Richard Thaler and Portfolio Manager David Potter interviewed on Citywire podcast
Nobel Prize winner Richard Thaler and David Potter, CFA, (portfolio manager of the Fuller & Thaler Behavioral Mid-Cap Value fund) are interviewed by Citywire’s US editor Alex Steger and head of research Frank Talbot. They speak about behavioral trends and common investor mistakes.
Richard Thaler: Rather than pick my biggest mistake, I’ll pick my most recent big mistake. Going back to April/May of 2020, the market has crashed, and I happen to be sitting on more cash than usual. I had sold a home and wasn't sure what to do with it, and I kept waiting for Dave to tell me “okay, now the market's going up”. That was my second mistake is listening to Dave. So anyway, the market started going up, before I thought it had any business doing so. And I ended up leaving the cash around longer than I should have. And this is something I've actually written about, so I should know better. Meanwhile, I'm making contributions every month into my retirement plan. And I'm not thinking about that one bit. I have picked an asset allocation. I stick with it every month. Money goes in. In my university accounts, some of it goes in, in a lump at the end of the year, I never think about that either, but this particular money is new money. The money I've already invested, or the money that's going in every month, they're all in different mental accounts. And it was hard to pull the trigger on this pot of cash, although there was much more money lying around in various accounts that I wasn't worried about a bit. I always warn people about this, but it's much easier to give other people advice than to follow it yourself.
Alex Steger: The mistake was, was this system or this mental accounting, this idea of sort of false silos of money and not treating it all the same or was obviously the mistake was just what being in cash when the market was doing something?
Richard Thaler: Yeah. I mean the market roughly doubled over this period. So that pot of money could have been twice as big, if only Dave had given me that the phone call telling me, “okay, today's the day”.
Alex Steger: Jeez Dave!
David Potter: Actually, no, we had a very good phone call, April sixth, when I was pounding the table.
Richard Thaler: No, no. But during that phone call, you said, “I'll let you know”. You were bullish. I grant you that. But you said, you're going to call me.
David Potter: I think we should forget the mental account and just take that pot of gold and give it to me. And that way you don't have to worry about your mental accounting. I will take care of your money.
Richard Thaler: And I know where it will be.
Alex Steger: Well, this is neat Dave, I mean, other than your biggest mistake being letting down your friend, mentor and boss, meaning he's got half as much money as he could have had today. What's your biggest mistake. And what have you learned?
David Potter: I run two different funds. One is called the Fuller & Thaler Behavioral Mid-Cap Value Fund and that only has about a four year track record, so there hasn't really been enough time for me to really screw it up yet. We also run a small cap value fund through JP Morgan called the Undiscovered Managers Behavioral Value Fund, and that's been around since 1998 so I've certainly had a lot more time to mess up there. So I'll give you an example of one. And, you know, the catch here is this investment lost about 75% to 80% in one day. Which, you know, it's quite horrifying. As an investor and as a client, it certainly wasn't a fun day. That day was April, actually August 1st, 2012, and the company that we're talking about is called Knight Capital Group. I'll just go through a little bit of the background and won’t spend too much time on it, but it is pretty interesting. And I think the lessons learned are also pretty vast. But, they were essentially the largest wholesale market maker in the United States. But anyway, at the time, you know, it was a wonderful business, very steady, stable sort of return on equity business, 12% they traded around book value, just sort of in and out. Not a lot of volatility, just a very easy way to accumulate capital over a given period of time.
However, unfortunately, the New York Stock Exchange changed, changed the rules a little bit. They had to rush and create some new order management system. They messed up when they actually implemented the software. I won't go into all the details, but they had eight servers, apparently they were doing this manually. And one of the engineers forgot to put the new code on the eighth server. And so what happened then the morning of August 1st, 2012, is that they sent out all of these false order requests and they were effectively buying high and selling low, which, you know, the last time I checked is not going to be your optimal financial strategy. They ended up being long three and a half billion, short, three and a half billion, and this is over the course of, you know, an hour or two. And before they could finally figure out what it was and they immediately shut it down. But, you know, because of the May flash crash, you might remember that in US, from, May of 2010, there were some additional constraints put in that would just disallow people to be able to simply cancel trades. And so unfortunately for my capital. They lost about $440 million on these trades (give or take). They couldn't cancel them because they didn't move the market up and up. You have to move at, I think 30% or more for these to be potentially canceled. So anyway, that was, well over half their capital, if not more. They needed to get immediate liquidity injections, Goldman bought the positions. They got some options bought at $1.50, the day before they had traded at $12. That morning they opened at $3.50 cents. So, we immediately sold our whole position, and it was a big position too, and that's what I'm getting to in term in terms of the mistake, but it was one of our larger ones.
Alex Steger: But what did you do wrong there? Because obviously you know, they had made a mistake there with the service and things. You, in terms of picking the stock, you couldn’t foresee that?
David Potter: That's very true. I wasn't the engineer manually putting in the code, but I think what you have to learn from something like this is there are two things here. One, I call the illusion of safety. So I had a very large stake, I think it was greater than 2% of the portfolio in one name simply because, you know, day in, day out, they were just earning their 12%, 13% ROE trading a book value at that point in time. That was a wonderful, safe trade. It was actually defensive too. When markets are volatile, this was actually quite defensive. So we let our weights in that type of a stock go up, without really perhaps focusing on the massive amount of power that such a company has to make a huge operational mess up. So the scale of this operational blip, if you will, cost the company, its entire 50 year plus history in one hour. And so a lot of investors, and myself included, seemed to focus more on the business models, the valuation, et cetera, without really looking and saying, okay, but when you do actually get your final weight in the portfolio, is there something you're missing. Are you lulled into this false sense of complacency, because you do think of this as a very safe business without perhaps realizing what can go wrong, if something happens. And so clearly you saw that, they lost over half their capital in one day. And that's fairly unique for a company. And I think a lot of these type of business models share those sort of same operational concerns.
Alex Steger: And you ended up exiting the position?
David Potter: Yes. Yeah. They were either going to go bankrupt or against them completely out of the money type, call option injection, which they did from a company called Get-go. Which valued the stock at $1.50. And so, we got out, but it was a hard day.
Alex Steger: Sure.
David Potter: But good lessons learned.
Alex Steger: Well, those are your mistakes gentlemen. So let's turn to the meaty topic of other people's mistakes, particularly at the moment. And we've got some pretty frothy markets. Meme stocks et al. What's your take on some of the stuff that you were saying at the moment that you just think is it's cringe-worthy and should people be doing it?
Richard Thaler: Well, you know, I think both of us, well, I won't speak for Dave, but, I suspect both of us are mystified, about these meme stocks. I’ve called it the Board Market Hypothesis. You know, again, if we go back to that fateful time in the spring of 2020, when there wasn't anything to do. There weren't even sports to bet on and people were stuck at home staring at their computer, supposed to be working. A lot of people seemed to start dabbling on Robinhood or wherever they happen to have an account. And so some companies started going up, sort of based on cheering from the sidelines. This is surprisingly dumb even to a Behavioral Economist.
Frank Talbot: So boredom is the catalyst here for people's behavior?
Richard Thaler: I mean, it's not a very satisfactory explanation for what's going on, but it's the best one I have. It seems to fit the facts, but, I think maybe even more surprising than it getting started is it continuing.
Alex Steger: Having another leg, year.
Richard Thaler: Yeah. Many people have been tempted to short these stocks at some time or another. And, that's been painful. I'm happy that we're a long-only company because I could see us having been tempted. I don't think we were ever attempted to go long those stocks, but there would have been a temptation to short them, and that would have been painful.
Alex Steger: Sure. I mean, how are you right now? Profiting from other people's mistakes?
David Potter: Yeah. I mean, I'll just give you some examples. You know, we do focus on the overreaction side and the Fuller & Thaler Behavioral Mid-Cap Value Fund, and really what that means is 2020 was honestly, COVID has been horrible for humanity, but it's been wonderful for prospective returns. And that's simply because of behavioral biases that took place starting in March, but, you know, lasting all the way really through the end of September we noticed early on the banks were getting hit hard, which is clearly what you would expect when there are potential massive credit losses on the horizon with something like this, when you have a whole economy shutting down. But you know, what I noticed was a couple of things. One, there were historic buys and insider buying, really across most of the banking sector in the United States.
Alex Steger: Just to say, just for our readers, when you say insider buying, this is people in those companies is when a CEO/CFOs. People would have to disclose when they're buying more shares of that company. Is that accurate?
David Potter: Right. Yeah. And the rule is within 48 hours of the actual purchase. They need to file what's called a Form 4 to the SEC, and then that's immediately disseminated to the marketplace. And so, you know, these were record number of buys. We have data aggregators that just show us all the historical and, you know, far surpass the days of the financial crisis in terms of the insider buying. That's music to our ears because obviously one part of our process is really seeing what the insider's do and sort of avoiding the analyst community, but trying to follow what the actual people that know what they're doing and work at the companies are doing with their own money. So that was one thing that I noticed, but then I also noticed that there were a lot of people that seem to immediately hark back to the financial prices and that this was the GFC two. In the sense that even, you know, in March, I was having a conversation with one of our larger clients and someone on the call said, well, I think this time might even be worse. I think we're going to see a major universal bank go under because of credit losses. You could sort of sense that emotion and what we call saliency because certainly the losses from the banks were real from the financial crisis and that was very poorly managed up to that crisis. But, you know, things were so different this time around with much higher capital levels for banks as a result of the financial crisis, you know, much more government intervention, both in terms of immediate monetary stimulus, but also fiscal stimulus that you really didn't have anywhere near the same degree. In the financial crisis and so you have this credit curve flattening going on that people I think were very slow to appreciate. I think a lot of investors willingly ignored these type of positive data signals. And just chose to ignore this sector, I'd had people call me and say, “look, I know that you think banks are cheap, but I just can't buy them. I just want to buy things that are sure not to go under no matter what the outcome of this crisis is.” And so on in saying that I think what they're doing is they're saying I don't care about valuation anymore. And that to me is the cornerstone of behavioral finance in a way, it's when people then start to become overly emotional and irrational and forget that, you know what chances are, on a probability basis, this is actually the best time to invest. And again, we use a lot of the information from the aforementioned insider buyers to give us some confidence that the timing is right.
Frank Talbot: So I was interested to know David, and Richard, I mentioned sort of you didn't This is your Edge, understanding investor's behavior and taking advantage of bad behavior here, but I suppose nowadays that data is I would guess, more easily available than ever. Let's take that example that insider buying is something a lot of people could get that. You know, Richard's work is more widely available and read perhaps than ever has been. He's been in a film for crying out loud. You know, a hit Hollywood movie. And Daniel Kahneman and he's obviously, you know, on the board of your firm and increasingly prevalent. Do you ever worry that this edge could be eroded as other people become more familiar with behavioral economics, behavioral sciences, and also with some of the data that is now out there, or do you think that that's fine?
Richard Thaler: Yeah. So let me take the first stab of that. Uh, they're kind of two levels of that question. Uh, one is a very general one that I get outside of investing. Which is very much the same flavor that you know, people are reading your books and they're reading Danny's book, aren't these biases going to go away because people are going to learn. And the answer to that is clearly no. People are not getting smarter. And the number of people who are reading our books are way more than we ever expected, but a tiny proportion of the world. Yeah.
Alex Steger: Humans can’t become Econs, right?
Richard Thaler: Humans are not going to become Econs in well, certainly not in my lifetime and not in my grandchildren's lifetime. It's a different question to ask. If there's some market anomaly that's been written about for a long time, such as insider buying, will a strategy that's based on that stop working? And that's entirely possible. So, yes, we're going to worry about whether some signal is going to continue to work. And so we're going to try to implement things in as sophisticated a way as we can. But we're going to also monitor. And like Dave said, he's been running this strategy for quite a while. And, it doesn't now outperform every year, although I wish you stop having occasional bad years, David. That would be even better, try to fix that. When we go around and talk to Institutional investors we find, they still look at us like we're weird and that's very reassuring.
Alex Steger: I wanted to switch focus for a second, if that was okay, because I want it to be very clear and he sent me, the final edition of Nudge which I’ve been reading over the last week here, but I have to profess I'd been reading it in tandem with another sort of book broadly in the behavioral science sort of world. Oh crap, potty training and this is, to help my two-year-old son do potty training. Now, I'll be honest with you. They’re both good books. One of them was written by a Nobel Prize winner and the other one wasn’t. Oh crap, potty training - It's not as much sort of libertarian paternalism is just straight up paternalism. You know, this, I thought it'd be helpful to read them in tandem, I thought I could become a choice architect for my son and help him make better decisions, but actually, no, it just forced him to use a pot. But they are both great reads.
I want to ask you one thing Richard, if that was all right. With regards to Nudge, Frank and I are both Brits. And before I was out here in the US, writing about investments, I spent a little time writing about investments savings in the UK and also enrollment came in in 2012. The big government pension to measure that made sure. I feel like it was a big Nudge. You have to opt out of your companies’ defined contribution schemes rather than opt into things. And I just wondered you knew to pay attention to stuff like that?
Richard Thaler: Absolutely. So, well, first of all, before we drop the potty training. You know, perhaps the most famous nudge is the fly. The fly in the urinal and the Amsterdam airport. And, It's been a while since I've been in this business. But, I hear that Cheerio thrown into the toilet can do wonders. I don't know whether your kid is a boy or a girl. But for boys I hear Cheerios are really as a target.
Alex Steger: You know what? That's the only thing that's not in any potty training.
Richard Thaler: So there you go. But, you know, back to investing. Look when Lord Adair Turner who ran the commission that created that system, and for non Brits, this is essentially a national run version of a 401k plan for firms that weren't offering such a plan. And by the way, the US should copy this because something like 40% of workers don't have a retirement plan where they work and that's bad. Adair had a decision to make, which was, should that be required? Or should it just be nudged? And the decision they made was to require firms to offer it, but only to nudge workers to join. So firms were required to offer it and to make enrollment automatic, but people could opt out. And that achieved about 90% enrollment. Which is a remarkable success. Now, some people have said “no, they shouldn’t have required it” and in fact, that's the way it's done in Australia.
And you can have an argument about superannuation, right? You can have an argument on which system is better. Personally, I find 90% enrollment plus freedom of choice is a pretty wonderful outcome. And they've also adopted what we call save more tomorrow. So the initial saving rates were quite low, but they've been ratcheting them up. Auto-escalation and the enrollments have stayed at over 90%. So this is probably the biggest victory of behavioral economics. It is the use of those two ideas: automatic enrollment and automatic escalation. Both in the private sector in the US and in the public sector around the world.
Frank Talbot: And of course the fly in the urinal.
Alex Steger: Those are the three, the three big ones. Those are the three big ones. Right.
Richard Thaler: And hey, we won't rank them.