- Investor biases can affect how the stock market behaves, leading to extreme and varied movements in stock prices.
- Investors who focus too much on the short term can miss out on opportunities.
- Stocks react differently to news. It takes research and investment experience to analyze how they might react.
Investors could learn a lot from Richard Thaler, who on October 9 won the Nobel Memorial Prize in Economic Sciences for his work on behavioral economics. Thaler’s key research was understanding economics and finance in terms of how people actually behave, rather than what had thus far been defined in economic theory as “rational” or “optimal” behavior. His insights about investor biases and market inefficiency have important implications for investment management and retirement planning.
Biases Can Drive Markets
In finance, the field of behavioral economics has its roots in separate works by John Maynard Keynes and Benjamin Graham in the 1930s, but it has blossomed in the past 30 years. Capital Group has also been involved in supporting this research, via the Robert Kirby Professorships, established in memory of our well-respected colleague who passed away in 2005.
Thaler developed groundbreaking insights on how the stock market behaves and how investors behave in response to stock movements. His most-cited paper is “Does the Stock Market Overreact?” Published in The Journal of Finance in 1985, it was an influential study of market inefficiency that continues to be relevant for investors today.
It had been known for a long time that people tend to attach too much weight to more recent information, also known as a recency bias. Thaler and his co-author, Werner De Bondt, found evidence that this tendency has affected stock market behavior in the following ways:
- Extreme movements in stock prices tend to be followed by price movements in the opposite direction.
- This effect has been much larger for losers than for winners.
- The effect has mostly occurred in the second and third years following the initial price movement.
Over the subsequent decades, further research has refined their findings. For example, Andrei Shleifer published a paper in 1998 showing that over longer horizons of three to five years, stock prices overreacted, especially to consistent patterns of news like earnings releases.1
Investors can take away a couple of key points from Thaler’s research.
First, longer investment horizons matter. Investors who focus on the short term may miss these opportunities.
Second, when we dig into the details, stocks don’t always react in the same way to news. Some react a lot more than average; others may not react at all. It takes research and investment experience to tell how they might react. A mechanical approach — such as an algorithm that does not involve human discretion or a rule based only on past returns — is unlikely to lead to the best results.
The bottom line: The equity market is not efficient, but this fact can be exploited by managers with longer investment horizons.
Thaler also pioneered the area of individual behavior by finding that investors bring a range of biases in trying to achieve financial security. He devised a simple but profound solution to one of these biases, namely the tendency for people to believe that they are financially strapped and therefore find it impossible to save. His program — Save More Tomorrow — in which employees sign up to automatically increase savings in future years, is now widely used in defined contribution plans in the U.S. and has resulted in significant increases in the health of many people’s retirement prospects.
1 Barberis, Nicholas, Andrei Shleifer, and Robert Vishny. “A Model of Investor Sentiment.” Journal of Financial Economics 49 (1998): 307-343.