MIND VERSUS MARKET

   Mind versus Market – How investment firms profit from people’s mistakes

Four months ago, I did something that in hind sight was astonishingly stupid. I clicked on a trading web page and bought shares of Citigroup. The company, like most of the Wall Street banks then staring down the subprime meltdown, was limping along. The headlines were bad. The chatter on CNBC was pessimistic.

I saw a bargain. I saw a company whose credit card bills and offers show up in millions of mailboxes everyday. Just as soon as the banks got their write-offs out of the way, optimism will return to the sector. There would be more buyers of the stock than sellers. I would profit. Now, here I am today: My investment is down 22 percent. And I am still holding on to the stock. Am I, as my wife and closest friends sometimes insist, the dumbest man walking the Earth?

“You are human” said Russell, chief investment officer of Fuller and Thaler Asset Management in San Mateo, California. His firm uses behavioral economic theories of Nobel Prize winners and university economists to profit from the everyday mistakes of the common investors and the pros on Wall Street.

Humans, no matter how hard we try, act in ways that causes us to make the wrong investment decisions almost all the time. We are absurdly over confident about what we think we know. We are – as I – am now- reluctant to part with our losers. We sell winners too soon, then we buy stocks that perform worse than the ones we sold. We get anchored on certain opinions about stocks and react too slowly to information that should change those beliefs. We believe things will happen based on how easily we think of recent examples.

The world of behavioral economics, which melds psychology, finance and emotion, seeks to explain and sometimes exploit why we do what we do when it comes to investing. It is a field that has become more accepted lately, particularly since 2002, when Princeton University psychologist Daniel K. was awarded the Nobel prize in economics for, as the Swedes put it, integrating “insights from psychology into economics, thereby laying the foundation for a new field of research.”

Daniel K. is a Director at Fuller and Thaler, a firm whose other namesake is Richard Thaler, a prominent University of Chicago behavioral economist and a frequent collaborator with Daniel K. Two of the funds the firm manages that use behavioral methods have beaten Russell benchmarks from their inception through the first quarter of this year. Nor surprisingly, Fuller & Thaler is not the only firm using to Alliance Bernstein say they seek to capitalize on the faulty investor mind.

For instance, Fuller & Thaler likes to pay close attention to analysts who may be anchored on a stock, not raising their earnings-per-share estimates enough even though positive information has come out about the company. Fuller and Thaler’s investment team pounces before the analysts realize they were wrong. As Daniel K. said in an interview,” I think that betting on mistakes of people is a pretty safe bet.” 

I asked Daniel K. what fools us most frequently. That was simple, he said: overconfidence.” It’s the idea that you know better than the market, which is a very strange idea,” he said.” Individual investor have no business at all thinking they can do better.”

Why do we?” it’s because we have no way of thinking properly about what we don’t know,” Daniel K. said.” What we do is we give weight to what we know and then we add a margin of uncertainly. You act on what you think will happen.” But Daniel K. added,” In fact, in most situations what you don’t know is so overwhelmingly more important than what you do know that you have no business acting on what you know.”Oops. 

Barbara Warner, a financial planner with Warner Financial said she sees a lot of overconfidence among two groups of people: relatively low investors to the market (me), particularly recent business school graduates and retirees. The latter group can be exceptionally frustrating. “Now they have entirely too much time on their hands to devote to CNBC and business magazines,” she said. “People suddenly think they are smarter than they used to be because they have more time to pay attention to it.”

That’s a disastrous situation. Daniel K. said, “The more closely you pay attention, the more you do things, the worse off you will be.” For proof, he pointed to groundbreaking research done by one of his former students, Terrance Odean, now a Professor at the University of California at Berkeley. Terrance has written that “overconfidence gives the investors the courage of their misguided convictions.”

It is particularly curious when investors hold on to loosing stocks. This is a function of something called los aversion, a discovery that helped Daniel K. win the Nobel prize. Loss aversion refers to the fact that we are wired in such a way that loosing money hurts more than getting money feels good.

When it comes to trading, this helps explain why we would want to hold on to losers. Selling the loser, even though it gives us a tax write-off, causes us to admit we have lost. So we do something that makes us feel better: we sell the winners. This feeds our overconfidence. We often sell winners that still have some winning to do. That puts stocks with upward momentum on the market for less than they are really worth long term, allowing savvier investors to snap them up.

Individual investors probably as a group create the dynamics by which they loose money and institutions make money. They create mispricings.