I’m a very powerful person in behavioral economics, because behavioral economics is generally only a critique of efficient markets, so what have they got without me?
Eugene Fama
Gene got all of it unsuitable. Without behavioral finance, he and French would have had nothing to do with one another for the last 25 years. He owes me all the things.
Richard Thaler
After reading these quotes from Fama and Thaler, you may conclude that they’re bitter rivals. But that is way from the case. Fama and Thaler are economics professors on the University of Chicago and well-known golf buddies. But despite the fact that they occasionally share 18 holes, there may be a really real tension between the 2. Fama is captain of the Efficient Markets team and Thaler is captain of the Behavioral Finance team. Both represent conflicting academic market philosophies which have been at war for years. It’s the tutorial equivalent of Lakers vs. Celtics.
The Efficient Markets team believes that market prices reflect all available information and are subsequently efficient. Its strongest proponents consider that risk-adjusted performance over long periods of time is just not possible. Over time, the philosophy has been expanded to incorporate risk aspects. Investors will be compensated for this by balancing their portfolios around risk aspects to realize higher returns. This team believes that performance over long periods of time is just not possible because this factor balancing represents increased risk.
Proponents of market efficiency argue that when empirical evidence shows that long-term risk-adjusted performance has been achieved, investors didn’t achieve it as a result of skill, but somewhat by targeting their portfolios toward a previously unidentified risk factor or by sheer luck.Buffett’s Alpha” broke down Warren Buffett’s phenomenal track record at Berkshire Hathaway into various explanatory aspects. The paper won the Graham and Dodd Award for best paper in 2018. The award recognizes excellence in research and financial journalism. Although the authors admitted that Buffett’s track record was not as a result of luck, it is difficult to read the paper without getting the sensation that it was intended to downplay Buffett’s performance.
The Behavioral Finance team, then again, believes that market prices reflect all available information more often than not, but that market participants are also influenced by behavioral tendencies. This behavior creates market inefficiencies that will be exploited to realize higher risk-adjusted performance, even over long periods of time. In terms of factor investing, the behavioral camp believes that “risk factors” represent price/value gaps as a result of behavioral tendencies, somewhat than increased risk-taking. As for Buffett, this camp is more prone to consider that his track record is as a result of his level-headed decision-making ability and access to unique sources of data.
Unfortunately, many problems arise when discussing market anomalies. The two foremost problems arise from the difficulties in hypothesis testing (e.g., how would you test for behavioral bias?) and the subjective interpretation required when a market anomaly is discovered (e.g., increased risk, behavioral inefficiency, or spurious correlation).
But fortunately, the respective philosophies of Fama and Thaler strongly influence two large asset management firms, Dimensional Fund Advisors (DFA) and Fuller & Thaler Asset Management (FullerThaler).
DFA founder David Booth worked as a research assistant at Fama while studying on the University of Chicago in 1969. The firm’s investment strategy relies heavily on Fama’s academic research, which led the firm to tilt its portfolios toward small, inexpensive firms with above-average profitability. Fama can be a director and advisor at DFA.
As the name suggests, Thaler co-founded FullerThaler with Russell Fuller. The firm seeks to take advantage of behavioral patterns to outperform the markets. Like DFA, the firm also tilts its portfolios toward value and size aspects. Unlike DFA, the firm seeks to take advantage of loss aversion since it believes investors overreact to bad news and losses and underreact to excellent news. As the name suggests, Thaler co-founded FullerThaler with Russell Fuller. The firm seeks to take advantage of behavioral patterns to outperform the markets. Like DFA, the firm also tilts its portfolios toward value and size aspects. Unlike DFA, the firm seeks to take advantage of behavioral patterns since it believes investors overreact to bad news and losses and underreact to excellent news.
Both firms have a mutual fund with an extended track record of success and the identical benchmark, the Russell 2000 Value Index. Figure 1 compares the competing philosophies to one another and to the funds’ benchmark.
Figure 1. DFA’s US Small Cap Value Portfolio (DFSVX), FullerThaler’s Undiscovered Managers Behavioral Value Fund (UBVLX) and the Russell 2000 Value Index.
Team Behavioral Finance outperformed Team Efficient Markets by an annualized 0.91% between December 1998 and July 25, 2024. However, many readers won’t agree that this proves Team Behavioral Finance’s victory because the outcomes don’t keep in mind the danger taken. Okay. To test this, I applied Jensen’s Alpha (Alpha) and used only the Russell 2000 Value Index as a benchmark. For the risk-free rate, I deannualized the three-month Treasury bond rate.
Figure 2.
After controlling for risk, Team Behavior remains to be ahead. This is confirmed almost unanimously in all risk-adjusted return metrics, apart from the data ratio, as shown below.
Although the outcomes suggest that investors can exploit behavioral tendencies even over long periods of time, staunch advocates of efficient markets could also be reluctant to vary their minds. In this case, I counsel these individuals to look at their very own behavioral tendencies to be certain that they exhibit the identical rational characteristics that the efficient market hypothesis assumes to be true.
