Stripping irrationality from the equity market

In the 1960s investors and financial advisors believed in the “efficient market theory” (EMT) which held that investors act rationally based on complete access to market information. But the thinking has since changed… says Hugo Snyman, MD of Third Circle

Investors who embodied the EMT definition were referred to as Homo Economicus. To categorise investors in this way is clearly wrong, because it assumes an 80-year old grandmother in frail care has access to the same quality and quantity of information as an investment professional.

Here’s a less extreme example. Let’s say an investor wants to move money into a money market fund based only on the fear that the USA will default on its debt responsibilities. By adding some information – and explaining that the USA debt problem is not about money but politics – the investment decision quickly changes.

An investor – after receiving the additional information – would have saved money by remaining in equities rather than going the conservative route. Sure enough on 1 August 2011 the Republicans signed a piece of paper that said, in crude language: “Ok Mr President – we will sign your proposal to borrow more – but remember you now owe us a favour.”

Pride can be expensive!

Over time it became obvious that EMT could not explain away the investment errors people made. Real people would often panic and sell all their shares when they shouldn’t. Likewise, they may not sell a share when they should, because they refuse to admit that they bought the wrong share.

Slowly but surely psychologists became interested in the behaviour of investors, and started wondering whether Homo Economicus was a myth. The reality is investors do as well as they can under the circumstances – whatever those circumstances may be – and with the information at their disposal. More importantly, they tend to follow the herd. If a number of people start selling a share, everyone starts selling. When everyone we know is buying gold, we all buy gold…

Stick with the herd

Like our cavemen ancestors we find it sensible to stick with the crowd. Investors are different to the nomadic beasts of prey who strike out in separate directions, and more akin to the herd animals such as zebra, impala and wildebeest. You need only look at crowd behaviour at Saturday’s rugby for a real world proof of this theory.

In the 1980’s the idea that psychology played a role in investing became accepted theory. The EMT was not thrown out the window, but economists and psychologists started understanding that behaviour also played a part in how people invest. A new science called behavioural finance was born. The first person to write on this subject – Mr Kahneman – won the Nobel Prize for economics.

To make sense of this science, experiments were designed to understand how investors made their decisions. A researcher might ask: “You can have R10, or you have a one in three chance of me giving you R20… Choose!” Research tells us that more men go for the riskier R20 than women, for example. This kind of research helps to explain how investors make their investment decisions and how errors are made.

Emotion trumps theory

Modern thinking is that investor behaviour can be explained by emotions and personalities rather than a mathematical model. That’s why investors expect their financial advisers to treat them as individuals rather than lump them in broad investor categories.

Nowadays fund managers favour personality questionnaires to determine the needs of individual investors and place their money in the correct “pain and pleasure” categories.