Back to the roots.
A look at why traditional models of finance are increasingly inadequate at explaining stock market movement and why the fledgling discipline of behavioural finance may hold some of the answers.
History seems to move in cycles and economics is no exception. In 1759, at the dawn of the industrial revolution, Adam Smith published his seminal treatise “The
Theory of Moral Sentiments”, he ushered in a new period in the history of economics, often referred to as the classical era, and produced a compelling account of human decision-making, which probably makes him the first behavioural economist.
A century later, the tide has turned. Neo-classical economists had assumed intellectual supremacy and severed all ties with the social sciences. In an attempt to emulate the success and splendours of the natural sciences, they developed an elaborate theoretical framework based on the rationality of human behavior, which enjoyed considerable popularity well into the second half of the 20th century. At the core of this model is the so-called Efficient Market Hypothesis, which posits that human beings are perfectly rational, maximise utility and act on the basis of full and complete information- a model of man often referred to as homo economics.
As we know today, if the majority of investors were completely rational, irrational behavioural patterns on the stock market should cancel each other out. Bubbles and crashes should not occur. However as the bumps and lurches of the 1980’s 90’s and the fin-de-siècle period show, (Black Monday of 1987, Asian crisis of 1997, Russian summer of 1998 and the bear market of 2001 to 2003), markets are not always efficient; nor are people always rational. You may test yourself: Have you ever wondered why today many people eat fast food, defer saving for retirement and watch popular movies, although most are determined to eat healthily, invest wisely and read a Dostoevsky novel tomorrow? The trouble with “homo economicus” is that, in a nutshell, he does not exist.
Today we have gone back to neo-classical models to make more accurate decisions about people’s decisions and how they affect markets. This revatilised approach is commonly known as behavioural economics or, when applied to stock markets, behavioural finance.
On a microeconomic level, behavioural finance explains the biases and decision making errors of individual investors that distinguish them from rational actors. These departures from rational behavior, whether occasional or regular, may be due to a variety of factors, such as incomplete information, limited cognitive skills or stress. Prospect Theory developed by Nobel laureates Kanheman and Tversky, points out that investors are risk averse when considering profits but tend to be risk takers
when faced with losses, which goes a long way to explaining why investors tend to cut their profits and let run their losses, instead of vice versa.
On a macroeconomic level, behavioural finance can shed light on market anomalies, such as stock or sector mispricing as well as well as market bubbles.
Interestingly one of the most persistent stock market anomalies is due to a calendar effect. It is encapsulated in the old adage “sell in May and go away but buy back on St. Leger day” What the saying in effect suggests is that positive stock market returns are usually a bit like the tourist market here concentrated in the months from November to April, whereas the period from May to October often exhibits poor or negative returns. As recent research on the Irish stock market, which is one of the oldest in the world, has shown, the excess returns that can be earned by following this strategy are statistically significant.
Even though trends are likely to persist in the future, it will be difficult for private investors to remain completely rational in their trading decisions, and to consistently capatilise on market inefficiencies. In this context, computer based investment programmes, which follow a disciplined trading strategy stand a better chance of long term success.
Maybe it is one of the ironies of behavioural finance that it teaches us not how irrationally other investors behave, but how biased we all are in our investment decisions.