Our worst enemy

In my august article I was talking about the subliminal function on the brain linked to a reflection on behavioral finance. I have since attended a three-day course on behavioral finance given by a great expert on the subject, who has been studying this theme since the 1970s, when no one outside of academia knew what it was. I must admit that the course was absolutely fascinating insofar as the theory (which is not one) of behavioral finance is in direct opposition to the theory of market efficiency, which states that the price reflects all available information and that the price reacts to, and integrates, almost instantaneously any new information, thus eliminating any possibility of arbitrage (the great defender is Eugène Fama, awarded the Nobel Prize in economics last month at the same time as Robert Schiller, who rather defends a market with certain inefficiencies, due precisely to the human behavioral aspect).

With nearly 40 years of data, crises and studies, theories and counter-theories
that analyze in detail all the biases that humans are victims of and that prevent them from reacting rationally in their financial decisions (but not only), there is no perfectly clear answer: the market shows behaviors that should not exist if they were rational, therefore efficient. Examples abound:

1. Several studies have shown that we sell stocks that perform too quickly and those that underperform too slowly (because the 'pain' of selling and taking a loss is about twice as great as the pleasure of taking a gain).

2. Stock prices have a tendency to 'drift', both to losses and gains. A positive announcement about a stock makes it rise instantly, but it can continue to rise for months after the announcement, whereas in a rational market once the price has adjusted it should not move. The corollary is the same, with some slight differences on the downside.

3. We extrapolate the past: we are (emotionally but not intellectually) convinced that, contrary to what all the brochures announce, the past is predictive of the future. This has as a consequence that a whole theory of contrarians has developed which can work…over a certain period of time.

4. We intuitively have very poor notions of statistics and cannot help but build scenarios of reversion to the mean. Thus after periods of prolonged decline or increase, we are inclined to see an inverse market set in and overestimate the opposite movement while statistically we should always count on historical growth (this is after all the most probable!)

5. We systematically confuse good stocks with stocks of good companies. This leads to expectations that go against logic: we expect higher returns from stocks of good companies than from bad companies. It's the world upside down: the less risk, the more return we expect.

6. We are too confident in ourselves! We overestimate our ability to estimate in general and especially possible extreme fluctuations.

The most surprising thing is that finance professionals are just as subject to these behavioral biases as non-professionals!

The 1000 franc (or € or $ or £) question is obviously: can we exploit these market distortions to arbitrate these price inconsistencies? And here it becomes very, very delicate because we are dealing with human beings and that is why behavioral finance is not a theory but an observation. We could, of course, but it is at our own risk. There is as much risk of being wrong as of being right. So the conclusion is, and this is where Hersh Shefrin* comes in: even if the market has proven many times that it is not efficient, for an investor it is better to consider that it is! This is the least risky way: invest in the market, funds that replicate the market and pay close attention to costs.

Where does this leave us with our dividends? That will be the subject of a future article…

*Beyond Greed and Fear, understanding behavioral finance and the psychology of investing, Hersh Shefrin, Oxford University Press,