Q&A: How the Fuller & Thaler Behavioral Fund Aims to Adapt to Irrationality

Investors are human. And as humans, they’re prone to biases and psychological influences that lead to irrational decision-making. You need only look at the stock market — which has soared to all-time highs despite a global economy still devastated by the COVID-19 pandemic — to see irrationality in action. Mix the human foible of irrationality with investing, and you often end up with errors in judgment as people lose sight of the importance of company fundamentals in favor of Reddit prognostications. Just look to GameStop (ticker: GME) for a recent example.

But while individual investors may be prone to emotional investing, they aren’t the only ones making errors in judgment. Financial professionals, including fund managers, can fall into the same behavioral traps. In fact, the S&P Dow Jones Indices found that more than three-quarters of U.S. large-cap active funds underperformed the S&P 500 between 2015 and 2020.

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To understand how advisors can capitalize on other investors’ mistakes to improve returns for themselves and their clients, we spoke with Fred Stanske, partner and part owner of Fuller & Thaler Asset Management.

Stanske, who is also lead portfolio manager for the Fuller & Thaler Behavioral Small-Cap Growth Fund (ticker: FTXNX), shares how his team identifies behavioral opportunities in the market and how financial advisors can do the same for their clients. Here are edited excerpts from that interview.

Why is taking a behavioral approach to investing valuable right now?

There has been a huge influx of individual investors who are even more prone to mistakes than investment professionals. We’ve all seen the stories about the irrational behavior in today’s stock market.

We find that individual investors are especially likely to ignore fundamentals in favor of what is grabbing their attention and are therefore subject to availability bias, which occurs when we overestimate the probability of an event happening because of a similar recent event. So now, more than ever, it’s valuable to have insights into what mistakes investors are likely making.

[READ: Q&A: BlackRock’s Jeff Rosenberg on Systematic Fixed-Income Investing.]

What are some behavioral biases that may hurt investor returns?

Psychologists have documented dozens of behavioral biases that can hurt investors. We group those biases into two broad categories: Some biases cause investors to overreact, while other biases may cause them to underreact.

Investors tend to overreact to vivid emotional stories. There isn’t much that’s quite as vivid and emotional as losing money. One of the biases associated with this phenomenon is loss aversion: The pain we feel from losses is about twice as powerful as any euphoria we may feel from a gain.

The availability bias can also cause investors to overreact. People estimate frequencies by how available similar examples are in their mind. If it’s easy to think of an example, then you think it happens a lot — meaning social media and news coverage can create distortions. For example, if you ask people to predict how common various diseases or disasters are, their answers will be correlated with reality — but also press coverage. People often overreact to the news.

One of the biases that may cause investors to underreact is anchoring and adjustment. When people make a prediction, they tend to anchor on a convenient number and make an adjustment, but they typically don’t adjust enough. One classic experiment had people spin a wheel of fortune from zero to 100, then guess whether the percentage of countries in the U.N. that were African was higher or lower than that number — and they’d guess the number. Spin to 10, people guess 25. Spin to 65, people guess 45.

Investors also often underreact due to confirmation bias and overconfidence. The confirmation bias is our tendency to only look for evidence that confirms what we already believe and ignore evidence that contradicts those beliefs. Confirmation bias is even more powerful if you’re overconfident, which pretty much describes most investors.

[Read; Q&A: David Rosenberg on Economic Recovery and a Stock Market Bubble.]

How can advisors and investors profit from common investor mistakes when taking a behavioral approach?

At Fuller & Thaler, we invest in companies where we think investors are either overreacting to bad news or underreacting to good news. At the individual stock level, we search for events that suggest these types of investor behaviors. If these behaviors are present, we then check fundamentals. If an investor mistake is likely, and the company has solid fundamentals, we buy the stock.

We adhere to a strict investment process. We know we are subject to these biases, just like everybody else. Our process is our best defense against our own biases.

For example, rather than reading, and overreacting to, the latest headlines, we identify opportunities through an event-driven, rules-based approach. In addition, we don’t forecast quarterly earnings or develop precise price targets, both of which can lead investors to underreact due to anchoring and adjustment. We also don’t meet with company management teams, which can cause investors to suffer from the halo effect, another often overlooked behavioral bias. The halo effect occurs when our positive impressions of people or products in one area lead us to have positive feelings in another area. Advisors and investors can best profit from the mistakes of others by developing a process that at least partially prevents themselves from the inevitable biases that arise.

How can advisors apply behavioral finance in their practice?

Advisors can apply behavioral finance by both playing defense and offense. Playing defense means helping clients recognize their own biases and guarding against them. The lesson of behavioral finance is not that other people are biased, it is that we all are biased. Advisors need to recognize that we are all human and subject to these behavioral pitfalls.

When an investment is losing money, it’s naturally tempting to panic and give up. But it’s important to recognize your own loss aversion and ask whether the bad news is truly bad or just a vivid, emotional story. When there is good news, many individuals and advisors may sell too early by being anchored in the past, rather than letting their winners run, which is often a very profitable thing to do.

We also play offense. We buy when we think others are overreacting to bad news or underreacting to good news.

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Q&A: How the Fuller & Thaler Behavioral Fund Aims to Adapt to Irrationality originally appeared on usnews.com

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