Behavioral Finance and Your Portfolio. Michael M. Pompian
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Technical Anomalies
Another major debate in the investing world revolves around whether past securities prices can be used to predict future securities prices. “Technical analysis” encompasses a number of techniques that attempt to forecast securities prices by studying past prices. Sometimes, technical analysis reveals inconsistencies with respect to the efficient market hypothesis; these are technical anomalies. Common technical analysis strategies are based on relative strength and moving averages, as well as on support and resistance. While a full discussion of these strategies would prove too intricate for our purposes, there are many excellent books on the subject of technical analysis. In general, the majority of research-focused technical analysis trading methods (and, therefore, by extension, the weak-form efficient market hypothesis) finds that prices adjust rapidly in response to new stock market information and that technical analysis techniques are not likely to provide any advantage to investors who use them. However, proponents continue to argue the validity of certain technical strategies.
Calendar Anomalies
One calendar anomaly is known as “The January Effect.” Historically, stocks in general and small stocks in particular have delivered abnormally high returns during the month of January. Robert Haugen and Philippe Jorion, two researchers on the subject, note that “the January Effect is, perhaps, the best-known example of anomalous behavior in security markets throughout the world.”15 The January Effect is particularly illuminating because it hasn't disappeared, despite being well known for 25 years (according to arbitrage theory, anomalies should disappear as traders attempt to exploit them in advance).
The January Effect is attributed to stocks rebounding following year-end tax selling. Individual stocks depressed near year-end are more likely to be sold for tax-loss harvesting. Some researchers have also begun to identify a “December Effect,” which stems both from the requirement that many mutual funds report holdings as well as from investors buying in advance of potential January increases.
Additionally, there is a Turn-of-the-Month Effect. Studies have shown that stocks show higher returns on the last and on the first four days of each month relative to the other days. Frank Russell Company examined returns of the Standard & Poor's (S&P) 500 over a 65-year period and found that U.S. large-cap stocks consistently generate higher returns at the turn of the month.16 Some believe that this effect is due to end-of-month cash flows (salaries, mortgages, credit cards, etc.). Chris Hensel and William Ziemba found that returns for the turn of the month consistently and significantly exceeded averages during the interval from 1928 through 1993 and “that the total return from the S&P 500 over this sixty-five-year period was received mostly during the turn of the month.”17 The study implies that investors making regular purchases may benefit by scheduling those purchases prior to the turn of the month.
Validity exists in both the efficient market and the anomalous market theories. In reality, markets are neither perfectly efficient nor completely anomalous. Market efficiency is not black or white but rather, varies by degrees of gray, depending on the market in question. In markets exhibiting substantial inefficiency, savvy investors can strive to outperform less savvy investors. Many believe that large-capitalization stocks, such as GE and Microsoft, tend to be very informative and efficient stocks but that small-capitalization stocks and international stocks are less efficient, creating opportunities for outperformance. Real estate, while traditionally an inefficient market, has become more transparent and, there are REIT index products for gaining direct market exposure. Finally, the venture capital market, lacking fluid and continuous prices, is considered to be less efficient due to information asymmetries between players.
Rational Economic Man versus Behaviorally Biased Man
Stemming from neoclassical economics, Homo economicus is a simple model of human economic behavior, which assumes that principles of perfect self-interest, perfect rationality, and perfect information govern economic decisions by individuals. Like the efficient market hypothesis, Homo economicus is a tenet that economists uphold with varying degrees of stringency. Some have adopted it in a semi-strong form; this version does not see rational economic behavior as perfectly predominant but still assumes an abnormally high occurrence of rational economic traits. Other economists support a weak form of Homo economicus, in which the corresponding traits exist but are not strong. All of these versions share the core assumption that humans are “rational maximizers” who are purely self-interested and make perfectly rational economic decisions. Economists like to use the concept of the rational economic man for two primary reasons:
1 Homo economicus makes economic analysis relatively simple. Naturally, one might question how useful such a simple model can be.
2 Homo economicus allows economists to quantify their findings, making their work more elegant and easier to digest. If humans are perfectly rational, possessing perfect information and perfect self-interest, then perhaps their behavior can be quantified.
Most criticisms of Homo economicus proceed by challenging the bases for these three underlying assumptions—perfect rationality, perfect self-interest, and perfect information.
1 Perfect rationality. When humans are rational, they have the ability to reason and to make beneficial judgments. However, rationality is not the sole driver of human behavior. In fact, it may not even be the primary driver, as many psychologists believe that the human intellect is actually subservient to human emotion. They contend, therefore, that human behavior is less the product of logic than of subjective impulses, such as fear, love, hate, pleasure, and pain. Humans use their intellect only to achieve or to avoid these emotional outcomes.
2 Perfect self-interest. Many studies have shown that people are not perfectly self-interested. If they were, philanthropy would not exist. Religions prizing selflessness, sacrifice, and kindness to strangers would also be unlikely to prevail as they have over centuries. Perfect self-interest would preclude people from performing such unselfish deeds as volunteering, helping the needy, or serving in the military. It would also rule out self-destructive behavior, such as suicide, alcoholism, and substance abuse.
3 Perfect information. Some people may possess perfect or near-perfect information on certain subjects; a doctor or a dentist, one would hope, is impeccably versed in his or her field. It is impossible, however, for every person to enjoy perfect knowledge of every subject. In the world of investing, there is nearly an infinite amount to know and learn; and even the most successful investors don't master all disciplines.
Many economic decisions are made in the absence of perfect information. For instance, some economic theories assume that people adjust their buying habits based on the Federal Reserve's monetary policy. Naturally, some people know exactly where to find the Fed data, how to interpret it, and how to apply it; but many people don't know or care who or what the Federal Reserve is. Considering that this inefficiency affects millions of people, the idea that all financial actors possess perfect information becomes implausible.
Again, as with market efficiency, human rationality rarely manifests in black or white absolutes. It is better modeled across a spectrum of gray. People are neither perfectly rational nor perfectly irrational; they possess diverse combinations of rational and irrational characteristics, and benefit from different degrees of enlightenment with respect to different issues.
Notes
1 1 https://www.dalbar.com/Portals/dalbar/Cache/News/PressReleases/QAIBPressRelease_2019.pdf
2 2 Robert Shiller, Narrative