Prudential Insurance Co. of America, Newark, N.J., is managing half of its $510 million voluntary employee beneficiary association plan using pioneering concepts of behavioral economics.
The firm also runs $100 million for outside clients using the large-cap strategy, and plans to introduce a $250 million midcap portfolio for outside clients by year end.
Behavioral economics is an unlikely marriage of behavioral science and economics that has produced a new body of investment theory.
Behavioral economics attempts to use behavioral science theories and techniques to understand why people make the economic and investment decisions they do, although those decisions often seem to be irrational in an economic sense.
Understanding why people make apparently irrational decisions may allow investors to discover market inefficiencies that can be exploited.
Some of the latest research findings were discussed at Harvard University Nov. 16 and 17 at a conference sponsored by the Cambridge Center for Behavioral Studies. Topics discussed included: "Optimistic Forecasts and Timid Decision Rules: Conflicting Biases in Decision Making;" "Myopic Loss Aversion and the Equity Premium Puzzle;" and "Why Smart People Persist in Making Stupid Choices."
Prudential is testing the application of behavioral principles to management of $250 million of its $510 million VEBA, which is a 501(c)9 defined contribution trust that also can be used for health and welfare benefits.
The hope is to eventually extend the strategy to its internally managed $6 billion defined benefit plan.
"What's nice about this whole marriage is it's giving a rationale to value investing. It's not just that the stock's been beaten up so much there's nowhere to go but up .*.*. Investors systematically make mistakes, which creates opportunities," said Mark Stumpp, managing director and chief investment officer at PDI Strategies, Short Hills, N.J., one of Pru's investment management subsidiaries.
"We've been using this strategy for a year, and we're beating the market with very little in technology," said Mr. Stumpp. He manages the VEBA.
In the first three quarters of 1995, the strategy has narrowly beaten the Standard & Poor's 500 Stock Index, with a return of 29.9%, vs. 29.7% for the benchmark.
Mr. Stumpp also oversees the $6 billion in-house managed defined benefit plan. "If the psychological stuff starts to look successful, we'll apply it to the larger pension fund," he noted.
Mr. Stumpp, who holds a doctorate in economics, said behavioral science has provided a theoretical underpinning for contrarian investing, a strategy that has worked well for years for reasons that are hard to identify.
"These psychological things tend to steer you toward a value style. People are lousy forecasters....People have overpenalized (companies for negative events) or overextrapolated good things."
Mr. Stumpp's strategy is to underweight what he calls "glamour" stocks in the S&P 500, in favor of stocks that are cheap and have been around for a while.
Mr. Stumpp said value managers tend to consistently overweight certain sectors like banking and underweight technology. In actuality, it's not possible for those sectors to be misvalued for several decades, he said.
"We don't believe sectors and industries can become systematically misvalued. So we pick companies in each sector that offer the most value."
Holdings include: Dow Chemical Co., Pacific Telesis Group, PPG Industries Inc., America West Airlines Inc., Consolidated Edison Co. of New York Inc. and, in technology, Digital Equipment Corp. and Motorola Inc.
His strategy tries not to make big sector or stock bets. The most it can diverge from any S&P 500 sector is two percentage points.
Behavioral scientists have demonstrated that "the old Chicago school of efficient markets is starting to show some chinks," Mr. Stumpp said. "Theories are changing. Markets are sometimes inefficient. People sometimes make bad decisions. (Behavioral) theory leads to TAA and contrarian investments....You're going to hear a lot more about this stuff in the future than flash-in-the-pan stuff like neural networks."
Mr. Stumpp has looked into other hot new quantitative strategies like artificial intelligence, but found that "conventional statistical tools work fine. You can test statistical reliability. Conventional tools can deal with non-linear problems too (just like artificial intelligence techniques) and the models can be based on theory. Without a theory you're just taking shots in the dark."
In his case, the theory is simple. Valuations - not momentum - are important. So measures like discounted cash flow are key.
Another factor he follows closely is sales growth. "If it's rapidly accelerating, investors will extrapolate that into the future and overpay for it. Those are generally companies we would not be investing in."
In fact, companies with declining historic five-year sales growth and low price-earnings ratios "are companies we load up on."
Because buying such turnaround candidates can be risky, PDI holds more than 200 stocks to diversify the bets.
"Given that it's been a growth stock year and we're ahead of the market with a value strategy, we're pretty happy," he said.
