Behavioral finance is one of the hottest buzzwords in investment management, but observers say many managers merely are giving the concept lip service.
Only a few managers, led by Fuller & Thaler Asset Management Inc., San Mateo, Calif., have made behavioral finance an integral part of their investment process.
Others, including Fisher Investments Inc., Woodside, Calif.; LSV Asset Management, Norwalk, Conn.; Dreman Value Management LLC, Jersey City, N.J.; and Jacobs Levy Equity Management, Roseland, N.J., have incorporated elements of the theory.
Behavioral finance -- understanding how and why investors make irrational decisions -- helps money managers improve their own investment processes, many managers say.
But some experts argue that managers are talking the talk but not walking the walk. "The biggest application of behavioral finance is not in changing the way you invest, but in justifying what you already are doing," said Ken Fisher, chairman and chief executive officer of Fisher Investments.
"There are not many things that behavioral finance has discovered that improve the tactics of investment technology," he added.
Richard Michaud, president and chief investment officer of New Frontier Advisors LLC, Boston, said many behavioral finance studies are flawed by "data-snooping" -- that is, people always will find something that works no matter how many years the database covers. And the academics tend to use the same database, he added.
In his 1999 study of decision-making biases in a cross-border context, Mr. Michaud found that behavioral finance theories didn't hold up, but cultural factors were important. He added that his study was the only one that examined investor behavior in an institutional setting.
Former academic and now private investor Russell Fogler of Gainesville, Fla., added that behavioral finance has not made many inroads. "I don't think it's taking over the world. Because once you tell people about it, how do you implement it?" he asked.
In reality, Mr. Fogler believes managers have used behavioral finance to improve their trading strategies, but not for long-term investing. "You have to separate investing from trading. In investing, by definition, a lot of the mistakes don't happen. A lot of behavioral finance is aimed at the trading mentality," involving such issues as momentum and earnings surprises.
That's not necessarily a bad thing, especially given the recent price-setting leadership of individual investors, said consultants at Watson Wyatt Worldwide, Atlanta.
"One of the issues we have been quite focused on in manager work is to find value managers who embed in their processes some recognition of these realities, so they can avoid jumping in when (a stock) looks cheap, only to see it get 50% cheaper," explained Brian Hersey, investment director.
"The old value manager was early in and early out," added Jeff Nipp, head of investment research. "A lot of value managers have been working on these timing tools . . . to better time their purchases and sales."
To a certain extent, some say that nearly every active manager uses behavioral tools. "A majority of managers employ investment processes that try one way or another to try to exploit behavioral anomalies," said Paul Greenwood, senior research analyst at Frank Russell Co., Tacoma, Wash.
"A lot of the anomalies discussed in behavioral finance have been anomalies that investors have been attempting to exploit for a long period of time," he added. Behavioral finance helps explain these anomalies.
One could argue all value managers exploit behavioral anomalies because they try to buy stocks where investors have overreacted to bad news, Mr. Hersey said. Conversely, added Mr. Nipp, one could argue that growth managers buy stocks where people have underreacted to good news.
For the few managers that make behavioral finance an integral part of their investment decision-making processes, it appears to be showing up in performance.
At Fuller & Thaler, considered the leading behavioral finance manager, assets under management have shot up by $1.1 billion in 1999 from $400 million. (Recent market turmoil has kept the firm at $1.5 billion, despite the addition of several new clients.)
In a recent paper Russell Fuller, president, explained investors typically make four errors because of mental shortcuts in forming biased expectations about stock prices:
* Representativeness -- in which people's expectations of an event's recurring are influenced by recent events -- can cause investors to overreact to new information.
* Saliency can cause investors to overestimate the chances that an infrequently occurring event, such as an airplane crash, will reoccur soon.
* Overconfidence can cause people to overestimate their ability and knowledge, leading to underreaction to new information.
* Anchoring can cause people to make estimates based on previous values, thus leading to underreaction to new information.
Mr. Fuller noted that mispricing based on these errors doesn't occur that often. "Among low p/e stocks, 90% are correctly priced," he said in an interview. But it's the 10% that are priced incorrectly that his firm is trying to capture.
Conversely, underreaction probably is the main source of added value related to earnings surprise and short-term momentum strategies, he wrote.
In addition to Fuller & Thaler's small-cap/midcap growth and small-cap value strategies, the firm recently introduced a large-cap strategy. Unlike small-cap strategies, mispricing among large-cap stocks occurs mostly on short sales. Wall Street analysts devote more attention to large-cap stocks than small-cap stocks, and the vast majority of portfolio managers never sell short, creating inefficiencies, firm officials believe.
The firm's eight-year-old small-cap/midcap growth composite returned 72% in 1999. Over three-and five-year periods, the annualized return was 54.9% and 41.2%, respectively, placing it in the third and second deciles of the PIPER managed account rankings. Its small-cap value approach also has performed strongly, although over a shorter time period.
Bruce Jacobs, principal of Jacobs Levy, declined to disclose how behavioral factors influence his firm's models. He noted, however: "We live in a behavioral world, securities prices are determined by human actions, and the behavior of company management, securities analysts and investors influence securities prices."
But some experts believe true behavioral finance investment firms are few and far between. "Most of the people pushing overreaction are themselves engaged in cognitive error. Most are value guys who are using this as a concept of why value is the right concept for doing the things they do," Mr. Fisher said.
At his firm, Mr. Fisher said, he uses behavioral finance tools largely to help educate his clients. Traditionally, money managers have dealt with fear and greed, but behavioral finance teaches that clients tend to accumulate pride from making good decisions and shun regret for making bad decisions.
"The correct way to proceed is to shun pride, accumulate regret, and use it to be introspective," he said.
Behavioral finance theorist Meir Statman, Glenn Klimeck Professor of Finance at Santa Clara University's Leavey School of Business, said the market is irrational, and people consider factors beyond risk and return, such as socially responsible investing.
"I think the market is crazy and behavioral finance has demonstrated in a number of ways that people behave in ways that are less than smart," Mr. Statman said.
But the evidence is that professional money managers fail to take advantage of these behavioral anomalies, he said. His advice: buy and hold index funds.
Money management's "dirty secret is, professionals do make money, not by beating the market but by stoking the hope of others," he said.
