FUD Investing
You may have noted a developing theme throughout our blogs recently on the uncertainty in the markets and what impact it is having and how investors are increasingly just parking their money in cash.
You can’t blame investors for taking such an approach – especially when you start considering some of the commentary out there.
In one recent restless night, this burningpants correspondent caught an interesting interview on the BBC with a trader. Essentially, the trader said that their role was to exploit human frailty and fear for profit. Arbitrage is not driven as much by the underlying economic dynamics.
Perhaps not surprisingly, the interviewer’s jaw dropped (as did mine) when he said this – mainly because of the honesty of the guy. But it got me thinking, to what extent does human behaviour drive pricing, and whether such products actually exist to exploit these behaviours.
If so, what are the ultimate implications for ordinary investors and the issuers of these securities?
JP Morgan’s Global Dynamic Fund is one such investment vehicle. The fund is largely grounded in the concepts of behavioural finance. Indeed, they are quite transparent on this point: “Human Behaviour can create unique opportunities for investors because emotionally influenced decisions made by many investors can cause market irregularities.”
The concept of behavioural finance has a short history in academic tradition. It started with the works of Daniel Kahneman and Amos Tversky in the 1970s where the concepts of heuristic biases and prospect theory started to become formalised and their impact on economic decision making explored. Though one could arguably link it right back to Keynes’s animal spirits idea in his General Theory.
The models were very much at odds with the standard rational expectations models as articulated and formalised by Robert Lucas – upon which the efficient market theory of securities prices, the permanent income and life-cycle theories of consumption and so forth are all based on the rational expectations theory.
Empirical evidence for the behavioural biases was later presented in the Journal of Finance in articles throughout the 1980s, generally by Werner De Bondt and Richard Thaler, Peter Bernstein and Richard Sweeney. Many empirical facts which standard rationality models could not explain were discovered including the now infamous January effect.
Much debate has ensued in academia in the subsequent decades as to the utility of such ideas and whether they actually translate into profitable trading and investment strategies.
At burningpants, we’d rather focus attention on the potential implications of such investment strategies for society.
As investment banks and other investment houses start moving toward exploiting these behavioural biases amongst humans (as the above-mentioned trader readily admits), will we start divorcing prices too much from the fundamentals?
To an extent it could be argued that this has already occurred. With the rise of managed funds and now ETFs, most ordinary investors probably don’t even know what underlying securities are in the portfolio – the same goes for superannuation.
To an extent, the process of arbitrage should ensure that prices are relatively efficiently priced.
However, with increasing volatility in the markets, the desire to exploit any opportunities due to behavioural biases must be tempting.
If security prices, and equities in particular, become ever more divorced from the fundamentals of the issuer, then the question must be asked: What is the point of investing? People might as well take their cash parked in the bank, go to the local casino, put their poker hats on and play away.
OK, we admit that’s a bit melodramatic. However, another factor that might need to be considered is to what extent the non-financial corporate world is prepared to see the valuation of their companies based on a framework of fear, uncertainty, doubt and irrationality? Will they start looking at new ownership and financing forms?
After all, how does one go about maximising shareholder value on such rickety grounds as that of human emotion?
No wonder many ordinary investors are just parking their wealth in cash.
2 Comments on “FUD Investing”
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Max Mac says:
There is a disturbing lack of any moral or ethical compass in the trader’s comments. His world-view could as readily be adapted to selling tents or blankets at inflated prices to the survivors of a natural disaster. His only driver is the ability to exploit the immediate situtaion and make more money, which should not be an end in itself.
Equally concerning is the fact that this is exactly the type of attitude which is likely to be rewarded by the major financial institutions and is the same attitude which got us where we are.
He reminds me of the drowning man who is thrown both a lifebelt and a gold bar. Instead of choosing the lifebelt, he grabs the gold-bar, because do you know how many lifebelts you can buy with a gold-bar!
Mark J says:
Doom and Gloom seems to the gist of the story. It does highlight some interesting points about who the winners are when all the rest of us are losing. I’m not sure if I should be refreshed by the honesty or dismiss the alarmist and his 15 minutes of fame.