This article is part of a regular series of thought leadership pieces from some of the more influential ETF asset managers in the money management industry. Today's article is written by Michael McClary, chief investment officer of Akron, Ohio-based ValMark Advisers, which markets the “TOPS” brand of asset allocation models.
While we believe that markets are generally efficient, it would be shortsighted not to acknowledge the irrational behavior markets sometimes exhibit in the short term.
We are often amazed at how events that might have a less than 0.1 percent impact on global GDP can sometimes wipe out 5 percent of global market cap in a short period of time.
Recent events in Greece would be an example. While Greece’s economy is only about half the size of Massachusetts, this debt-laden country helped to impact a pullback in world stocks of about 5 percent in just a week’s time.
Many times behavioral finance plays a key role in short-term market movements. Behavioral finance, according to author Michael Pompian in “Behavioral Finance and Wealth Management,” attempts to understand and explain observed investor and market behaviors. As portfolio managers, we recognize that behavioral bias is a frequent distraction for markets and investors, so we have to deal with it and build investment processes that allow for them.
To study the behavior of markets at a macro level, it may be helpful to start with the micro level. In this piece, we will review factors of behavioral finance and theories on how emotions may be exhibited in markets and investment decisions.
There is a vast body of work that has been completed in the area of behavioral finance. Accomplished researchers, such as Meir Statman from Santa Clara University, have been working for decades to outline and help explain why investors make the decisions they make.
In his book, “What Investors Really Want,” Statman outlines several key ideas, including:
- We want to be No. 1 and beat the market
- We want to nurture hope for riches and banish fear of poverty
- We want to feel the pride of profits and avoid the regret of losses
- We want the sophistication of hedge funds and the virtue of socially responsible funds
- Cognitive errors mislead us into thinking that investments with profits higher than risks are easy to find
Statman’s work is remarkable and has helped to outline why investors continue to make bad decisions and pay handsomely for their mistakes. After all, investors are all humans. Even program trading involves an algorithm that is developed, reviewed and approved by a human at some point. Nobody’s Bloomberg terminal wakes up on Monday morning and all of a sudden decides to start making trades on its own.