source: CRSP Database

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

17. Behavioral Approach To Asset Management

18. Investors Are Biased

19. Roulette Anyone? 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

20. Question: You’re 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”?

21. Representativeness Heuristic • 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 Gambler’s Fallacy says: • 5 “reds” in a row in a fair game…black is due! 21

22. 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?

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

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

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

26. Biases Often Persist

27. Immediate Gratification

28. Is there learning?

29. Biases Are Not Always Arbitraged Away

30. Arbitrage Concentrates In Only A Few Markets ? Source: Shliefer and Vishny (1997) 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

31. Arbitrage Doesn’t Necessarily Correct Mispricing Source: Brunnermeier, and Nagel (2004) 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

32. Behavioral Effects Can Be Hard To Arbitrage Source: Benartzi and Thaler (1995) • 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?

33. Long Term Capital Management 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

34. Example Of Implementing A Behavioral Approach

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

36. Causes Of Under-Reaction Source: Fuller (2008) • 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

37. 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)

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

39. Causes Of Over-Reaction Source: Fuller (2008) • 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

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

41. Disclosure Statement 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 firm’s history. *Assets in a composite may exclude accounts in a strategy that do not comply with the composite’s 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.