Behavioral finance is the study of how human behavior leads to investment errors, including the mispricing of assets. Some investors believe that such mispricing can be exploited to generate higher returns. To find out if this is true, the authors of the study “Behavioral Finance: Are the Disciples Profiting from the Doctrine?” analyzed 16 behavioral funds to determine whether they successfully attract investment dollars and earn abnormal returns. Here’s what they found:
- Behavioral funds are successfully attracting investment dollars at a significantly greater rate than index and matched actively managed non-behavioral funds.
- While the funds do outperform S&P 500 Index funds, they have significant exposure to value stocks, which have historically provided a higher risk premium. Thus, after accounting for risk, they do not earn abnormal returns.
- Behavioral mutual funds are tantamount to value investing and not much more.
While behavioral finance seems to be gaining greater acceptance among investors, there doesn’t seem to be any evidence to support the raison d’etre for the funds — anomalies that can be identified and exploited on a persistent basis.
Even if there are anomalies, there are two simple and plausible explanations for the findings of the study. The first is that 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. The second is that once an anomaly is discovered, and attempts are made to exploit that anomaly, the very act of exploiting it will serve to reduce or eliminate the size of the pricing error.
