Small-Cap Fund Looks to Benefit from Investor Mistakes

Fuller and Thaler Behavioral Small Cap Equity Fund

Human behavior does affect the price of stocks in a meaningful way, as evidenced by the work of Richard Thaler, who even has a fund to show this work in real life.

There is a view out there that financial markets are perfectly efficient, based upon two major principles that simply do not hold true in real life. Economic models first assume that we always have complete information, and then assume that we will always act perfectly rationally in applying this perfect information.

Perhaps a lot of economists are not too familiar with either the way that financial markets work nor the human condition. Anyone who has observed humans in action for any period of time can attest that they do not always act rationally, and often act pretty irrationally.

This certainly extends to the way we manage our investments, decisions that often involve non-rational motivators such as greed or fear. It’s even quite hard to educate this out of someone, to get them at least thinking more rationally, and the biggest challenge with educating traders is getting them to set aside their emotions such that they don’t interfere so much with one’s trading plans that they end up bringing themselves down.

The perfect information idea is even further out of touch. Investors do not have perfect information about the past, and certainly do not about the future, and it is actually the prospects of the future that mostly drives prices.

At best, we can make educated guesses about the future prospects of an investment, where we’re looking for these guesses to be more probable than not. The degree that we’re right rather than wrong, less trading costs, is our edge.

This is not an easy thing to do, and does also require a fairly high degree of rationality as well. If we are good at this, if we devote ourselves to overcoming our natural tendencies to react emotionally to decisions that involve our financial well-being, we can manage both. However, this is something that seasoned professionals aspire to, not your average investor with virtually no real knowledge of what they should be looking at to assess changing probabilities properly, or the resolve to follow through with a good plan should they find one.

We Can Only Guess at What May Happen

The fact that what will happen is not completely known is what is behind all the vacillations in prices of securities. We see these vacillations, or waves, in any timeframe, from yearly charts to tick by tick ones. We move from what we could call overbought and oversold conditions because opinions out there do differ, and even conflict with one another. This is a far cry from a fully informed and fully efficient market.

The fact that markets are not completely efficient should therefore be quite obvious to us, at least when we move from the realm of theory to see how our theory plays out in real life. This theory does not, and the best we can do to defend it is to try to use a circular argument, assuming that whatever the outputs of markets are expressions of this efficiency, even though this not only proves nothing but is actually quite ridiculous.

One of the things that we see when we use psychology to analyze market behavior is the tendency to overreact. This serves to have us tending to hold our positions too long or too short, deviating from the efficiency. This can also have us missing out on opportunities by delaying our entries, much like someone who sold at the bottom will just sit back in horror as things turn around, berating themselves for exiting and not realizing that the right move right now is to re-enter.

With markets, beliefs become transformed into reality, and regardless of the merit of those beliefs, they do drive prices. We can see this on both sides, with people both having the tendency to become afraid when their investments are going down, and to get greedy when they go up.

Fundamentalists, those who make hard business and economic data their focus, and together with this broken theory of perfect efficiency, base their judgements on what should happen with a given fundamental outlook, miss the act of agency, the human element in the equation. While this data may be important, we still need to account for investor behavior itself, and technical analysts base their entire forecast on where the rubber hits the road, the ingestion of all the information we have and the actions taken upon it, manifest in trends in price.

Both approaches involving using tools to assess probabilities of future price action, and in all cases, we do need to take into account the human element, the so-called imperfections that have their say in these prices. Technical analysis already builds this in, where fundamental analysts need to adjust their view that this can all be properly understood by just looking at things like balance sheets and economic data.

Most mutual funds end up failing to beat the market because they are too married to this idea of efficient markets, where fundamental data is the only thing that really drives prices. Not all mutual funds fail to deliver on their promise to at least beat a random portfolio, one chosen by a monkey perhaps or the selection of stocks in an index, and some do have insights sufficient to beat this by just a little, but others feel that a more balanced approach is more likely to deliver better results.

Small Cap Fund Seeks to Put This Information to Use

Such is the case with the Fuller and Thaler Behavioral Small Cap Equity Fund. When you come right out and call yourself a behavioral fund, and also have Nobel prize winning behavioral economist Richard Thaler as a principal, it’s clear that this isn’t your average fund.

The views of Thaler, who believes that markets are swayed to a considerable degree by human behavior, wouldn’t stand out anywhere near as much as they do if not for the fact that we mistakenly believe that the behavior aspect is of little or no account, At the very least, if we think of this even a little, it should be rather clear that behavior does have at least some say here.

Fund manager Raife Giovinazzo describes their approach as basing their decisions on “how people behave, as opposed to how they should behave.” This is what technical analysis does, with the difference being their focus on how markets behave, as opposed to how people think they should.

Focusing on “behavioral finance” may still be somewhat distanced from what really goes on, meaning that it is based upon beliefs surrounding behavior, as opposed to watching price and see this behavior and everything else influencing prices unfold together, this still has a leg up on those who choose not to account for the behavioral characteristics that mold markets.

As it turns out, this fund is also heavily influenced by fundamentals, where they seem to be seeking a combination of what they perceive is fundamental value together with accounting for the over-reactions that we see in the market driven by human behavior. You do need a benchmark here to decide whether a move is an over-reaction, and by how much, so this part makes sense.

While this fund hasn’t set the world on fire by any means, they at least have shown that they can beat the market averages with this approach, at least from looking at returns from 3-5 years. More recently, they have been underperforming the market a little, in 2018 and in the first couple of months of 2019, but to be fair, the longer-term numbers are more important.

When we look more closely at their approach, it turns out that they rely a lot on the degree that companies buy back their own stock to make their decisions. This is generally seen as a bullish move, and does directly put the price of stocks up after all, so if we have a trend here then this can indeed make a stock more attractive at times for several reasons.

We may wonder what this has to do with human behavior, but if we see insider behavior as being more reliable than behavior in general, that of the investing public, which is often wrong to some degree, then they may indeed have something here.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.