STOCK-MARKETS-THINKING FAST AND SLOW - KAHNEMAN

January 19, 2015

By Steven Butler

Thomas Howard may have one of the oddest investment approaches ever. The 66-year-old former business school prof buys and sells stocks without even knowing the names of the companies. He’s got no idea how much he has paid for the stocks. And he doesn’t bother to keep track of whether the stock is winning or losing. But, hey, in 12 years, through the wild ups and downs of Wall Street, this close-your-eyes approach has managed to average roughly 25 percent annual returns on his flagship Athena Pure fund, making it one of the better investment products out there. 

But if you’re going to take Howard’s best advice: Don’t buy it just because he made money in the past for somebody else. 

If that sounds nutty, consider the emotion-driven mistakes that most of the rest of us make. For starters, most investors get scared when the market tanks, and sell low before buying back high, sacrificing huge potential gains. As a result, the average stock investor has trailed the market average (Standard & Poor’s 500 index) by more than 4 percentage points over 20 years, according to Dalbar, the market research firm. Are the pros any better? Maybe not. Last year, 79 percent of so-called active fund managers, the pros who are supposed to be experts at picking stocks, failed to match their own benchmarks for market averages, according to Morningstar, the investment research company. 

Howard is not surprised, and he thinks he has found a fix. He is a pioneer of figuring out how to make money from research on human behavior, essentially profiting from the emotion-driven follies of other investors. Economist Daniel Kahneman won a 2002 Nobel Prize for work in the field, called behavioral economics, and later wrote a best-seller on the topic, Thinking, Fast and Slow. The research challenged the reigning assumption among economists that people act rationally in their own best interest. Instead, for example, we’re hardwired to feel the pain of loss more intensely than the pleasure of gain, so we sell out at the first sign of trouble. But how to make money on the insight? That’s where Howard comes in. 

The Denver-based fund manager knows a thing or two about stress. Forty years ago, he spent his days in an underground bunker in North Dakota, staring at the “launch missile” button that could wipe out the world. The Idaho native, who once laid pipe in a potato field, swings his thick bald head back as he talks, his broad smile crowded by dimples when he laughs, with plain gunmetal frames and a lavender pinstripe shirt. The only hint of his new career is the twinkling row of diamonds adorning the wedding band on his huge farmer’s hand.

He doesn’t care what the companies do, what they’re called or who runs them.

A dozen years ago, Howard, who once lived off food stamps, bet the family’s savings on the emotional irrationality of investors. He does it to make money, naturally, but says he enjoys trying to figure out the great mystery that is the stock market.

So how does he do it? Crunching the numbers, he has zeroed in on a mix of criteria for companies that he thinks makes for a winning formula: those that pay nice dividends and have a steady flow of funds to pay them but also still take risks borrowing. He has set his computers to scour the universe of companies for candidates with that mix, and then he buys 10 of them and checks back every month and sells or buys different companies. He doesn’t care what they do, what they’re called, who runs the things or whether they’re in an industry that’s growing or shrinking. He says there might be a hundred different ways to exploit his quantitative behavioral research. “It is fun to see my research actually working in the real world,” he says.

Naturally, there are doubters. Kenneth French, professor of finance at Dartmouth’s Tuck School of Business, says that the implementation of this sort of idea often resembles what quantitative fund managers are already doing. And rarely can active managers overcome the extra cost of doing business and beat the market averages. “I’m skeptical,” he says. Research by fund manager Vanguard suggests AthenaInvest’s 0.5 to near 1 percent management fees may be too high to sustain superior performance, according to Christopher Philips, senior investment analyst at Vanguard. Athena Pure has so far been sold mainly through investment advisers but will be available as a mutual fund in the coming months. (And, hey, just to be clear, we’re not saying you should buy it.)

In a way, Howard’s whole approach challenges the need for active fund managers.

But even if not everyone loves his blindfold approach, others are practicing a form of therapy on professional fund managers. Michael Ervolini, chief executive at Cabot Research, runs a hands-on coaching service for more than 100 active fund management companies aimed at giving minute behavioral feedback, sort of like a baseball pitching coach giving intense feedback on windup and delivery. At Brinker Capital, an investment management company, Executive Chair Charles Widger has found that simple-to-explain goals are more successful at preventing individual investors from freaking out and selling too early. Why the need for hand-holding products? “Investor education has failed,” says Lou Harvey, CEO at Dalbar. 

In a way, Howard’s whole approach challenges the need for active fund managers, an enormous business by itself. But surprisingly, Howard says he has respect for fund managers, who, his research shows, are usually good stock pickers. “It’s a pretty talented group,” he says. Their downfall is in the warped incentives of the industry, where essentially a fund manager may make money by having a larger but not necessarily more successful fund. “There are diminishing returns to skills,” Howard says. “If all you had to do was pick 10 to 15 stocks, they would outperform.”

Shannon Sims contributed reporting.

Photography by Cary Jobe for OZY.

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Steven Butler

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