Do Behavioral Biases Lead to Profitable Investment Strategies?


We recently came across a research paper that examined the performance of “behavioral mutual funds.” We put this term in quotations since it is hard to nail down exactly what type of investment strategy these types of mutual funds are implementing other than the fact that they state in their prospectuses that they take behavioral biases into account when making investment decisions.

The 22 mutual funds referenced in this particular study date all the way back to 1982, but the vast bulk were created after the “dot com crash” in the early 2000’s after many saw what seemed to be “irrational exuberance,” particularly in the technology sector of the U.S. stock market. These funds attempt to find and exploit mispricings in the stock market that are due to irrational investor behavior.

This is a hotly debated topic in the academic world in terms of market inefficiency and irrational investor behavior. As the author of the study points out, “Gromb and Vayanos (2010) have shown that assets’ mispricings may be persistent due to a series of frictions that prevent arbitrageurs from eliminating them.” On the other hand, Nobel Laureate Eugene Fama believes market fluctuations, even those during 2001 and 2008, are in fact rational. During his Prize Lecture in 2013, he explains that his research behind the predictability of variation in return is rational based on variation in perceived risk (start at minute 19:00).

The biggest problem is that we are only able to identify what seems like inefficiencies or behavioral biases after the fact. In other words, during the 2008-2009 financial crises, it was extremely difficult to determine whether or not prices reflected rational expectations of future returns based on the collective estimation from all market participants or whether there was a herding effect that drove prices well below their intrinsic value. Likewise, it was very difficult to identify whether prices during the “dot com bubble” were accurate estimates of future expected return or whether there was a herding effect of people driving up prices because they saw the opportunity for potential profits based on nothing other than greed versus underlying economic fundamentals.

In all practicality, it is probably a blend of both, but what really matters is if any behavioral biases can actually be exploited into tangible results. This is a question that can’t be addressed by theory, but rather hard-nosed data. The study examined the performance of 22 mutual funds from January 2007 – March 2013 and attempted to answer the following questions:

  • Did these behavioral mutual funds outperform the overall market?
  • Did these behavioral mutual funds exhibit abnormal risk-adjusted returns (based on asset pricing models like the CAPM or the Fama-French-Carhart 4-Factor Model)?
  • Did these behavioral mutual funds outperform their own designated benchmark?
  • Did these managers display superior stock picking or market timing ability?
  • Are there any particular trends in investment strategy that we can see in these funds based on factors like size, value, or momentum?
  • Were there any trends between performance and fund attributes like age of fund, expense ratio, and assets under management?

The results do not bode well for believers in behavior investment strategies. Of the 22 mutual funds examined:

  • Not a single fund produced economically or statistically superior alpha based on both CAPM and the Fama-French-Carhart 4 Factor Model
  • 8 of the 22 mutual funds displayed a negative alpha that was statistically significant
  • Not a single fund beat their analyst assigned benchmark
  • The majority of funds displayed negative alphas that were statistically significant alpha during both crisis periods (2007-2009) and post-crisis periods (2010-2013)
  • There are no trends in terms of strategies based on size, value or momentum
  • There was not a single fund that produced a positive value in stock picking nor market timing ability
  • The only significant relationship found was a negative correlation between size of the fund and performance (i.e. funds with more assets under management did worse.)

Deciding whether or not the markets display periods of systematic irrationality is yet to be completely put to rest. There is no current evidence that convinces both sides of the debate. This is not important from the standpoint of the individual investor. As this study has shown, there is currently no observable data that we can use to conclude that investors can take advantage of any perceived market inefficiencies based on irrational behavior. We all know that investors sometime make investment decisions on emotion. IFA has seen this with our own clients. Emotions can be a very destructive force in individual financial plans, but nothing more than pure randomness in the entire market as a whole. In other words, behavior has been shown to be a tremendous risk for individual investors, but not for entire markets. We can expect to go through another financial crisis during our lifetime. It is best to accept prices as rational and try not to meddle in exploiting them for profit. As research has shown, even the professionals cannot do it.