Behavioral Image

Market Efficiency & Behavioral Biases

Behavioral Image

One of the most misunderstood tenets of the efficient market hypothesis (EMH) has to do with the assumption that all decisions made by market participants have to be rational. In other words, the millions of people who are buying and selling securities act as robots where they are continuously pricing and re-pricing securities based on the change in future expected cash flows. We then see events such as the “tech bubble” or the housing crisis and say, “well that cannot be true because the markets got it so wrong in those instances.”

There is another field in finance that starts with understanding human nature and then extrapolates that understanding in explaining how markets work. This field is called behavioral finance. Through games, economists and researchers in this field have been able to explain that humans struggle with making complex calculations based on vast amount of information. We also exhibit certain biases that influence our perception of what is actually going on in the market and how we are able to influence or control it. There is a vast body of literature that supports these ideas and anybody would be naïve to think that they are not true. You would be displaying the bias of overconfidence.

Behavioral finance has taught us a lot of how investors actually behave when it comes to dealing with uncertainty. It has influenced how we as advisors work with clients. Unfortunately, there are some who have taken the ideas of behavioral finance and have tried to turn them into tactical investment strategies. This is not supported by theory or empirical evidence.

Are there displays of irrational behavior going on in the market? Of course there are. The problem is that it is hard to decipher to what degree the market is exhibiting irrational behavior. This is due to market efficiency. Let us give a simple scenario to emphasize this point.

In our simple world, let’s focus on only 3 investors. Kathy is a seasoned investor who has developed an emotionless approach to her investments given her decades of experience in the industry. Gary is closet day-trader who has no background in investments or finance and loves to pick stocks off of a whim or “gut feeling.” He enjoys the adrenaline rush. Lastly, there is yourself, and let’s assume you are somewhere in the middle of the other two in terms of investment demeanor.

June 24, 2016 rolls around and you wake up to find that the citizens of the United Kingdom have decided to leave the European Union. You turn on Squawk on the Street and you see that markets are in a frenzy as we would expect. Unbeknownst to you, Kathy is updating the assumptions in her very complex model, which indicates more uncertainty about the future cash flows of global enterprise. She sells some her personal portfolio in order to accommodate for this uncertainty and re-price risk in the market, pushing stock prices down. At the same time, Gary believes that the world is coming to an end so he is going to liquidate his entire portfolio, which pushes prices down even further. All you see as an investor is that prices are currently down. How much is due to a rational re-pricing of risk and how much is due to simple fear? It’s hard to tell.

Now let’s expand our narrow view to a more realistic version of the capital markets in which we scale this simple scenario by millions of participants who are either re-pricing risk based on updated models, pure emotion, or somewhere in between. As an investor, the only information you have is the “price.” Is it the “right” price? Possibly! Most institutional investors are like Kathy in that they are experienced in seeing how major events influence the market.  But there is also your neighbor, Gary, and more people like him who are just plain scared and want to try and exert as much control as they can given the new uncertainty. So they sell. You cannot decipher how much influence one has over the other in terms of the price you are looking at so you have two choices.

First, you believe the price is right and you decide to hold tight because you know that many investors are re-pricing risk for you, so you are expected to be compensated accordingly. Or, you decide that the price is wrong because you think that most investors are acting on whims and fear so you decide to get out as soon as you can.

The main problem with the second scenario is that you are now on the sidelines and will have to decide for yourself when the market has started to become more “rational,” which usually means that you are looking for less volatility. By the time the markets have decided to become less volatile, you have already potentially missed out on the recovery, locking in your losses and possibly creating a completely different financial scenario for you personally.

The fact that it is hard to tell speaks to how efficient the market is. Events happen, market participants react, and prices adjust. The speed at which this happens speaks to market efficiency. So market efficiency and behavioral biases are not mutually exclusive.

What about the “tech bubble” and the housing crisis? Markets were inefficient in these instances right? Wrong! While it is easy for us to sit here now and look back and say, “wow, things seemed out of control in terms of valuations,” we are only able to do so in hindsight, which is always 20/20. How many people were able to call these events accurately before they happened? A handful? This also speaks to market efficiency.

As we mentioned before, behavioral finance has been important in terms of understanding our clients behavior so that we can assist them from becoming their own worst enemies when markets get volatile. It does not suggest that markets are now inefficient and that we can tactically profit from investors’ behavioral biases. Can we assume that some investors are trading out of fear? Of course! If when you look at the price of a certain stock or market index and say to yourself, “it’s hard to tell,” then the markets are pretty efficient. In our experience, it is never a good idea to try and outsmart the price the market is currently estimating. You are more likely to be left on the sidelines if you bet against it.