Wealth and Investment Management Global Research & Investments

Behavioural biases in the market

Daniel Egan
+1 212 526 0549 daniel.p.egan@barclays.com

Sell in May and go away is an old adage. It implies that returns are as predictable as the seasons and that beating the market is easy. This stands in stark contrast to the premise that markets dont offer, simply risk-free ways of enhancing returns. By studying psychological biases we all have in common, behavioural finance has identified a number of irrational market anomalies which may contribute to persistent patterns in stock prices. But beware using these insights to try to beat the market A break from our regularly scheduled programme

A critical factor is that we humans (and our opinions) are less independent than we believe. In fact, most cognitive and behavioural biases will be shared by many people.

In this months Compass we break our (intentional) silence thus far on the use of behavioural finance at the market level. The silence has been intentional because our focus is on helping each individual client outperform themselves by understanding their unique strengths and weaknesses, and constructing a portfolio which enables their better angels and constrains their lesser demons. With the average equity investor underperforming the index by nearly 8% in 2011 2 , there is considerable room for improvement in individual investor behaviour, long before we start trying to beat the market. Additionally, the Efficient Market Hypothesis (EMH) states that market prices tend to reflect all available relevant information, and therefore the current price is a pretty good predictor of future value. This implies that it is very difficult for investors to outperform a buy-and-hold strategy of the relevant indices on a risk-adjusted basis. This is consistent with evidence that 73% of active managers underperform their benchmark 3 . Markets are not born efficient however. They are made so by individuals actively looking for good deals and potential mis-pricings. The EMH actually relies upon some investors trying to outperform a passive strategy, and thus keeping the market efficient. A key component of the hypothesis is that many different independent investors bring different information and knowledge to the market, and the market integrates that information by allowing people to buy and sell until no-one finds transacting at a given prices attractive. This results in an inability to improve on the current market price as a prediction of the future, a key emergent property of the stock market. How comfortable each individual is pursuing (and paying for) an actively managed portfolio is largely a matter of preference, depending on their Belief in Skill.

Biases in the aggregate

However, behavioural finance has been very good at finding market-wide anomalies. A critical factor is that we humans (and our opinions) are less independent than we believe. In fact, most cognitive and behavioural biases will be shared by many people. Were all human, after all. When a large proportion of market participants exhibit a given bias at the same time, the bias is evident in the aggregate market prices. Evidence showing that prices arent only about price-to-earnings ratios has been inspired by a number of cognitive biases, including (but not limited to):

2 3

Source: Dalbar QAIB Report, 2012. Malkiel, B. G. (2005). Reflections on the Efficient Market Hypothesis: 30 Years Later. The Financial Review, 40(1), 1-9.

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Wealth and Investment Management Global Research & Investments

The SAD Truth: The idea that the weather influences our mood is not controversial. However, that also influences our investment decisions might seem far fetched. In a study of 26 stock exchanges around the world between 1982 and 1997, returns were 24.8% higher on unseasonably sunny days compared to cloudy days 4 . The researchers hypothesise that sunny days lead to optimism and a lower sensitivity to negative information, which in turn raises equity prices. This finding is particularly interesting since weather forecasts are widely available, and thus constitute publically available information which could be used to forecast stock returns, in contradiction to the EMH. Beware a bad morning: Traders who experience morning losses are about 16 percent more likely to assume above-average risk in the afternoon than traders with morning gains. This behaviour has important short-term consequences for afternoon prices, as losing traders are prepared to purchase contracts at higher prices and sell contracts at lower prices than those that prevailed previously. Consistent with these findings, shortterm afternoon price volatility is positively related to the prevalence of morning losses among market participants 5 . Momentum matters: Past performance is no indicator of future success? When it comes to stocks with positive momentum, thats not true. A strategy based on going long stocks with positive momentum over the past year, and short those with low returns has been found to earn positive excess returns, even controlling for other relevant factors 6 . Exactly why the momentum effect exists is still being discussed, but the most popular explanation is behavioural there is a delayed reaction to information. However, the reaction does eventually occur, which leads to mean reversion of returns in the long-run. Be aware that momentum can lead to bubbles and thus abrupt crashes, so it is not riskless strategies based on it have to make sure they arent the last ones buying A stock by any other ticker: Think a stocks ticker is just a little detail? Consider that ticker symbols which elicit affective responses (LUV Southwest Airlines), or are fluently processed (for example GOOG for Google, HOG for Harley Davidson and IBM for... IBM) tend to trade at a relative premium to those who dont. Things which are familiar tend to benefit from a halo effect when we assess a fair price for a companys stock, making us feel more comfortable or more optimistic about their prospects 7 .

The limits to arbitrage and a self-fulfilling hypothesis

While all of the above may lead one to conclude that great investment returns can be made by taking advantage of the markets irrationality, we shouldnt jump to that conclusion. There are limits to arbitrage which make some strategies either infeasible or unprofitable. First, there are costs associated with implementing strategies to take advantage of any of the above biases, and sometimes those costs outweigh the potential for profit. Second, its uncertain when these patterns might resolve themselves. In the words of John Maynard Keynes: the market can stay irrational longer than you or I can remain solvent.

Hirshleifer, D., & Shumway, T. (2003). Good Day Sunshine: Stock Returns and the Weather. Journal of Finance, 58(3), 1009-1032. 5 Coval, J. D., & Shumway, T. (2005). Do Behavioral Biases Affect Prices? Journal of Finance, 60(1), 1-34 6 Jegadeesh, N., & Titman, S. (1993). Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency. Journal of Finance, 48(1), 65 7 Head, A., Smith, G., & Wilson, J. (2009). Would a stock by any other ticker smell as sweet? The Quarterly Review of Economics and Finance, 49(2), 551-561

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Finally, the EMH is correct in that, as these biases have been discovered, their premiums have been quickly eroded away as active managers and hedge funds seek to exploit them 8 . There is thus strong support for the idea that for most investors, the EMH is practically true. This does not mean that the market is actually perfect at forecasting the best use of capital, but simply that the ability to make above-market returns without taking on more risk is rare and temporary, and may require a lot of work to exploit.

A more useful definition of outperformance Low composure individuals are more likely to churn their portfolio and react to uncertainty and recent performance in harmful ways.
This brings us back to our original goal how can we use behavioural finance to improve our performance? The answer is that we can use it to understand ourselves, and construct portfolios and decision-making frameworks that leverage our strengths and mitigate our weaknesses. Individuals are systematically different than one another in terms of what factors are likely to cause them to underperform. Some (for example, very high composure) individuals are too blas about their portfolios, and let them drift for too long. Low composure individuals are more likely to churn their portfolio and react to uncertainty and recent performance in harmful ways. With knowledge of ourselves we can structure our portfolios and decisions such that we exhibit better behaviour. Our Financial Personality Assessment gives us a six dimensional high resolution view of our investing traits and preferences, and can be used to inform both portfolio construction and implementation 9 . It also can guide our investor management, i.e., how we pre-emptively structure our reactions and decisions in times of stress. As mentioned in last months Compass, Feeling decomposed? Consider options, the investment journey we experience can drive our behaviour, and therefore long-term performance. Constructing a portfolio which delivers not only the appropriate level of risk, but also the right amount of liquidity, smoothing, and active management can lead to a more comfortable journey, which engenders better investing behaviour throughout the market cycle. When planning your investment journey, the big question is not whether the market is efficient or not its how will you make the most of the risk and opportunities it presents?

Marquering, W., Nisser, J., & Valla, T. (2006). Disappearing anomalies: a dynamic analysis of the persistence of anomalies. Applied Financial Economics, 16(4), 291-302 9 You can see FPAs for our entire strategy team on the last page. If you have never been taken through the Financial Personality Assessment, speak with your relationship manager its free for all clients.

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