With markets running nicely it might be time to revisit an old paper I have mentioned before called “Do investors behave like lemmings?” by Professors Richard Dale and Johnie Johnson* and Dr Leilei Tang. To which my immediate response was thank you for stating the bleeding obvious – next monkey and organ grinder please.
The topic is once again do investors behave rationally during times of extreme market activity. The answer to which is off course they don’t, people cannot even behave rationally when doing their Christmas shopping. I just wish they would stop giving out grants and Ph.D’s for a question that has already been answered.
The rather grandiose sounding press statement that accompanied this piece originally said that they had unearthed new evidence that investors in financial markets can behave irrationally – I’m sure this is news to the people who bought AMP at $32.00 who have just paid well over the odds for the house down the road.
The esteemed academics based their findings on the South Sea Bubble of 1720 which I have spoken about before and which Charles Mckay in his book Extraordinary Popular Delusions and the Madness of the Crowds gives an excellent insight into. The interesting thing is that McKay made these observations in 1841 after a study of a series of financial debacles. McKays work was (and still is)stunningly original and should be compulsory reading not only for students of market history but also for anyone who is serious about trading.
What is even more interesting is that most of the world of finance ignored this rather obvious pattern of human behaviour and insisted that humans behave rationally when making decisions that revolved around the comparison of instruments or in choosing the projected economic utility of an instrument.
Lo and behold the efficient market hypothesis popped into existence, an economist got a Nobel Prize, which as a former hardcore scientist I regard as somewhat akin to giving someone a Nobel Prize for the academic equivalent of astrology. Since then markets have been based upon a misunderstanding of the basics of human behaviour.
Whilst not wanting to smack the authors of this paper around too much since they are obviously earnest in their endevours, they really should get out more and observe human behaviour. Simply watching two people argue over a car parking space in the local shopping centre should convince you that most peoples level of rational thought never gets much higher than that of a very hormonal teenage girl who has discovered that her mobile phone has a flat battery.
The interesting thing about irrational behaviour is that everyone is prone to it and it creeps into all traders decision making at sometime. For example consider this short list and see if at anytime in your trading career you have been prone to any of these actions.
- Being impatient to sell a profitable position
- Making predictions based upon very limited knowledge as if you had the gift of precognition.
- Ignore information that runs contrary to a long held belief. For example you may choose to ignore that a stock you hold is no longer profitable and only seek out information that confirms your original decision.
- Having expressed a preference for an investment, people often distort any other information in order to add weight to their decision. Thereby falling in love with the stock.
- Remember your success but fail to remember your failures.
- Become a risk avoider when faced with a certain gain but then become risk seeking when faced with a certain loss.
The question is that given that we are human how do we avoid irrationality creeping into our trading system. The answer is actually quite simple – have a trading system. Most people’s trades are based upon a loose aggregation of random inputs that they cannot make systematic. A trading plan removes most of the discretion from a trader, this is a good thing since it cuts down on the potential for emotion driven errors. It does not mean you wont be wrong but it does mean that you will limit the damage from being wrong.
*In an interesting coincidence Johnnie Johnson was also the name of the RAF’s highest scoring fighter ace of WWII