Sondey, John

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South Dakota State UniversityOpen PRAIRIE: Open Public Research Access InstitutionalRepository and Information ExchangeEconomics Commentator Economics4-26-2001Random Walks, Lemmings, and Behaviorism:Looking For A Market LodestarJohn SondeySouth Dakota State UniversityFollow this and additional works at: http://openprairie.sdstate.edu/econ_commPart of the Agricultural and Resource Economics Commons, and the Regional EconomicsCommonsThis Newsletter is brought to you for free and open access by the Economics at Open PRAIRIE: Open Public Research Access Institutional Repositoryand Information Exchange. It has been accepted for inclusion in Economics Commentator by an authorized administrator of Open PRAIRIE: OpenPublic Research Access Institutional Repository and Information Exchange. For more information, please contact michael.biondo@sdstate.edu.Recommended CitationSondey, John, "Random Walks, Lemmings, and Behaviorism: Looking For A Market Lodestar" (2001). Economics Commentator. Paper411.http://openprairie.sdstate.edu/econ_comm/411ECONOMICSCOMMENTA TORSouth Dakota State UniversityRandom Walks, Lemmings,And Behaviorism: LookingFor A Market LodestarJohn SondeyAssociate ProfessorRandom WalkBurton Malkiel defines a random walk as"one In which future steps or directions cannot bepredicted on the basis of past actions/ Within thecontext of the stock market, a random walk for astock's price rrteans that if is as iikeiy to fall as torise, regardiess of previous price performance(Maikiet. 1996). Essentlafly, random waik impiiesthat "winners" couid not consistently be picked.The Wait Street Journal lends credence to thishypothesis with its long-running contest of "dartsversus the experts." where stocks selected by dartstossed at the financial page are matched,performance-wise, with stocks seleaed by marketexperts. The random walk hypothesis is notparticularly popuiar in the general financialcommunity as it implies that financial managementbrings only a layer of cost - and the investor isbetter served by investing in a fund that cioseiyrepresents the overall market. "Random walk" wasderided as an academic contrivance by many in thefinancial sector. However, the hypothesis gainedsupport as financial Information fiowed more freeiyand in greater volume over time, andmarket/industry/firm transactions became moretransparent.Random walk can be viewed as a variationon the efficient market hypothesis. An efficientmarket can be proposed to exist when the foiiowingconditions hold:a. Many active, weii-infofmed, andrational investor participate in amari<et where no one individual hasany power to manipulate a security'sprice.No. 419 April 26,2001b. information is reiativeiy costless and isequally available to all investors.c. New information is generatedrandomiy, with information eventsindependent of one another.d. Investors act quickly and rationaily inresponse to new information.To a large extent, these conditions reflectthe cufrent state of securities markets. Moreover,in their presence, new information about corporations wil! be quickly incorporated into stock prices.Furthermore, price movements are independent ofone another and tend to be random in nature. Thatis, today's price change is in response to newinformation - different information from that whichdrove yesterday's price change. (Jones, 2000).The Efficient Market Hypothesis (EMH). tothe extent that it is heid, is disquieting to thefinancia! Industry. A "true believer' would have nouse for technical analysis, evidence on deviationsfrom intrinsic value, or money management skiils ingenerai; he/she would simply take what the marketgives them by buying into a fund (or seiectingindividual stocks) that is/ are representative (ablood sampie) of tbe overaii stock market.That being said, the EMH is most useful asa benchmark for efficiency; a means of comparisonbetween the ideal and the actuai. Many studieshave attributed strong deviations from EMH toinvestor overreaction and underreaction, theJanuary effect, the small-cap effect, the weekendeffect, herd behavior, momentum investing - toname a few. Most investors believe they can outperform the stock market; othenvise, they'd placetheir savings in index funds and be done with it.The decision to buy a particular stock at aparticular time and the choices among alternativeinvestments are grounded in psychoioglcai andsociological factors as weli as eoonomics, Rationaieconomic man (homo economicus) recognizes thatirrational investor behavior is normal and must befactored into the investment decision. In this day ofinformation overload, few investors are zeaiots whoascribe to only one theory of sound ittvesting; tse itfundamentai-vaiuation; technical analysis; orbehavioral reactiveness. The irony, and the focusof this paper is that as market informationbecomes more voiuminous, timely, accurate, ahduniversally available, the validity of the EfficierJtMarket Hypothesis may diminish,Fundannental AnalysisContemporary investment phiiosophy canbe segmented into four loosefy perimetered camps;fundamental vaiue, technical analysis, momentum,and behaviorist Fundamentalists attempt to aniveat a film's intrinsic value by iooking at earnings,dividends, earnings grm^rth, and income/balancesheet ratios. After calculating a stock's Intrinsicvalue with a standard formula, It is compared tomarket price to determine whether the security is abuy or a sell- John 8urr Williams, in Theory ofV^iae, was first to develop an actualformuia, the Dividend Discount Model (DDM)forcalculating a stock's fundamental vaiue. (Malkeil,1996), However, the 'value school of Investment*was inshtutlonalized by Benjamin Graham, whowith David Dodd authored Security An&fy$i$ and,individually, The Intelligent investor. Graham took aconsenratlve tack In his investment strategy;carefully drawing the line between 'speculation*and inveshnent. Per Graham, "An Investmentoperation is one which, upon thorough analysispromises safety of pnncipai and an adequateretumi. Operations not meeting these nsquirementsare speculative,'' {Graham, 1973),Technical AnalysisTechnical analysts pride themselves inbeing oblivious to intrinsic value. Rather, it is thepotential supply (sellers) and demand (buyers) for astock that matter. Technicians study price andvoiume data for trends that tend to repeatthemselves over time and form the basis for thebuy/seil decision. Appiying patterns of past stockperfonnanoe to present market data enables thetechnician to identify buy and sell signais.Momenhtm inveshngAmentum investing hinges about avariation on the theme of inertia - that a body inmotion tends to remain in motion. Hence, acompany whose growth is fiat tends to remain thatway and a stock experiencing rapid growth is likelyto do so for a considerable pedod of time.Responding to sustainable growth signals,investors exhibit femming-like behavior in rushinginto a stock, providing evidence of the "bandwagoneffecf, where an object becomes more vaiuabie asmore people buy it. Momentum investors forgosearching for hidden vaiue in perceptibiy "dead*stocks and, instead, look for companiesexperiencing some signal event that is iikely todrive stock price upward for an extended period oftime. Momentum investors tend to lag behind valueinvestors in buying a particular stock and tend tohoid the stock after value investors have takenprofits.Anknai Spirits and BehavlorlemBehavioral investing involves thepsychological analysis of overall market behaviorand individual investors, who, m the aggregate,comprise the market. According to Shefrin (2000),there are three psychoiogicai elements underlyinginvestor behavior. First, investors tend to fali backon past experience in establishing their futureinvestment strategies. The Oxford Dictionary andTheaaurvs defines the heuristic method as' asystem of education under vs^ich pupils are trainedto find things out for themselves," investorsdevelop and adhere to certain ailes of thumb inundertaking financial investments. Thesebenchmarks tend to t)e efTOf»prone and, as a resuft,most investors terKl to act in a pre-disposed andbiased manner. Investors wiil prefer certainbehavioral frames to others. Erroneous heuristicguideiines and frame dependence may, in turn,affect stock prices and move them away from,rather than toward, intrinsic value, it fotiows thatsuch behaviomMI! make markets less, rather thanmore, efficient (Shefrin, 2000),John Maynard Keynes aptly tied the term'animal spirits' to Investor behavior. Animai spirits,per Keynes, are not solely instinctive reactions tonew market Information; they are a positive for themarketplace; driving trading and transactions whenInformational signals are mixed ^ or absent. Givenuncertainty, and the lack of a clear (lodestar)course of action, animai spirlte provide the investorwith the impetus to overcome risk aversion(Matthews, 1991).At the core of investor behaviorism and thesubsequent deviations of stock prices from fairvalue and bubble creation, lies investoroverconfidence, Daniel, et al. (1998) proposes thatvariatbns In investor confidence stem from 'biasedsetf-attribution.* If the investor incomesincreasingly confident In his ability to ferret outimportam data, assimila^a and evaiuata it,ganerating ''privata informaUon" he wiii under*estimate his own forecasting errors whileovervaiuing his abiiitias as a stock-picker.Moreover, the informed, overconftdent investor wiffoverreact to his self-generated private informationand under-raact to putjlic signals (stock splitannouncements, dividend changes, insider tjuyingor selitng) that may counter or corroborate hispersonal perspective on a stock. Studies indicatethat personal overconfidance, in general, tends tobe stronger for more complex tasks (illnessdiagnoses, stock analysis) than for relativelystraightforward, but cerebral, tasks - such asmathematical calculations. The overreactlon -correction behavior in the stock market Is reflectedin negative long run autocorreiation In marketreturns such as excess volatility in stock prices(Daniel, et ai„ 1998). Moreover, publicinformation supports investors' private signals,confrdence levels rise signiflcantiy. However, whenpublic information contradicts private signals,confidence levels fail only modestiy as investorsattribute (investment) failure to external events ~beyond their control.Psychologists find that people systematically discount certain types of Information when itis inconsistent with a held set of beliefs whileplacing a premium on information that fits theirparadigm, Odean (1998) notes that ifoverconfidenttraders weigh their own (self-generated) signalsmore than public or common signals, the privatesignals will be dissimilar among traders and nssultin a higher volume of trading - than if ali tradersgave a greater weight to the common signals,Psychoiogists have opined that the motivatjonaistate is characterized by impulses (animal spirits)such as the particularly American taste for victory,perse, and aggression (Matthev>«, 1991), Applyingmotivational theory to investor behavior, Princeton'sDaniel Kahneman writing in Psychology Today(1999) proposes the followir^; (a) inve^ors(American) are enamored with their own skiils andregard themselves to be better than other investors;(b) the disutility of losses is greater than the utilityof gains, with the result that investors hold ontolosers ~ in tacit denial of having made a poorchoice; and, (c) investors like to be in control andevidence this in (too) frequent ttading to create theillusion of 3 sttuctured approach to weaittienhancement.Individuais tend to weigh more recentinformation more heavily and short weight ciderinformation, if ail the traders in the stock marketwere homo economicus, the market would act as ifit had a "single driver." Biased self-attributioninserts a "second driver* into the investment seatwhich. In turn, distorts prices and increasesvolatility (and volume) while reducing marketefficiency (Odean, 1998).Internet, Infoirnatlon Overtoad,Dimming LodestarThe modest point of the paper is thatfinancial markets will become more voiatile overtime. The added volatility, ironksaliy, will stem inlarge part from improved technology which, mtheory, should make the very same markets moreefficient and less volatile.In irratfomi Exuberance, Robert Schillertraces the various factors from the media, to thematuring of the baby boomers, to the internet, thegrowth of mutual funds, hegemony of the US in theinternational arena, that wH be behind the growth offuture market bubtiies. However, this authorproposes, it is the peculiar chemistry of optimism,hubris, and tedinology that wiil drive the market,with larger gaps between fundamental and papervalues, increased market volume and volatility, andrecurrent bubbles. In data compiled by theInternational Data Corporation, the numt>erofinternet users in the US wilt exceed 17S million by2003 (ShHIer, p. 206), The internet itseif, with itsimmediacy of information, gives the viewer a senseof empowerment; of being on top of any investmentsituation, kindling investor confidence and hencesupport for high market valuations. The number ofon-line brokerage accounts ~ while growing rapidly,has much further to go till the saturation point. Online accounts numbered 3.1 million in 1999 and areprojected to grow to 9 million in 2003 (Schiiler),The potential for explosive growtti in on-iineaccounts wiii become a reality if 1%-2% of Did Ageand Survivors insurance tax (6.2% per individuai) isallowed to be funneled into private accounts. Online investing generates an exuberance of its own,boosting confidence, trading, and voiatility. Internetinvestment and financial sites can provide theinvestor wth encyclopedic infonnation about aparticular company or industry wHh a keystroke.However, the torrent of information nowavailable to the individual investor is not withoutcost. More than forty years ago, Herbert Simonidentified two factors which tended to negaterationality in decision-making: (a) because of timeconstraints, it is not possible to consider ai! theInformation necessary to arrive at a rationaldecision; and (b) there are insufficient Inner*programs to properly digest aii the infofmation,resulting in informational overload {Schwartz,1S98). In the mtemet age, Simon's axiom holdstruer than ever; finite timeframea piua overloadtransiate into iess rational decisions.Thus, a critical determinant in Investorpsychology Is over-confidentse (weak case) orhubris (strongcase). There are strong elements ofboth empowerment and the casino involved in omline investing which are heightened by the never-diminishing waterfall of fresh information. Internetinvesting has become the perfect cottage industryfor the 21** century; low barriers to entry, perfectinformation, and innumerabie price-taking ffinms,"The irony is that more perfect information ispresumed to move prices more quickly toward aninherent value. And well it might, absent hubris,frame and heuristic dependency, and investors'psyche, .SISyCKSRAPHYDaniel, Kent, Dewd Hlrshlisfer, and Avfandbar Suttfahmanyan.nnveslor Psychologyand Seairily MarketUnder ~ endOverreaceon," Jotm$} of Finanae, voi, Llil, no,e, pp.1S39-1S0S.GreheftJ. Senjamin, The InteSpenf Invdsfor, revised 3 ed,.New Tofk, Haiper and hew, 1973."Tho Irrationaf investor,' in Psyctiohgy Today, (no author)January 16 . page 16;Jones, Charts P, }nvest!mats,T^ ed.. New York, John Wiiey &Sons, 2006.Keynes, John Mayhard, The Gamrsi Thaoryof Empkiyrr^ot,intamaf and Money, NewYork, Hartwurt Brace andWofid, 1936.Maildel, Burton, Random Wa^ Down WaB Street, New York,W.W, Norton, 1^.MatdMgws, Robin, 'Animal Spirits," in Jay Meeks, ed-Econon^ Men, Oxford, CambridgeUrwverstty. 1981,Odean, Terrance, 'Vdume, Volatiiity, Price, end Profit, WhenAii Trades are Atxjve Average," Joumei of RnarKe, voi.Uii, no.6, December, 1898, pp. 1887'1934.Scheftin, Her^, Beyond Greed end fear, Boston, HarvardBusiness Schod, 20®).SchHter, Rotjert J„ irrationat ExuOerence, Princeton, PrincetonUniversity Press, 2000.Schwartz, Hugh, RstioneMy Gone Awry, Weelport, CT,Praeger, 19^.SCONOMiCS CmmHTATORSCONOkdCS DtmASTMENTJMm S&K UaiventSyaro0fcxaas.SD S7007J>S95Pbcsae; |605} 6»S4HtF«xStavar Hsiay^^sdsUts.Miui«s{«es oftfels visnspevtiwjeJ W»rest ofiess ifeen SJOO

Random Walks, Lemmings, and Behaviorism: Looking For A Market Lodestar

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Random Walks, Lemmings, and Behaviorism: Looking For A Market Lodestar

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