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.
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
Published or updated November 3, 2009.