Reason #2 Why Markets Are Not Efficient: People Are Emotional

Last update on Sept. 19, 2013.

 

The 'Efficient Market Hypothesis' (EMH) is like a religion. Believing in it has a dramatic influence on the way you actually invest. Plenty of financial advisors believe in EMH, which makes this subject very relevant for us. In this series, we discuss what EMH is, why it's wrong and why that matters.

In part 3, I raised the first real objection to EMH, which is that people often act stupid when it comes to investing. In this installment, I launch a second volley against the EMH. I can summarize today's argument in this single sentence:

People act with their emotions.

What I Learned From Playing Settlers Of Catan

My biggest achievement in life, second to getting married, was winning the Canadian Settlers of Catan championship. For those of you who don't know, Settlers of Catan is a very famous board game. I played the game religiously, and I even got involved in an online forum that discussed strategies for the game. You can go ahead and call me a big geek.

In 2004, I got to learn about this little known Settlers championship. I beat out 23 other people, and won. My prize was a trip to Germany, where I represented Canada in the world championship. I'm sorry to say that I didn't do very well over there. The dice rolls just didn't favor me, or at least that's my excuse.

I learned a lot from playing Settlers. In Settlers, you can rob another player. I did everything I can to persuade another person not to rob me. I would often explain in detail why someone shouldn't rob me, and/or why someone should rob someone else instead. Sometimes, my persuasion worked, but more often, it didn't. Not because the other players had different explanations - they often didn't know enough strategy to offer counter-arguments. But they ignored my argument because by talking a lot, I drew the players' suspicions.

That suspicion alone was enough to make them rob me, time and time again.

What does this have to do with EMH? Like in Settlers, people don't form rational reasons before they act in the financial markets. They act with their emotions.

Why Irrational Behaviour Breaks EMH

EMH assumes that investors make purey rational decisions. In other words, each investor invests after they've gathered and analyzed all the available data. This means EMH assumes that each investor pores over the company's financial statements, press releases, and everything else. Based on these data, investors take action if they think that a financial asset is mispriced. This is like a player at Settlers of Catan carefully considering all the possible moves, and making the optimal move that will help him/her win the game.

Not going through this process, or even doing it wrong will make the markets inefficient. Suppose that a company's true worth is $20 a share, and it's priced at $15 a share today. If an investor calculates the value incorrectly and concludes the company is only worth $10 a share, the investor will make the wrong decision and sell. This moves the price of the shares closer to $10. In other words, EMH breaks down if investors don't act rationally.

Yet ask any competent salesperson, they'll tell you: people don't act rationally.

Irrational Behaviour 1: Social Proof

One of the most famous books on sales and marketing is a book called 'Influence' by Robert Cialdini. In this book, Cialdini explains 6 principles that one can apply to influence other people's behaviour. You can read a brief synposis of the 6 principles here.

One of the influences that Cialdini talks about is called 'Social Proof'. Basically, it means that people copy other people. If your friend owns Apple stocks, you're more likely to own it too. Ask people who bought Apple stock, and you'll find that for the most part, people haven't taken the time to read and interpret Apple's financial statements. They just heard from somewhere that it's a good stock own.

Irrational Behavoiur 2: Positive Emotional Feedback Loop

Cialdini's book doesn't capture all of our psychological quirks, of course. There's also one irrational influence not mentioned in Cialdini's book, that's also very relevant in the investing world. I'm referring to the phenomena where people expect past results to continue into the future.

In Canada today, there's a prevailing idea that real estate is a good investment. If you ask somoene why they think real estate is a good investment, they're not likely to tell you something like this: "because my home is worth twice as much as it was 10 years ago".

If you think about it, this is not rational. Going to back to the example of stocks, let's say analyzing the company's financial statements lead us to think the company is worth $20. But the company's stock price has been on a tear, going from $15 share to $25 a share. In the meanwhile, there's been no significant news. What do you do?

The rational decision is to sell. The higher the price, the less attractive it is to hold it. However, the human mind works in the opposite way. When the stock goes from $15 to $25, the investor feels good. They just experienced a positive emotional feedback. They're therefore likey to try and hold it for longer.

Other investors will watch the stock in envy, and they'll feel the urge to participate. They missed out on the stock going from $15 to $25, but it feels like it'll go up to $35. Seeing the stock go up almost every day tricks them into thinking it'll go up tomorrow. So they buy.

Why Bubbles Happen

Do you ever wonder why bubbles happen? It's not because there's a rational reason. There's no rational reason why the money losing eToys.com was worth some $8 billion during the internet bubble, for instance. It's because of social proof and the positive emotional feedback loop. During the internet bubble, everyone bought internet stocks because 1. everybody was buying it, and 2. internet stocks kept going up.

Bubbles are not limited to stocks, of course. Bubbles came and went for U.S. real estate as well as for gold in recent years. It even happend to tulips in Holland in the 17th century.

Secret To Investment Success

The bottom line is, investors are not rational, and no one is immune from our own emotions, including investment professionals. No wonder then, when an interviewer asked fund manager Mohnish Pabrai what his secret was, he simply stated.

Pabrai: "Control over my emotions"

Interviewer: "That's it?"

Pabrai: "It's huge. You'd be surprised."

Food for thought.

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