Behavioural finance is more than just a collection of curiosities, or a self-cancelling mix of over-reaction and under-reaction, writes Justin Fox in ‘ The Myth of the Rational Market: A history of risk, reward, and delusion on Wall Street ’ (www.visionbooksindia.com). He finds that the most consistent trait identified in behavioural research is overconfidence, which leads investors to think they know more about a stock’s value than they actually do.
“Overconfidence is so valuable in other endeavours – finding a mate, starting a company, making a living as a TV stock market pundit – that there’s no reason to think that it will ever die out. And in finance it helps explain such phenomena as excess volatility, momentum, and that there’s enough trading to keep markets going.”
The equilibrium edifice
The author finds that while behaviourists and other critics have poked a lot of holes in the edifice of rational market finance, they haven’t been willing to abandon that edifice. Nor have they been willing to dispense with the equilibrium framework that Irving Fisher imposed on the field a century before. “They spend their days studying disturbances and biases, but they still trust that Merton Miller’s ‘pervasive forces’ are out there somewhere, pushing prices at least in the general direction of where they belong.”
Is that really as far as the rebellion is going to go, wonders Fox. Looking at the status of ‘equilibrium’ in economics, he reminds how economists in the Austrian tradition avoided equations not just because they were poor mathematicians, but because they thought equations failed to allow for the uncertainty and change inherent in economic life.
“The American institutionalists believed that more intensive empirical study could give them a better feel for evolving market realities. Even neoclassical titan Alfred Marshall pined in the pages of his ‘Principles of Economics’ for an approach that more closely resembled that of evolutionary biology.”
Enter, chaos
Even as the alternative approaches were not too successful against equilibrium economics that had the benefit of ‘precision’ borrowed in part from nineteenth-century physics, something interesting happened in the 1980s: The physicists came calling on economics again.
In the intervening century, much about their science had changed, the author narrates. They had been through the theory of relativity, then quantum mechanics, he traces. “Now many physicists were becoming fascinated with what they called chaos – the study of how simple initial causes led to dramatic effects that, with the right nonlinear equations, could at least partially be predicted, like that butterfly flapping its wings in Brazil and setting off a hurricane in Texas.”
As a result, there has been a transformation in the study of long-term economic growth, the author reports. “By ditching the equilibrium while sticking with math, economists are finding better ways to describe the dynamics of growth and change. A key word in the new growth theory is ‘endogenous’ – that is, arising from within.”
Endogenous factors
In contrast, emphasis on equilibrium implied that all disturbance had to come from outside. So much so, as Fox analogises, ‘explaining a spurt in economic growth required a deus ex machina such as the discovery of the Americas or the invention of the electric motor.’ Not so in the new growth theory, where the technological drivers of growth are depicted as the result of economic forces and decisions.
Introducing the concept of endogenously-generated change to a study of the shorter-term fluctuations of the market can be a complex endeavour, he cautions. “These models tend to be populated by rational but half-informed actors who make flawed decisions, but are capable of learning and adapting. The result is a market that never settles down into a calmly perfect equilibrium, but is constantly seeking and changing and occasionally going bonkers.” Examples of model names mentioned in the book include ‘adaptive rational equilibrium,’ ‘efficient learning,’ ‘adaptive markets hypothesis,’ and ‘rational belief equilibria.’
Hard to beat the market
What we have on hand may look like a muddle of neoclassical and behavioural and experimental and asymmetric-information economics and finance, yet there are practical lessons, assures Fox.
The first lesson, according to him, is that it is hard to beat the market. If you have money to invest, the only sensible place to start is with the assumption that the market is smarter than you, he begins. “You don’t have to stop there. But if you do come up with an idea for beating the market, you need a model that explains why everybody else isn’t already doing the same thing that you are.”
In some cases, the advantage can be due to expertise in a domain – ‘say you’re a petroleum engineer and you have good reason to believe Schlumberger has figured out some big advance in drilling technology that archrival Halliburton has not.’
At times, a behavioural explanation might make sense. A certain stock is cheap because it is unfashionable, or maybe it is at the limits of arbitrage, the author elaborates. Professional investors don’t have the luxury of patience that you as an individual investor do; however, you need to watch out that your own behavioural quirks aren’t leading you astray, he advises.
To those who are picking somebody else to manage the money, Fox counsels that the chances of finding a market-beating path can be even harder, because you are now paying a fee that cuts into your performance. “The only measure that seems to have any predictive value is the management fee funds charge. The higher the fee is, the worse the subsequent performance,” he writes, citing Jack Bogle’s studies on the determinants of mutual fund performance.
Crowds and wisdom
On the question whether ‘wisdom of the crowds’ applies to markets, the author is sceptical. Crowds and markets possess many useful traits, but wisdom is not one of them, he says.
“When men are brought together, they no longer decide by chance and independently of each other, but react upon one another,” reads a thought of Henri Poincaré quoted in the book. “Many causes come into action, they trouble the men and draw them this way and that, but there is one thing they cannot destroy, the habits they have of Panurge’s sheep.”
Reference to Panurge occurs in the phrase ‘mouton de Panurge,’ which describes an individual that will blindly follow others regardless of the consequences, educates a sobering page in Wikipedia . “This, after a story in which Panurge buys a sheep from the merchant Dindenault and then, as a revenge for being overcharged, throws the sheep into the sea. The rest of the sheep in the herd follow the first over the side of the boat, in spite of the best efforts of the shepherd.”
Stock prices, notes Fox, contain lots of information. Markets are the best aggregators of information known to man, he adds, paraphrasing Friedrich Hayek. “Yet mixed up amid the information in security prices is an awful lot of emotion, error, and noise.”
Recommended addition to the professional investors’ shelf.
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