Download EMH Lecture2

Are Markets Rational?
Part 2 – Behavioral Finance
References
• Mauboussin (www.capatcolumbia.com) –
“What have you learned in the last two
seconds?”
• Hagstrom, Ch. 7 – “The Psychology of
Investing”
• “Mind over Markets” (videotape)
Benjamin Graham and “Mr. Market”
• The story:
– “Imagine you and Mr. Market are partners in a business. Each
day, without fail, Mr. Market quotes a price at which he is
willing to either buy your interest or sell you his. The business
that you both own is fortunate to have stable economic
characteristics, but Mr. Market’s quotes are anything but. You
see, Mr. Market is emotionally unstable. Some days he is
cheerful and can only see brighter days ahead. On these days,
he quotes a very high price for shares in your business. At
other times, Mr. Market is discouraged and, seeing nothing but
trouble ahead, quotes a very low price for shares in your
business. …
Benjamin Graham and “Mr. Market”
• The story continued:
– “Mr. Market has another endearing characteristic. He
does not mind being snubbed. If Mr. Market’s quotes
are ignored, he will be back again tomorrow with a
new quote. [I]t is Mr. Market’s pocketbook, not his
wisdom, that is useful. If Mr. Market shows up in a
foolish mood, you are free to ignore him or to take
advantage of him, but it will be disastrous if you fall
under his influence. …
Benjamin Graham and “Mr. Market”
• The story concluded:
– “The investor who permits himself to be stampeded or
unduly worried by unjustified market declines in his
holdings is perversely transforming his basic
advantage into a basic disadvantage. That man would
be better off if his stocks had no quotation at all, for
he would then be spared the mental anguish caused
him by other persons’ mistakes of judgment.”
• Adapted by Warren Buffett from Benjamin
Graham’s The Intelligent Investor
Benjamin Graham and “Mr. Market”
• Investors who do independent valuations of companies can take
advantage of Mr. Market, buying when “he” is overly pessimistic
(and selling when he is overly optimistic)
• Investors who let Mr. Market influence their valuations too greatly
will end up making poor investments
– E.g., buying Amazon.com, Cisco, and Yahoo! at the end of ’98, bolstered by
new valuation metrics developed to account for high market prices
– “If you aren’t certain that you understand and can value your business far
better than Mr. Market, then you don’t belong in the game” and are better
off investing in index funds (Buffett)
• Note: Investors’ paying too much attention to Mr. Market, and
adjusting their valuations in response is the source of Haugen’s
price-induced volatility
Emotional Baggage / Foibles
What are some of the emotional foibles that
investors face that lead the market to behave like
the Mr. Market analogy?
• Note:
– Some of these may have had survival value in the dark
reaches of history (which would be why these traits
have remained in human beings), but they can be
seriously detrimental to investment performance!
Emotional Baggage / Foibles
• Desire to be part of the crowd
– Offers comfort, safety, confirmation
• Overconfidence
– Most people are overconfident in their own
competence and judgment, esp. when
answering moderately to extremely difficult
questions
– “The wise man knows what he doesn’t know”
Emotional Baggage / Foibles
• Inability to assess probabilities rationally
– Humans are influenced by how information is presented
– Individuals tend to ignore the fact that extreme events
tend to regress to the mean in subsequent trials
– “Three years of losses often turn investors with 30-year
horizons into investors with 3-year horizons – they
want out.” – Ken Fisher and Meir Statman
• Escalation of commitment
– “once committed to a course of action, executives often
allocate resources in ways that justify their previous
choice, whether or not they now appear valid.”
Emotional Baggage / Foibles
• We love a story
– The brain will actually make up causes for a
given effect (LeDoux)
Some Impacts on Investing
• Described in video, “Mind over Markets”
What about the Professionals?
• Buffett’s view:
– the professional is more speculative, not less;
the view that the professional keeps his cool
while the amateur falls victim to emotionalism
is inside out
What about the Professionals?
• “It might have been supposed that competition between expert
professionals, possessing expert knowledge beyond that of the
average private investor, would correct the vagaries of the ignorant
individual left to himself. It happens, however, that the energies
and skill of the professional investor and speculator are mainly
occupied otherwise. For most of these persons are, in fact, largely
concerned, not with making superior long-term forecasts of the
probable yield of an investment over its whole life, but with
forecasting changes in the conventional basis of valuation a short
time ahead of the general public. They are concerned, not with
what an investment is really worth to a man who buys it ‘for
keeps,’ but with what the market will value it at, under the
influence of mass psychology, three months or a year hence.”
– John Maynard Keynes (1936)
What about the Professionals?
• Key insight of Keynes – how crowds can influence
stock prices
• The crowd revalues prices every day, even every hour,
yet the true outlook for a given business changes far
more slowly – e.g., Disney:
– The public’s appreciation for Toy Story, for example, is
unlikely to change much from Tuesday to Wednesday, or
even over a month or two
– Most of the fluctuations in Disney’s shares, therefore , derive
from changes not in the business itself but in the way it is
perceived
– Pros are focused on staying a step ahead of fleeting shifts in
opinion
What about the Professionals?
• “We have reached the third degree where we
devote our intelligence to anticipating what
average opinion expects the average opinion to
be.”
– Keynes
• “For stock speculation is largely a matter of A
trying to decide what B, C, and D are likely to
think – with B, C, and D trying to do the same.”
– Graham and Dodd
What about the Professionals?
• Haugen’s view – agency problems enforce
“sheepishness” and an adherence to the mob
• Under ERISA, professionals can be held legally
liable if they drift too far away from what the
market is doing
• Also, they may have problems with their managers
or clients if they miss out on the stocks in the
news that are making the big moves
• Such potential problems are why Buffett makes
such an effort to ensure that his investors view
their relationship with him as a partnership
Beating the Biases
1. Understand the biases
2. Know why you are investing
•
Have specific investment goals
3. Have quantitative investment criteria
•
Have specific investment criteria
4. Diversify
•
•
Own many different types of stocks
Don’t overinvest in the firm you work for
•
remember Enron – you don’t want to risk losing both your
job and your retirement!
Beating the Biases
5. Control your investing environment
•
•
•
Check your stocks once per month
Make your trades only once per month
Review your portfolio annually and compare with
your specific goals