Our worst enemy

In my august article je parlais de la fonction subliminale sur le cerveau lié à une réflexion sur la behavioral finance. J’ai depuis assisté à un cours, sur trois jours, sur la finance comportementale donné par un grand ponte du sujet, qui étude ce thème depuis les années 1970, alors que personne, hors du monde académique, ne savait ce que c’était. Je dois avouer que le cours était absolument fascinant dans la mesure où la théorie (qui n’en est pas une) de la finance comportementale entre en opposition directe avec la théorie de l’efficience des marchés, qui veut que le prix reflète toute l’information disponible et que le prix réagit à, et intègre, quasi instantanément toute nouvelle information, éliminant ainsi toute possibilité d’arbitrage (le grand défenseur est Eugène Fama, récompensé par le Nobel de l’économie le mois passé en même temps que Robert Schiller, qui lui défend plutôt un marché avec certaines inefficiences, dues justement à l’aspect comportemental humain).

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,