The Birds Eye View

“Economists who adhere to rational-expectations models of the world will never admit it, but a lot of what happens in markets is driven by pure stupidity — or, rather, inattention, misinformation about fundamentals, and an exaggerated focus on currently circulating stories.” (Robert J. Shiller)

Psychological insights have proliferated across almost every aspect of business, whether it is explicit or implicit; on a macro or micro level. Both financial institutions and economists, however, have lagged behind in utilizing these actionable insights to their full potential. They fail to account for any of the psychological biases that affect the markets on a daily basis. These biases are hardwired into some of the most primitive portions of our brains and cause us to trade and behave irrationally. For most readers of Freakonomics, Irrational Exuberance, and Predictably Irrational, this ideology is old. Many have embraced the role that behavioral science plays in economics, but the role it has in financial markets is a little bit more specialized, and harder to break into. Nevertheless, avoiding it, as most economists have done can have massive effects on long-term wealth. In this article, we explore several aspects of behavioral finance and go against some of the theories made about financial markets. We dive into the various biases that affect the way we buy and sell in the market, the idea of herding, anchoring, and loss aversion. We will also discuss how markets are affected today and what behavioral finance indicators are telling us about the ever-rising market.

Eugene Fama’s Efficient Market Theory in simple terms declares that the current stock price is always right. It takes all available information into account (both public and private) to generate the most accurate value. Eugene Fama argued that assets always traded at fair value, making it impossible for investors to buy undervalued stocks and on a risk-adjusted basis it would be impossible for investors to beat the market. I would like to point to the people that consistently do beat the market: George Soros, Warren Buffett, Seth Klarman, Peter Lynch, Ray Dalio, and David Einhorn and many more. The second part to this question that comes to mind, is how is it possible to have so many bubbles in the market if it’s priced correctly at all times. This grows from the Normal Distribution, that we continue to use in the financial industry. As Benoît Mandelbrot has proven, the stock market does not follow the normal distribution and instead has a higher kurtosis and follows the fat tail theory. This means that the anomalies that were supposed to happen only once in a lifetime are happening more often (1893, 1896, 1901, 1907, 1929, 1937, 1962, 1987, 1989, 1990, 2000, 2001, 2008). But, why is this case? Why does this theory collapse in the real world? In large part, this has to do with behavior and the biases that affect the market on a daily basis: not only with the individual investor but also with large institutional ones and CEO’S.

Mutual funds fall victim (as do many money managers) to the idea of herding. Herding is a recognized phenomenon where people follow crowd behavior, which can amplify these events. A series of classic psychological studies — commonly well known as the Asch paradigm (after the famous Polish psychologist Solomon Asch) — illustrate how group behavior influences our beliefs and opinions. In one of the aforementioned studies, Asch discovered that a large number of subjects made an erroneous decision in a simple line-matching task if the confederates (actors) gave an incorrect answer first — in this case when the confederates claimed that two lines of different length were the same. Respondents provided the wrong answer (i.e., picked the wrong line) despite knowing that their answers were wrong. The maximization of reward taking plays a large role in social conformity (Reeves et al., 2007). A 2009 study by Klucharev and colleagues used functional magnetic resonance imaging (fMRI) to show that conflict with group opinion caused a decline in activity in rewards centers such as the nucleus accumbens. The nucleus accumbens is an area that is deemed to be crucial for processing rewarding behaviors such as intake of addictive drugs, exercise, sex, etc. These studies play out significantly in the Money Manager industry.

Consider this scenario, mutual fund manager Jessica realizes that markets are highly overvalued. But, she can’t short the market due to strict regulations, and uncertainty on when the bubble will pop. So she decides to sell her overvalued stocks and move into safer options. She goes a year with underperforming assets, and when she is measured up with her fellow mutual fund managers, she underperforms. As capital leaves her fund, due to underperformance, she is replaced by a new manager James who understands the idea of following the herd and playing the protection game. The new money manager re-invests in over-valued stocks in a similar risk fashion, just as Jessica had before she divested the fund. A year later Jessica’s prediction of a market crash comes true. However, because the new money manager James failed with the group as opposed to going against the herd, he kept his job. The idea that it’s better to fail conventionally than to succeed unconventionally holds very true to money managers. Jessica was correct about the market, but her timing was off, and unfortunately, her investors were inpatient and overall the irrational investors ended up losing a large portion of their money. The problem here lies with short-term incentives. Money managers have three main goals which in part have been determined by the marketplace, (1) make money (2) beat the benchmark and (3) protect your job at all cost. These short-term goals cause erratic trading and large losses. The issue here is that money managers have no long-term incentives. This idea to fail with the group causes funds to follow each other in a rather predictable manner. As one can imagine this causes a huge increase in asset prices. Creating large bubbles that pop and cause massive losses and is a key reason these anomalies happen more frequently than we predict.

Money managers are not the only influencers of bubbles; it goes all the way up to the CEO’s. The CEO payment structure and the shareholder pressures make company valuations extremely important. Perhaps the most widely used valuation in finance is the Price/Earnings Ratio (P/E), one that is heavily influenced by company buybacks (when companies buy their own shares to reduce the supply and increase the market price). Last year alone, companies spent $1.5 trillion on buybacks to raise their price and look more attractive in the market. Does this improve their earnings, reduce their overhead, or reduce their debt? (Now the notion that companies use buybacks to award shareholders instead of using dividends because of double taxation, is a valid point, but the question arises long-term shareholders who experience bubbles and crashes, that don’t sell their shares are simple looking at theoretical profit not realized gains so yet again short-term incentives, instead of long-term goals). No, all of the other indicators of success or failure are still present and available, but buybacks artificially inflate the most important aspect of numbers, stock price, and we all know it sells. Price psychologically has a huge role in the market. It is everywhere: on your cell phone, your favorite network, your magazine and even on your favorite website. For investors, however, the price per share can deter you from making smart decisions. The last thing an investor should look at is price, however, in this era of information, it is the first. The price doesn’t tell you if the company will be successful 5–10 years down the line, it tells you what the group feels will happen and as we know following herds, as James our money manager has done, can cause massive losses. The table below shows how business is decreasing in revenue but dramatically increasing their stock buyback and the total cash return. This is a clear sign that things in the market seem to be deviating in the wrong direction. Companies seem to be borrowing at low rates and not investing in CAPEX (5% growth) but in their stock (30% growth in expected 2017 numbers).

The price point plays a huge role in the individual investors eyes, even though it shouldn't. The reason why is because the average individual investor is not a rational decision-maker. In textbook Economics, one of the basic lessons is that the market, being ever so efficient, is operated by millions of rational investor who never trade off of emotion, but instead off of very cold calculated formulas like cost-benefit analysis and the PV functions and other valuation metrics. However, this theory is false, as Dan Ariely has proven throughout his book Predictably Irrational we are not rational people. We rarely make the best decisions, let alone the right decisions. This is due primarily to our lack of self-control; we procrastinate a lot and seek immediate gratification from craving everything now (present bias). We often get in these Jekyll-and-Hyde moments that result with us making wild decisions. We are essentially Predictably Irrational and don’t seem to learn from our past mistakes, doing the same thing over many times again. What we fail to understand is that emotion changes our behavior and our decisions. It is the animal-like behavior hindering rational behavior and proper decision-making. We herd markets and tend to sometimes mistake luck for skill. We often fall victim to the law of small numbers, which is “Judgmental bias which occurs when it is assumed that the characteristics of a sample population can be estimated from a small number of observations or data points”. If 5 red cars pass my house, I assume every car on the block is red. As one can imagine using a small set of data points in your analysis can cause very misleading numbers and models. But understanding this aspect can help you avoid these biases. But how is this playing out today?

Consumer confidence as of March 2017 is at an all-time high, the VIX index (indicator which displays the volatility in the market using SP500 options) is at an all-time low and people believe that we are back to good standing. But, what’s odd is the Valuation Confidence Index is at an 18 year low. Meaning individuals have a negative view of the confidence in the valuation of the market. Why is this the case? The logical answer to this conundrum is fear of missing out. People now more than ever are fearful of missing out on the stock market rally. Even though they see overvaluation in the market they look the other way. They behave irrational and in this case start investing heavily in markets that already seem overvalued. As investors, we care less about the risk and more about how we compare to our competitors ever quarter. But, it is important as always to realize where fundamentals end and where mania starts. The current cyclically adjusted price to earning ratio for the SP500 is roughly 30x. The average for the SP500 is 19x, which tells us that over the next 5–10 years we should expect negative returns. But, what many will tell you is that we are in a new era and a new time. In Finance words like these tend to be the pre-notion for a collapse. Nevertheless, we are now in a “ Fear of Missing out Bubble”. A bubble that has been forming since 2011 and deregulating slowly but surely. We see retirees leaving bonds and entering stocks, we see journalist reporting on all-time highs, and most importantly we view the stock market as the economy. Which is a recipe for Irrational Exuberance. As many great historians have said, “ History is bound to repeat itself”.