Are Markets Rational? Part 2 – Behavioral Finance

1. Are Markets Rational?Part 2 – Behavioral Finance

2. 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)

3. 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. …

4. 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. …

5. 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

6. 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

7. 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!

8. 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”

9. 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.”

10. Emotional Baggage / Foibles • We love a story • The brain will actually make up causes for a given effect (LeDoux)

11. Some Impacts on Investing • Described in video, “Mind over Markets”

12. 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

13. 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)

14. 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

15. 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

16. 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

17. Beating the Biases • Understand the biases • Know why you are investing • Have specific investment goals • Have quantitative investment criteria • Have specific investment criteria • 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!

18. Beating the Biases • 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