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Apr 30, 2020

Oh Behave!

by John DeGoey

John De GoeyIn a past issue, I wrote about how a strategy based on principled risk management was being criticized. While I have found that tribal rejection of the placement of meaningful hedging approaches is likely in general, I’ve also felt that the most vigorous lack of acceptance came from my friends who are proponents of market efficiency, as promoted by one of my heroes, Nobel laureate Eugene Fama. Here’s a quote taken directly from Wikipedia regarding the Shiller Cyclically Adjusted Price Earnings (CAPE):

There are some economists who challenge the predictive power of Shiller’s publication. Eugene Fama, the Robert R. McCormick Distinguished Service Professor of Finance at The University of Chicago and co-recipient with Shiller of the 2013 Nobel Prize in Economics, has written that Shiller “has been consistently pessimistic about prices”, so given a long enough horizon, Shiller is bound to be able to claim that he has foreseen any given crisis.

Essentially, I found myself caught in an intellectual debate that I had no interest in participating in. Shiller and Fama are rivals of sorts. I’ve watched a few YouTube video lectures given by Shiller. He does not claim that his CAPE is particularly useful in timing markets. Neither he nor I are making any claims to that effect. All Shiller is saying (and I agree) is that the U.S. stock market is expensive.

Allegedly, part of why Shiller and Fama won their Nobel Prizes concurrently is that the selection committee did not want to be accused of “taking a side”. I have enormous respect for both and did not see my actions (i.e. using inverse products) as “taking a side”. Furthermore, it follows that my respect for both men and acceptance of their research is not mutually exclusive. I’m interested in evidence, not religious interpretation or dogma. My sense is that too many Fama acolytes are unduly critical of Shiller – even as they purport to be champions of evidence.

The thing that I find fascinating is in determining how best to apply various behavioural insights. So much is now understood about the subtleties and vagaries of human behaviour and decision-making, yet there is a relative paucity of meaningful applications for advisors and portfolio managers. Shiller doesn’t suggest that CAPE is valuable in market timing. I don’t suggest CAPE is valuable for market timing. I didn’t put inverse products in place as a result of market timing. It was done to provide insurance – full stop.

Richard Thaler And Eugene Fama Are Golfing Buddies

I’ve watched videos where Fama and Thaler banter about capital markets, explanatory variables and paradigms. One of Fama’s jokes was that the behaviouralists owe their very existence to him because they’ve spent all their time and energy looking for anomalies to his efficient markets and three-factor models without putting forward a coherent model of their own. They agree on facts. They simply disagree on why those facts are true, and what to do in light of their disagreements. Thaler, in turn, has a couple of anecdotes in his book Misbehaving that are uproariously hilarious. Fama and Thaler banter and kid each other playfully, but obviously have a strong amount of mutual respect, as well. While Shiller has been magnanimous regarding Fama’s work, I don’t get the sense that it cuts the other way. The quote above illustrates this.

It seems some traditionalist, neo-classical, left-brained, number-crunching academics are disdainful of behavioralists…. and it seems to be tribal. To some, this is a quasi-religious cage match where there can only be one winner—as if competing explanations of agreed-upon phenomena are necessarily mutually exclusive. To be clear, I respect and admire both—and have since lost some respect for the traditionalists because they don’t seem inclined to allow that the “other side” might have a point to make. I want to hear both arguments. I want to explore them all in search for what is best for my clients on a balance of probabilities basis, since no one knows for sure.

Shiller, Thaler and Kahneman are the alpha dogs among the very limited fraternity of behavioural laureates. Collectively, they have been challenging the precepts of traditional neo-classical economics. Specifically, they question the previously unchallenged (and presumptively self-evident) assumption that people consistently act rationally and in their own self-interest when making economic decisions. There are copious examples of people acting in a predictably irrational manner that is at complete variance with what traditionalists have always assumed to be true.

Choice Architecture

Thaler’s big breakthrough was the concept of Choice Architecture. He showed that people are essentially lazy (an attribute that Kahneman had already uncovered regarding thought processes in general) and therefore quite willing to accept the default option when given a choice. As such, policymakers could engage in something Thaler (and research partner Sass Sunstein) called “Libertarian Paternalism” through “nudges”. Basically, give people access to all available options (i.e. don’t exclude any), but set the system up so that they are most likely to choose the one that you think is likely to provide the optimal self-interested outcome. Try to get people to do what you think they should be doing, but don’t deprive them of their right to be wrong. The example that is often cited involves organ donor card completion. It is well documented that organ donations are useful for both people who need new organs and for medical research. In countries like Austria, the percent of donors is around 98%; in Canada it is around 3%. This can be explained almost entirely by choice architecture. In Austria, organ donations are the default and motorists need to opt out. In Canada, not donating is the default and motorists need to opt in.

My sense is that the flack I’ve received could be explained (and rectified?) through choice architecture. Many advisors, especially those who work exclusively with mutual funds, have simply been conditioned to NOT put hedges in place under any circumstances ever. The most likely response is to trim equity positions and re-balance portfolios back to something more conservative (i.e. closer to the long-term strategic asset allocation) if markets have risen strongly in the recent past. The red herrings that are trotted out to defend this default choice are numerous. Can we all just acknowledge the elephant in the room—industry attitudes and self-interest:

  • The financial services industry has a bias in favour of being fully invested.
  • The industry doesn’t take kindly to pessimism.
  • The industry has strong incentives to keep money “coming in” and to mitigate money “going out”.

There is no reliable evidence that anyone can time markets predictably (neither getting out nor getting back in again), so people pretend that putting insurance in place (which is something a responsible, prudent fiduciary would do in keeping with his or her stewardship obligations) is something that it is not. Critics call it “market timing” and make all sorts of allegations. Where does the burden of proof lie?

More precisely, how does someone put insurance in place without being accused of being a market timer? If the answer is “it cannot be done”, then the choice (I use the word deliberately and advisedly) becomes clear, you can either:

      i.         do what you believe is right for your client and endure unproven allegations of market timing, or

     ii.         do nothing new, go with the flow and take a pass on portfolio insurance.

Speaking of the word “libertarian”, one of the great drummers (and lyricists) of all time, Neil Peart of Rush, passed away in early 2020. He was a well-known libertarian. In the song Freewill by the band Rush there is a Neil Peart lyric that reads: “if you choose not to decide, you still have made a choice”. That cuts to the heart of the problem. Here is a critical insight that no one seems to want to acknowledge. The people who accuse me of market timing often ask me to explain my choice. I have done that here. Now it’s my turn. To everyone who did not put an insurance policy in place for their clients’ portfolios (in the form of a judicious inverse position or something similar), please explain your choice not to. You have a choice. Even if you passively choose not to exercise that option, you have still made a decision. What if the default was set differently? I’ve asked friends who are Fama disciples if they would put insurance policies in place (i.e. use inverse products) at varying valuation levels. Whether the Shiller CAPE was at 25, 35 or 85, it seems they would not deviate from their religious belief of “putting insurance in place constitutes market timing”.

Kahneman Ties It All Together

The éminence grise of behavioural finance is Daniel Kahneman. His work in Prospect Theory shows that people feel the pain of a loss about twice as intensely as the joy of a gain. If the stock market moved, the emotional response is consistent and predictable. If it went down by 1,000 points, it would feel as bad as it would feel good if it had gone up by 2,000 points. This is called “loss aversion”. Lots of people talk about it. I see virtually no one taking steps to mitigate it proactively. The strategy of portfolio insurance using inverse notes on a large minority portion of equity holdings accomplishes this quite nicely.

In his breakthrough book, Thinking Fast and Slow, (a book that Fama’s colleagues have previously endorsed), Kahneman talks about System 1 and System 2—the former being instinctive, primitive and lazy; the latter being a recent brain development that is unique to humans and requires focus and effort. Together, these constructs form a simple, but effective paradigm for decision-making. Part of the problem, it seems, is that advisors are guilty of a whole host of behavioural sins including:

  • Herding.
  • Status Quo Bias.
  • Overconfidence.
  • Narrative Fallacy.

Rather than explain these terms, I’ll invite you to read about them on your own. Better still, my team at STANDUP Advisors has developed an “Attitude Assessor” tool that can assist with the diagnostic uncovering of certain behavioural tics that we all suffer from in one way or another.

I continue to lament the sorry state of financial advice, given the evidence as we now understand it. In Canada, there are approximately 100,000 financial advisors. Of those, perhaps only 5,000 understand and apply the concepts taught by John Bogle regarding the importance of cost (and low turnover). Of the 100,000 only about 3,000 are Investment Counsellor or portfolio managers who are held to a higher, fiduciary standard. Of the 100,000, only about 200 advisors embrace Fama’s research (i.e. reject stock-picking as a reliably value-adding activity).

Alas, perhaps worst of all, the majority of advisors seem to reject the work of Thaler, Shiller and Kahneman... and the Fama proponents might even be the biggest opponents to the behaviouralist paradigm. Perhaps the word “reject” is too strong. My sense is that very few advisors have the courage to act on the insights that have been gleaned by multiple behaviourally-based Nobel laureates over the past generation. How long before advisors, even those who are “evidence based”, accept the behavioural evidence beyond simple lip service?

For those who want to read more about behavioural economics and Behavioural Finance, please consider the following titles:

Irrational Exuberance – Robert Shiller

Thinking Fast and Slow – Daniel Kahneman

Nudge – Richard Thaler and Cass Sunstein

Misbehaving – Richard Thaler

Predictably Irrational – Dan Ariely

The Upside of Irrationality – Dan Ariely


John J. De Goey, CIM, CFP, FELLOW OF FPSC™ is a registrant with Wellington-Altus Private Wealth Inc. (WAPW). WAPW is a member of the Canadian Investor Protection Fund (CIPF) and the Investment Industry Regulatory Organization of Canada (IIROC). The opinions expressed herein are those of the author alone and do not necessarily reflect those of WAPW, CIPF or IIROC. His advisory website is: