Make Money From Investors' Mistakes?

The best plan is to profit by the folly of others. -- Pliny the Elder

Investors commit errors as surely as the sun rises in the east, so it’s natural to ask whether we can bank on those tendencies. In light of the plethora of academic studies about the psychological glitches that cause us to screw up, you’d think the answer would be a resounding yes. We’re overconfident and short-sighted. We tend to overreact to information, sell too soon and hold on to losers too long. The list is goes on and on. (The many mistakes we make and how to correct them are the subjects of Kiplinger’s yearlong Your Mind, Your Money series.)

It turns out, however, that beating the market by exploiting knowledge of human frailties isn’t easy. Richard Thaler, one of the fathers of behavioral finance, the science that studies financial decision-making, also helps run mutual funds based on behavioral-finance principles -- and they haven’t set the investing world on fire.

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Undiscovered Managers Behavioral Growth (symbol UBRLX) and Undiscovered Managers Behavioral Value (UBVLX) have each been around for more than ten years. Behavioral Value tries to make money, in part, by exploiting investors’ overreaction to bad news (a company’s earnings coming in below expectations, for example) and their underreaction to positive information. Over the ten-year period through April 23, the fund’s institutional share class returned 9.8% annualized. Over the same period, the Russell 2000 Value index, which tracks the kinds of small, undervalued companies that Behavioral Value focuses on, returned 10.4% annualized. Meanwhile, the average small-company value fund returned 7.1% a year.

In truth, you could argue that the fund’s reliance on behavioral finance is succeeding. Were it not for annual expenses of 1.4%, the fund would be beating the small-company value index. Making comparisons with the average performance of small-company funds is trickier because that figure is dragged down by fund expenses, too.

One fund’s performance does not a damning case make. But a 2006 study that looked at all 16 of the behavioral-finance funds in existence at the time reached a similar conclusion: The funds performed no better than funds that did not rely on behavioral finance to pick securities.

Colby Wright, one of the study’s authors and now a finance professor at Central Michigan University, says that no one has yet come up with a “systematic trading” scheme that can exploit biases. So much of the literature leaves him thinking, “Well, that’s a nifty finding, but how am I supposed to use it?” says Wright. He also surmises that as investors discover and disseminate the biases, their effects “dissipate and disappear,” as you’d expect would happen.

Another explanation for the shortcomings of behavioral-finance funds is that they don’t dig deep enough. That’s according to Richard Peterson, whose firm runs a hedge fund that seeks to profit from behavioral patterns. Peterson is a psychiatrist and partner in MarketPsych, which, in addition to running the hedge fund, offers psychological training to traders and money managers.

Peterson says that the funds using behavior do look at biases, such as our tendency to overreact to certain types of news or to make evaluations based on familiar standards. But, he argues, those biases are based on emotions. To really tap the psyche of investors, you should look not at what they’re doing but at what they’re thinking.

His hedge fund examines language in sources such as Securities and Exchange Commission filings, earnings conference calls, executive interviews, social-media chat rooms and news reports. He won’t divulge too much about his formulas, but he suggests, for example, that a high degree of fearfulness about a company is actually a bullish sign.

The fund, which can sell stocks short, launched September 2, 2008, nearly a year after the start of the bear market but just before its most dramatic declines. From its inception through the end of 2009, the fund gained 37%, beating Standard & Poor’s 500-stock index by about 47 percentage points, Peterson says. Those are impressive results, but the track record is short and, at any rate, it’s not easy to get in because the initial minimum is $250,000.

So, for now at least, there are no clear ways you can profit from the folly of others by using behavioral finance. But you’ll get a nice-enough payoff if you can use the lessons of behavioral finance to trim or eliminate emotion-driven errors in your own portfolio.