Reasons Why You're Crazy

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During the 1960s and 1970s, financial economists began to take a slightly strange view of human beings, replacing Homo Sapiens with Homo Economicus—a perfectly rational, totally self-interested economic expert concerned only with maximizing his own self interest at every turn. The most influential application of this idea came from University of Chicago professor Eugene Fama’s Efficient Market Hypothesis (EMH). The EMH rests on three basic assumptions: (1) Most investors are rational, and incorporate all known and relevant information into their decisionmaking—thus, the price of a security reflects its real “value”; (2) when investors are irrational, they trade randomly and cancel each other out; and (3) since only some investors are irrational, even if they do cause prices to go out of line, rational arbitrageurs will bet against them by purchasing underpriced assets and selling, or even short-selling, overpriced assets. These insights helped lead to a number of important developments for investors. The largest is the field of indexing. If markets are generally efficient, it is theoretically impossible for stock pickers to beat the market on a consistent, risk-adjusted basis. This theory was largely confirmed by the fact that most investors—from large mutual funds to individual stock-pickers— actually underperform the market as a whole. Into the void stepped index funds like the S&P 500 and Vanguard 500 (which was created specifically to put Fama’s ideas into practice).

The EMH also propped up the arbitrage industry. Sure, markets are quick to punish irrational investors as inefficiencies, and the profits that come with them, are quickly gobbled up. However, for the fastest and boldest arbitrageurs, there are enormous profits to be found in those temporary inefficiencies, and a new generation of quantitative arbitrageurs stepped in to take on the profitable role of returning markets and securities prices to rationality. By the late 1970s, the evidence supporting efficient markets was so strong that economists like EMH co-creator Michael Jensen were making statements like “there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Markets Hypothesis.”

“Such strong statements,” Harvard economist Andrei Shleifer later wrote, “portend reversals, and the EMH is no exception.” That reversal has come in the form of “behavioral economics,” which challenges EMH and its view of rational investors by using insights from fields such as psychology to better understand how and why actual people—even professional investors—make decisions.

The theories and mathematical proofs of behavioral economics were largely spurred by discrepancies between the theoretically rational markets of the EMH, and the messier real world. Fama himself found that investors tend to extrapolate the earnings of small “growth” stocks too far into the future—assuming a tree can grow to the sky, as the old joke goes—while undervaluing unsexy value stocks. Other studies found that stocks that performed poorly over the preceding years outperformed those that did extremely well during that same time frame, likely due to the pendulum swing of investors under- and overrating them. However, in the shorter term, the opposite happens— over the course of a few months or a year, a stock can maintain its momentum. In fact, some market inefficiencies actually stem directly from the Efficient Market Hypothesis’ impact on markets, particularly with index funds. When companies are added to the list of stocks in the S&P 500’s basket, their stock price rises for reasons that have nothing to do with the company itself. Even the very management of index funds requires inefficient and irrational behavior—buying and selling stocks not because they are winners or losers, but simply to keep the index balanced to reflect the market as a whole.

Both the real-world evidence and abstract explanations for why markets behave irrationally have been around for decades, but behavioral economics’ impact on mainstream financial thinking remained small until the fiscal collapse of 2008, which left even Alan Greenspan admitting that maybe the central philosophy of his career was wrong.

Where does this leave the institutional investor? In terms of stock-picking, studies have found a cornucopia of strange, but usually understandable, irrationalities in the movement of securities prices. According to EMH, stock prices should be affected by new information like earnings reports, and that information should be incorporated almost immediately, but people are not so quick to take in information, process, and react to it. Thus, new info (good news, in particular) is usually met with a more gradual creep in stock prices, not a sudden jump. Unsurprisingly, this seems particularly true of new information that is released on Fridays (when bankers are apt to be on their way to the Hamptons), with smaller stocks, and with stocks of companies with fewer analysts watching them.

This reality points to one of the central flaws of EMH: the belief that all public information is immediately consumed and reacted to. Transfer this belief to other industries and the naivete of such a phenomenon becomes clear. If true, there would never be any need for long-form journalism—all the information we ever need would be uncovered immediately and examined in newspapers and blogs. Every professional athletic team would offer free agents almost the exact same contract, and every league with some kind of salary cap would be filled with teams with a record that hovers around .500. After all, everyone is privy to the same game film and statistics, so how could anyone have any unique insight, or disagree on how much different players are worth?

Of course, even in financial markets, not everyone does his homework, and not all information is immediately obtained and analyzed by every trader on the market. This is pretty clearly demonstrated by the link between supplier and consumer companies. The performance of a firm is, of course, deeply linked to its business partners. Cotton farms affect textile companies affect apparel companies affect retail stores affect commercial real estate outfits—and a publicly traded company’s major suppliers are discovered easily in public documents. As such, there’s a strong link between the performance of a company and the companies it buys things from, yet Wall Street is very slow to incorporate that link into the stock price of suppliers, leaving easy profits on the table for anyone able to connect the dots. The academic literature on behavioral economics is chock-full of such useful little trading tips—Andrei Shleifer’s 2000 book Inefficient Markets: An Introduction to Behavioral Finance, is one of the more informative, readable books on the topic.

On the more psychological end of behavioral finance is the importance of how an investment decision is framed. Investors have been found to put more money into stocks when shown the better long-term returns of stocks over bonds, but to lean more toward bonds when shown shorter timelines, which generally depict the more volatile returns on stocks—something worth considering for a CIO trying to convince his board of trustees of a change in investment policy or asset allocation. However, for all the potential uses of such insights from the field of behavioral finance, there is a sizable dose of caution that must come with them. If nothing else, behavioral finance as a field serves as a reminder of the inefficiencies that can crop up in even the most seemingly efficient fields and of the unintended irrationalities that can stem from the most rational actions. It is impossible to tell when Farm’s arbitrageurs will step in and shrink the returns on such inefficiencies. Small stocks famously have outperformed larger stocks over time and, for whatever reasons, this was particularly true in the month of January but, during the 1980s and 1990s, this January phenomenon disappeared.

While markets often are irrational, it can take quite a bit of time, effort, and staff to discover and exploit such irrationalities—making the process potentially more work than it’s worth. Additionally, those trying to exploit the irrationality of other professional investors are vulnerable to their own biases. In fact, it is the people most confident of their own rational exceptionalism that often are prone to the biggest blind spots and errors. So, while markets might be irrational, remember John Maynard Keynes’ warning: Sometimes markets can remain irrational a lot longer than you can remain solvent. Act accordingly. —Joe Flood