ARE YOU A RATIONAL INVESTOR IN AN IRRATIONAL FINANCIAL WORLD?

The traditional finance theory suggests that the price of a public listed company is a reflection of its true value based on the information available on the company, this is known as the Efficient Market Hypothesis (EMH). Under the EMH, investors should value the company based on its fundamental value, which is the present value of future cash flows, discounted by a rate appropriate to its risk level, then quickly and rationally bid up the share price to reflect its true value immediately. Should there be any deviation from the fundamentals (caused by minor irrational investors), the active and unlimited rational arbitragers will countervail and bring the prices back to right levels (Fama, 1970).

However in practice, proponents of Behavioural Finance uncovered that share price of a firm not only jump on news, other factors such as human emotion also influence security prices. Clearly, the traditional EMH is insufficient to explain certain abnormal behaviour of asset prices. For example, it is common that share price of a firm jumps upon the announcement of positive earnings where earnings was viewed as an accounting fiction describing past events, with no bearing on future cash flows of the firm that should not “by theory” cause any price changes (DeBondt and Thaler, 1985). Another example is the “January Effect” where investors generally expect higher mean returns in the month of January as compared with other months which often lead to profitable trading for average investors (Rozeff and Kinney, 1976; Bhardwaj and Brooks, 1992). Proponents of EMH classify the above phenomenon as “anomalies” (not normal).

Indeed, if all available information, be it on fundamental analysis, technical analysis or even insider’s information is already reflected in the current price, then no other information be used to predict future price movements. Then how to explain the consistent excess average returns generated by famous investment gurus like Warren Buffett, Seith Karman and Peter Lynch? While Buffett said “I’d be a bum in the street with a tin cup if the markets were efficient.” Peter Lynch claims “Efficient markets? That’s a bunch of junk, crazy stuff” (Fortune, April 1995)

From the chart below, we can see that Berkshire Hathaway out-performed the Dow Jones Index consistently over the long term.

Figure 1: Berkshire Hathaway vs Dow Jones Index 1964 - 2014

(Source: Business Insider)

The traditional finance theory has failed to explain why some investors can consistently outperform the market, and why historical earnings (earnings announcement) can cause overreaction and underreaction. Similarly, why is what seemingly undervalued share can overnight lose much of its value due to a financial market crash? Hence, supporters of the Behavioural Finance believe that investor emotion pushes the price of a share wildly above or below its fair value.

Rational Decision Model

Economists argue that people are rational. Rational people make decisions or judgement using reasoned thinking, based on facts, applying rules, and those decisions are consistent over time. According to Bayes’ law, a typical, rational person chooses what options to pursue by assessing the probability of each possible outcome (Stigler, 1983). For example, what is the likelihood of a given political party winning an election? Or what are the chances of surviving a breast cancer? The answer is based on an assessment of the evidence collected through sampling and statistical calculation.

Behavioral finance attempts to understand and explain how human emotions influence investors in their decision-making process. In real life we do not make all decision based on thinking through and weighing up the alternatives for mundane simple task such as what to eat, where to shop or what to wear, we make these simple decisions based on intuition or “gut feeling”. However, when it comes to investment or children’s education, we will spend more time to gather information, do some analysis and then make decision. Hence, decision making is a complex process, involving both analysis and intuition: analysis involves computation and more “rational” thought, but is slower; intuition, by contrast, is much faster, less accurate, and relying on “gut feeling”.

Research conducted by Herbert Simon (1982) proved that “full” rationality was an unrealistic standard for human judgment. Instead, he proposed a more realistic theory known as “bounded rationality” which acknowledged that inherent processing limitations of the human mind. People reason and choose rationally, but only within the constraints imposed by their limited search and computational capabilities.

Building on Simon’s work, Kahneman and Tversky introduced the idea of heuristics (mental shortcuts or intuitions). This idea means that people tend to use intuitions and bias to cope with their insufficient ability of processing information fully and rationally due to time pressure.

Kahneman and Tversky defined heuristic as: “Heuristics are rules of thumb, educated guesses, intuitive judgment that help people to make decisions. These rules work well under most circumstances, but in certain cases may lead to cognitive bias.”

Investors’ Irrational Behaviour

In Professor Kahneman’s research, he got together a group of people whose brains had been damaged due to tumour removal or accident, and let them play a little game with the other group of normal people. Starting with $20, each one flipped a coin and called it: heads or tails. If the participant called it correctly, he won $2.50. If he called it incorrectly, he would lose only $1. If he was feeling unlucky, he could pass.

Given the odds of winning were tilted to participants favour, any player who wanted to maximise his or her returns would never pass. But the result showed that the “normal” group passed more than the “damaged head” group. Does that mean the best investors are mentally defective? No, the conclusion is that emotions get in the way of successful investing. Emotions caused participants to react to “illogical” ways by refusing to bet, even when the odds were clearly in their favour. The un-emotional players, by contrast, did “rational” thing more often and won more money.

History of Financial Crashes

In the past, the history of financial manias and panics has been repeating over and over since the seventeenth century. From 1634 to 1636, “tulip mania” spread through Holland, causing the price of tulip bulbs to skyrocket to ridiculous levels, and wilted suddenly in 1636, creating widespread panic and financial dislocation during that time. Other examples include the England’s South Sea Bubble of 1720, the U.S. Black Monday of 1987, the Japanese real estate bubble of the 1990’s, the dot com era of 2000, the Asian financial crisis of 1997 and the 2008 subprime mortgage crisis in U.S.

There were a series of stages, beginning with a market or a sector that is successful, with strong fundamentals such as the banking sector. Then credit expands, and money flows more easily creating excess liquidity in the economy. For example, near the peak of Japan’s bubble in 1990, Japan’s bank were lending money for real estate purchases at more than the value of the property, expecting the value to rise quickly. As more money is available, prices rise. More investors are drawn in and expectations for quick profits rise. The bubble expands, and then finally burst.

Shefrin (2000) described the above phenomena caused by the fear and greed inherent in all mankind. What we see over the past and today is that there were different themes of share market crashes, but same patterns occur over and over again.

Proponents of Behavioural Finance uncovered that humans are endowed with basically the same qualities - being fearful and greedy today as they were in the seventeenth century and that rational behaviour is not always as prevalent as we might believe.