step2_gold

Richard Thaler's Nobel Prize and Practical Implications for Investors

step2_gold

Professor Richard Thaler from the University of Chicago received the 2017 Nobel Memorial Prize in Economic Sciences for his work in behavioral finance. This comes just four years after his colleague, Eugene Fama, received his Nobel Memorial Prize for his work on asset pricing and stock market behavior. This adds another Nobel Prize to the University of Chicago's pristine record, now totaling 90. Overall, the Economics Department has been the most successful, now boasting 29 prizes alone.

A Little Background Info

While these thought leaders have offices just a mere feet away from each other at the University of Chicago, their ideas are often pitted against each other in terms of explaining how markets work. The Efficient Market Hypothesis states that all information is already embedded into market prices and since news and events are random in terms of their occurrence, subsequent market price movements follow a random walk. Professor Thaler’s research begins with understanding the drivers of markets: market participants.

Because humans have inherent biases that helped us survive and thrive early in our evolution and because we also have limited faculties in terms of processing computing large amounts of information, we do not always behave rationally or optimally. Nobel Laureate Daniel Kahneman and his partner, Amos Tversky, were made famous as being the pioneers in using their background in psychology to develop simple games that exposed these faulty characteristics among people. Most of their story is published in their 2011 book, Thinking, Fast & Slow.

This isn’t to say that information is not embedded into market prices rapidly. It suggests that this information isn’t always rational and market prices can deviate from intrinsic value from time to time. In theory, if an active manager can have enough foresight to see market environments acting irrationally, then there could be a chance to capture abnormal profits.

The video below was produced by The Chicago Booth Review where both Eugene Fama and Richard Thaler sit down to discuss the question of, “are markets efficient?” in the context of their own view of how markets work. It is by far one of the most articulate and insightful interviews to date that show both sides of the market behavior debate.

Practical Implications for Investors

Whether or not markets actually are efficient, the big take-home for investors is that they should definitely act like they are. In other words, while academics are debating these issues in their research, individual investors should side with markets being efficient and invest accordingly. We believe this is best accomplished through a globally diversified portfolio of index funds, with tilts towards the different dimensions of expected return, and an overall risk exposure that properly matches the investor’s risk capacity.

Why should investors do so?

First, there has been no sufficient evidence that suggests that active managers deliver superior risk-adjusted results over time. This could be due to the high costs associated with active management or the high efficiency associated with the capital markets. It is probably a combination of both, but the point is that the alternative provides no better outcome, at least from an empirical standpoint. Again, this is regardless of whether or not the markets are always “rational.” We always like to say that if it is hard to tell, then markets are efficient.

Second, there is a growing body of literature that suggests that investors who succumb to their own biases usually cause more personal financial harm than those who exercise self-discipline. In other words, these behavioral biases will usually cause more devasting individual financial consequences versus the entire market in the aggregate. The Dalbar Study of Quantitative Analysis of Investor Behavior and IFA’s Client Study both highlight this specific point.

While hindsight is always 20/20 and we can look at specific market periods like 2007-2008, or 2000-2001, or the 2010 Flash Crash, or Black Monday of 1987, there wasn’t enough foresight by the majority of financial professionals to profit handsomely from these events whether it was caused by the "wisdom of the crowds" or "the madness of the mobs."

Further, these types of anomalies don’t necessarily suggest that markets are not efficient. The 8-minute video below is an interview with Eugene Fama explaining the Efficient Market Hypothesis under the backdrop of one of the biggest market contractions since the Great Depression.

 

As Professor Fama points out, “The market can only know what is knowable. It cannot resolve uncertainties that are unresolvable. When there is a large amount of economic uncertainty, there is going to be a large amount of volatility, and that is exactly what you would expect in an efficient market.”

Now during these events, was it possible that some investors made big profits by making the right call? Of course, but it was hard to decipher ahead of time which ones would be successful in doing so.

How Have the Behavioralists Done?

Fama correctly notes that most of the advocates of behavioral investing instruct investors to stick with low-cost index funds and not to attempt to exploit the poor behavior of other investors. The actual record of behavioral investing as a form of active management is spotty, at best. One fund for which we were able to procure data is the Undiscovered Managers Behavioral Value Fund (UBVLX), which is managed by Richard Thaler and Russell Fuller.  It is a domestic small cap value fund, and for the fifteen years ending 9/30/2017, it has performed almost identically to the DFA U.S. Targeted Value Fund (DFFVX). Where it gets interesting, however, is the difference in investor return, the dollar-weighted return received by all investors as a whole.

Difference of DFA and Behavioral Fund
15 Years (10/1/2002 - 9/30/2017)
Name 15-yr Dollar Weighted Return 15-yr Time Weighted Return Difference Success Rate
DFA US Targeted Value I 11.78% 12.40% -0.62% 95%
Undiscovered Managers Behavioral Val L 11.54% 13.74% -2.20% 84%
The DFA Advantage* 0.24% -1.34% 0.02 11%

The numbers above show that the investors in UBVLX have not displayed good behavior, obtaining only 84% the return of the fund itself. How ironic is that! Investors’ behavioral biases got in the way of their ability to profit from the exploitation of investor’s behavioral biases. In contrast, investors in DFFVX as a group achieved almost the entire return generated by the fund. By coupling an investment philosophy rooted in empirical research and exercising self-discipline, investors in DFFVX outperformed their behavioral counterparts by 0.24% per year. To top it all off, UBVLX costs a full 1% more per year in the fund expense ratio compared to DFFVX. 

Conclusion

We applaud Professor Richard Thaler for his work in behavioral finance. Understanding the pitfalls in the biases and characteristics of market participants has highlighted the importance of bringing discipline to the investment process. This is one of the many reasons we believe investors should be working with an independent fiduciary wealth advisor when it comes to their personal finances. What Professor Thaler’s work DOES NOT suggest is that there are inefficiencies in the market that professionals can consistently exploit for profit. While many like to pit Professor Fama against Professor Thaler in terms of explaining market behavior, their groundbreaking research compliment each other in providing a more well-rounded view in describing how markets work.