As human beings, we are attached to stories, perhaps irrationally so. In what Nassim Taleb calls the "narrative bias," we are really good at crafting a logically tight story to explain nearly anything -- but only after it has already happened! Sometimes this story is so good that we convince ourselves that we believed it all along.
Because of the power of a story, the narrative that we use to explain "the market" matters a lot. And over the years, there have been some rather extreme narratives.
At one extreme, economists think of the market as a cool and rational intrinsic-value calculating machine. When new information becomes available, the market reacts almost instantly, like a machine, quickly adjusting its prices accordingly.
At another extreme, the market can sometimes seem like a petulant child, wildly swinging from one extreme of emotions to another, with little rhyme or reason.
This article will look at which of these "stories" is more accurate, and how we can reconcile them both with what we know from scientific research.
Behavioral Finance and the Efficient Market Hypothesis
The industry-standard Efficient Market Hypothesis says that it is impossible to "beat" the markets, because there are so many smart, rational, and profit-seeking investors searching for any securities that might be mis-priced, that they very quickly make them all go away.
But if most market participants exhibit systematic psychological biases, then this introduces the possibility that these biases may make their way into "the market", which is after all just an aggregation of the views of a lot of individual market participants. Perhaps the market is not a cool and rational "intrinsic-value finding machine," but instead a very human construct that is subject to the same extreme swings of greed and fear that individual human-beings are.
In recent years, a behavioralist school of economists has arisen and attempted to prove that the biases that psychologists have shown that we all show in making decisions at an individual level do indeed make their way into the markets in the form of what they call "anomalies." They try to prove the existence of anomalies by demonstrating trading strategies that would have been systematically profitable. The next section will look at some of the anomalies they have found.
An Introduction to Market Anomalies
A small sampling of the "anomalies" that have been found include:
- Stock prices underreact to news. Studies show that stock prices continue to drift up after the announcement of a positive earnings report or other piece of good news. This may be explained by the fact that we all tend to anchor ourselves to past events, and are overconfident in our understanding of our view of the future, so are slow to adjust to new information [see http://onlinelibrary.wiley.com/doi/10.1111/0022-1082.00184/abstract for example]
- The stock market is more volatile than it "should" be. Evidence shows that the stock market fluctuates much more in the short-term than would be warranted by changes in the underlying fundamentals of the economy. While stock prices "should" discount earnings forever into the future (the definition of intrinsic value) they seem to fluctuate wildly based on expectations of corporate earnings over the next six to twelve months. This may be explained by the fact that money managers and traders have somewhat of an irrational but behaviorally-ingrained bias towards action of one kind of another, which leads to trading more frequently than is warranted by new information alone. There is also likely a "herding" effect that is exacerbated by the "career risk" that money managers face if they miss out on a big move in the markets [see http://www.businessinsider.com/jeremy-grantham-explains-why-the-stock-market-is-19-times-more-volatile-than-it-should-be-2012-4 for instance].
- "Glamore" stocks underperform "value" stocks. Evidence shows that the fast-growing glamorous stocks that tend to get news coverage actually significantly underperform "boring" value stocks that are cheaper relative to their fundamentals. A tendency to anchor based on the latest news might be responsible.
- Stocks outperform bonds by more than they "should." Economists call the annual amount by which stocks outperform bonds the "equity risk premium." While models show that, given the relative risks of the two asset classes, outperformance of one or two percent would be warranted in a rational world, historically stocks have outperformed bonds by 6 or 7%. This may be because of a kind of loss aversion (fear of losing money) that goes beyond a mere preference for lower volatility [see http://www.cfapubs.org/doi/abs/10.2469/faj.v59.n1.2503?journalCode=faj for example].
- Stock market performance depends on the calendar, day of the week, and period in the month. While in a rational world the day of the week or time of the year would have no effect on stock prices, in the real world stocks seem to go up more in January, on Mondays, and around the turn of the month.
While some still adhere to the EMH and argue that with so many smart and profit-seeking professional investors that any profit-opportunities are likely to be short-term and fleeting nature, the behavioralists continue to demonstrate that the financial markets might not be as cool, rational, and impossible to beat as economists used to assume.
So just as a parent has to be prepared for occasional bouts of extreme irrationality from a six-year old, there are good reasons for an investor to be prepared for the market to throw an occasional temper tantrum. And there are steps that we as investors can take both to defensively protect our capital from bouts of irrationality, and to offensively seek to profit from them. More on those in the next article.
Get our next article delivered to your inbox.
Sign up below and be the first to know about our freshest data-driven thinking on the markets, and investing. We will send you no more than one email a week. This is free.
Ready to start putting this into action?
Take a free two-week trial to IvyVest premium -- our premium subscription service. You'll get access to our rules-based dynamic asset allocation model, tools that will show you exactly what you need to buy in your own discount brokerage account (and when to re-balance) to implement it for yourself, and an insightful monthly newsletter that will keep you on abreast of the most important things going on in the markets. There is no credit card required. Get Started Now!