Guest Post: Tim Richards from PsyFi Blog: An Investor’s Behavioral Guide To Inefficient Markets: The Opportunity of a Lifetime – Again

My friend Tim Richards is the  master blogger responsible for the PsyFi blog. He has crafted a wonderful piece for us….I feel blessed – Tim’s writing reminds me of  James Montier.

An Investor’s Behavioral Guide To Inefficient Markets: The Opportunity of a Lifetime – Again
In 1907 there was a nasty credit crunch. Then there was a financial crisis during the World War I and its aftermath, followed by the Wall Street Crash and the Great Depression. After World War II there was another market slump as everyone expected a repeat of the crashes after the US Civil War and World War I. This was followed by the rise and fall of the Nifty Fifty, an eighteen year long market hiatus with an oil supply crisis thrown in, the unexplained crash of 1987, the Asian Crisis, the Long Term Capital debacle, the dot com crash and, with neat symmetry, another credit crunch. With clockwork precision an investing opportunity of a lifetime has arisen once a decade, if not more often.

This sequence of calamities has happened regardless of the current political orientation, the state of regulatory controls, the dominant investment theory or the world’s latest set of popular Armageddon scenarios. Lots of people come up with explanations in hindsight, a few people get to go to gaol (jail), others legislate to prevent the last crisis and lots of government money gets burnt very quickly. About the only constant is human nature, greedy and fearful by turn.

Efficiency and Uncertainty
From the early 1970’s onwards the main investment ideology was of the efficient markets flavour – the idea being that all market information is reflected in the current price of a security. For a long while this seemed to have solved most of our investing problems but was, in fact, merely a product of a very long bull market run during which pretty much everyone became complacent about tail-end risk – so-called Black Swan events.
Yet stockmarkets have always been a dish characterised by ambiguity, leavened by uncertainty and flavoured with a pinch of irrationality. The world of investment is a swirling mass of contradictory ideas and opinions, most of which are untroubled by any requirement for a relationship to reality, some companionship with evidence or an association with logical thought processes. Anyone trying to make sense of anything is a victim of hope over expectation.

Unprofessional Investing
Most of us spend our lives acquiring certain skills in pursuit of a career. We become plumbers, chefs, cab-drivers, baristas, surfers, doctors, etc, etc. By and large we undergo some form of education program (politicians excepted, of course), develop experience through work, undergo some chastening failures and achieve a few glorious moments of success on the way to attaining the skills we need to succeed in our chosen professions.

Quite why any of this entitles us to think we should be good at investing, a world of mysterious acronyms, undetectable frauds and incomprehensible jargon is one of life’s great mysteries. Yet it’s clear that millions of people take exactly this approach to one of the most difficult environments known to humanity: the perfectly unnatural, mean regressing world of the securities markets.

Cognitive Biases Rule
The standard explanation for this type of bizarre behaviour comes from research into behavioral finance: the study of human psychology at work in the field of investments. The list of behavioral biases that have been shown to underpin people’s irrational investing inclinations is now very long indeed: overconfidence, hindsight, recency, confirmation bias, anchoring, money illusion, mental accounting … the list goes on and on. This paper by David Hirschleifer gives a reasonable overview of the topic.

Despite the wealth of evidence that cognitive biases damage investor returns there’s not yet much follow through into the wider reaches of investment management. To a large extent this is because behavioral finance points us in exactly the opposite direction to the way that the securities industry has been determinedly moving for the last half century: away from a concern with the individual to a mass-market approach that wants to fit everyone into a mental and fiscal straightjacket.
Perfectly Wrong

So, in recent decades the industry’s approach has been to develop mathematical models which can relegate human behaviour to a set of probability equations, thus allowing profitability and risk to be actuarially managed: fraud is no longer unacceptable – it’s now just a number to be factored into earnings forecasts. This is simply the latest in a long line of industry fads, using the ideas of efficient market theories to design approaches which are right quite a lot of the time and then very, very wrong all at once.

Given the amount of money that’s been spent developing these models it’s unlikely that they’ll fade gently away, despite the fact that behavioral finance tells us to a degree of certainty, that only a generation of economists whose next port of call is the grave can now ignore, that individual human biases play a huge role in the unpredictable, uncertain and ambiguous nature of markets. They’re not remotely efficient and it’s just a shame the world had to be brought the edge of financial meltdown before anyone started listening.

Risk Today, and Tomorrow
However, although behavioral finance tells us what’s wrong it doesn’t really tell us what to put in its place. So everyone muddles along, hoping that something better will appear without really knowing what to do. Of course, efficient markets theorists point out that behavioral finance offers no solution to the problems of market prediction and risk management.

Take, for instance, the idea that advisors should ascertain how risk adverse or otherwise their clients are, in order to decide on the type of investments to select for them. Such a simple idea is, under behavioral finance, replete with difficulties. Consider the concept of “risk”. Does anyone really believe that the idea of risk to the person on Main Street is the same as the idea of risk to the person on Wall Street? Even making sure that someone understands the concept is a Herculean task before you start. Pan and Statman cover a lot of this ground in their paper Beyond Risk Tolerance: Regret, Overconfidence, and Other Investor Propensities:

“… investors’ risk tolerance varies by circumstances and associated emotions. High past stock returns endow stocks with positive affect and inflate investors’ exuberance, misleading them into the belief that the future holds high stock returns coupled with low risk. Risk tolerance questions asked after periods of high stock returns are likely to elicit answers exaggerating investors’ risk tolerance. Conversely, low past stock returns burden stocks with negative affect and inflate investors’ fear, misleading them into the belief that the future holds low stock returns coupled with high risk. Risk tolerance questions asked following periods of low stock returns are likely to elicit answers underestimating investors’ risk tolerance”

Of course, the answer given in these two cases will, in hindsight, be perfectly wrong. When everyone thinks that markets can’t fail is the time to be very risk adverse, when no-one wants to invest is the time to be greedy. Yet what’s an advisor to do when the know-your-customer questionnaire tells them to do exactly the opposite of what’s in the customer’s best interests?

No Certainty in an Algorithm
Just because behavioral finance says efficient market theories are wrong doesn’t mean that it can replace the spurious accuracy of the latter’s models. What psychology tells us is that life and markets are unpredictable – which may be uncomfortable for people who want to see certainty in an equation but is nonetheless a truth that needs to be universally acknowledged.

Still, the securities industry is attempting to co-opt behavioral finance to its own ends. Quantitative models being developed along behavioral lines and work on neuroeconomics is attempting to pull economic behaviour out of our brains. There are even a range of behavioral funds which supposedly use behavioral psychology.

For people willing to take the time and effort to get to grips with behavioral finance in the markets this is terrifically good news because, as it stands, it’s impossible to see how the real lessons of psychology in the markets can ever be mastered in this manner. So the opportunities generated from time to time by mass market delusions or crazy industry trends won’t go away.

The Opportunity for Investors
The study of behavioral finance makes available to a much wider group of people than ever before the psychology behind investment approaches and the tools to learn how to control our biases whether it’s through contrarian strategies based on using mass psychology against the crowds or passive investing approaches that allow the craziness to be safely ignored.

Few things in life are predictable so it’s nice that we can rely on investment markets to go completely mad at least once a generation. If you can take comfort in that thought then you’re a proper investor. That’s Simoleon Sense.

To read more from Tim please visit The PsyFi Blog