Economic Nobel Prize Stock Picking

Mon, 2017/10/09 - 1:31pm | Your editor
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A reader who calls himself Carter and Brewer—sturdy Anglo-Saxon job names both—wants me to predict whether stock markets are toppy and ripe for a fall, or not. Should we exit shares (call that Carter) or pile in with the rest (Brewer).

Since there is no right answer I am taking refuge in the so-called Nobel Prize for Economics given today to Prof. Richard Thaler, who combines economics with psychology in helping run two small cap funds at Fuller & Thaler.

The question comes down simple either or: if an investment strategy has worked in the past, will it continue to work or will it reverse? This is the stock market version of the gambler's dilemma: do hot hands continue to win? Do cold hands lose again? In basketball or horse racing, winners tend to win more, because of the psychology of players or jockeys.

But in strict games of chance, like in Las Vegas, some punters take an alternative view: if there has been a streak of wins or losses the odds are higher that the next play will reverse the trend. If the one-armed bandit or the roulette wheel are honest and not fiddled with, the odds of a reversal and the odds of the trend continuing are identical. Red or black, odds or evens, are equally likely on the next toss or turn regardless of the past trend.

But most gamblers believe in “hot hands” and “cold hands.” Behavioral biases mean that error-prone gamblers do not realize this. Some bet on reversal and some bet on continuity based on earlier results. These miscalculations of the odds, called the “hot hands fallacy” mean the odds are better for those betting on a reversal of the trend.

Another behavioral insight is that losses are twice as worrying to investors than merely lowered gains.

In investing, the hot hands fallacy would ignore a profit warning on a stock which has done well in preceeding quarters and would overreact by dumping after profit warning from a company which warned earlier. You won't buy the index but will seek out stocks dumped in a seller's panic and short stocks that arrogant managers continue to buy and talk up.

Fuller & Thaler, which aims to gain from investors' and managers' behavioral biases, until today officially had only $61 mn in assets under management (AUM). Now it gets ~$1 mn more if Thaler puts his Nobel winnings into the pot. There is already another Nobelist economist on board, Daniel Kahneman who won the Nobel economics prize in 2002, formally called the Sveriges Riksbank Prize in Memory of Alfred Nobel, essentially for examining the hot hands fallacy.


Not enough exercise; too much chocolate cake: Nudge, nudge

Thaler's insights follow Kahneman's. Thaler's insights are contained in the Nudge (his term) strategy, government use of taxes and other policies to get people to do what is best for them long-term. Nudging means “if you want people to do something make it easy”, as Thaler said in a radio interview with The Economist a year ago. People do not make economic decisions rationally. They choose what's easiest, not what's best.

We eat unhealthily or fail to save for retirement or choose the wrong mortgage. So you “nudge” folks to automatically increase their IRA contributions if they get a raise (which worked in the UK) or collect for wildlife preservation or the collection when they enter a national park or museum. A paternalistic and benevolent government nudges by requiring that competing investment or mortgages programs be easily comparable. A nudge exposes sneaky marketing gimmicks. We don't want to think about organ donation after our death so you make that the automatic option when people renew their drivers' licenses (as in Spain.)

Prof Thaler famously commented after British voters opted to exit the European Union that “People are voting with their guts. There is no spreadsheet. This is much like a divorce without a prenup. You're voting to leave and we'll take care of the financial details later.” He also said in the same interview: “People do not act with proper understanding of risks. People attracted to Trump for example.”

But asked about financial markets Thaler avoided the question from Brewer and Carter: should you invest in the market which has fallen furthest (then Japan) or the one hitting new highs (US tech.) He took refuge in the classic example of the beauty contest, where you win if you correctly guess which woman will be selected by the most voters. The stock market is like a beauty contest, Prof Thaler replied, quoting Maynard Keynes who argued that you have to pick the woman who will appeal to the most ill-informed judges, not the one you think is prettiest.

The two mutual funds F&T runs are open-end, so we don't normally cover them: Fuller & Thaler Behavioral Small-Cap Equirty (FTHNX) and the Undiscovered Managers Behavioral Value Fund (UBVAX) which F&T recently brought back in-house after managing it on behalf of Allianz SE of Germany. AZSEY owns Pimco fund, and UBVAX was a distraction. It has about $6 bn under management solo, not counting the former Allianz fund. Fuller also runs separately managed accounts also not included in its AUM total. Unless you switch your money to one of these funds you cannot benefit from the Nobel Prize in economics.

But what you can do is avoid exchange-traded funds whose future strategy is required to copy that of the past—to invest robotically in stocks which have gone up.

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