This research paper deals with the importance of rationality in decision-making and how, due to certain biases, investors are not always rational when making their investment decisions. A rational individual is one that, when making an investment decision, chooses the act that maximizes his/her utility, among other things. We will first attempt to understand which biases are present and how to avoid falling prey to them. The stock market crash of 1929 and 2008 provide a global example of irrationality and their effects on the economy. We conducted interviews with two investors of varied experience in order to understand their approach to decision-making and the outcomes. Our interview conducted with a psychometrist allowed us to better understand the concept of objectivity and how the human brain is capable of processing both emotional and empirical information.
The efficient securities market theory states that all publicly known information is reflected in the prices of securities that are traded on that market. The rational decision theory underlies this theory in that a large number of rational individuals interact in these security markets and the prices "fully reflect the collective knowledge and information-processing expertise of investors."[1]
A rational individual has the ability to consider and analyze all possibilities before making a decision in order to achieve the optimal result, and in the case of a rational investor, the optimal result is the act maximizing his/her utility. The rational investor constantly revises their beliefs about future firm performance as information becomes known to them, they are risk adverse or more conservative when investing, and they diversify their portfolio in order to reduce risk.[2] The decision made by the rational individual should be independent, objective and the investor's estimate of security values should also be unbiased.[3] Therefore, if an individual wants to make a good decision(s), this is how they should proceed.
Behavioural finance theories suggest that investors are not always rational when making their investment decisions. Investors succumb to certain biases clouding their rationality. These biases cause people to under/over react to information, and when enough people react this way, as they have in the past, the security market becomes inefficient and in the extreme case it can collapse.[4]
Through the course of our research and interviews, we have realized that although certain people attempted to proceed in a rational manner, they failed to utilize their research and rationale when making their final decision. We will discuss the stock market crash of 1929 and 2008 allowing greater insight into the repercussions of irrationality along with the results of an interview with an expert and amateur investor. Our interview with a psychometrist allowed us to understand how the human brain processes information, the meaning of objectivity and how one can learn to become objective in order to avoid the pitfalls of subjectivity.
In the 1970's, research conducted by the psychologists D. Kahneman and A. Tversky, confirmed that cognitive errors and emotional biases can lead to poor decisions. These findings gave economic researchers psychological models for studying how investors make decisions.[5]
Some of the irrational behaviours that investors may be victims of are overconfidence and overreaction, loss aversion, mental accounting and the prospect theory which leads to the disposition effect. The most critical issue is whether as investors, we behave in an extreme manner to any one of these. After considering each deficiency, we will discuss strategies that can help investors in identifying the presence of any one of these behaviours, as well as some ideas for improving investment decisions and overcoming these decision-making barriers.
According to Efficient Market Hypothesis (EMH) investors are rational and whenever new financial information is released they interpret it accurately. However in reality most of the time this in not true. Behavioural finance theories on the other hand argue that EMH does not take into consideration the overreaction hypothesis. The theory states that when news is released the market overreacts and this overreaction is normalized or corrected with time. This means that prices in the market may be inaccurate but, ultimately, there will be a price correction when the initial error becomes apparent (Owen 2002).
Theorists have also argued that investors often overweight new information and give it more importance than it deserves, without really considering its quality or relevance. So this takes us back to the question of whether investors are rational and interpret information accurately.
Investors react differently to information, depending on the news, which further elevates the problems of overreaction. A possible cause for this variation may be due to the difference in expectations and the news that is released. If the new information released is similar to the investor's prior beliefs for a company, then this will not have a significant impact on the share prices. On the other hand if the news released is different from what the investor had previously believed, then this will have a greater impact on the company's share price (Owen 2002).
Overreactions in markets are attributed often to overconfidence that the investors have leading them into making the wrong decision. Therefore, overconfidence can cause both overreaction and volatility in market prices. Overconfidence arises because individuals are often unrealistic about their limits of understanding. This is evident when surveys were taken and majority of people thought themselves to have above average abilities. This belief held by individuals lead to systematic errors in judgement as individuals are unable to correct for their overconfidence (Owen 2002).
Theories have also stated that investors often make extreme judgements about probabilities. This happens when an event which was likely to take place was thought of as certain, while on the other hand, an unlikely event is completely dismissed as impossible to happen. This indicates that investors can make errors of judgement when evaluating the probability of an occurring outcome (Owen 2002).
The problem of overconfidence can lead investors to overestimate the performance of good stocks, and underestimate the performance of poor stocks. Another related theory is the winner-loser hypothesis, which says that previously good stocks perform poorly compared to investor expectations. If the investors are overconfident, they may overestimate how certain stocks will perform leading, almost inevitably, to disappointment. Theorists Dremen and Lufkin (2000) found in a research done on investor behaviour, that market overreaction to new information is due to the possibility that investors are driven by sentiment in addition to their expectations about the future returns on their shares. On the other hand Barber and Odean (2001) conducted their research and found that overconfidence generates high levels of speculation as overconfident investors believe that their interpretation of the available data is superior to anyone else's and they invest accordingly. These authors also found evidence that overconfident investors trade significantly more often than other people, and expect their portfolios to outperform the market by a significant margin (Owen 2002).
Solution to overconfidence:
Overtrading can be measured by keeping track of the investment returns and trading costs. Market timing is an investment approach that is based on buying or selling securities, with the expectation of changes in market or economic conditions. Studies have shown that over long time periods, market timing will not typically provide higher returns than maintaining a buy-and-hold strategy. It is very important to keep a sense of perspective. While it is easy to get caught up in the latest news, short-term approaches don't usually yield the best investment results. If you do a thorough job of researching your investments, you will have a better understanding of the significance of the recent news and will be able to act accordingly. Investors should recognize the importance of focusing on the long-term picture. It is important to learn about the historical trends and average returns for specific investments. The more risky certain investments are, the more possible a higher return, which just means that one can lose money as well as earn on an investment. Therefore, knowledge of the historical performance of investments helps establish the appropriate amount of asset allocation. Greed can heavily influence our actions, and it is important to control this behaviour. Overall, people have a tendency to overstate their abilities, knowledge and skill, and this leads to overconfidence and people should realize the associated pitfalls associated with this type of behaviour.
Another common behaviour found within individuals is when uninformed traders will simply follow any trend that they believe exists in share price behaviour, and this "trend chasing" increases the volatility displayed by the markets. These investors are unaware of the fundamental prices of the stocks they are trading and are therefore unable to stop trading when that value is reached (Owen 2002).
Trend chasing is similar to herd behaviour, in which individuals ignore the information they receive and simply try to act or make decisions so they can replicate the actions of other people. Regarding herd behaviour, Sian Owen states in his research paper, "This behavioural pattern occurs when individuals become convinced that the herd has better information than they do, irrespective of the quality of their information. The classical theory of rational expectations would suggest that this is not possible but, in truth, it is unrealistic to assume that people are not influenced by the actions of others. Once people start behaving in this fashion, an informational cascade soon develops in which the decisions of the majority overwhelm the signals received by any one individual" (Owen 2002).
Another irrational behaviour often observed in investors is loss aversion, which is basically excessive fear of loss. While it's rational to want to avoid losses, it's also true that an excessive fear of loss can negatively affect an investor's prospects. For instance, during bear markets, many investors become excessively risk-averse and decide to move some or even all of their money out of stocks; a decision that's likely, over the long term, to leave their savings susceptible to inflation. "Loss aversion can be particularly damaging when it's associated with certain types of market timing," says Hammond. "Sometimes investors react to immediate losses in stock funds by pulling money out of these funds, with the idea that they will reinvest it when the equity markets are better behaved." Such behaviour can result in a systematic "buy high" and "sell low" strategy that can lead to lower returns and higher risk.[6]
Solution for Loss Aversion:
It is necessary for the investor to pay attention to their attitude towards investing. If they are worried of even the slightest amount of loss, then it is important for him/her to examine the potential returns, along with particular attention given to the accompanying risk. Rather than focusing too much on what happens in the market on a day-to-day basis, look for information based on the various asset classes along with their historical performance track records. If they decide to stay the course, then it is more likely for them to experience that track record than if they had bailed out every other time the market proceeded downward. Consideration of one's goals and their investment time horizon is also very important.
The investor should ensure that their investment decisions are closely aligned with their long-term goals. Again, it is important to look at the big picture; focus on the overall returns of the portfolio rather than on the losses in the individual accounts.[7]
Mental accounting refers to people who tend to separate their money into separate accounts based on a variety of subjective criteria, like the source of money and the intent for each account. Each asset group is assigned a different function, and this separation may negatively impact their spending decisions and other behaviours.[8] This point has been raised earlier, and is equally important here that investments should be made in relation to the existing portfolio. Each new prospect should be weighed in terms of its effect on the existing portfolio, as separating the assets may very likely lead to inappropriate actions and possible failure. This can be better understood with an example. Some people spend freely with credit cards while being much more careful with using their cash, not realizing that their overall wealth is of primary concern and is affected either way.
Solutions for Mental Accounting:
Investors should pay particular attention to the way assets are being categorized, including retirement accumulations, savings and salary. Only then is it possible to understand how to further proceed with their investment decisions. One way to get a handle on attitudes toward spending and investing is to analyze the overall cash flow- the money taken in each month and the money that is paid out.
Devise a budget based on needs; once all assets have been categorized, goals should be defined and a strategy based on those goals should be designed. It is very likely that spending and investing habits may be holding an individual back from realizing their goals.
According to prospect theory, losses have more emotional impact than an equivalent amount of gains. The prospect theory can be used to explain quite a few illogical financial behaviours. Prospect theory also explains the occurrence of the disposition effect, which is the tendency for investors to hold on to losing stocks for too long and sell winning stocks too soon.[9] Many people may agree that the action that makes the most sense is to hold on to winning stocks in order to further increase the gains and to sell losing stocks with the intent to cut ones losses, or to avoid an excessive loss.
Avoiding the Disposition Effect:
Investors should avoid emotional investing. It is very important that risk management is incorporated into the investment strategy in order to avoid any detrimental actions taken by the investor later on.
In the past, investors are known to have responded at the wrong time with the 'fight or flight' response to news, events or what they believe is expert advice. They need to recognize this behaviour may very likely become a serious problem and keep away from it in order to become more successful investors.[10]
When interviewing a psychometrist, we learned that professional investors may come to rely on their personal experiences too much and develop bad behavioural patterns that are based on their own subjective singular experiences. The human brain is certainly capable of simultaneous processing. A stimulus may contain many dimensions that the brain will pick up. Even a simple stimulus, such as a ball can have multiple attributes such as physical dimensions (the shape of the object), historical dimensions (your memory of playing with the ball) and the emotional dimensions (how you felt about the ball). Thus, the brain is capable of registering both emotional and empirical aspects in any given situation. Whichever takes precedent really depends on a person's own appraisal.
Our psychometrist referred to objectivity as the ability to see things for what they are. An objective person is one that sees things for what they really are without being swayed by subjectivity. In its most basic terms, it refers to an impartial view of the world. In order to improve objectivity, it is important to understand that humans have a tendency to bias opinions based on their own personal experience. This in a sense is the ultimate form of subjectivity. For example, many individuals prefer to rely on expert opinions in regards to certain subjects. This can lead these individuals to rely too heavily on expert testimonies, when in fact, while experts are better informed, do not render them unbiased. Therefore, in order for a person to become more objective, it is best to be aware of the pitfalls of subjectivity. One strategy to attain objectivity is to average the different possible outcomes, while being as informed as possible.
Stock Market Crash: 1929 and 2008:
The theory of gravity, "what goes up must come down," can be applied to the financial market. In the stock market there is a cycle which consists of four phases: Accumulation, mark-up, distribution, and markdown. For the purpose of our discussion, we are interested in the mark-up phase. It is during the mark-up phase when "price breaks out of range and begins a sustained uptrend." (Schaap) At this phase, stock prices begin an upward trend and build momentum. The earlier the investors enter into the stock market at the mark-up phase, the greater the profit and utility; as "this is the most profitable time to own the stock -an opportunity to let your profits run." (Schaap)
As time goes by, more and more investors will recognize the upward trend, adding to the momentum, pulling in other investors, resulting in an upward push of the stock price. The prices of stock eventually hit a peak, after which stock prices will fall, sometimes crashing down. This cycle can be applied to the price behaviour of all traded commodities. There have been numerous instances of market crashes over the years. Our focus will be on the market crash of 1929 and 2008.
Between the years of 1927 and 1929, the United States experienced an economic boom, fuelled by new technologies, production processes and firm management. As the US economy grew, so too did the stock market which peaked in September 1929. There is no consensus on the exact causes for economic crash, but there are some theories available. The stock prices and their fundamental value were far from similar due to speculating investors, causing a bubble in the market. The attempt to stop market speculation by government, influential people and the media may have contributed to the market crash. Another probable cause could be attributed to the purchase frenzy of public utility stocks. The prices of these stocks were driven up by the expansion of investment trusts, public utility holding companies, and the amount of margin buying. The highly levered investment trusts, public utilities and the holding companies were vulnerable to negative news. The statement by Philip Snowden, England's Chancellor of the Exchequer, describing America's stock market as a consisting of too much speculation, may have triggered the snowball to roll. Investors were starting to be fed the emotion of fear by media and influential government officials. Many feared the stock market was overvalued, although it can be argued that stock market prices reflected the real economics of firms. First quarter earnings statements of firms surveyed "showed a 31% increase compared to the first quarter of 1928. In August, 650 firms were surveyed and the increase for the first six months of 1929 compared to 1928 was 24.4%. In September, the results were expanded to 916 firms with a 27.4% increase. The earnings for the third quarter for 638 firms were calculated to be 14.1% larger than for 1928. This is evidence that the general level of business activity and reported profits were excellent at the end of September 1929 and the middle of October 1929." (Bierman) Therefore, the belief that stocks were overvalued is more of a myth. Irving Fisher, a leading U.S. economist at the time, wrote a paper that contained data indicating the existence of real growth in the manufacturing sector. Fisher observed rapid increase in manufacturing efficiency, output, and the use of electricity. Like Fisher, many economists at that time had optimistic outlooks for the stock market. However, even the most prominent economists couldn't predict and were susceptible to the stock market downfall; Irving Fisher and John Maynard Keynes were "heavily invested in stocks; Fisher lost his entire wealth." (Bierman) As fear began to accumulate in the minds of investors, a panic selling resulted. Many invested in stocks on margin, using loans with stocks as the collateral. As stock prices began to slide, many investors were forced or tried to sell their shares.
As we turn our attention to a more recent period, from the years 2007-2009, the financial market found itself to be in a crisis. Major businesses could not withstand the downturn of the economy such as: Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac, and AIG. The wealth of consumers declined dramatically, estimated to be in the trillions of U.S. dollars. For the causes of this modern period economic crash, there have been many ideas with varying degrees of support by experts. At the time, easy credit was available to the market. The Federal Reserve encouraged borrowing by lowering interest rates to combat the effects of the dot-com bubble burst, the 9-11 terrorist attacks, and deflation. The price of houses on the U.S. market had sky rocketed between 1997 and 2006 because almost anyone was able to obtain a mortgage. "The value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007, with over 7.5 million first-lien subprime mortgages outstanding." (contributors) The huge amount of sub-prime lending clearly illustrates that even borrowers considered to be risky were given mortgages. To meet the increasing demand for mortgages, the U.S. government created financial agreements called mortgage backed securities (MBS) and collateralized debt obligations (CDO). Financial institutions were damaged when the value of securities tied to housing prices declined due to the housing bubble burst. Soon after, the stock market suffered enormous losses as a result of declines in investor confidence, available credit, and an increase in questions regarding bank solvency, leading to panic selling.
Interesting to note, the crash of 1929 and 2008 are similar. As pointed out by Selwyn Parker, "The banks slipped the regulator's leash - although there was hardly any regulation in the 1930s - but we have had a massive amount of regulation since then and the regulators are clearly a step or three behind the practitioners." (Barnes) In a sense, the presence of regulators in 2008 can be compared to the effectiveness of little to no regulators in 1929. AIG is a perfect example of an organization where regulation was ineffective since $85 billion in debt was overlooked. Easy credit availability is another similarity between 1929 and 2008. In both periods, investors were faced with accumulated debt that only kept growing. For 1929, it was buying stocks on margin that increased investor debt. During 2008, the catalyst was highly leveraged housing loans. The question of whether the investors were rational or not in 1929 and 2008 remains to be answered. For rational investors, we expect them to: choose acts that yield the highest expected utility, be risk adverse, utilize portfolio diversification, and use new information to revise beliefs of future firm performance. Instead, investors use their emotions more so than rationality. In Models of Man, Herbert Simon points out that "most people are only partly rational, and are in fact emotional/irrational in the remaining part of their actions." Investors are emotional human beings. Greed and fear drives the market as much or more than anything else. Unfounded expectations, band-wagon effect, market momentum, conflicted analysts speak to and indicate a less than rational market; increasing volatility and causing bubbles. The stock market bubble and housing bubble of 1929 and 2008, respectively, were driven by investor momentum rather than rational assessment. Investors failed to measure the risk that came with MBS's and CDO's. With regards to mortgages, investors observed the potential profit and actual profits that were achieved by other investors which in turn encouraged them to invest. This band wagon effect also occurred in 1929 with the purchasing and selling of stocks. What is actually happening in the financial market may not be accurately reflected by the notion of a rational investor using rational decision models. Similar to the 'bounded rationality' decision model, investors may not have the time, inclination or ability to process all available information.
We now discuss our interview with the expert and amateur investor:
The first interview was conducted with a professional trader at a major bank. She specializes in trading foreign exchange, oil and natural gas. Professional traders are considered 'rational' as they use as much information as is available in the market to make informed decisions. There are two major types of analysis employed by professionals: Technical analysis and Fundamental analysis.
Technical analysis "studies supply and demand in a market in an attempt to determine what direction, or trend, will continue in the future. In other words, technical analysis attempts to understand the emotions in the market by studying the market itself, as opposed to its components."[11] This type of analysis relies heavily upon extrapolations from historical prices and volumes to plot charts and graphs. A pattern can then be identified for prediction of future activity. Whether a stock or commodity is over or undervalued is not of significant importance to a technical trader. The field of technical analysis is based on three assumptions:
The first point reinforces Efficient Market Theory. Technical analysts believe that a stock's price at any given time fully reflects all information available on the market about a particular company. Once the need to study other qualitative and quantitative information separately has been removed, the analysis of price movement of a stock can fully reflect the market's supply and demand. The second and third points are self-explanatory; they both stem from market psychology. This form of investing has been heavily criticized because it assumes that strong form efficiency exists. While we agree that historical prices, charts and graphs may be useful, they are by no means the only tools that rational investors should employ in making decisions.
There are two aspects to fundamental analysis: qualitative and quantitative. "The biggest part of fundamental analysis involves delving into the financial statements. Also known as quantitative analysis, this involves looking at revenue, expenses, assets, liabilities and all the other financial aspects of a company. Fundamental analysts look at this information to gain insight on a company's future performance."[13] Qualitative aspects include "the breakdown of all the intangible, difficult-to-measure aspects of a company."[14] Our first interviewee conducts fundamental analysis more frequency than technical ones. Since she trades commodities instead of equity, financial statements are not relevant. She can be referred to as a top down investor. "The top-down investor starts the analysis with global economics, including both international and national economic indicators, such as GDP growth rates, inflation, interest rates, exchange rates, productivity, and energy prices... The bottom-up investor starts with specific businesses, regardless of their industry/region."[15]
We went through an example to illustrate how she devises her investment strategy. During winter times, due to cold weather, the market expects that a lower than usual quantity of gas will be injected into storage. In the US market, a Natural Gas Storage Report is released on a weekly basis specifying working gas in underground storage in billion cubic feet. This figure is compared to what has been released last week, a year ago, and a five-year average.[16] Based on the assumed market condition, a negative storage figure for the week is expected. If this is not the case and storage of gas is fuller than market's expectation, price of gas will fall.
Our first interviewee points out that based on all information gathered, she forms expectations on future prices of commodities and enters into future agreements based on those expectations. As such, as in our example, if gas storage amount decreases in comparison to last week, gas price is not predicted to have any significant movements. On the contrary, if the storage figure comes out higher than last week's, price of gas will fall since this piece of information has not yet been incorporated into current gas price. This reinforces our belief that an efficient market will only react to announcements that is not expected. This belief is backed up by Ball and Brown's 1968 empirical test. "An impressive body of theory supports the proposition that capital markets are both efficient and unbiased in that if information is useful in forming capital asset prices, then the market will adjust asset prices to that information quickly and without leaving any opportunity for abnormal gain."[17] After release of information, investors have a narrow time window to respond.
We conducted another interview with an amateur investor who also studies the market extensively utilizing fundamental analysis. Instead of commodities, our second interviewee trades stocks, margins and options. In terms of stocks, fundamental analyses include companies' financial statements, news, analysts' upgrades, downgrades, etc. He places heavy focus on a firm's income statement, cash flow statement and most important of all, the consistency of good performance year over year.
Some common mistakes committed by investors include the tendency to trade too much without taking transaction fees into consideration, maintaining an undiversified portfolio, holding losing positions for too long, over-confidence, and greed, just to name a few. Our second interviewee shared with us what he considers his most 'irrational' trade. Shortly before the 2008 stock market crash caused by the United States housing bubble and easy credit conditions, he practically used up all his available cash to purchase AIG stocks. He followed news on AIG closely, studied their financial statements and reviewed many analysts' opinions for a period of time. After conducting this extensive fundamental analysis on AIG, he concluded that this is a solid company with good financial backgrounds and good cash flow, hence a stock worth investing in. He admitted to us that by not diversifying his investment and putting all eggs in one basket, he was over-confident and greedy. He relied too heavily upon the results of his fundamental analysis. Soon bad news was released:
"This week, Moody's Investors Service, the credit-rating agency, announced that it was less confident in AIG's ability to pay all its debts and would lower its credit rating. That has formal implications: It means AIG has to put up more collateral to guarantee its ability to pay. Just when AIG is in trouble for being on the hook for all those CDS debts, along comes this credit-rating problem that will force it to pay even more money. AIG didn't have more money....All of this has pushed AIG's stock price down dramatically."[18]
To backtrack slightly, the dramatic decrease in AIG's stock price was due to the fact that it had issued a lot of Credit Default Swept on bonds. "A CDS is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) goes into default (fails to pay). Less commonly, the credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy, or even just having its credit rating downgraded."[19] The bankruptcy of Lehman Brothers followed by bonds default forced AIG to admit that it didn't have enough cash to cover $440 billion in bonds that its CDS covered. In a strong form efficient market (if there ever was one), investors should know about this type of information. But this clearly wasn't the case. So our second interviewee, after his detailed fundamental analysis, did not discover this piece of insider information that was crucial to his investment. The information also turned out to be crucial for health of the world market.
After interviewing two individuals with very different backgrounds, one similarity is found: they both try to collect as much information before making an investment decision. During non-critical times when prices don't fluctuate as much, many investors have the leisure to form a game plan and make rational decisions. In situations such as the 2008 stock market crash, not only individual investors, but big companies also panicked. In the AIG example above, our second interviewee was irrational by not diversifying. AIG was irrational by insuring too much on bonds that it didn't have sufficient cash flow to cover. Large banks were irrational by purchasing an excessive sum of CDS from one insurance company. Based on these, we conclude that although educated investors try to form rational decisions, sometimes insider information prevents the existence of true 'rational investors'.
Taking all the above information into consideration, we can conclude that the majority, if not all of investors, in their own way perceive themselves as proceeding with an investment opportunity in such a manner so as to maximize their wealth. The main issue here is the process of reaching the final decision and the level of assurance and analysis along with the amount of information gathered to reach the ultimate choice. There are many behavioural biases investors may be unaware of preventing them from making the correct decision. If this type of behaviour is repeated among several others, it creates inefficiencies in the market that may prove to be detrimental to the efficient functioning of the capital markets. If we understand some of the factors that cloud our judgement or influence our decisions, we will be better able to make choices that are more closely aligned with our goals.[20]
References:
