The second and third quarters of the 20th century saw huge progress in economic theory.
In 1934 professors Ben Graham and David Dodd, often referred to as the fathers of value investing and who taught Warren Buffett among others, wrote their seminal book Security Analysis. They cited numerous cases of the market’s tendency to irrationally undervalue certain out-of-favour securities. Mr Graham once famously stated that in the short run the market is a voting machine, but in the long run it is a weighing machine.
By the 1950s, modern portfolio theory was introduced by Harry Markowitz who highlighted the benefits of diversification within a portfolio. Economists Jack Treynor and William Sharpe, through their capital asset pricing model, built on Mr Markowitz’s work by breaking down risk further into systematic and unsystematic risks.
Later in the 1970s professor Eugene Fama of the University of Chicago developed the efficient market hypothesis, which posited that it is impossible to beat the market because stockmarket share prices reflect all known information and therefore trade at ‘fair value’.
It was really only during the last quarter of the 20th century that the prevailing economic consensus began to be questioned. A number of psychologists started to challenge whether investors were entirely rational; indeed, they have been unearthing a number of occurrences where the opposite is true and decisions are affected by a number of predictable behaviours (biases).
Humans appear to make decisions using heuristics or, put more simply, ‘rules of thumb’. We also appear to have asymmetric reward reactions to gains and losses. Surely if we were rational we would treat gains and losses equally? But that isn’t what happens, as Daniel Kahneman and Amos Tversky found in their work on prospect theory – an analysis of decision-making. In general, the psychologists found that humans are loss-averse and predisposed to run losses and prematurely take gains. We have to address our failures when we accept losses, which we find uncomfortable, but we can smile contentedly when we take gains basking in the sunshine of how clever we are.
Among other observations that have been noted by behavioural economists is availability bias, where investors place too much emphasis on the most recent piece of news rather than take a more balanced look at further data points.
There is evidence humans are also prone to ‘anchoring’, where we look back at recent information and then forecast from that standpoint rather than take a clean-sheet-of-paper approach to that data. Herd behaviour has been blamed for market bubbles and subsequent crashes.
Analysts also tend to ‘under-react’ to new information, which is why companies that produce earnings surprises (either positive or negative) tend to have their estimates revised a number of times as analysts catch up with reality.
Hindsight bias is another pernicious occurrence, where investors typically conclude that some events were bound to happen although they were less convinced of the outcomes before the events.
Given the miniscule amount of time man has had to evolve, it is wholly unsurprising we are riddled with emotional baggage that almost inevitably leads us to make poor decisions. Investors need to be aware of the traps to which our natural inclinations tempt us.
Stephen Watson is chief investment officer at Beaufort Investment Management
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