Introduction

Behavioral Finance spans a number of fields including economics, history, psychology, sociology, epidemiology, and communications.

As far back as 1841, Charles MacKay described the “madness of crowds”.1

[ROBERT SCHILLER AND RICHARD THALER]

Robert Schiller, a Nobel prize winning economist at Yale University, defines a speculative bubble as:

a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, and in the process, amplifies stories that might justify the price increase and brings in a larger and larger class of investors, who, despite doubts about the real value of the investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.2

Investors act irrationally, with a mindset that justifies the price increases. They become complacent about market risk. They engage in wishful thinking. In short, they are gambling.

Shiller terms this ‘irrational exuberance.’ Human beings are inherently emotional. They can succumb to speculation, misplaced trust in ‘experts’, and herd behavior. Even the smartest investors can make errors in judgement. They may become overconfident in their abilities and the probability of their success.

Nate Silver maintains that we must accept the fallibility of our judgment. “To the extent that [financial] markets are reflections of our collective judgment, they are fallible too. In fact, a market that makes perfect predictions is a logical impossibility.”3

Most people believe that they are better than average. But, to beat the market, they must be well above average to cover their costs. However, there is an inverse correlation between confidence and performance.4

We extrapolate the recent past indefinitely into the future. We are prone to chasing past performance. For example, one of the most common ways to select a mutual fund is to examine Morningstar’s star ratings.

We seek patterns where none exist.

We extrapolate from small samples. We erroneously believe that small sample is representative of the entire data set. This leads us to make irrational decisions based on short-term data.

Hindsight bias: We exaggerate our ability to make predictions, our pre-event estimate of the probability of that event occurring. We recall our successes but not necessarily our failures.

Historical Bubbles

Identifying Future Bubbles and Corrections

All bubbles–at some point–must end. For equities, Shiller measures the real (inflation corrected) price of the S&P index relative to a 10 year average of real earnings (“CAPE”). For bonds….

 

Additionally, there is information asymmetry (which favors sellers) and imperfect competition.

 

Summary

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For More on this Topic

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Updated on January 13th, 2019