A few years ago, two Israeli professors looked at the World Cup and wondered if somewhere amid the collective angst of fans might lurk an investment opportunity. Guy Kaplanski and Haim Levy knew from research that bad results in important football matches could depress local stock market returns. As the number of losing countries increases during the tournament, they reasoned, the aggregate effect would drive down world stocks. The numbers showed they were right: Standard & Poor’s 500-stock index has lost about 2 per cent on average during World Cups since 1950. The so-called “World Cup effect”, in their words, “is very large and highly significant”.
Conventional economics tends to ignore the sports page. Economists assume people are rational and that stock prices efficiently reflect all the information available in the marketplace at the time of the investment. This may be a mathematically elegant thesis, but it is flawed. The so-called efficient market thesis has no way of pricing in the fear, greed, despair and triumph that chaperone investors through the trading day, affecting what they buy and sell.
In the late 1970s, economists and psychologists began to try and account for the emotions. They found that investors chase performance, obsess over irrelevant financial data, follow the herd, are over-confident in their stockpicking abilities and have little understanding about their successes or failures. Today, behavioural finance plays the joker in the buttoned-down world of academic economics. Using surveys, experiments, real-world data and the occasional MRI scan, economic journals explain why men take more risks with their investments than women, how sunny weather can improve returns on a given day, and the role of sport in market returns.
Stockpickers are trying to trade on these insights, and not merely by hiring a woman who supports FC Barcelona, to balance their portfolios. Over the past few years, a slew of large American and European investment firms, including Allianz, Barclays, Bank Degroof, JP Morgan, and the LGT Group of Liechtenstein, have launched funds that trade on behavioural findings. Mitsubishi UFJ Trust Bank of Tokyo announced in December that it wanted to add more behaviour-based investing to its asset management business. The financial crisis has only heightened scepticism about the idea of efficient markets. How can such unstable systems work rationally?
Many behavioural funds are black boxes, relying on sophisticated formulas to exploit weaknesses in investor behaviour. While a traditional fund may buy and hold a stock that managers think is undervalued, those at behavioural funds mine academic research to predict market movements. So behavioural financiers pay less attention to corporate earnings reports than to anomalies such as the “January effect” – the tendency of stock prices to rise in the first month of the year. The reason, they concluded, is that investors sell poor-performing stocks in December to generate tax losses. After the tax-related selling stops, prices are primed to rise the next month.
At this time of year, behavioural financiers are also tracking what they call “mental accounting” – the idea that investors do not treat all their assets equally, spending bonuses more riskily than money from a regular pay cheque. In Taiwan, employees often get generous bonuses before Chinese New Year, mostly paid in January. Researchers found the demand for more volatile stocks on the Taiwan Stock Exchange increases in January, especially in years when bonus payments are larger. While each market has its nuances, similar behavioural effects have been observed in stock exchanges from Botswana to Vietnam.
The cutting edge of behavioural finance research is trying to move past reading investors’ minds and into those of corporate executives. Two Stanford University business professors, David Larckery and Anastasia Zakolyukina, studied thousands of earnings calls and identified the corporate suite’s version of a poker tell: untrustworthy executives tend to overuse words such as “we” and “our team” when talking about company performance. Honest ones tend to take ownership of their actions with words like “I”, “me” and “mine”. Horacio Valeiras, chief investment officer of Allianz Global Investors, is trying to incorporate such findings into his firm’s behavioural formulas.
But as a group, behavioural funds have yet to live up to their hype. “The theory is more novel than the practice,” says Christopher Davis, an analyst with Morningstar, a mutual fund research firm. Studies of returns find that on average these funds do no better against their benchmarks than non-behavioural funds. Even more damning, a recent study by Alessandro Santoni and Arun Kelshiker of the Research Laboratory for Behavioural Finance discovered that behavioural funds tend to do worse in bear markets, the very time you would expect them to outperform given their insights into hysterias and panics.
For all its cocktail-party-friendly research, behavioural finance in practice may not be that much different to what investors have been doing for some time. Eric Schoenberg, a professor at Columbia Business School in New York and a psychologist who studies stock market bubbles, thinks behavioural finance can explain why investors act in bizarre ways, but it has limited predictive power. Traditional “value investors” have always been attuned to behaviour, says Schoenberg, hunting for cheap stocks they think the market has undervalued because investors have overreacted to bad news.
As more investors are informed by behavioural finance, the power it has to generate profits will diminish. Yet economists and money managers will continue to probe the depths of our psyches looking for an edge. “Behavioural finance is becoming a worldwide phenomenon,” says Valeiras. “It’s early days and we have so much more to learn.”
Tom Anderson is a financial writer and editor at SmartBrief
Winning ways: behavioural finance pioneers
A €100 gain should be the same as a €200 gain followed by a €100 loss. But in 1979, psychologists Daniel Kahneman and Amos Tversky found that people took greater pleasure from a clear win than a similar result derived from a bittersweet experience. Their finding illuminated why investors sell winning stocks early and hold on to losers dearly. Their paper was the second-most cited research in economics from 1975 to 2000 and spawned volumes about how we frame money decisions. Tversky went on to pioneer studies in cognitive science and died in 1996. Kahneman, now a professor emeritus at Princeton, won the 2002 Nobel Prize in economics.