This is a guest article by Scott Treadwell, a long-time Consumerism Commentary reader and graduate student at the University of New Hampshire. Scott is studying finance and is conducting a study in behavioral finance. Please look for the survey below and help Scott conduct his study.
We are only a year removed from the greatest financial crisis that has been seen since the Great Depression, and many voices have vowed reform throughout the industry and have assured us that these events would never happen again. The world of academia, however, needs to catch up to reality. As our engine of intellectual innovation, they should be on the cutting edge, but the same flawed precepts that have been taught to our business and finance students over the past twenty years continue to be taught (although the smart instructors will deliver the material with a caveat).
The standard methodology has been the Efficient Market hypothesis. Since news and information is so prevalent, academics assume the massive army of savvy investors that are active in the financial markets will instantly price the stock at the appropriate value. Given that assumption, most variables in the financial markets including human error are factored out and statistics are easily utilized to measure risk.
However, factoring out the human element was a mistake. Humans are the actors who analyze stocks and choose to buy, sell, or hold, thus determining the stock price. This is true whether the investor is an individual trading in her own account or a manager of a large mutual fund or trust. Based on recent events, it became clear that these three key assumptions surrounding efficient markets were incorrect:
- Prices DO NOT reflect all available information. Not all information that is acted upon is available to the public. Frequent and chronic insider trading nullifies this effect. The problem is not just Wall Street; corporate executives and employees with a shareholder interest in their own company can, and do, cash out before unfavorable information becomes public, although few get caught.
- Public information IS NOT always interpreted correctly. For example, many companies’ exposure to Mortgage Backed Securities was clearly stated in their financials, however that was determined to not be a problem until default rates skyrocketed. Some in the financial community warned that the level of risk was being underestimated for years, but inertia trumped their few voices and valuations remained unchanged, and wrong.
- Human Beings are NOT rational actors. Many precepts of economics are based on the assumption that the average human will optimize his economic interest at any given time by making the optimal decision. If this were the case, impulse consumer buying, groupthink, and stock market booms and busts would never happen. This is like saying that when there is a fire in a crowded theater, people will calmly line up in the reverse order of their seating arrangement and orderly file out of the building because they know this behavior is in their best interest. The concept sounds ludicrous in that context, so why is it applied to financial markets? People panic due to fear, they over-extend themselves due to greed, and they make foolish decisions. In other words, they behave like humans, not robots.
Enter the field of behavioral economics and finance, one that has been on the fringes of academia for many years. Once viewed as a disparate group of contrarians who analyzed strange aberrations in the market, their work was discounted by mainstream. However, in light of recent events, academics and investors are paying new attention to this field and the body of research conducted over the past several decades.
So what is behavioral economics? Essentially, it is study of trading behavior that is not rational. The trading behavior of humans is analyzed to gain insight about financial markets and to account for deviation from normal behavior. Here are some examples of these unique trading patterns:
- emotional or vested attachment to stocks
- panic selling and impulse buying
- recency effect (you are more quick to sell a stock you just bought rather than one you have owned for awhile)
- disposition effect (people are more willing to sell stocks that increase in value and hold the stocks that decrease losers)
Now the next question is, why do you care? Accepting where we went wrong is the first step, however everyone from finance professors to Wall Street professionals need to understand how the forces in play that can shape the investment environment now and in the future. If non-rational human behavior is truly a large factor in the market, we need to be aware of it and consider it as we formulate our individual investment strategies.
In order to gain some more insight about individual behavior, I have a quick survey about your trading habits. It’s quick, easy, and totally anonymous. The goal is to gain as much input as possible. Five minutes of your time will yield great results which I will be happy to share with Consumerism Commentary readers once the data and reports are available.
Please complete this anonymous survey.
Editor’s note: I completed the survey in under two minutes. Please take a moment to complete the short questionnaire and help Scott, a graduate student, complete his research study and earn his Master’s degree. ~ Flexo
This is a guest article by Frank Curmudgeon, author of the Bad Money Advice blog. For updates from Frank, subscribe to the Bad Money Advice RSS feed.
We often see the struggle to get control of our spending as being the conflict between our emotional and logical selves. Emotion wants to go out to that new restaurant tonight, logic says cook at home.
We say to ourselves “If only I could stop and think about all my spending decisions, I’d soon be rich.” That’s not wrong, exactly, but it makes at least one big faulty assumption, that it is easy for us to be logical around money when we want to be. The truth is that just thinking about it is not always enough.
There is an entire field of economics, behavioral economics, which studies the differences between what logic would have people do with their money and what they really do. The academics in this area have collected many such “anomalies.”
One that illustrates well the illogic of our thinking selves is anchoring, the tendency for people to be influenced by even the most ridiculous estimates of a number. The classic example is that if you ask people if the Mississippi is more than 6000 miles long and then ask them to guess its exact length, they will give much higher guesses than if you had just asked them to estimate its length. (It is 2340 miles long, by the way.)
Dan Ariely, a professor at MIT/Sloan, conducted a striking demonstration of this effect. He asked a group of MBA students to write down the last two digits of their social security number. Then he asked them if they would be willing to pay that amount of dollars for a bottle of fine wine he was holding. Finally he had them submit actual bids for the wine, which he really sold to the winner.
Sure enough, the students tended to bid higher if they had social security numbers that ended in higher digits. So the anchoring effect was there even though the participants were fully aware that the suggested value was completely random, even though they were sophisticated and thoughtful (have I mentioned I got my MBA at Sloan?) and even though it was their own real money at stake. This was not an impulse decision in which consumers let emotion get the better of them. These were would-be shrewd businessmen who undoubtedly assumed that Prof. Ariely was up to something sneaky.
And anchoring explains a few oddities in our everyday lives. It is why houses, cars, and jewelry often have high “asking” or “sticker” prices. The seller does not really expect to get this price and the buyer does not expect to pay it. So why bother? Because by attaching a tag on a watch that reads “$500″ the jeweler can more easily talk you into paying $425, even if you know full well that the $500 price was just for show.
And anchoring also helps explain some stock price movements, specifically the phenomenon called price momentum. That is the tendency for stocks that have been going up over the past few months to continue to do so.
Imagine that there is an exciting growth company that announces some positive news when its stock trades at $50. There is a large group of investors who love this company, are excited by the news, and would, in principle, pay $100 a share. However, because of anchoring, they just cannot bring themselves to pay more than $10 above what the stock was trading at in the past month. It just seems expensive. When the stock goes above that level these buyers back off, temporarily. After a few weeks, the current price does not seem so unreasonable, because they get used to it, and they resume buying. The result is that even though in a more logical environment the stock would have gone to $100 immediately, what actually happens is that it climbs steadily at about $10 per month over five months.
It’s important to understand that anchoring doesn’t happen because you are stupid, or too emotional, or overly influenced by advertising. It happens because you are human. It is the way your brain is wired up. You can’t stop yourself from doing it, although being aware of it is a great help.
The point is that merely resolving to think about how you spend is not enough. Spending logically is harder than it looks.
Photo credit: Don3rdSE
Behavioral economics, a mix of psychology and finance, is an interesting field, and has taught those who choose to listen why they’re less likely to benefit from thinking they can predict the performance of a stock price.
The human brain is simply not wired to make good choices in the stock market. Traders will lose 3.8 percentage points annually (in a recent study) due to fees and poor decisions compared with a benchmark index. This is simply because we are overconfident. We know what we know, but we don’t know what we don’t know, and tend to discount the latter while giving more importance to the former.
As ordinary investors in the market, why do we believe that we have an advantage over the market as a whole? Why do traders insist that they have some knowledge of a bargain that no one else has? This recent article from the Washington Post, How Thinking Costs You, touches on behavioral economics and why we think we can make “informed” decisions about stock market transactions. I’ve heard this over and over again. Don’t believe you can beat the market. Don’t look at index funds as providing “average” returns; over long periods of time, this is the best you can get for the risk that you take.
[Terrance Odean, professor at the University of California at Berkeley] has gathered trading records from discount brokerage houses for hundreds of thousands of investors, and in several published studies, he has shown that when people had a choice of two stocks to sell, more often than not they sold the stock that did better in the future and held on to the one that did worse. And when they bought something new, they tended to buy a stock that did worse than the stock they just sold. As Kahneman once told Odean, “It is expensive for these people to have ideas… “What I believe is that individual investors probably as a group create the dynamics by which they lose money and institutions make money,” Odean said. “They create mispricings.”
Not all of my investments are in index funds. My 401(k) doesn’t offer pure index funds, and I had a small amount of free money to put into ETFs and individual stocks. But every large investment I make, if the time horizon for withdrawal is at least a decade away, will be in an index fund. There are hardly any expenses and my returns will match or come close to the overall market.
Since “thinking” (i.e., considering trades and acting on decisions) has a detrimental effect on investments, and investing in an index for the long term frees your mind from these decisions, index funds have been again proven to be the best option for long term investments.
I’m a smart guy but it would be egotistical for me to think that I know something about a publicly traded stock that the rest of the investing world doesn’t already know, even if I pored over quarterly reports and had lunch with the CEO every other day.
Would I invest in a private business? Possibly.
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