Rationally Irrational

The finance world has long assumed that markets are “efficient”. In other words, investors’ actions are perfectly rational and they act in their self interest in order to maximize their personal benefit. It also assumes that everyone has access to perfect information and makes logical decisions on that perfect information.

By contrast, an inefficient market is one where asset prices do not accurately reflect their true fundamental value. Market inefficiencies typically expose investors to their emotional biases, causing them to buy high when they are motivated by greed, and sell low when they succumb to fear. The Fear and Greed index, a tool developed by CNNMoney, can be used as a market proxy for these two emotions that influence how much investors are willing to pay for stocks. One year ago today, when the market first learned of the severity of COVID-19, the index indicated “Extreme Fear”. However the fiscal stimulus policy responses to the pandemic have fuelled a significant rise in asset prices and the index has now swung to “Greed” a year later.

As we all now know, March 2020 was one of the most violent and rapid drawdowns in market history. The extreme fear of the unknown overwhelmed market participants, and led them to sell down their positions, providing an opportune time for investors with and strong stomach and available cash to enter at attractive valuations. Buying when everyone else is selling is no easy feat. A quote from Harley Bassman, a former derivatives specialist at Merrill Lynch, captures this emotional sentiment well; “The only time I buy at the bottom is when I am desperate to sell, and I hit the ‘buy’ button by mistake”.

Investors’ aversion to loss can be best explained by Prospect Theory, first introduced by Daniel Kahneman and Amos Tversky in 1979. This theory explains how the same investor values gains and losses differently. For example, most individuals prefer winning $50 with certainty rather than taking a risky bet in which they can toss a coin and either win $100 or nothing. In this example, the expected value of each outcome is the same, as measured by the probability of the outcome multiplied by the value of that outcome. They go on to conclude that individuals are twice as sensitive to a loss as they are a gain of the same amount.

This can largely explain why markets tend to behave in a similar manner to my recent skiing experience in Revelstoke. The gondola ride up is slow, gradual, and offers a calming view of the Columbia River and surrounding landscape. However, if you take a wrong turn at the top and you may find yourself crashing down a double black diamond run (cynically named “Kill The Banker”). In the blink of an eye, you find yourself at the bottom of the mountain, car keys in hand, on your way home vowing to never do that again!

Fast forward to today. The performance of the market since the COVID crash has led investors to flock into growth investments, further driving the prices up, seemingly without concern for extreme valuations. As the banker JP Morgan mused, “Nothing so undermines your financial judgment as the sight of your neighbour getting rich.” In today’s language, this phenomenon is called FOMO or the “Fear of Missing Out”.

With the persistent market ‘noise’ in the news today, it can be easy to get caught up in the day to day and stray away from your long-term financial objectives. It is important to have a clear financial plan, know how much (or little) money you need to make to meet all your objectives, and stick to that plan no matter what is going on around you. Hard to do, but worth it in the end.

PS – For those who enjoyed this article, I highly recommend reading Thinking Fast and Slow by Daniel Kahneman to dive deeper into the emotional hurdles and mental shortcuts our minds take when faced with decisions.