As the bull market continues, Statman urges financial advisors to "adjust the aspirations of clients who look to the recent past to formulate an investment strategy. Financial advisors need to dampen down investor enthusiasm and expectations in a bull market, recommend appropriate diversification strategies, and remind people that no one can predict when the market will go down."
But first, they may need to curb their own enthusiasm. "Some advisors study the market so much that they see patterns that simply don't exist. They try to sound like gurus, and are overconfident in their ability to beat the market. Those individuals need to heal themselves before they can heal their clients."
Russell Fuller
Founder, RJF Asset Management
Advice: Exploit irrational behavior
When Russ Fuller began his investment career in the early 1970s as a sell-side analyst, he "couldn't understand why stock prices moved up and down." Returning to graduate school, becoming a professor, and combining his academic career with professional money management in the 1970s and 1980s brought him no closer to an answer.
The picture became somewhat clearer in 1990, when he decided to study behavioral finance during a sabbatical. He has since left the academic world behind, but continues to manage money based on what he learned about the topic 14 years ago.
Today, Fuller co-manages two mutual funds that base their investment strategies on behavioral finance theories. One, the J.P. Morgan Fleming Undiscovered Managers Growth Fund, relies on investors' tendency toward "anchoring" to find companies that have the potential for earnings surprises. "Psychologists have documented that when people make quantitative estimates, their estimates are heavily influenced by previous values of the item," he says. "That explains why a car salesman will start with a high figure and work his way down." Similarly, he says, earnings forecasts are a powerful anchor and analysts are very reluctant to revise them radically. The trick is finding companies that will deliver earnings surprises most people are not expecting.
Analysts also tend to be overconfident in their predictions, another bias that gives investors the opportunity to find companies that exceed market expectations. Fuller finds most earnings surprise stories in small and mid-sized companies in the technology sector, which comprises nearly half of fund assets, and consumer products and services, which account for nearly one-third of the portfolio.
In value and contrarian investing, the goal is to exploit investor overreaction to past negative information. "People evaluate the probability of an uncertain future event by the degree to which it is similar to a recently observed event," he says. "There are many cases where analysts stereotype beaten-down companies as permanent losers. But not all of them are." To find stocks for the J.P. Morgan Fleming Undiscovered Managers Behavioral Value Fund, Fuller looks for positive signs that others may be missing, such as insider buying among small-cap value companies. He usually finds them in sectors such as consumer products and services, technology, financial services and health care. Together, these sectors account for more than 80% of the fund portfolio.