Animal Spirits

In his 2010 book Trade the Trader: Know Your Competition and Find Your Edge for Profitable Trading, author Quint Tatro observes that “…what most investors don’t understand as they start to learn their basic technical patterns…is they are the ones actually in play. Seasoned traders are no longer just cuing off of charts or indicators, they are also analyzing those same charts to determine what the amateurs are doing, and are seeking to profit from the ignorance of the newcomers. It’s a chess game where the successful traders are thinking two and three moves ahead, playing off the basic strategy of the newcomers. Those simply pursuing a basic path of understanding technical analysis will find it is a road that ultimately leads to frustration, whereas those looking to trade the traders will be met with an endless world of opportunity. …If you don’t know on which side you fall, odds are you are someone’s next meal.” Some notable points from the book are: Keep Reading

Is aggregate equity investor fear multifaceted? In the August 2010 version of his paper entitled “The Equity Fear Premium and Daily Comovements of the S&P 500 E/P ratio and Treasury Yields before and during the 2007 Financial Crisis”, Christophe Faugère introduces a Total Fear Premium derived from independent flight-to-safety and flight-to-liquidity impulses. The flight-to-safety component assumes investors fleeing stocks buy long-term Treasuries, driving the real, after-tax yield on Treasury bonds below long-term trend (growth rate of real Gross Domestic Product per capita). The flight-to-liquidity component assumes investors fleeing stocks buy short-term instruments (such as Treasury bills), driving their yields below the federal funds target rate. Using daily levels of the S&P 500 forward earnings yield, Treasury yields and S&P 500 Index implied volatility (VIX) over the period July 2004 through February 2010, he finds that: Keep Reading

Author Meir Statman states that his 2010 book What Investors Really Want “is about what we want from our investments. It is about how we think about our investments, how we feel about them, and how investment markets drive us crazy as we try to cajole them into giving us what we want… The sum of our wants and behaviors makes financial markets go up or down as we herd together or go our separate ways, sometimes inflating bubbles and at other times popping them.” Reflecting on “what we really want from our investments” with citations to a large body behavioral finance research, he concludes that: Keep Reading

Is participation in stock message boards/forums a net plus or net minus for the typical investor? In their July 2010 paper entitled “Confirmation Bias, Overconfidence, and Investment Performance: Evidence from Stock Message Boards”, JaeHong Park, Prabhudev Konana, Bin Gu, Alok Kumar and Rajagopal Raghunathan investigate how investors process message board information and analyze the impact of message processing on return expectations and investment performance. Using an incentivized online experiment conducted via the South Korean Naver.com message board to measure prior beliefs, information processing behavior and expected performance of 502 individual investors during October 7-21, 2009, they find that: Keep Reading

Given Warren Buffett’s long-term record of outperformance via Berkshire Hathaway, rational investors should consider following his lead as the the company discloses its holdings. Why would the market not immediately discount his moves as announced? In their July 2010 paper entitled “Overconfidence, Under-Reaction, and Warren Buffett’s Investments”, John Hughes, Jing Liu and Mingshan Zhang investigate how other experts/large traders contribute to market underreaction to Berkshire Hathaway’s moves. Using return, analyst recommendation, insider trading and institutional holdings data for publicly traded stocks listed in Berkshire Hathaway’s quarterly SEC Form 13F filings during 1980-2006 (2,140 quarter-stock observations), they find that: Keep Reading

Do naive investors, lured by news they encounter while the stock market is closed, bid up the prices of attention-getting stocks at the open? In their June 2010 paper entitled “Paying Attention: Overnight Returns and the Hidden Cost of Buying at the Open”, Henk Berkman, Paul Koch, Laura Tuttle and Ying Zhang examine whether attention-based trading by individual equity investors reliably causes temporary mispricing at the market open. Using intraday bid and ask price data for the 3,000 largest U.S. stocks over the period 1996-2008 (13 years), along with contemporaneous measures of retail investor attention to individual stocks and overall market sentiment, they conclude that: Keep Reading

How much individual investing is lottery-like, just hoping for a big score with no analysis? In their June 2010 paper entitled “Natural Experiments on Individual Trading: Substitution Effect Between Stock and Lottery”, Xiaohui Gao and Tse-Chun Lin relate individual trading activity to national lottery jackpot size in Taiwan. Using twice-weekly lottery jackpots and contemporaneous Taiwan Stock Exchange individual trading data at the market and firm levels spanning 2002-2009 (1,495 lottery drawings), they find that: Keep Reading

Do investment choices derived from experiencing and visualizing returns differ from those derived from analyzing numerical return distribution statistics? In their May 2010 paper entitled “How Much Risk Can I Handle? The Role of Experience Sampling and Graphical Displays on One’s Investment Risk Appetite”, Emily Haisley, Christine Kaufmann and Martin Weber examine how different types of five-year investment performance information (numerical statistics, simulations of portfolio allocation outcomes, graphical displays of the distribution of these outcomes and a simulation/graphics combination) influence the investment risk taking of individuals in an experimental setting. Using data from a series of three experiments in which 133 German, 188 American and  362 American participants choose allocations to a risk-free and a risky asset, they conclude that: Keep Reading

In the opening paragraphs of his April 2010 article entitled “Traditional vs. Behavioral Finance”, Robert Bloomfield handicaps his subject contest as follows:

“The traditional finance researcher sees financial settings populated not by the error-prone and emotional Homo sapiens, but by the awesome Homo economicus. The latter makes perfectly rational decisions, applies unlimited processing power to any available information, and holds preferences well-described by standard expected utility theory. Anyone with a spouse, child, boss, or modicum of self-insight knows that the assumption of Homo economicus is false.”

Might some other frame of reference relieve the asserted asymmetry in self-insight and more equally burden the contestants, rationalist and irrationalist? Keep Reading

In his 2010 book entitled The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy, author James Montier states: “I…highlight some of the most destructive behavioral biases and common mental mistakes that I’ve seen professional investors make. I’ll teach you how to recognize these mental pitfalls while exploring the underlying psychology behind the mistake. Then I show you what you can do to try to protect your portfolio from their damaging influence on your returns.” Biases he surveys include: action bias, bias for stories, confirmation bias, conformity bias (herding or groupthink), conservatism (including sunk cost fallacy), disposition effect, empathy gap, endowment effect, hindsight bias, illusion of control, inattentional blindness, information overload, loss aversion, myopia, overconfidence, overoptimism, placebo effect, self-attribution bias and self-serving bias). Value investing provides the context for discussion. Citing a number of studies, he concludes that: Keep Reading