Fear, greed and ego are some of the biggest influencing factors in stock markets...
Logic, sense and rationality drive most investment decisions, correct? Actually, fear, greed and ego are some of the biggest influencing factors in stock markets – and the sooner we accept that, the better investors we can be.
The myth of rational markets
Once upon time, many investors and economists – including a few Nobel Prize winners – subscribed to the idea of the efficient market hypothesis. That’s the theory that all relevant information is rationally priced into a market as soon as it becomes available. That, in turn, renders it difficult to outperform the market for any decent period of time as the price of stocks and shares will quickly reflect their fair value.
But numerous anomalies in market valuations have challenged this idea. Indeed, the regular occurrence of stock market "bubbles" followed by sharp corrections suggest that something far less rational is at work. That’s perhaps not surprising when you remember that stock markets are ultimately thousands of human beings making decisions to buy and sell – which means that emotions, biases and assumptions are bound to come into play.
Plotting our behavior
But just because the market is often irrational doesn’t mean it’s wholly unpredictable. Economists and market theorists over the past 20 years have looked to categorize the unconscious human behaviors – or "cognitive biases" – that influence decision-making . In this series we’ll be looking at some of the most prevalent behaviors. We’ll show how even the smartest of us can be fallible to our emotions when making all kinds of financial choices – and what we can do to help us make smarter decisions.
But just because the market is often irrational doesn’t mean it’s wholly unpredictable.
1. Behavioral biases: Anchoring
Making an informed decision can be tough. Given all the information and "noise" bombarding us, it can be tricky to know what to take notice of and what to ignore. Which is why, both in investing and other areas of life, we will tend to latch onto irrelevant or insufficient information to guide us.
These "anchors" can include past events, rules of thumb or even a single fact we’ve chosen to fixate on to, just to help us arrive at a decision – even if new and conflicting information becomes available. (Indeed, people often will focus on the facts that justify a decision they’ve already chosen to make – a "confirmation bias" we’ll explore in a future installment of this series). Here are a few examples of anchoring:
i. Past imperfect
Q: For the past four years, a stock market has delivered an annual return of 10%. This year, however, it has delivered a return of 5%. What would you accept as a reasonable annual return from this market for the next 5 years?
A: Did you guess around 7.5%? If so, you’re probably not alone – most people would try to average the two figures they have been given. But what if we now tell you that the average return for this particular market for the past 10 years has been just 3% a year? Would you revise your forecast?
This illustrates two things: one, the danger of focusing on very recent events when making a value judgement (and nowhere are memories shorter than in the stock market); and, two, how we tend to base opinion on past events. After all, why should past performance tell you what is a reasonable return to expect in the future?
ii. False targets
Q: You hear that a house in a neighborhood sold for a record price of $400,000. You purchase a nearby house for $350,000 as a "buying opportunity". Average house values subsequently fall to $320,000. At what price are you subsequently willing to sell?
A: Chances are you’ll be holding out for at least $400,000. Because this is the price homes have reached in the past, it’s easy to become focused on this as the price they ‘should’ be. In reality, you should be looking at the overall market and demand for that neighborhood. Are there any new external factors (e.g. plans for a highway) that are driving prices down for the foreseeable future?
iii. Rules of thumb
Q: A man earns $60,000 a year. He falls in love and wants to propose to his girlfriend. What should he expect to pay for a diamond engagement ring?
A: Did you suggest $5,000? While it makes no sense whatsoever, clever marketing has inculcated into us that a diamond ring should cost a month’s salary – regardless of the fact of how pay rates have changed since that marketing ploy was first devised in the 1930s. But if you’re a young man living in the U.S. count yourself lucky. In Japan, a price tag of three months’ pay was marketed in the 1970s as a display of true love.
You tend to focus on just a few fact when making decisions
You are heavily influenced by the past when assessing the price of shares and other investments
You find it hard to incorporate new information into your decision-making
- Try to ignore an investment or asset’s previous performance and concentrate on its future worth and market demand
- If you have a mental target for a selling price – always ask yourself what it is based on, if it’s rational and incorporates the most up-to-date information
- Never assume a price should return to a previous high ‘by rights’