How the financial crisis turned everyone into a behavioral economist

Trader Talk

It was some time in the first quarter of 2009, standing outside the NYSE, when I realized that my entire generation got scalded.

I mean the baby boomers. I didn’t know it at the time — no one did — but March 6, 2009, was the intraday bottom for the stock market, when the S&P 500 hit 666 (the closing low of 676 was a few days later, on March 9).

Not that it mattered. I had just witnessed and reported on one of the great investment debacles of all time, a roughly 50 percent decline in the S&P 500 from its peak in October 2007 to its bottom on March 6, 2009.

No one had seen anything like it since the Great Depression.

And it affected the generation born between 1946 and 1964 the most because that cohort was in their prime earning years. They were putting money into stocks and bonds, but they were also putting money into real estate, including secondary homes.

Boomers bought stocks and bonds and real estate with gusto from 2002 to 2007, and then proceeded to dump a large portion of it at fire-sale prices in the next two years.

At the end of it all, the average household was 20 percent poorer in 2009 than just two years before: The net worth of U.S. households and nonprofit organizations went from $69 trillion in 2007 to a trough of $55 trillion in 2009.

That’s depressing enough. What’s really depressing is that at the moment the market was approaching a bottom, and I am talking about the very end of 2008 and the first quarter of 2009, investors were continuing to dump stocks.

The age-old advice is to buy low, sell high, and not to buy high, sell low. But that’s exactly what a huge group of investors did. They sold at the bottom. That’s when I became a convert to behavioral economics.

I spent Wednesday morning reading my Trader Talk blog from the first quarter of 2009, and it’s clear I was then struggling to understand where the bottom was and why investors were continuing to sell.

February 2009 was a fearful time. An attempt to bottom had been made in October 2008 (October is a traditional month for market “bottoms”), but it had failed. Then, in November we hit new lows.

From my Trader Talk on Feb. 17, 2009: “We are at the November lows, the hope now is that a final capitulation in second half earnings will create a new low that may be the bottom we need.”

But it got worse. You could smell the despair in my March 5 blog, the day before the market bottomed: “We go down for 3 weeks and cannot even sustain a two-day rally.”

The next day — March 6, 2009 — was the bottom, but my blog sounded even more desperate: “Traders believe a rally is coming, but few are positioned to take advantage of it. Why? Because no one can afford to be wrong … ‘no one can afford another 10 percent down month,’ as one analyst said.”

A week later, the market had staged a notable rally as bank stocks rocketed off a bottom. The bank index was up 45 percent from the previous week on positive comments from bank executives. The S&P 500 was up 12 percent

But investors did not believe a bottom was in. Indeed, I noted several weeks later that the data firm Trimtabs was reporting there were continuing outflows from equity funds in February and March.

By the last day of July that year, I was still lamenting that investors were continuing to put money into bond mutual funds but not stock funds: “Despite a notable stock market rally in the first six months of the year (the S&P was up 1.8 percent, but up 36 percent from the March lows) , there were OUTFLOWS from stock mutual funds in the first half of the year of $396 million (there’s about $4 trillion in stock funds). What’s up? Retail investors have been so badly burned by stocks last year that they still do not trust the market; they are showing classic signs of risk aversion by continuing to put money into bonds.”

And that’s what troubled me most. I had seen my share of modest panics, but I still believed that investors were fundamentally rational in their economic decision-making. Not here: “Buy low, sell high” went out the window; waves of investors sold stocks at their lows, and many, particularly those of my generation, never returned.

Even during the financial crisis, certainly most investors realized the U.S. economy was not going to go to zero, so selling this far down made no economic sense. But that is exactly what happened, and this event helped popularize the entire school of behavioral economics, which emphasized how people really behaved under economic stress, not how they were supposed to behave.

A key figure was Yale professor Robert Shiller, who had been publishing research since the 1980s that concluded that the volatility in the stock market could not plausibly be explained by rational expectations of future returns. Shiller concluded that investors often make decisions on emotions rather than rational calculations.

He was awarded the 2013 Nobel Prize in economics (with Eugene Fama and Lars Peter Hansen) for his contribution to behavioral science and the analysis of asset prices.

Same with Richard Thaler, who won the Nobel in 2017 for showing how human traits (limited rationality, lack of self-control) affect market outcomes.

It wasn’t just the rationality of humans that took a hit. Efficient market theory, which says humans act in a rational way and make the right decisions because they have access to all available data, also took a hit. Stock market bubbles and panics are now largely viewed through the lens of behavioral economics. It is now a given that markets may not be perfectly efficient and that irrational decisions made by investors have a big impact.

What’s all this mean? It means that, under certain circumstances, it may be possible to train people to think more rationally about investing. Does that mean that “smart” people can take advantage of “dumb” investors, which is the basis for active management? Under some circumstances yes, but even Thaler thinks it’s just about impossible.

“The active management industry as a whole doesn’t really provide much in the way of value,” he said in a recent interview. “I say that as a principal in an active money management firm where we do think we provide value.”

The more important insight from behavioral finance is that stocks can indeed be mispriced, that is, it’s not always true that a stock price is exactly equal to the true intrinsic value. That’s because investors display biases. For example, they believe that because a stock has done well in the past it will continue to do so in the future (the gambler’s fallacy). They will look at data that support what they want to believe and ignore other data (confirmation bias). They will blindly follow what other investors are doing (herd behavior). If they have been on a winning streak, they will come to believe they are infallible as investors (overconfidence). They will overreact to certain pieces of news and fail to place the information in a proper context (availability bias).

Most important is the concept of prospect theory, developed by Daniel Kahneman, whose seminal book, “Thinking Fast and Slow,” popularized the idea that humans fear a loss much more than they get pleasure from a gain.

That “loss aversion” went a long way to explain the panic selling we saw at the bottom in 2009. The opposite is true as well: Investors tend to hold on to losing stocks for far longer than is rational to avoid the pain of the loss.

Bottom line: There’s still plenty of fundamental and technical analysis going on, but we have all become behavioral economists as well. And we are better off for it.

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