Behavioural Finance: Part 1




In today's article Wim Steemers educates us on behavioural finance: how to use behavioural science to invest your money wisely. This is part one of this mini-series. Behavioural Finance plays a central role in the world of investing. It goes to the heart of two main questions that are frequently debated in the world of investing:

  1. Are markets efficient? If they are, trying to ‘beat the market’ is a fool’s game, and the best strategy is ‘passive investing’: you will earn market returns at the lowest possible cost.

  2. Even if they are not efficient, how does one go about ‘beating the market’ and/or how does one identify a fund manager who can?

This essay will focus on the stock market, but the general principles apply to other asset classes as well. We’ll start with some definitions.


Some Definitions:

  • Passive investing = buying shares pro-rata according to the weights of the shares in your chosen universe or in your chosen index

  • ·Active investing = everything else

  • Outperformance = A portfolio outperforms when it achieves a greater return than a chosen benchmark, usually the broad stock market index. Outperforming is also called “generating alpha”[1]

  • Market Efficiency: There are some highly technical definitions of what it means that markets are efficient, but here is a workable definition in everyday language[2]: "The efficient market hypothesis (EMH), alternatively known as the efficient market theory, is a hypothesis that states that share prices reflect all information and consistent alpha generation is impossible. According to the EMH, stocks always trade at their fair value on exchanges, making it impossible for investors to purchase undervalued stocks or sell stocks for inflated prices. Therefore, it should be impossible to outperform the overall market through expert stock selection or market timing, and the only way an investor can obtain higher returns is by purchasing riskier investments."


Part 1: Active vs. Passive Investing We’ll frame the debate around active vs passive around a series of often-made statements. No prizes for guessing where this is going:

  • “Active managers as a group cannot outperform the market, therefore active investing is a fool’s errand”

  • “Given that active managers cannot outperform the market, the end-investor’s best option is to try to find the passive manager with the lowest fee”

  • “There is mean reversion in managers’ performance: the manager that outperformed this year tends to underperform next year”

  • “When active managers say ‘The market is currently against active investing’ they are just making excuses”

  • “As we all know, share markets are efficient. Therefore, the concept of outperformance is an oxymoron right from the start”

From a Behavioural Finance point of view the last one is the most interesting. However, given how often the first four are banded about, it makes sense to quickly point out how these are suffering from sloppy maths and lazy thinking.


“Active managers as a group cannot outperform the market, therefore active investing is a fool’s errand”

This statement suffers from what Kahneman[3] would call “Cognitive Ease”: it sounds logical when you first hear it, and therefore it ‘feels’ true. However, mathematically this is only true if the following (unspoken) assumption holds:

“The market is made up of two groups of investors: active managers and passive managers.”

If that assumption is not true (and it isn’t), then the statement above is not the mathematical truism that it is presented to be. In fact, the real world can be better approximated by the following:

“The market is made up of three groups of investors: professional active managers, passive managers, and amateur investors.”

In this model of the world, it is entirely possible (mathematically, that is), that, in aggregate professional active managers outperform, passive managers achieve market returns, and amateur investors underperform. In fact, there is (some) evidence to suggest that this is exactly what happens.

“Given that active managers cannot outperform the market, the end-investor’s best option is to try to find the passive manager with the lowest fee”

As mentioned before, the premise of the statement is not necessarily correct. However, there is another flaw in the logic here. Even if the sum total of all managers couldn’t outperform, that doesn’t mean that any individual manager can’t. And by extension it is therefore possible that an active manager outperforms even after the fees being charged. What people actually mean when they make the statement above is:

An active manager has to outperform by more than the fee she charges for management to be of any use to the end-investor; Outperforming the market is very hard; It is impossible for an end-investor to identify ex-ante which active manager will outperform (by more than the fees they charge); Therefore, the end-investor may as well go passive.

This statement has a lot more truth to it – but note how we have gone from “active managers cannot outperform” to “I have an issue identifying which active managers will outperform”.


"There is mean reversion in managers' performance: the manager that outperformed this year tends to underperform next year" This statement is closely related to the previous one. It speaks to the difficulty of identifying managers that will outperform. There is certainly a lot of empirical (statistical) evidence that points in this direction. However, there are two issues here:

  • If you use this statement as an underpinning of the conclusion that one cannot identify outperforming managers, you are implicitly saying: “My strategy for picking next year’s outperformer is to pick last year’s outperformer[4]. The data says this doesn’t work, so now · I’ve proven it’s impossible to pick winning managers”. My response would be that all you have proven is that you are using the wrong strategy.

  • The statistical evidence for this statement is just that, statistical evidence. It speaks to the fact that on average, across the universe of managers, there is a tendency to mean-revert. It says nothing about any individual manager’s possibility of serial outperformance.

"When active managers say ‘The market is currently against active investing’ they are just making excuses”

It is certainly tempting to dismiss any “the dog ate my homework” argument. However, active managers actually do have the facts on their side on this one. It goes beyond the scope of this essay to show the maths, but one can show mathematically that it is harder to outperform in a “narrow” market (a few stocks go up and many go down) than in a broad market, and it is also harder to outperform in a low-dispersion market (the difference between the best and worst stock is small) than in a high-dispersion market. In this context “harder” means that for the same level of skill the rewards accruing to the portfolio are smaller. Over the past decade or so, markets have been unusually narrow – as reflected e.g. in the enormously strong performance of the so-called FAANG[5] stocks relative to the broader market.


"As we all know, share markets are efficient. Therefore the concept of outperform is an oxymoron right from the start" Always be careful when people start a sentence with “As we all know” – in my experience this is shorthand for “Don’t ask me too many questions about this, because I don’t have any answers”[6]. In fact, “we don’t all know this at all” would me my response. Behavioural Economics is posing a serious challenge to the idea of efficient markets. The theoretical underpinning of the Efficient Market Hypothesis (EMH) includes the classical assumption in economics of Homo Economicus, (or as Thaler calls them: Econs[7]), i.e. the assumption that people are rational beings, armed with complete information and forever seeking to maximize their selfish personal utility. However, we now know that real people are Humans, not Econs: they have biases, and emotions, and they take short-cuts in decision making. This alone might be sufficient to undermine the EMH[8]. If people are Humans, and have biases and judgments that deviate from so-called “rational” behaviour in predictable ways (i.e. their biases and emotions tend to move decisions in a certain direction that is constant over time), it follows that asset prices will deviate from EMH-fair values in predictable ways. An active manager should be able to take advantage of this.

However, there is a deeper issue here. Ask yourself: Even if markets were efficient, how does this come about? The definition of efficient markets says that market prices at all times reflect all available information. But how does this information find its way into the market price? Answer: active investors, i.e. those who are trying to get the maximum return possible, evaluate all the available information all the time, and then engage in buying or selling transactions. The buyer thinks the asset is worth more than what he is paying for it, the seller thinks it’s worth less than what he is selling it for. Were it any different, the transaction wouldn’t occur. If nobody were thinking about new information, there could be no opinions about what it means, and no price movements as a result of new information.

The conclusion has to be: an efficient market can only exist by virtue of its participants not believing that markets are efficient. Or conversely, if everybody would switch to passive investing on the basis that markets are efficient and therefore there is no point in trying to beat them, markets would become inefficient as a result.

Note an interesting side observation here. The larger the proportion of the market that is held by passive investors, the longer it will take for information to be reflected in share prices, and therefore the larger the opportunity for active investors to make money. Oh, the sweet irony: the more people turn away from active investing, the more money active investors can make!

"Oh, and another thing… What are share markets for anyway?"

One of the reasons why some countries or economic systems do better than others, is that some are more successful in allocating capital to those places where it can be most efficiently used – thus minimizing waste and maximizing economic output at the lowest possible cost. The share market has proven to be the most successful (only?) way to achieve this optimal allocation of capital. But this will only work if investors (read: active managers) actively evaluate investment opportunities and favour those that have the best chance of achieving a satisfactory return. This outcome could not be achieved in a world of passive investing.


Conclusion about Passive vs. Active investing.

  • · Mathematically it is not true that active managers must underperform in aggregate

  • · Mathematically it is not true that an active manager cannot outperform over the long term, even after fees.

  • · It is true that is hard to identify good active managers – in particular when one tries to do so by looking at last year’s performance.

  • · It is true that there will be times when it is harder for active managers to outperform, and times when it will be easier.

  • · If Behavioural Economics is right, and Classical Economics is wrong (i.e., we are Humans, not Econs), then markets are likely not efficient, and active investing can work.

  • · Without active managers there could not be a functioning share market.

  • · The larger the share of the market that is managed passively, the more money active managers can make.

  • Without active managers capital allocation throughout the economy would be less efficient, to the detriment of society at large.


Tune in next week to read part 2, further educating us on the wonderful world of behavioural finance. Wim will be looking into how to actively invest and make it work for you!

References and Notes [1] Like any other self-respecting profession, the investing world has a body of jargon. In most professions this serves the purpose of keeping things opaque to outsiders, and thus making insiders seem more knowledgeable than they are. Go ahead, call me a cynic! [2] Source: Investopedia.com. Note that technical definitions are more involved and distinguish between strong, semi-strong, and weak forms of efficiency. [3] Daniel Kahneman: Thinking, fast and slow [4] This is known as the “Hot Hand Fallacy” in sports [5] Facebook, Apple, Amazon, Netflix, Google [6] Using this expression probably also tries to induce Cognitive Ease in the listener, thus automatically reducing the need to give a further explanation. [7] See e.g. Richard Thaler: Misbehaving: The Making of Behavioral Economics [8] One line of defense against this critique of EMH is that it can be shown that markets can be efficient even with a lot of Humans around, as long as there are a few Econs with enough money to arbitrage the inefficiencies away. The counter to this argument is twofold: First, the argument assumes that all Humans cancel each other out – which they don’t, given that their biases are systematic, not random. Second, in the real world, arbitrageurs are always capital-constraint.

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