Greed, Fear, and Fallacy
October 17, 2017
Please read the important disclaimers at the bottom of this post. Past performance is not indicative of future results. Not a recommendation to buy or sell securities. Nothing in this presentation is intended to be construed as investment advice.
Greed, Fear, and Fallacy
: Behavioral economics and finance combine financial theory with psychology to challenge the assumptions of traditional models, and we applaud the recent recognition of the field with Dr. Thaler’s Nobel Prize. In today’s market environment, characterized by Fed-interpretation, passive fund flows, and geopolitical news, the arguments made by the behavioral camp are as important as ever. In this commentary, we analyze household ownership of equities as a proxy for herd behavior, and share analysis showing the relationship between household equity ownership and future returns.
September Market Recap: The S&P 500 capped off a strong third quarter with a 2.1% gain in September. The quarterly gain of 3.96% was the index’s eighth consecutive quarterly gain, the fifth longest streak on record. Energy stocks benefitted from rebounding oil prices, while Utilities struggled. The Federal Reserve announced plans to begin unwinding its bond portfolio, which sent interest rates higher in the US and Europe. The Fed’s announcement caused the US Dollar to strengthen against most currencies and weighed on inflation-sensitive metals, including Gold, which traded down 3.3% for the month.
Earlier this month, Richard Thaler received the Nobel Prize in Economics, and his recognition was long overdue. In a world where conventional economics is driven by simplifying assumptions — assumptions like “markets are efficient” and “investors are rational” — Thaler’s contributions to the field as one of the founding fathers of behavioral finance bring a realistic perspective. The underlying principles of behavioral finance, blending financial theory with psychology, accept the emotional and cognitive biases of most investors. Instead of assuming investors are rational, Thaler and others acknowledge that, on the contrary, most investors are irrational, emotional creatures that are driven by a combination of greed, fear, and fallacy, and that it is these behavioral issues that can cause bubbles and overreactions.
Despite tidy econometric models that peg investors as rational creatures, we value the contributions of the behavioral camp; we believe that emotions and irrational decision-making tend to govern investor behavior, oftentimes to the detriment of the investor. There are numerous behavioral biases prevalent in investing; some of the more notable include loss aversion (losses are generally 2-3X more painful than the positive feelings associated with similarly sized gains), confirmation bias (only pay attention to opinions that agree with you), and endowment bias (what we own is more valuable than what we don’t). Ultimately, these behavioral fallacies can result in investors buying high (chasing) and selling low (out of frustration and fear), the consequences of which are long-term wealth destruction.
One of the key concepts in behavioral finance is called herding, which is the tendency of individual investors to follow the actions of a larger group. Herd behavior happens because people implicitly trust the collective wisdom, and because of the pressure to conform. Think of the 1990s technology stock bust or the 2007-2008 housing crisis; part of the driving force of the bubbles preceding those crises was a fallacy that suggested “everyone is doing it, so it must be right, and I should do it too.” I saw some charts recently that brought herd behavior to mind; in a post titled “Two Key Indicators Show the S&P 500 Becoming the New ‘Cash’”, FF Wiley (ffwiley.com) highlighted that investors hold more equities as a percentage of total assets than any other time since 1946 except during the height of the dotcom bubble in 1998-2000. Wiley takes his analysis a step further by showing that high equity ownership is generally followed by low 6-10-year future returns, while low equity ownership is generally followed by higher returns. Some of this growth is certainly caused by the price of the market itself; household ownership of equities will rise organically as markets rise, as equity ownership percentage will fall as stock prices fall. The fact remains that, if history is any guide, the current level of equity ownership by households is associated with very low future returns.