Herd behavior and market inefficiencies

18/07/2018

The value of investments will fluctuate, which will cause fund prices to fall as well as rise and you may not get back the original amount you invested.

Which are the key principles underlying the world of behavioural finance?

‘Behavioural finance’ encompasses a broad sweep of ideas. What they share however is a reaction against pre-existing models of market efficiency which were built on very simple conceptions of human behaviour (see answer to question two).

The key arguments of behavioural finance were that this model of the world didn’t appear to be true: asset prices were more volatile (and there were enough examples of anomalous behaviour) to suggest that markets were not efficient.

Simply observing these apparent contradictions did not necessarily mean that something related to human behaviour was going on. However, concurrent work looking at individual human decision making began to be held up as a possible driver of market inefficiency. These studies uncovered emotional or cognitive biases that individuals make, while others began to focus on social dynamics such as ‘herding’ and peer pressure.

How does behavioural finance relate to behavioural economics and the work of Richard Thaler, the latest Nobel Prize winner in economics sciences?

Behavioural finance and behavioural economics each encompass a relatively broad array of topic areas. What they have in common is a reaction against models of human behaviour based on ‘rationality,’ perfect information, and utility maximisation. 

Although there aren’t strict definitions, we would characterise behavioural finance as relating to markets and how asset prices are determined. This could be considered a subset of behavioural economics, which focuses more broadly on the decisions that human beings make in their day to day lives and how these drive broad economic outcomes.

Both disciplines observe how individual human decision making can be subject to biases and then aim to consider how these biases may manifest themselves at a broader level, whether it be markets (behavioural finance) or the economy as whole (behavioural economics). Thaler’s work has largely focused on seeking to identify individual bias, but his more recent work on ‘nudge theory’ (along with Cass Sunstein) has sought to integrate these observations with how policy is framed and the influences this can have on economic outcomes.

Is behavioural finance an expanding field in the world of finance pretty much the same way behavioural economics are, following up on the works of researchers like Richard Thaler?

Both behavioural finance and behavioural economics have struggled to move meaningfully beyond identifying that biases exist at an individual level toward being able to help use this knowledge to interpret broad social dynamics.

For example, Thaler’s work has been useful in suggesting how we can influence decision-making in particular arenas like consumer behaviour. The importance of these advances to influence our everyday lives should not be understated, but when applying the insights of behavioural economics to big macroeconomic questions such as what drives recessions, booms, inflation and so on, finding useful practical applications remains a work in progress.

This may be even more true of behavioural finance. While we have observed that markets appear to be inefficient and that individuals can display bias, the next step is to more rigorously consider how these dynamics might work in aggregate, for example in asset pricing bubbles or crashes.

There has been a lot of progress in this arena, and the best approaches to doing this may not fit squarely within the ‘behavioural finance’ canon. However, there is often significant overlap (such as Andrew Lo’s ‘adaptive markets hypothesis,’ Mordecai Kurz’s ‘theory of rational beliefs’ and more recently Xavier Gabaix’s work on ‘behavioural inattention.’)

Based upon your experience, how has behavioural finance evolved over the past years? Did you witness any changes?

Behavioural finance has had to move beyond simply establishing flaws in the old models of rationality and market efficiency, to becoming useful in its own right. It has frequently been suggested that behavioural finance is interesting but lacks practical application, and this criticism has some substance.

Perhaps as part of this dynamic, we have very recently seen more forthright challenges to some of the most fundamental tenets of behavioural finance. Both Nicholas Taleb and David Gai/Derek Rucker have challenged the validity of ideas that ‘loss aversion’ is genuinely irrational, or if it exists in all contexts.

We have touched a little on these issues at our blog

However, as noted above, important steps are being made in our understanding of asset pricing and these acknowledge a role for human emotion in the price determination process.

How do you leverage these principles to develop multi-asset investment strategies?

We believe strongly that markets are inefficient and that human psychology has a strong role to play in this, creating opportunities. Perhaps this is most strongly evident in terms of the role psychology can play in promoting myopia at a market level.

In terms of myopia, the stress caused by changing prices impacts our decision making. When prices are moving rapidly (meaning there is ‘no time’ to decide) investors can give up on any sense of what they think an asset is worth. Time horizons shorten as individuals’ experiences of loss (or missing out) create an emotional response. These episodes create investment opportunities because it is the fundamentals that matter as we extend our time horizons, not short-term volatility.

What are the reasons behind the recent market correction? Do you think it was just an episode?

The volatility seen in February and March was ostensibly caused by investor concern over rising rates (in response to signs of US wage pressures on inflation), which led to a rapid increase in bond yields. The potential for global trade war and the associated effects on growth and inflation, following the announcement of import tariffs by US president Donald Trump, was another source of disquiet. Investor concern over regulatory pressure experienced by global technology stocks – on the basis that this could limit their strong earnings growth – also weighed on stock markets. In our opinion, these moves were ‘episodic’ – at odds with the macroeconomic fundamentals, as most economic indicators remained unchanged. Therefore, despite the impact on valuations of various asset classes from rising interest rates, the medium-term fundamental outlook has not changed materially.

Based upon the volatility’s comeback in both equity and bond markets, is this another year for multi asset strategies?

As we have seen in recent months, the correlation between asset classes has shifted. In the absence of a proven ‘safe-haven’ asset class, flexibility and selectivity – being able to seek opportunity throughout the global investment landscape – are key to being able to take advantage of market movements.

Equally important for managers is the ability to avoid holding any asset they don’t believe is offering good value. This could include the ability to go short of what a manager regards as an unattractive asset class, or go negative duration.

For the second half of the year, do you see any new source of volatility?

We believe that the dynamic that caused the initial period of market turbulence at the beginning of this year may herald the end of the ‘Goldilocks’ scenario; the combination of low inflation and moderate economic growth seen in most of 2016 and 2017. As investors adapt to a new pricing regime, this has the potential to cause further bouts of volatility.

However, we remain broadly positive on economic growth and believe that the recent increase in volatility has to be seen in context, merely representing a move back to more ‘normal’ conditions following the remarkably low-volatility situation experienced until early 2018.

In your opinion, which are the main risks now facing investors?

We define risk as the chance of a permanent loss of capital and our view of the main risk faced by investors has not changed - buying overvalued assets represents the greatest risk in investing. To us, asset price volatility does not in itself represent a risk rather than a potential buying opportunity.

How should the end of QE impact EU equities & bonds?

As mentioned above, indications that the sustained low-inflation environment is coming to an end are causing concern among investors, who are starting to reassess price levels across all asset classes. While we are watching economic developments carefully, as ever, we position the portfolio based on our assessment of value in the current economic environment. We always prefer to observe the facts, rather than predict future price movements.

At present, we believe that the economic fundamentals – including company earnings – remain strong. Indeed, earnings have been rising faster than prices in some quarters, leading to improved valuations. In several regions, recent price falls have coinciding with improved earnings, to make equities look more attractive than they did, not less. April’s bond market sell-off reinforces our view that bonds have been over-valued and UK and core European sovereign bond markets remain vulnerable to confidence improving again in the UK or the eurozone.

The views expressed in this document should not be taken as a recommendation, advice or forecast.

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The value of investments will fluctuate, which will cause fund prices to fall as well as rise and you may not get back the original amount you invested.