It's hard not to think of the stock market as a person: it has moods that can turn from irritable to euphoric; it can also react hastily one day and make amends the next. But can psychology really help us understand financial markets? Does it provide us with hands-on stock picking strategies? Behavioural finance theorists suggest that it can.
Beliefs and findings of behavioural finance
This field of study argues that people are not nearly as rational as traditional finance theory makes out. For investors who are curious about how emotions and biases drive share prices and markets, behavioural finance offers some interesting descriptions and explanations.
The idea that psychology drives stock market movements flies in the face of established theories that advocate the notion that markets are efficient and rational. Proponents of efficient market hypothesis say that any new information relevant to a company's value is quickly priced by the market through the process called arbitrage.
This is where someone spotting a stock that is too cheap or too expensive takes advantage of the difference between the real value and the market one and as new information is widely available, it efficient market theory means that a change in circumstances is quickly jumped on and exploited until the stock or commodity reaches its 'fair' value and stops moving — at least until something new is discovered and the process starts again.
For anyone who has been through the Internet bubble and the subsequent crash, the efficient market theory is pretty hard to swallow. Behaviourists explain that, rather than being anomalies, irrational behaviour is commonplace. In fact, researchers have regularly reproduced market behaviour using very simple experiments.
Importance of losses versus significance of gains
Here is one experiment: offer someone a choice of a sure £50 or, on the flip of a coin, the possibility of winning £100 or winning nothing. Chances are the person will pocket the sure thing. Conversely, offer a choice of a sure loss of £50 or, on a flip of a coin, a loss of £100 or nothing. The person will probably take the coin toss.
The chance of the coin flipping either way is the same in both scenarios, yet people will go for the coin toss to save themselves from loss even though the coin toss could mean an even greater loss. People tend to view the possibility of recouping a loss as more important than the possibility of greater gain.
The priority of avoiding losses holds true also for investors. Just think of Northern Rock shareholders who watched their stock's value plummet from more than £12 a share in early 2007 to nothing by early 2008 when the bank was nationalised. No matter fast the price dropped or how much it was in the news, investors, believing that the price would eventually come back, not only held onto the stocks, but some even started buying more shares.
The herd versus the self
Herd instinct explains why people tend to imitate others. When a market is moving up or down, investors are subject to a fear that others know more or have more information. As a consequence, investors feel a strong impulse to do what others are doing.
Behavioural finance has also found that investors also tend to place too much worth on judgments derived from small samples of data or from single sources. For instance, investors are known to attribute skill rather than luck to an analyst that picks a winning stock.
On the other hand, investors' beliefs are not easily shaken. One belief that gripped investors throughout the late 1990s was that any sudden drop in the market was a good time to buy. Indeed, this view still pervades. Investors are often overconfident in their judgments and tend to pounce on a single "telling" detail rather than the more obvious average.
How practical is behavioural finance?
We can ask ourselves if these studies will help us beat the market. After all, rational shortcomings ought to provide plenty of opportunities for people wise to them. In practice, however, few people — if any — are deploying behavioural principles to sort out which cheap stocks actually offer returns that can be taken to the bank. The impact of behavioural finance research still remains greater in academia than in practical money management.
Perhaps one telling conclusion from all the research is not to trust the market value or past performance of a stock or commodity. This conclusion is, of course, nothing new. It's what billionaire investor Warren Buffet has based his fortune upon. In a recent example, he pumped money into Goldman Sachs bank at the height of the credit crisis that swallowed up fellow investment banks Bear Stearns and Lehman Brothers in 2008.
While others frantically followed the market in a herd and sold shares in all the investment banks, driving all their share prices lower, Buffet saw a good bank. He made billions from the deal by bucking the market trend. However it's not an easy trick to repeat.
While it points to numerous rational shortcomings, the field offers little in the way of solutions that make money from market manias. Robert Shiller, author of 'Irrational Exuberance' (2000), showed that in the late 1990s the market was in the thick of a bubble. But he couldn't say when it would pop. Similarly, today's behaviourists can't tell us when the market has hit bottom. They can, however, describe what it might look like.
The bottom line
The behaviouralists have yet to come up with a coherent model that actually predicts the future rather than merely explains, with the benefit of hindsight, what the market did in the past. The big lesson is that theory doesn't tell people how to beat the market. Instead, it tells us that psychology causes market prices and fundamental values to diverge for a long time.
Behavioural finance offers no investment miracles, but perhaps it can help investors train themselves how to be watchful of their behaviour and, in turn, avoid mistakes that will decrease their personal wealth.
Ben McClure, 15:11, Tuesday 18 October 2011
@ moderators please move to the appropriate section if you need.