. On the next page is a summary of an interview with Russell Fuller, a fund manager with a behavioral finance approach to investing. Analyze the interview by covering the points below. I want your perspective, informed by the material in this class. Hint: these are anomalies for the rationalist paradigm. Recall what rationalists assert 1) about individual market participants and 2) about the operation of the market.

a) What individual level anomaly is described by Fuller? Why is it an anomaly?

(5 points)

b) What the market anomaly is described by Fuller? Why is it an anomaly?

(5 points)

THE INTERVIEW

MIND GAMES: A MANAGER SEEKS PROFITS BY PLUMBING ANALYSTS PSYCHES

Money, April, 98, Vol. 27, Issue 4

Here's one way to stay ahead of the market: read people's minds. That, in a sense, is the tactic of former finance professor Russ Fuller, who uses the principles of behavioral psychology to try to one-up Wall Street's analysts. Don't laugh: Fuller has racked up annualized gains of 26.9% over the past five years in the private accounts he manages. Now he's applying the same techniques at the Undiscovered Managers Behavioral Growth Fund.

The portfolio is currently available to institutions and through some financial planners. MONEY's Pat Regnier recently went head to head with Fuller, so to speak, and found that there is some logic to his theories. (U of Chicago professor Richard Thaler is a partner in the firm of Fuller-Thaler Asset Management Inc.)

(Note. Analysts are experts who study individual companies and industries. Many investors base their stock buying and selling decisions on analyst recommendations. Thus, demand for a stock and its selling price are affected by analyst recommendations.)

Q. What personality traits cause analysts to make investment mistakes?

A. One is overconfidence. People are grossly overconfident about what they think they know. Securities analysts who are overconfident don't give new information enough weight when they revise their earnings forecasts for companies. "Anchoring" is another potential pitfall. Many analysts under react to new data because they are fixated on the first numbers that come up.

Q. Interesting, but how do you come up with specific stock picks?

A. We look for a stock that's had a positive earnings change we don't think is a fluke but is still under priced because anchoring and overconfidence have prevented analysts from revising earnings estimates upward enough. A recent example of this is the retailer Best Buy, whose shares were selling for $24 when the company beat earnings expectations last September. It took about a month for analysts to push up their profit projections and for the stock to take off. It recently sold for about $56.

Q. How do you decide that analysts are anchored and overconfident, as opposed to just being prudently skeptical?

A. One way is by participating in conference calls between analysts and company managers and by reading analysts' commentary on stocks. People don't want to admit they're wrong, so we look for instances where analysts say "I don't believe it" or "It's just temporary."

Q. How do you know you're not making the same mental mistakes that lead other investors astray?

A. We're human, so we're vulnerable too. But we've set up procedures to prevent lapses. To avoid overconfidence, we've developed a strict set of sales rules. If in the first quarter that we've owned a stock it has a negative earnings surprise, or analysts revise estimates downward, we sell it. We don't like to recognize our mistakes. But one of the biggest errors you can make is to refuse to own up to your own mistakes.

Q. Eventually, won't analysts just catch on to these lapses, correct them and do away with the mispricing you try to exploit?

A. If I showed you an optical illusion, you would still see it after I explained how the illusion works. Our mistakes are the result of mental habits that are like hardware in our brain that can't be reprogrammed. Analysts and portfolio managers will always be overconfident and vulnerable to anchoring. So there should always be opportunities to profit from these mistakes.