Why Behavioral Finance Matters.

When you think of the stock market, what comes to mind first? Apple? Amazon? Algorithms? Those are some of my first thoughts. We’ve come a long way from the time when railroad stocks were hot and ticker tape was considered high-speed. One thing hasn’t change though, but I’ll save that for later. With so much information at our disposal, we as investment professionals sometimes forget its derivative. The unemployment rate is a number, Household Debt is a number, and Aggregate Price to Earnings is a number. We look at these numbers and try to asses where we are in the business cycle and use that to make prudent decisions. The headline numbers give us a feel for the situation, but if not on guard, anecdotal evidence is more likely than not to be what persuades a human decision.

                Back to the initial question: “When you think of the stock market, what comes to mind first?” What causes stocks to move? What causes the unemployment rate to change? What causes household debt to change? 

People

             When we look at Price to Earnings ratios of the largest 500 US companies, one could argue that stocks are overvalued. This is confirmed when we smooth out earnings over the past 10 years. We sometimes look at stocks as inanimate, opaque and ominous mechanisms. When a company issues debt, goes public, makes an acquisition, misses earnings or goes bankrupt it is really just a chain of decisions made by people.  When household debt climbs, massive amounts of different people make individual transactions, for specific reasons to contribute to that number.

                There is a story behind the numbers and sometimes that is what is forgotten. More importantly, the story is played out by a multitude of imperfect and often fearful protagonists. Stocks don’t boom and bust because they feel like it. People cause these changes based on emotions, and on occasion based on analysis. Even the most seasoned professionals fall prey to emotion, after all we aren’t robots. Speaking of, algorithms are programmed by humans. They are human decisions, based on rules, made at lightning speed.  Rules seem to be a step in the right direction, but the rules must work after all. One example is low volatility ETFs. When more and more individuals put money into an index fund, that fund puts money in the same stocks every time-no matter valuation. This may cause a smooth ride for specific stocks that, under a situation where an index wasn’t so prominent, would be quite volatile. Sometimes rules are meant to be broken.

People make mistakes. People run the markets. As Soren Kierkegaard put it, “life can only be understood backward but must be lived forward.” That is why Behavioral Finance is so important to study.

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