Emotional Investing
Are you a bull or a bear? A tortoise or a hare? Your answer is not as important as how you arrived at it. The investment world's biggest divide these days is between two competing interpretations of reality: the efficient market theory and behavioral finance. The University of Chicago is home to two of the most distinguished champions of these beliefs: Eugene Fama for the efficient market approach and Richard Thaler for behavioral finance.
Efficiency theorists argue that markets are completely rational and stocks are priced to reflect all information known to investors. If there's a piece of news about a stock, investors will act promptly and adjust the share price. If the market is efficient, you can't beat it. At least not consistently and over a long span of time. The only exception is small and mid-cap stocks that are generally less followed.
But while the market efficiency theory is useful, it doesn't convey the whole story of how people invest. Human emotions, such as fear and greed, drive investor decisions. Behaviorists hold up studies showing that the cheap shares, those with low price/earnings ratios, beat expensive (high price/earnings) offerings, over time. Value trumps growth, in other words. If share prices are completely rational, then how can one type of stock outperform another?
Behavioral academics cite the 'madness-of-crowds' phenomenon by pointing out the fact that most people make the same mistakes over and over. The most prevalent one is to pile in at the peak with everyone else. Since fitting in is easier than sticking out, investors tend to flock together even when the results turn out bad.
Harvard professor Jeremy Stein explored the complexities of behavioral science, and he explored a behavioral quirk known as the "recency effect." That's when people overweight current information and assume that the future will follow the present. So they buy what's hot and they avoid what's not.
Another behavioral quirk is overconfidence. A word to the wise: People rarely know as much as they think - creating still more price inefficiency.
Behavioral finance substantiates many of the core tenets of value investing - chief among these is buying great businesses when they are out of favor and selling below their intrinsic worth.
* * * * *
Efficiency theorists argue that markets are completely rational and stocks are priced to reflect all information known to investors. If there's a piece of news about a stock, investors will act promptly and adjust the share price. If the market is efficient, you can't beat it. At least not consistently and over a long span of time. The only exception is small and mid-cap stocks that are generally less followed.
But while the market efficiency theory is useful, it doesn't convey the whole story of how people invest. Human emotions, such as fear and greed, drive investor decisions. Behaviorists hold up studies showing that the cheap shares, those with low price/earnings ratios, beat expensive (high price/earnings) offerings, over time. Value trumps growth, in other words. If share prices are completely rational, then how can one type of stock outperform another?
Behavioral academics cite the 'madness-of-crowds' phenomenon by pointing out the fact that most people make the same mistakes over and over. The most prevalent one is to pile in at the peak with everyone else. Since fitting in is easier than sticking out, investors tend to flock together even when the results turn out bad.
Harvard professor Jeremy Stein explored the complexities of behavioral science, and he explored a behavioral quirk known as the "recency effect." That's when people overweight current information and assume that the future will follow the present. So they buy what's hot and they avoid what's not.
Another behavioral quirk is overconfidence. A word to the wise: People rarely know as much as they think - creating still more price inefficiency.
Behavioral finance substantiates many of the core tenets of value investing - chief among these is buying great businesses when they are out of favor and selling below their intrinsic worth.
* * * * *
posted by Bob Moser at
6:30 PM
0 Comments:
Post a Comment
<< Home