Rationalising the Irrational
Michael Gray, Research Analyst
At the end of last year, whilst having lunch, I decided for my sins to watch an American financial news channel - I won’t tell you which one (it will become obvious why).
The news anchor was typically brash, and with some gusto was gesticulating and talking about Trade Wars and other news deemed negative to market developments. He then switched over to his ‘charts guy’ who was wearing a typically quirky outfit - large black rimmed glasses and a polka dot bow-tie – who then frantically scribbled over a flip chart in an effort to explain why the S&P 500 index had fallen and why the ‘technicals’ suggested it would continue to do so. This was while he was standing in the pit at the New York Stock Exchange, with traders shouting orders in the background, whilst bright red letters at the bottom of the TV screen said ‘Market Sell-off’. All very dramatic.
As the day went on and stock prices recovered, I thought I would check what the reaction was from the channel. Needless to say, there was now bright green lettering on the TV screen saying ‘Stocks Surge’ whilst our news anchor was talking extremely positively about newly released US economic data, and Mr Flipchart was now drawing an upward sloping chart with multiple annotations.
In an attempt not to be overly harsh to the broadcaster, I must reference that this was during a period when markets were more volatile than usual. And as amusing as it was to watch this spectacle, it did concern me how frivolously evocative language and iconography was used, jumping from one extreme to the next in a matter of hours.
It did concern me how frivolously evocative language and iconography was used
I’d like to think this broadcaster was a particularly bad offender, but after viewing other market commentaries around the same time, I saw that a significant amount of the press do overdramatise, with even us supposed understated folks in the UK being guilty as well.
This got me thinking about not only the impact that the press have on investors' decision making, but also the overall effect that human nature has in determining market prices, prompting me to revisit the various teachings from the field of Behavioural Finance.
In classical financial theory, markets are said to be ‘efficient’ whereby they perfectly reflect all information correctly and as a result, financial assets always trade at ‘fair value’. Now we all know that’s not true, as we wouldn’t have had such events as the Dotcom Crash or the 08/09 Financial Crisis! There are a few reasons for this, but the key determinant is due to the behavioural biases that we exhibit.
The extent of this influence can be seen in a paper co-authored by economist Larry Summers which investigated the 50 largest moves (positive and negative) in the U.S. stock market between 1947 and 1987. It concluded that on most sizeable return days, the information that the press cite as the cause of the market move is not particularly important. Press reports on adjacent days also fail to reveal any convincing accounts of why “future profits or discount rates might have changed.” In layman’s terms, more than half of the largest market moves were completely unrelated to anything that might be classed as fundamentally affecting a company’s operating performance or the valuation.
Our evolutionary needs have meant that our brains are hard wired for survival, and depend on fast pattern recognition and decisive action.
So what aspects of human behaviour cause these unsubstantiated price movements? Our evolutionary needs have meant that our brains are hard wired for survival, and depend on fast pattern recognition and decisive action. This was dubbed as System 1 by behavioural specialist David Kahnman, who wrote the best-selling book ‘Thinking, Fast and Slow’. Whereas the System 2 part of our thought process has developed relatively more recently and is considered to be slow, rational and deliberate. Unfortunately, the stereotyping and generalising of System 1 that helped in our survival, doesn’t bode well when it comes to investing. This means some investors look for patterns that may not exist - particularly within the short-term – resulting in a number of behavioural biases.
We can apply two of these biases, herding and loss aversion, to explaining how the number one no-go of investing is committed time and time again: buying high and selling low.
With herding, individuals follow the actions of the larger group. Due to our evolutionary need for security, it actually causes us social pain not to fit in with the majority. This can be difficult in many aspects of life, but particularly when it comes to investing and potentially missing out financially. The effect of herding amplifies market price movements and can lead to market bubbles and panic selling.
Loss aversion is a result of the pain we experience from a loss being nearly twice as strong as the pleasure of a gain. This leads to some investors selling at low prices, as markets fall, to avoid more losses and also causes them to miss out on buying opportunities due to fear of further losses.
Now linking this all back to my initial observations from our American broadcaster, these biases are accentuated by our susceptibility to useless information, or words that have no grounding, peddled by the financial press. Psychologists have found that when placebic information (words that mean nothing) are presented in a format that we are familiar with, we will mindlessly process it. No wonder that some investors, when faced with uncertainty, will cling to any vaguely plausible explanation, allowing media outlets to achieve the ratings they do!
The irrational behaviour of market participants is excellently described by Benjamin Graham’s (‘The father of value investing’) analogy of Mr Market:
“Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or sell you an additional interest...Sometimes his ideas of value appear plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you little short of silly.”
In summary, those that focus upon market price for advice are destined for failure. Celebrated economist John Maynard Keynes further points out the irony of the situation: “It is largely the fluctuations which throw up bargains and the uncertainty due to the fluctuations which prevent other people from taking advantage of them”.
So how can we save ourselves from ourselves, and ultimately make it more likely that we achieve our investment objectives? Firstly, it’s important to recognise and accept the biases we all have. We also need to comprehend that important decisions should take time and that we should deliberately seek impartial views that challenge our own. Finally, a robust, objective and structured process is vital to minimising biases.