Historians who have examined the behavior of financial markets over time have challenged the assumption of rationality that underlies much of efficient market theory. They point to the frequency with speculative bubbles have formed in financial markers, as investors buy into fads or get-rich-quick schemes, and the crashes with these bubbles have ended, and suggest that there is nothing to prevent the recurrence of this phenomenon in today's financial markets. In fact, the evidence on price patterns, in the short and long term, in different calendar months and on different weekdays suggests that there is much about markets that we cannot explain with a rational investor model. In this section, we will begin by considering some of the evidence accumulated by psychologists on human behavior and then consider financial market phenomena that seem more consistent with an irrational market than an rational one.
At the risk of stating the obvious, investors are human and it is not surprising that financial markets reflect human frailties. In an extraordinary book (at least for an academic economist), Robert Schiller presented some of the evidence accumulated of human behavior by psychologists that may help us understand financial market behavior. He categorizes these findings into several areas:
When confronted with decisions, it is human nature to begin with the familiar and use it to make judgments. Kahnemann and Tversky, whose research has helped illuminate much of what is called behavioral finance, ran an experiment where they used a wheel of fortune with numbers from 1 to 100 to illustrate this point. With a group of subjects, they spun the wheel to get a number and then asked the subjects numerical questions about obscure percentages Ð the percent of the ancient Egyptians who ate meat, for instance. The subjects would have to guess whether the right answer was higher or lower than the number on the wheel and then provide an estimate of the actual number. They found that the answer given by subjects was consistently influenced by the outcome of the wheel spin. Thus, if the number on the wheel was 10, the answer was more likely to be 15 or 20%, whereas if the number on the wheel was 60%, it was more likely to be 45 or 50. Shiller argues that market prices provide a similar anchor with publicly traded assets. Thus, an investor asked to estimate the value of a share is likely to be influenced by the market price, with the value increasing as the market price rises.
For better or worse, human actions tend to be based not on quantitative factors but on story telling. People tend to look for simple reasons for their decisions, and will often base their decision on whether these reasons exist. In a study of this phenomenon, Shafir, Simonson and Tversky gave subjects a choice on which parent they would choose for sole custody of a child. One parent was described as average in every aspect of behavior and standing whereas the other was described more completely with both positive (very close relationship with child, above-average income) and negative characteristics (health problems, travels a lot). Of the subjects studied, 64% picked the second. Another group of subjects was given the same choice but asked which one they would deny custody to. That group also picked the second parent. While the results seem inconsistent Ð the first group chose the second parent as the custodian and the second group rejected the same parent, given the same facts Ð they suggest that investors are more comfortable with investment decisions that can be justified with a strong story than one without.
As you have undoubtedly become aware from your interactions with friends, relatives and even strangers over time, human beings tend to be opinionated about things they are not well informed on and to make decisions based upon these opinions. In an illustrative study, Fischhhof, Slovic and Lichtenstein asked people factual questions, and found that people gave an answer and consistently overestimated the probability that they are right. In fact, they were right only about 80% of the time that they thought they were. What are the sources of this overconfidence? One might just be evolutionary. The confidence, often in the face of poor odds, may have been what allowed us to survive and dominate as a species. The other may be more psychological. Human beings seem to have a propensity to hindsight bias, i.e., they observe what happens and act as it they knew it was coming all the time. Thus, you have investors that claim to have seen the crash in dot.com companies in the late 1990s coming during earlier years, thought nothing in their behavior suggests that they did.
The tendency of human beings to be swayed by crowds has been long documented and used by tyrants over time to impose their will on us. In a fascinating experiment, Asch illustrated this by putting a subject into a group of people, asking them a question to which the answer was obvious and then inducing other people in the group to provide the wrong answer deliberately. Asch noted that the subject changed his answer one-third of the time to reflect the incorrect answer given in the group. While Asch attributed this to peer pressure, subsequent studies found the same phenomenon even when the subject could not see or interact with others in the group. This would suggest that the desire to be part of the crowd is due to more than peer pressure.
While there is a tendency to describe herd behavior as irrational, it is worth noting that you can have the same phenomena occur in perfectly rational markets through a process called information cascade. Schiller provides an example with two restaurants, where people come into town one after another. Assume that the first person to come in picks the first restaurant and assume that the choice is random. The second person who comes into town will observe the first person sitting in the first restaurant, and is more likely to pick the same restaurant. As the number of subjects entering the market increases, you are likely to see the crowd at the first restaurant pick up, while business at the second restaurant will be minimal. Thus, a random choice by the first customer in the market creates enough momentum to make it the dominant restaurant. All to often, in investing, investors at early stages in the process (initial public offering) pile into specific initial public offerings and push their prices up. Other initial public offerings are ignored and languish at low prices. It is entirely possible that the first group of stocks will be overvalued, while the latter are undervalued. Since herd behavior is made worse by rumors by the spreading of rumors, you could argue that the coming together of the available data and media sites such as CNBC and MSNBC has made it more possible for herd behavior to spend and not less.
It may be human to err, but it is also human to claim not to err. In other words, we are much more willing to claim our successes than we are willing to face up to our failures. Kahneman and Tversky, in their experiments on human behavior, noticed that subjects when presented with choices relative to the status quo often made choices based upon unrealistic expectations. They noted that a person who has not made peace with his losses is likely to accept gambles that would otherwise be unacceptable to him. Anyone who has visited a casino will attest to this finding.
In investing, Shefrin and Statman call this the disposition effect, i.e, the tendency to hold on to losers too long and to sell winners too soon. They argue that it is widespread and can cause systematic mispricing of some stocks. Terrance Odean used the trading records of over 10000 customers at a discount brokerage house to examine whether there is evidence of this behavior among investors. He notes that investors realized only 9.8% of their losses each year, whereas they realize 14.8% of their gains. He also finds that investors seem to sell winners too soon, since winning stocks that get sold continue to go up for months after the sale. Overall, he argues that there is evidence of the disposition effect among investors.
While it is evident that human beings do not always behave rationally, it does not necessarily follow that markets will also be irrational. In fact, you could argue (as some believers in market efficiency do) that markets can be efficient even with irrational investors. First, it is possible that there is a selection process that occurs in markets where irrational investors lose consistently to rational investors and eventually get pushed out of the market. Second, it is also possible that irrationalities cut in both directions Ð some leading investors to buy when they should not and others leading them to sell when they should not; if these actions offset each other, you could still have a market price that is unaffected by rational investors. The only way to resolve this debate is to look at the empirical evidence on the presence or absence of irrationality in market behavior. In this section, we will begin by looking at experimental studies that claim to document irrational investors, and then consider the evidence accumulated through the centuries on bubbles and whether their existence alone indicates irrational investors. In fact, this is a discussion we will revisit in the chapters to come, since investment philosophies are based upon specific (and often contradictory) views of human irrationality.
One of the problems we face when we test for irrationality in financial markets is the number of variables that cannot be controlled for. Investors enter and leave markets, new information arrives constantly and the macroeconomic environment changes frequently, making it impossible to construct a controlled experiment. A few researchers have attempted to get around this problem by constructing experimental studies, similar to those used by psychologists and sociologists in the previous section, to examine how investors behave in financial markets.
One such study was done at the University of Arizona. In this study, groups of students were chosen as subjects and asked to play the role of traders in a single asset for 15 trading days. They were told at the start of the experiment that a payout would be declared on this asset after each trading day, and that it would take one of four values- 0, 8, 28 or 60 cents Ð with equal probability. Consider how a rational investor would value this very simple asset. Since the average payout is 24 cents, the asset's expected value on the first trading day of a fifteen day experiment should be $3.60 (24*15), the second day should be $3.36 and so on. The traders were allowed to trade each day and the entire experiment was repeated 60 times. The resulting market prices each day, averaged across all 60 experiments, are reported in figure 7.10 and contrasted with the expected values to a rational investor.
Figure 7.10: Prices from Behavioral Experiment
There is clear evidence here of a 'speculative bubble' forming during periods 3 to 5, where prices exceed expected values significantly, The bubble ultimately bursts, and prices approach the expected value by the end of the 15th period. Furthermore, when price curbs of 15 cents were introduced, the booms lasted even longer because traders knew that prices would not fall by more than 15 cents in a period. Thus, the notion that price limits can control speculative bubbles seems misguided. Does this experiment conclusively prove that investors are irrational? Of course not. It is worth noting, though, that it bubbles are feasible in as simple a market as this one, where every investor obtains the same information, it is clearly feasible in real financial markets, where there is much more differential information and much greater uncertainty about expected value.
In fairness, it should be noted that the evidence from other experimental studies is largely supportive of rationality. Investors do seem to make reasonable judgments based upon the information they have, and markets do a good job of aggregating this information in the market price.