[The power of the behavioral component in most human activities cannot really be dismissed, especially as drawn out in today’s current pandemic and economic crisis environment. We are seeing otherwise termed “rational” people be driven by fear, uncertainty, confusion and anxiety.
To better explore and understand the behavioral effects on investing, we decided to go to the veritable source of this topic Fuller & Thaler Asset Management — a firm that has pioneered the application of behavioral finance in investment management by combining cognitive psychological theory and conventional finance. The firm was built by what has been recognized as the founders of the fields of behavioral economics and finance — Dr. Russell Fuller (founder, CIO, and Graham & Dodd AIMR award from the CFA Institute), Dr. Richard Thaler (fFounder, principal, 2017 Nobel Prize for Economic Sciences), and Dr. Daniel Kahneman (2002 Nobel Memorial Prize in Economic Sciences and author of Thinking Fast & Slow). Not resting on their laurels, the firm was named as a finalist for 2020 Asset Manager of the Year by Envestnet and Investment Advisor Magazine that recognizes high-conviction portfolio managers that exemplify investment management best practices.
We spoke with Fred Stanske, CFA, portfolio manager of the Fuller & Thaler Behavioral Small-Cap Growth Fund (FTXSX) to provide us with more perspective and context on their investment philosophy and process.]
Bill Hortz: What do you see as being the major sources of alpha and their relative benefits for investment managers?
Fred Stanske: To generate alpha, an investment manager must have some sort of advantage, or edge, over their competition. The two most common claims lie in having either better information (Information Edge) or better analysis (Analytical Edge).
Generating alpha via better information implies that the information collected is either better than what others have access to, or altogether different information than what others are looking for. To have an Information Edge, an investment manager must know something that others do not, which in today’s connected world is incredibly difficult.
More recently, due to the increase in the speed and access to information, many traditional investment managers seek an Analytical Edge. That is, while the information gathered is the same, it is processed better, or differently in order to gain an advantage.
At Fuller & Thaler, we think we have pretty good analysis capabilities — but one of the lessons of behavioral finance is to beware of confirmation bias — that you are not as smart as you think you are. So instead, we rely on having a Behavioral Edge. Our non-quantitative, event-driven, rules-based approach is designed not only to avoid, but to capitalize on the behavioral mistakes that other investors make. Investors make mistakes because they have emotions, use imperfect rules of thumb, and have priorities beyond risk and return. At Fuller & Thaler, we look for those mistakes.
Hortz: Is there research or data that proves a relative benefit and why do you think behavioral sources seem to be more effective?
Stanske: Our behavioral approach works because we exploit the mistakes made by other investors, the overwhelming majority of whom employ a fundamental investment approach. Fundamental investors inevitably fall prey to the human biases of over-confidence and anchoring, and this leads them to under-react to situations where new information undermines their existing assumptions. This type of under-reaction stems from innate human psychology and has been well documented by behavioral finance scholars for decades in top tier journals like The Journal of Finance.