The underlying premise of the Efficient Market Theory is that market participants are rational and do somewhat predictable things when news appears. It is the news that is random, and thus the day-to-day fluctuations in stock prices are random as well. The result (random movements in stock prices) does not change in the event that some investors act irrationally.
Stock prices will not be affected, as their trades will be canceled out due to their randomness. What happens when (such as in bubble) irrationality strikes the behavior of many investors at once? Rational arbitrageurs will correct their influence on prices. Under EMH, arbitrage is quick and effective because the arbitrageurs are competing with each other to earn profits, and, because of this competition, the price of a security can never get far away from its fundamental value.
Originally, arbitrage referred to the clever practice of buying an asset in one market at a low price and selling it in a different market at a higher price. Today, the term is used to describe any trading strategy that takes advantage of mispricing to make a profit. Arbitrage strategies are nearly riskless. Such an ideal investment is impossible to find in an efficient market, at least according to the EMH.
The irrational investor, it seems, has a very short life expectancy in the markets. Milton Friedman pointed out that irrationality causes them to earn lower returns because they cannot lose money forever: they must become much less wealthy and eventually disappear from the market. If arbitrage does not eliminate their influence on asset prices instantaneously, market forces eliminate their wealth.
EMH champions, then, have done their best to show us that irrational actors in the markets do not invalidate the theory. It seems that a more logical conclusion may be that the theory is partially correct because human decision-making is partly rational. Critics have found several limitations to the EMH. Perhaps the most fundamental of these is the simple fact that it is difficult to believe that investors are fully rational all the time. Fischer Black, for example, found that investors tended to trade on “noise” instead of “information.” They follow the advice of friends, hot tips from strangers, and the talking heads on television. Many investors trade too often and fail to diversity. They tend to sell winners too soon and hold losing stocks for too long. They are also detrimentally loss averse, looking at losses in a vacuum and not comparing them to a relative benchmark.
Speculative bubbles also limit the useful scope of the EMH. If prices are instantaneously reflected with all information, stock market bubbles should not exist. Bubbles show that the market is often driven by the emotions of buyers and sellers, or as Alan Greenspan called it, “irrational exuberance.” Bubbles typically form due to overconfidence in the market, in oneself, and when investors are buying into the current fads. These bubbles are usually created by herd mentality.
As Keynes suggested long ago, it can be understood that the everyday investor can act irrationally on emotions, but so can professional investors. Professional investors face pressures to match and surpass the returns of their competitors, so purchasing stocks that are no longer in demand can cause them to fall behind. According to Keynes, the world of professional traders is a battle of wits fought in the trenches of short-term markets. Their actions may not ultimately be irrational in the strict sense of the term, but they are playing a different game with different rules than that of the long-term “buy and hold” retail investor.
This does not lend itself to fundamental analysis working very well in the short run. Keynes argued that psychology of the human mind caused unforeseen volatility in the stock market. He said the animal spirits or the “spontaneous urge to action rather than inaction” affect behavior. These “animal spirits” heavily influence the equities markets. Keynes argued that Investors do not think that the current situations will change, but instead act as the current situation will continue.
We are merely reminding ourselves that human decisions affect the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the bases for making such calculations does not exist; and that it is our innate urge to activity which makes the wheels go around, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance.
Kahneman and Tversky found that how we value an item is based on a reference point or value. In other words, it is more difficult for humans to determine this level originally than it is to understand the changes in value over time. In essence, it is easier for us to evaluate the changes in levels, than it is to understand fully the levels themselves. This observation led to the conclusion that the mind looks for a reference point when making decisions. This suggests that the average investor will likely determine value based on what a stock has done in the recent past and not conduct a thorough fundamental analysis of individual companies.
In addition to recent reference points, loss aversion plays a huge role in the way average investors buy and sell stocks. Studies show that investors are quicker to sell a stock that has increased in value by X than they are to sell a stock that has decreased by value X. The idea of a loss is more painful (in the terms of classical economics) or outweighs the joy of the gains. Investors tend to hope that the fallen stock will bounce back to a break-even point, while investors who have seen a gain are worried about a “loss” if the stock falls back to the break-even point.
Wall Street wisdom tells the investor to “let your winners run and sell your losers.” Behavioral economics tells us that the average person does the exact opposite. The reasons for this are certainly not rational, and boil down to feelings: Investors ride losers to postpone regret and sell winners too quickly because they want to hasten the feeling of pride at having chosen correctly.
Herd behavior in financial markets is the propensity for individuals to follow the actions of other investors in the market, whether rationally or irrationally. Rational herding is based on information, whereby rational investors will adopt the same response to other investors who share the same stock strategies when receiving new information.
Irrational herding focuses on investors who blindly follow other investors without adequate information or accessing the risk of doing so. In the short term, this phenomenon can be observed in “chasing” a stock. The trader sees that a stock price is rising rapidly, and buys shares. The idea is to capture the “momentum” as the share prices go up even higher. This dangerous strategy usually results in the trader losing money. When people are seeing decisions made by large groups of people, (e.g., the FANG stock explosion in price during 2017) people tend to believe that group of people must know something they do not know, as they all cannot be wrong. On Wall Street, everyone can be wrong, and they frequently are.
The above discussion of behavioral finance barely scratches the surface of a fascinating subfield of economics that blends in ideas from psychology and sociology to produce a multidisciplinary approach to investing. We must appreciate the fact that there is a wide chasm between saying how something works and how something is used. Economists are in disagreement as to how all of this influences the workings of the market. Unfortunately, it does not give the investor any edge in picking investments and timing markets. The biggest benefit you can gain from the study of behavioral finance is to understand the irrational (dare I say stupid?) things that investors do. By knowing how people think, you can understand how you think, and hopefully head off bad decisions before they damage your portfolio.