Exploiting Behavioral Finance

Behavioral finance is all the rage.  Ever since the release of Daniel Kahneman’s Thinking, Fast & Slow” and Dan Ariely’s Predictably Irrational and a dozen other books like them, we are all ready and excited to admit that human aren’t the number-crunching automatons the Efficient Market Hypothesis made us out to be. Many people in the industry felt entitled to overwhelmingly criticize Eugene Fama’s Nobel Prize award (as if the man did not dramatically advance our understanding of finance and the investment marketplace). We love to pick on investor sentiment surveys with their backwards-looking tendencies and watch cash flows into mutual funds explode at market tops and say “See! People are irrational and dumb.” And we are!  Investors do the wrong thing at the wrong time, practically every time.  Take this chart from Blackrock from last year:

blackrock flows

People are throwing money at the market as long as it is going up, and then there is a stampede for the exits when prices fall.  Proof that investors (in sum) are often irrational – why in the world would you want to buy an asset at an expensive price and subsequently sell it at a cheaper price?  But collectively investors do this time and time again.  The result is the now-famous “behavior gap” – how poorly investors perform relative to the markets and their own investments. Depicted below from JP Morgan via the DALBAR study:

DALBAR

At this point, we all know this.  We know that investors aren’t perfectly rational creatures making calculated long-term investment decisions based on current market prices.  We are herd animals, hoping to get in on the action while it’s hot and not be the weak member of the pack when there is trouble about.

If the masses are irrational, emotional fools, can they be exploited? If greedy investors are bidding up the market to insane levels and fearful investors are dumping high quality stocks at bargain-basement prices, surely there is an opportunity for the patient, rational, long-term investor to take advantage of these weaker beings!

Actually, my answer is: yes.  There is a way to exploit the nonsense that happens in the market year in and year out.  It doesn’t require a crystal ball, a complex trading strategy or a black-box algorithm. It is simple: rebalance.  Rebalancing is a gift from the market gods.  Rebalancing forces us to go against our animal instincts.  Rebalancing leads us to sell high and buy low.  In the late 1990’s, a diversified investor was forced to sell into the tech rally by following an already-established investment policy.  As large-cap US stocks went on a tear, the investment policy forced an investor to behave rationally and sell those stocks and subsequently buy unloved bonds, REITs and small cap stocks.  When US real estate was going gangbusters from 2004-2006, rebalancing again sold into large gains and bought boring bonds (just in time for the market to crater in 2008 and 2009).  When blood ran down the streets in 2008 and 2009, rebalancing forced us to swallow hard and buy stocks at generational low prices, selling high-quality bonds to the masses who demanded “safety” at any price.

Is rebalancing perfect?  No.  It’s not a market-timing tool.  Investors who rebalanced in the late 1990’s sold large cap US stocks for years, trimming gains before the tech bubble burst, and this pattern repeats regularly.  But an intelligent investor who stuck to a long-term investment policy certainly outperformed an irrational one and had every opportunity to outperform the “average investor” according to the DALBAR study, all while managing the level of risk in his/her portfolio.

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