Like weather forecasters, economic forecasters must deal with a system that is extraordinarily complex, that is subject to random shocks, and about which our data and understanding will always be imperfect. In some ways, predicting the economy is even more difficult than forecasting the weather, because the economy is not made up of molecules whose behavior is subject to the laws of physics, but rather of human beings who are themselves thinking about the future and whose behavior may be influenced by the forecasts that they or others make. To be sure, historical relationships and regularities can help economists, as well as weather forecasters, gain some insight into the future, but these must be used with considerable caution and healthy skepticism. -US Federal Reserve Chairman Ben Bernanke
Last week we introduced the topic of behavioral finance in an article titled "The Rational Economic Man, The Irrational Politician, and You" in which we discussed the difference between the rational economic man who knows all things and makes perfect decisions, and the average human being whose emotions can lead to irrational decision making despite our best intentions. This week, we dig further into the subject by looking at how traditional finance and behavioral finance differ on a macro level.
In general, the big difference between traditional finance and behavioral finance is a question of what should happen (traditional) and what actually happens (behavioral). It is, in many ways, analogous to predicting the weather. In the morning we wake up and turn on our television and the weather forecaster tells us what he or she expects the day to be like based on all of the signs and data collected by the meteorology center at your local news station. At the end of the day when you’ve returned from work, you turn on the nightly news and they tell you what actually ended up happening. As science has evolved and gotten better over the years, meteorologists have gotten more and more accurate at predicting the weather, but it remains an imperfect art.
On a micro level, we learned last week that individual investors should act a certain way when making decisions, but often act differently in reality. On a macro level, we find this to be true as well. Traditional finance is predicated on a theory known as the Efficient Market Hypothesis. Developed by economist Eugene Fama, it basically says that it should be impossible to beat the market because the market reflects all available information. If we assume the world is entirely made up of little rational economic men making perfect decisions based on perfect information, then we can also assume that the market operates with perfect efficiency and the best return we can earn is that of the market. Of course, last week we discovered that everyone is not rational, which would lead to the conclusion that while highly efficient, the market itself is not perfectly efficient.
To illustrate my point, consider a story published in the New Yorker in 2007 by Malcolm Gladwell (you can read the full story here). The story, titled Open Secrets, is about the Enron scandal and ends with a short paragraph about how, in the spring of 1998, a group of students at Cornell University did a term project on Enron. In the course of their research, the group concluded that Enron was engaging in a very risky strategy and “may be manipulating its earnings.” Gladwell notes that the information was published on Cornell’s business school website and has been there ever since. The information was there, and yet the markets completely missed it.
There are similar stories like that of the Cornell students that prove to us that the markets aren’t perfectly efficient. What this means is that we have to be alert not only to our own decision-making, but also to what’s going on in the world. The markets may operate efficiently most of the time, but there remain discrepancies, not to mention, some markets are less efficient than others because the information about them is harder to come by. As Mr. Bernanke put it “historical relationships and regularities can help economists, as well as weather forecasters, gain some insight into the future, but these must be used with considerable caution and healthy skepticism.” Stay tuned over the next few weeks as we dive further into the behavioral side of finance and look at some of the biases we’re all prone to and how to combat them.
Gladwell, Malcolm. “Open Secrets.” Gladwell.com. January 8, 2007. http://gladwell.com/open-secrets/.
Institute, CFA. 2016 CFA Level III Volume 2 Behavioral Finance, Individual Investors, and Institutional Investors. CFA Institute, 07/2015. VitalBook file.