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Are Behavioral Finance Anomalies Exploitable in the Real World?

It seems like a simple method for generating superior returns: Identify human behaviors that lead to pricing errors, then exploit those errors. Unfortunately, a new study shows that theories don't always mean great results in the real world.

More and more mutual funds are marketing themselves as behavioral funds that try to exploit such anomalies. Pricing anomalies present a problem for those that believe in the Efficient Market Hypothesis. However, the real question for investors isn't whether the market persistently makes pricing errors. Instead, the real question is: Are the anomalies exploitable after taking into account real world costs?

The authors of the study "Behavioral Finance: An Analysis of the Performance of Behavioral Funds" examined the results of 31 funds that claim to apply behavioral finance in their portfolio strategy. Collectively, they managed $16 billion. The study included the Fuller & Thaler fund family, JPMorgan's Intrepid funds, the Bank Degroof funds, LSV funds, and LGT funds. They analyzed their performance from inception (early 90s in some cases) until August 18, 2009 and found:

  • There was no clear evidence of outperformance of behavioral funds against their respective indexes.
  • Over a five-year horizon, only 47 percent of these funds beat their benchmarks.
  • Among behavioral funds, there was a very low correlation between fund diversification and its ability to beat the benchmark -- concentrating assets didn't help.
  • On average, behavioral funds weren't particularly good in beating the market during bear markets -- in two out of three cases, the performance was poorer than their benchmark.
These findings mirror the results of a similar study asking if behavioral funds attract more assets and provide greater returns. That study concluded that behavioral funds were nothing more than value funds.

While behavioral finance seems to be gaining greater acceptance among investors, there doesn't seem to be any evidence to support the belief that anomalies can be identified and exploited on a consistent basis. Even if there are anomalies, there are two simple and plausible explanations for the findings of the study:

  • Strategies have no costs, but implementing them does. Thus, a strategy may appear to work on paper, but the costs of implementation can exceed the size of the pricing errors.
  • Once an anomaly is discovered, the very act of exploiting it will serve to eliminate/reduce the size of the pricing error.
Those who seek to exploit market anomalies almost inevitably find that the markets are tyrannical in their efficiency. Economics professors Dwight Lee and James Verbrugge put it this way: "The efficient markets theory is practically alone among theories in that it becomes more powerful when people discover serious inconsistencies between it and the real world. If a clear efficient market anomaly is discovered, the behavior (or lack of behavior) that gives rise to it will tend to be eliminated by competition among investors for higher returns."

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