Bias and Exuberance

It is rather interesting reading Robert Shiller's book 'Irrational Exuberance' after/during a major market crash given that it was written at the height of the bubble in 2000.

Chapter 2 lists a number of precipitating factors that he believed led to the bubble.

1. The baby boom and its perceived effects on the market
2. A Republican Congress and Capital Gains Tax cuts
3. Cultural changes favouring business success or the appearance thereof
4. Triumphalism and the decline of Foreign Economic Rivals
5. The arrival of the Internet at a time of solid earnings growth
6. Expansion in media reporting
7. Analysts increasingly optimistic forecasts
8. The expansion of DC pension schemes
9. The growth of mutual funds
10. The decline of inflation and the effects of money illusion
11. Expansion of the volume of trade: discount brokers, day traders and 24 hour trading
12. The rise of gambling opportunities

An interesting quote is:

'... it is worth remembering that there is no air-tight science of stock market pricing. Economists have certainly made progress in understanding financial markets, but the complexity of real life continues to prevail.'

In order for you to believe that it is possible for investors to be able to destroy the work done by good managers by exhibiting the wrong behaviour, you have to reject the efficient market hypothesis (EMH). That is an extension of believing that it is indeed possible for there to be good managers.

The argument in favour of index funding because of the average manager fund not out performing the market while incurring additional costs, implicitly accepts the EMH.

If the EMH holds, basically the timing of entering and exiting funds shouldn't really affect the chance of you performing better or worse than the fund you are invested in, since the price is always fair.

I have so far worked through the first half of Barberis and Thaler's (2003) Survey of Behavioural Finance. The arguments of Behavioural Finance to counter the EMH are centered around two major areas. The first is 'Limits to Arbitrage', where the argument is that even when the market is incorrectly priced, mechanisms to correct the mispricing are limited. The second is Psychology and looks into the various biases that people exhibit.

The most striking thing for me is that it seems self-evident that the psychological errors in particular are clearly real. The argument over whether markets are rational and always correctly priced seems to be a distraction from trying to find ways to correct the investor biases. They also seem so consistent with biases people exhibit beyond the world of finance that the problem is one that the field of finance can learn a lot from areas outside of our traditional academic world.