Market Insanity

A Brief Guide to Diagnosing the Madness in the Stock Market

Michael Taillard

• Publisher: Academic Press
• Year: 2018
• ISBN:
  9780128131169
• Topic: Betriebswirtschaft
• Subtopic: Aktien

Market Insanity: A Brief Guide to Diagnosing the Madness in the Stock Market is an engaging and accessible primer which applies modern behavioral finance to equity markets. It helps readers understand how logical investment decisions can be betrayed by what Taillard calls "the insanity, " all those behavioral quirks which cause us to achieve less than optimal utility. The book describes how limited information, habit, the rules of the game, asymmetric information and ego blend together in potentially toxic ways in market environments, thus creating bubbles, stock runs, and more prosaically, even 'normal' equity prices.

In addition, the book discusses the implications of these behaviors in-depth. In so doing, it helps the reader to not only predict the madness within equity markets, but also helps them develop solutions that address and mitigate outcomes.

• Provides detailed and accurate descriptions of the most relevant behavioral anomalies for finance
• Entertainingly written by a veteran consultant with 15+ years experience helping companies explain anomalous finance behavior in non-economic language
• Shows how educated finance professionals can use behavioral insights to help build finance solutions
• Addresses the implications for equity markets in deviations from rationality paradigms
• Draws on a vast range of literature in explaining anomalous behavior, including economic psychology, economic psychology, evolutionary psychology, anthropology and animal behavior

Chapter 1

Introduction

Abstract

Introducing some of the basic concepts of economics and psychology, this chapter provides some prerequisite knowledge you will need to tackle the rest of the book.

Keywords

Economics; Psychology; Scientific method

The only investing advice I ever give anyone is to never trust anyone giving you investing advice. If you came to this book wanting to know whether you should invest in some call options of Class-A convertible shares for a dog grooming start-up from Namibia cross-listing on the US OTC market, then you should absolutely read this book because you will learn to avoid making that sort-of mistake again in the future. No, you will not learn to avoid the mistake of making bad investments because, as I said, this is not that type of book. Anyone who promises you they can guarantee you will not make a bad investment is full of crap. Even assuming they are competent (which is a rarity, in itself), there is no guarantee they are not corrupt. Instead, by reading this book you will learn to avoid mistakes like taking investing advice from books that promise to make you rich on the stock market. Quite frankly, that is what this books is really about – the dumb decisions we make, why we make them, and the impact they have on our investments. None of the things we do are as prudent or sensible as you think, and while reading this book it should become clear that I am taking full advantage of that – something which is a rare treat for both readers are writers, as far as academic books go.

The publisher has encouraged me to be “irreverent”, allowing us to have a bit of fun with the contents of this book. Quite frankly, that was the point anyway, since we are basically talking about people acting like clowns, and the stock market has no shortage of clowns. The tone of the book is just a personal expression of the problems faced in the financial industry, though. That does not mean this book is cuts corners on the facts, though. Everything described in this book is based on valid, scientific research published in reputable journals, and there will be citations and references abound.

The research being compiled and described here, all on the topic of behavioral economics as applied to the stock market, is a sharp departure from traditional finance and economics books, which make assumptions like people acting rationally and the markets being efficient. There are some old-timers and undergrads out there who still hold onto those ideas, but they have been thoroughly debunked since the 1970s, when behavioral economics really developed as a field of study. In fact, among the various citations included in this book, you will notice a few names are mentioned multiple times, throughout. These are the pioneers of the field (aka: old), including:

Daniel Kahneman and Amos Tversky: Both quantitative psychologists by origin, they both delved into research on how people make decisions. Each of them have their own unique careers and contributions, but their work together is considered by most to be the seminal point at which the field of behavioral economics was born. Together, they contributed a vast array of research and theory which solved problems that daunted economists using the assumption of rational decisions. The foundations of behavioral economics, including concepts such as psychological framing, and prospect theory, upon which much of the bulk of behavioral economics extends.

Robert Shiller: Shiller is an extremely influential economist, and the namesake of the Case-Shiller Price Index, which is the predominant measure of real estate prices. Shiller dedicated most of his career to exploring the cause and nature of economic bubbles, particularly in real estate and other investment markets. It is because of Shiller that we now know the cause of bubbles is not a rational one, but rather they are the result of behavioral insanity.

George Akerlof: A prominent economics professor, he produced groundbreaking works into the economics of asymmetric information and the manner in which behaviors are exhibited under conditions of asymmetry. He also produced research on the economic impact of social identity, and choices made as a result of one's own perception of social status and the expectations laid upon them by the norms of that status.

The role of this book is not to make any major contributions to the field, although I do point-out a few things here and there, particularly in Chapter 7. The role of this book is to bring together all the research on behavioral economics available, both old and new, and summarize how it applies specifically to the actions of stock investors, translated into normal-people talk. Researchers, and economists especially it seems, like to use ridiculously complicated jargon; and it is in the nature of doing proper scientific research that studies must be written in a manner that is painfully tedious to read. Be honest, you and I both know that you have opted to skip the majority of more than 1 research paper, instead reading just the abstracts and conclusions. Well, rejoice and give thanks, because it is the entire point of this book to force me to read all the stuff you do not want to and then write about the interesting parts. While this does not sound like much, it does play an extremely important role because behavioral economics is a very new field of research, and since it combines elements of psychology and economics, it tends to be difficult for people to understand. Much of the criticism about behavioral economics comes from a lack of understanding about what is being accomplished. Sure, there are other books which do the same thing, but none of them focus on the implications of the field exclusively on the stock market, and apparently only the stock market warrants the author of an academic book to be snarky. Do not discount the importance of sarcasm and cynicism in books like this, either. It is important to be able to communicate with people in a way they will appreciate in order to hold their attention long enough to teach them something. So, if you were expecting something written in the formal snootiness of traditional academia, then you can give a sigh of relief now. At this point there seems to be a broad consensus that we need to improve our communication skills because historically our writings have been boring and hard for the general public to understand.

Before we jump into it, though, there is some basic concepts you need to know. I do not want you writing back to me ranting about how none of this is real science, or sending some long-ass manifesto on why you think all economists are wrong, because printer paper is expensive and I can light my firepit with much cheaper quality paper, improving our cooperative resource efficiency.

Let us start by establishing what economics and psychology really are. They are both forms of applied neurology. Economists use the scientific method to study peoples' behavior in terms of resource utilization and distribution, while psychologists use the scientific method to study peoples' behavior in terms of understanding their health and development. Both of these things stem from neurological processes in the brain, which means when you stick someone under a brain scanner (ideally and fMRI, but those things are really expensive to operate), you can actually see that wrinkled blob of an organ in your head go to work. Neurologists can study your brain and its functions, but would have no idea exactly how those functions cause you to act in different ways, just as economists and psychologists can explain how you will behave but rely on neurologists to explain what makes us behave the ways we do. Behavioral economists take all 3 of these things and smush them together to answers a question as old as humanity, itself: What the hell is wrong with us?

As far as the stock market goes, it is very much the epitome of the irrational human. The global stock markets are forums for people from all nations and walks of life to come together peacefully with the single goal of acting like utter fools (if ever there was proof that all people were created equal, it is our capacity to make fools of ourselves). In case you were not aware, the basic premise is this: Corporations are companies owned by stockholders. Ownership of the company is split into millions of pieces, and those pieces are sold to stockholders, so that they are paying to own a small part of the company. The stock market is the place where people go to buy and sell shares of ownership. Ideally, the point is to buy ownership in companies that are successful, so that the company will be worth more, resulting in the value of their ownership in that company being worth more. Then you can sell the stock to someone else at a higher price than you bought it. Simple enough? Good, because we are going to spend the rest of the book explaining why people take this seemingly simple idea and turn it into one of the most complicated things you can imagine.

When I say “people”, what I really mean is investors. There are lots of different types of investors, including people who just stick money in their retirement accounts and hope for the best. Some chapters of this book apply to the hands-off investors who would rather have a real life they can enjoy, but for the most part we are talking about people who do this sort of thing for a living – either they are professional investors in some capacity, or they are amateurs who manage their own investment portfolios full-time from home. Either way, these active investors can be split into two broad categories: traders and value investors.

Value investors are people who look long and hard for companies that they think have a fantastic future ahead of them, and then buy those stocks while they are still nice and cheap. Value investors hold-on to their investments for the long-haul, ignoring the daily turbulence of the markets. Traders do not care so much about the individual companies as they do movements in the market. They try to take advantage of all the ups and downs, buying while prices are down and then selling them while they are high, doing this in high volume and making a little bit of money each time (if they are successful in doing it, which generally is not the case).

One final term you need to know is “portfolio”. Anytime someone buys an investment, it is considered part of their portfolio. The reason we give it a special name is that once a person invests in a variety of different investments, then they can start performing analyses and managing strategies that take into consideration the way the different stocks interact together. For example, it is common for investors to hold some stocks that are very low risk, some that are moderate risk, and some that are extremely risky. They believe that there may be opportunity for massive gains in the extremely risky stocks, so they pursue them to a limited degree, ensuring the majority of their investment portfolio is dedicated to low or moderate risk stocks. Once you delve a bit deeper into the behaviors of investors, you will find that there are many different styles and strategies, but this is just Chapter 1. Let us take it slow and enjoy our time together.

For now, it is time for the obligatory summary of contents necessary for all non-fiction authors to include as a part of the introduction in order to avoid getting scolded by their publishers (help me!). The book is divided into chapters, and each chapter is divided into sections. The individual sections each talk about a specific type of behavioral anomaly, describing what it is, when and how it was discovered, how it makes you suck at investing, and what you can do to minimize or prevent it from occurring. Each of these sections are then clustered into chapters, based on common traits between them. There is a chapter dedicated to different type of biases (Chapter 3), for example, and another dedicated to flaws in perception of the world around us (Chapter 5), and another chapter dedicated to simply acting like a dummy (Chapter 4). To quote William Shakespeare, “Love is merely a madness; and, I tell you, deserves as well a dark house and a whip as madmen do; and the reason why they are not so punished and cured is that the lunacy is so ordinary that the whippers are in love too.” So, certainly a chapter on the lunacy to which we are driven by our emotions is included (Chapter 6), and we take things a bit further in Chapter 7 to explore how prevalent mental illness truly is among investors and the manner in which specific ailments of the mind will influence our investing decisions. This particular organization not only makes the book easier to read because it is broken-up into smaller units so you do not have to worry about stopping mid-chapter, but this particularly style of organization also makes this book easier to use as a reference guide, should you find yourself in need of such a thing. Clearly Chapter 1 is merely an introduction, while Chapter 2 sets some foundations about the ridiculous notions of rationality and efficiency which so many economists and investors have assumed to be true for far too long; none of these 2 chapters hold to the same structure as the bulk of the book. There are also a conclusion and an afterword. The former is just a conclusion, and the latter touches on how we are driving to madness the very technologies that were developed to help prevent our own irrational decisions.

So, that about sums it up. Turn the page so you read something more interesting than an introduction chapter.

Chapter 2

The Rational Fallacy

Abstract

It has been assumed for a very long time that people are rational, and capable of maximizing the utility of their own decisions. By extension, this would imply that the stock market is efficient. However, we know these things to be at least partially false, if not entirely.

Keywords

Utility maximization; Efficient market hypothesis; Behavioral paradigm

We all like to think we are rational – that the decisions we make are based on informed assessments. Regardless of how little faith we have that those around us are capable of doing the same, we each convince ourselves that we alone can at least recognize what is best, even if we do not always opt to pursue it. Much of the society we have constructed is based on the assumption that, when taken collectively, the whole of our actions will be logical; but it takes some Olympics-level mental gymnastics to look at the stock market and deny the chaos. Fortunately for us, some of humanity's greatest minds have spent more than a century developing ways for us to cling to the belief that there is some grand pattern of efficiency built into the markets that is simply too complex for individuals to predict. There is even a treasure trove of mathematical equations which model the value or price of individual investments, or the markets as a whole, based on the idea that investors are able to optimize the value of their decisions. Thank goodness we can rest our minds easy and continue to pretend that markets are efficient and people are rational (or, at least, you are rational while everyone around you is an idiot). It is a comforting idea, really, to think that your retirement savings are safely in the hands of people who know what they are doing, or at least safely in the invisible hands of a market that automatically works-out for the best. It is also really easy to believe: Finance is nothing but numbers, right? There is no possible way people could be looking at the exact same numbers and come to different conclusions! No sir!

Well, I have got some bad news and some good news. The bad news is that we are all nuts. “I'm mad, you're mad. You must be or you wouldn't have come here.” (Quote: Lewis Carroll) On a daily basis, the decisions we make deviate so far from rationality that by using what is rational as a benchmark, collectively we swing around it like a tetherball around a pole. That difference between rational decisions and real decisions is what we are going to call “The Insanity”. The insanity includes all the little things we do that cause us to make less than optimal decisions, and there are plenty of them. That is the all the bad news for now, but we will expand upon it throughout the remainder of this book, so remember that you have something to look forward to.

The good news is that it is way more entertaining to read about the wacky antics that we get up to rather than a book about rational expectations. It is also not bad that over the past 50 or so years, researchers have started to make sense of these behaviors. Being able to identify the quirks in our decision-making processes has made them predictable, along with the influence each has on our behaviors, including our investing behavior...