Behavioral Finance in Practice

Punch & Associates
Investment Management Inc.
BEHAVIORAL FINANCE IN PRACTICE |
Behavioral Finance in Practice

Punch & Associates Investment
Management, Inc.
To obtain better than average investment

results over a long pull requires a policy of
selection or operation possessing a twofold
merit: (1) it must meet objective or rational
tests of underlying soundness; (2) it must be
different from the policy followed by most
investors or speculators.
Benjamin Graham, The Intelligent Investor
The track record of most professional and

individual investors is less than admirable.
According to Standard & Poors, fully 63% of
largecap U.S. equity funds underperformed
their benchmark index in the five years leading
up to June 30, 2009. For smallcap U.S. equity
funds, that proportion is 68%. For all U.S.
equity funds, over onequarter of them ceased
to exist over that same fiveyear time frame,
many because of continued
poor performance.1
Why do the odds of success seem to be tilted so

heavily against investors? How is it that so
many
intelligent
professionals
with
sophisticated tools for analysis still cannot
outperform their benchmarks with any
consistency? Are investors better served by
simply buying the index and hitting the beach?
Active money management is not deficient
because the tools of the trade are flawed. The
same tests of underlying soundness that are
used today have been used for generations to
objectively and subjectively gauge the worth of
corporate securities: earnings multipliers,
growth rates, management skill. Despite what
some marketers of index funds might say, these
are timetested metrics for investing and form
the basis for making intelligent decisions about
which securities are attractive and which are
not.
The deficiency in active money management is

not in the operation, but rather in the operator.
Investing is prone to flaws because humans
beings are flawed. Judgments are prone to
error in predictable ways, making investment
decisions susceptible to mistakes that cost us
money.
And because
money is the subject
Judgments are prone to error in
matter,
emotion
and
predictable ways, making
instinct figure heavily into
our
ability
to
make
investment decisions susceptible to
successful
investment
mistakes that cost us money
decisions.
The record for individual

investors is even more
dismal.
Those investors
who trade in and out of
mutual funds tend to
underperform the managers of those funds by
an additional 6%. Investors who traffic directly
in stocks underperform their benchmarks by a
staggering 6.5% annually.2 Beating the market
is an elusive bogey.
Investing is a twostep process.

First,
investment decisions must be based on the
solid foundation of sound, timetested methods
of valuing companies and securities. Heavy
emphasis on the record of history, conservative
assumptions about the future, and reasonable
valuation expectations form the basis of
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determining whether a security is undervalued,

fairly valued, or overvalued.
But that is not enough. There must be a second
step to the process, a more human one, which
takes into account where most investors go
wrong. The odds for success increase by
searching for investments in those places where
human nature has created conditions where
prices are most likely to be dramatically
different than fair value. This is the starting
point in the search for undervalued securities,
though it also serves as an important
touchstone at every step of the investment
process.
In investing, other peoples perception of

reality influences price more than any
underlying truth.
Seth Klarman, Baupost Group
To understand how investor behavior creates
opportunities for astute investors, we must first
understand how most investors operate.
Human nature allows us to make some
generalizations;
despite
innumerable
differences in background, personality, and
style, everyone is prone to the same mistakes
simply because our brains are wired the same.
If the majority of investors have losing track
records, it is because they are likely making the
same mistakes.
Investors make predictable, repeated errors in
judgment. We offer here three examples, and
how they create opportunities for investors to
increase their odds for investment success:
incorrectly reacting to new information,
allowing bias to affect decisionmaking, and
ignoring areas out of the purview of most
investors where security prices are most

inefficient. In all three cases, it is investor
perception, rather than fundamentals, that
drives prices away from fair value.
A wealth of information creates a poverty of

attention
Herbert Simon, Psychologist
In the late 1980s, MIT professor Paul
Andreassen performed an experiment using
graduate students who were each allowed to
choose a portfolio of stocks. The students were
divided into two groups: the first group was
only allowed to see the price movements of
their stocks and this information alone served
as the basis for further investing decisions. The
second group, by contrast, was allowed to use a
wide array of sources including television,
newspapers, and research reports to make
decisions for their portfolio. After a period of
time when the students actively managed their
portfolios, two observations surfaced: first, the
students with access to more information
engaged in far more trading than those who
could only see price movements and
presumably had no understanding of why prices
had changed.
Second, those students who
could only see price data were twice as
successful as the rest.3
Two conclusions can be drawn from this
experiment. First, human beings are wired to
react. When confronted with new information,
relevant or not, our instinct is to do something
about it. Taking action is preferred to sitting
idle, even though doing something may in fact
be detrimental.
Second, when we are
bombarded with conflicting information and
opinions, our brains tend to become
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overwhelmed.
We have a hard time
deciphering which information is truly relevant
and which is not.
Investors are prone to making mistakes when
they either react to irrelevant information or
when they do not react to relevant information.
In the age of cable news and internet
journalism, it is easy to become overwhelmed
by the constant flow of information, allowing
shortlived events to influence our reasoning for
owning or not owning a stock, and blurring the
distinction between which information truly
affects the longterm value of a company.
There are many examples of situations where
kneejerk reactions by investors are the
completely wrong thing to do. Quarterly
earnings surprises and flashy news headlines
are glaring examples of investors myopically
marking up or down a stock price. Broken IPOs
are another brand of the same folly, as
investors who participated in overhyped
offerings get frustrated with disappointing
performance and quickly dump their shares en
masse. Companies that announce liquidations,
change their dividend policy, or whose share
price falls below a certain level (say, $10 or $5
or $1) also usually evoke a quick reaction as
investors dump companies that no longer fit
their investment criteria regardless of value.
Investors who are willing to look beyond near
term concerns and tune out the immediate
verdict of the market can often find value in
others unwillingness to do the same.
Among all forms of mistake, prophecy is
most gratuitous.
George Eliot
UCBerkeley professor Philip Tetlock began a
largescale study in the early 1980s with one
question in mind: how good are experts at

predicting the future? He tallied more than
82,000 predictions made by 284 people whose
professional lives were dedicated to offering
advice or commentary on political and
economic trends. His conclusion, perhaps not
surprisingly, was that these socalled experts
performed no better than random guesses.
Having roughly three potential outcomes to
choose from for each prediction, the
forecasters were correct only about onethird
of the time. What is more interesting about Mr.
Tetlocks findings, however, was that those
experts who were most eminent (and
presumably considered most accurate by the
public) turned out to be even less accurate than
the group as a whole. The dominant danger,
he concludes, remains hubris, the vice of close
mindedness,
of
dismissing
dissonant
possibilities too quickly.4
Preconceptions are powerful factors in
decisionmaking, and they often are the least
recognized. In the above experiment, the likely
reason that the most wellknown experts
were the least accurate was that they made
bold predictions with great confidence,
staunchly defending their positions rather than
entertaining
nuances
and
dissension.
Successful investors recognize their own biases
and
limitations
and
make
decisions
independently of consensus opinions. We are
wellserved to remember the words of
American politician Morris Udall: if you can find
something everyone agrees on, its wrong.
All too often, investors commit the sin of
certainty by avoiding those stocks or asset
classes that have performed the worst recently,
that have negative stigmas attached to them, or
that simply are not exciting. Most often, these
stocks are the cheapest, have the lowest
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expectations, and are the best candidates for

exceeding these low expectations in the future.
In these cases, the overwhelming consensus
opinion is that what has performed poorly
recently will continue to perform poorly in the
future. If we become entrenched in our
thinking or in the opinions of those around us,
we risk not recognizing changing conditions or
overlooking value that may have been missed
by most investors.
Success comes to those who are too busy to

be looking for it
Henry David Thoreau
Consider the fact that when Maria Bartiromo
mentions a stock during her afternoon
television program, the volume in that
particular stock increases nearly fivefold in the
minutes following the mention.5
Or that
investors at large discount brokerages make
nearly twice as many purchases as sales of
stocks experiencing unusually high trading
volume.6 Investors frequently pay too much
attention to stocks that are widely held, in the
news, or that are experiencing large price
movements.
Conversely, those stocks not fortunate enough
to be mentioned by the money honey or any
other talking head are often neglected, with
few investors scrutinizing their prospects and
valuation. Stocks with little or no analyst
coverage can suffer from a similar lack of
attention, and news or changes in a companys
prospects
can
go
unnoticed
or
underappreciated for long periods of time.
Whenever there is a dearth of information or
analysis on a stock or security, the probability of
its price being different than fair value goes up

as hearsay, speculation, and guesswork figure
more heavily into its price. Small and micro
cap stocks with low analyst coverage and few
institutional shareholders are prime examples
of this type of inefficiency. Spinoffs, where a
company divests itself of a division by
distributing shares of the new company to
current shareholders, usually exhibit these
same characteristics as there is generally a
quiet period when the new company is
establishing itself and beginning an investor
relations effort. During this time, information
on the company is scarce, analysts have not yet
picked up coverage, and shareholders who have
suddenly found themselves with shares they did
not buy may be unloading them. Companies
that have recently emerged from bankruptcy
usually exhibit the same quiet period effect as
well as having shareholders who may not be
able to or care to own shares.
Those investors who are willing to search for
value in areas out of the spotlight, rather than
where the media or others have led them, have
the benefit of being early to the party. By being
claustrophobic, the odds of loss go down.
Investor Mistakes & Opportunities

Mistakes
Incorrectly reacting to
new information
Allowing bias to affect

decisionmaking
Ignoring areas where

prices are most
inefficient
And Opportunities
Quarterly Earnings
Surprises, Broken
IPOs, Liquidations,
Changes in dividend
policy
Lagging stocks or
sectors, Stigmatized
investments, Boring
companies
Stocks with low
analyst coverage,
Spinoffs,
Bankruptcies
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No man prospers so suddenly, as by others

errors
Sir Francis Bacon
increase their odds for success by searching for

value in those areas where investor behavior
has created security prices that are most likely
to be significantly different than fair value.
When used in combination with the timetested
methods of assessing value, behavioral finance
can be a valuable tool in the tool kit of both
individual and professional investors.
It may not surprise many to learn that the best

performing U.S. stocks over the past seventy
five years have been smallcap stocks. In fact,
the smaller the market capitalization, the better
the historical track record.
Performance of SizeDecile Portfolios of NYSE, AMEX, and
This asset class is the most
NASDAQ Stocks
inefficient because few
From 1926 to 2009
20%
investors are focused on
17.4%
18%
15.2% 15.1%
it, creating a dearth of
16%
14.5% 14.0% 13.9%
13.3%
12.6% 12.0%
analysis and research
14%
12%
10.4%
which ultimately leads to
10%
pricing inefficiencies. It is
8%
the ultimate arena to
6%
3.1%
4%
witness behavioral finance
1.3% 1.6% 1.6% 1.2% 1.3% 1.2% 0.8%
0.5%
2%
in action.
Smallcap
0.1%
0%
investing is dominated by
2%
10
9
8
7
6
5
4
3
2
1Meg
individual investors and
Micro
Cap
Cap
Mean Return (Annualized)
suffers from a lack of
Excess RiskAdjusted Return (Annualized)
professional
attention:
only 13% of U.S. equity mutual funds are
Source: Kenneth R. French
focused on small cap stocks, and even those
Punch & Associates Investment Management Inc. is
funds that do invest here gravitate to the high
a registered investment advisor located in
end of the market cap spectrum, leaving a wide
Minneapolis, Minnesota. We manage investment
swath of small company stocks completely
portfolios for both individual and institutional
neglected. Fully 70% of all microcap stocks
clients with a focus on small and microcap
have fewer than three analysts covering them.
domestic equities. The firm was founded in 2002.
Although investor behavior and error creates
significant opportunities in every asset class and
1
Standard & Poors Indices Versus Active Funds Scorecard,
among stocks of all market capitalizations, it is
Midyear 2009
2
in small and microcap stocks that the effects
Quantitative Analysis of Investor Behavior (QAIB) Survey.
Dalbar.
of these errors are most pronounced and where
3
How We Decide. Lehrer, Jonah.
4
they are most persistent.
Expert Political Judgment (2005). Tetlock, Philip E.
5
Translating the predictable, repeated mistakes

that investors commit into investing
opportunities is key to formulating a successful
investing strategy.
Investors can greatly
Market Efficiency in Real Time (2001). Jeffrey A. Busse

and T. Clifton Green.
6
All That Glitters: The Effect of Attention and News on the
Buying Behavior of Individual and Institutional Investors
(2006). Brad M. Barber and Terrance Odean.

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Investment Management Inc.