Behavioral finance looks to predict investor action.
Do investors in general act rationally? The question
is being hotly debated by practitioners and academics alike. The answer
may well lead to an understanding of individual investor behavior, and
explain why markets occasionally seem to overreact on both the upside
and downside.
Underlying the growing interest in behavioral
finance is the notion that investors are not always rational, but
sometimes act irrationally or emotionally when faced with difficult
decisions.
Researchers site numerous examples of individuals
displaying irrational behavior, being inconsistent and making errors in
judgment and incompetent decisions when faced with uncertainty.
In an interview last year, Nobel laureate Daniel
Kahneman (Financial Advisor, June 2004) discussed the principles
underlying behavioral finance, which offers financial advisors the
promise of helping clients avoid common errors they are prone to make.
Behavioral finance departs from classical financial theory by dropping
the basic assumption that investors are rational and substituting the
notion that they act emotionally and are therefore prone to making
mistakes.
One such common mistake is called "narrow
framing"-looking at investments in isolation from their entire
portfolio. Most financial advisors usually recognize clients prone to
this problem during their initial meeting, and attempt to solve it by
having the client provide a list their assets and allocation. How can
advisors otherwise help design complete investment programs most likely
to meet clients' financial goals?
Another common mistake individual investors make is
called the "disposition effect"-the reluctance of some investors to
sell a stock that has lost money. They avoid taking losses in order to
avoid confirmation of the fact that they made a mistake. A reverse
consequence of the disposition effect is their tendency to take gains,
thereby rewarding themselves for being right. Here again, the trained
financial advisor can reduce or eliminate these tendencies by
dispassionately recognizing that the value of an investment is based on
its future, and not its past, prospects, and by being willing to sell
an investment unlikely to recover and to hold investments yet to
achieve their full potential.
Financial advisors are interested in the lessons
behavioral finance teaches because they strongly imply that individual
investors need professional guidance to avoid the mistakes their
natural tendencies will cause them to make. These mistakes are avoided
when advisors follow a series of steps in designing investment
programs, which typically include defining a client's financial goals,
assessing their risk tolerance, doing a complete audit of their assets
and allocation, estimating their current and future income, the number
of working years left, their annual savings and the length of their
retirement.
Nevertheless, there are limits to what behavioral
finance can do. Some proponents of behavioral finance argue that,
if a plausible theory of investor irrationality can be found, it can be
used to predict and control aberrant behavior and profitably exploit
market inefficiencies arising from it. At market bottoms, some
investors are observed to become overly risk averse, while rational
investors search for undervalued investments. At market tops emotional
investors may become "irrationally exuberant," while rational investors
consider market values to be overextended and busy themselves taking
profits.
Much of the enthusiasm for developing a behavioral
theory of finance is based on the observation that extreme market
movements occasionally deviate from "fair values," and that such
deviations are the result of some investors, not all, making irrational
choices. Recall that there are two sides to a trade; at times the buyer
might be right, at others, the seller. If the causes of irrational
behavior can be identified, it should be possible to anticipate and
time extreme market moves.
This view, however, oversimplifies a more complex
process. By their very nature, quantitative models used to estimate the
"fair value" of investments must simplify real-world processes. The
usefulness of a model depends upon its simplicity-identifying the main
factors that influence a phenomena while omitting those that are
difficult, if not impossible, to predict in terms of their timing and
magnitude of influence.
The terrorist attacks on the World Trade Center and
the Pentagon on 9/11 caused the stock markets to close, and investors
to become uncertain about the long-term economic, military, political
and social consequences. This uncertainty increased investors'
perception of risk, resulting in a wave of selling that plunged market
values. Should those extraordinary adjustments in valuations be
characterized as irrational, or as an appropriate response to
investors' perception of increased risk?
A statistician would classify the event as a "four
or five sigma event," meaning that the plunging market values
associated with those events were well beyond those that would be
defined by a normal distribution, in which 99.7% of all observations
are contained in a range between plus or minus three standard
deviations of the mean value of the distribution. (A standard deviation
is statistically described by the Greek letter "sigma.") A four
or five sigma event is therefore inconsistent with a model that uses
only endogenous factors in the context of a stable, normal, bell-shaped
distribution.
For investors to be able to fully profit from an event, they must have
two pieces of information: the magnitude of the event's impact on an
investment, and its timing. By their very nature, exogenous events are
not predictable with regards to magnitude or timing. The possibility
that an exogenous event might occur can be surmised, but the degree to
which it will impact an investment, or its timing, can not.
Few, if any, financial advisors could have predicted
the heights to which the dot.com bubble would rise, and the timing of
the bust, or the extent to which Enron's hidden losses, or WorldCom's
bankruptcy, would undermine stock market values. Yet those events had
an unmistakable effect on the investing public's assessment of risk and
stock market values. How, then, could an investor have accurately
determined the timing and magnitude of their influence on the overall
market or specific segments of it? The simple answer is that he or she
could not.
It is perhaps more productive to maintain the
assumption of rationality in trying to understand investor behavior,
and use it to determine the likely choices a rational investor might
make under extraordinarily difficult circumstances.
A half century ago Nobel-prize winning economist
Milton Friedman and Leonard Savage, in Foundations for Financial
Analysis, observed that most rational investors had diminishing
marginal utility for wealth, coveting their first dollar more than
their second. Friedman and Savage also observed that some investors
seemed to have less utility for their first dollar than their next,
being willing to accept disproportionately greater risk to acquire
wealth. This apparent paradox confused some economists, who considered
such behavior irrational. Instead, Friedman and Savage maintained that
investors living at one socio-economic level, who aspired to another,
higher level, would rationally gamble the security of the lesser level
for the possibility of achieving the higher one. In other words,
seemingly irrational behavior can have a rational explanation.
The tendency for speculative price changes to follow
a distribution which has more observations at the tails than a normal
distribution is well documented. Benoit Mandelbrot concluded that
changes in speculative prices follow a "stable Paretian" distribution,
which has denser tails than a normal distribution, but did not offer an
explanation of why investor behavior would cause those extreme changes.
Another Nobel-prize winning economist, Eugene Fama, subsequently
confirmed that stock price changes also had denser tails than might be
expected, but offered no explanation based on investor behavior.
However, S. James Press, a University of Chicago
doctoral student, departed from these earlier researchers by offering a
theory as to why there are more extreme values in actual stock price
movements than are possible if they were normally distributed. Simply
stated, he argued that stock price returns are normally distributed,
but the mean of the distribution is unstable and exogenous shocks cause
it to move up and down, thereby creating more observations in the tails
of the distribution.
In recalling the events of 9/11, Press' explanation
offers a plausible explanation of the stock market's precipitous
decline. On the day before the attack, investors held one assessment of
risk and made decisions based on information known on that date. On
9/11, after the terrorist attacks, with the World Trade Center
destroyed and the Pentagon badly damaged, the financial markets closed,
communications impaired and fears that other attacks were imminent,
caused a massive shift in investors' assessments of the risks involved
in holding stocks. Was the flight to the safety of cash irrational, an
error in judgment, or incompetence? Probably not, because investors had
another set of facts with which to assess the risk of holding stocks,
and the increased risk required a higher rate at which to discount
future earnings-which meant that stocks had diminished in value in a
single day.
This is not to say that speculative bubbles do not
contain elements of irrationality or bad judgment. Evidence of large
numbers of investors acting irrationally and even stupidly is
well-documented in Charles McKay's On Popular Delusions and the Madness
of Crowds, in his descriptions of the South Sea, Bubble, Tulipmania and
others. Yet, it seems unlikely that investors, either individually or
collectively, who display irrational behavior, make errors in judgment
or remain incompetent could have anything but a temporary impact on
market valuations. Instead, investors displaying rational behavior,
making objective and competent judgments, are more likely to
consistently profit from their decisions.
Behavioral finance may produce important insights
about irrational investor behavior, but its potential should not be
overestimated. A substantial body of sound economic and financial
theory exists, based on the assumption that parties having access to
all available information, acting in their own self-interest, will make
rational and competent decisions.
C. Michael Carty is principal and
chief investment officer of New Millennium Advisors LLC, a New York
City-based investment advisor. He can be reached at
[email protected].