When Daniel Kahneman shared the Nobel Memorial Prize in Economic Sciences in 2002, it was music to the ears of Carol Clark. The music has been sounding sweeter ever since.
The recognition was unusual because Kahneman is a psychologist, not an economist. He was honored for his pioneering work in theorizing that emotions count for more than rational thought in influencing economic behavior.
For Clark, a money manager at Lowry Hill Investment Advisors in Minneapolis, it was an affirming moment. She had been in Kahneman’s camp for years, when it wasn’t such a fashionable place to be.
Mainstream economic and financial theory held that investors acted rationally, and so did the stock market. Kahneman’s award signaled revisionist thinking. Behavioral finance has been picking up ground ever since.
With the rebounding stock market now reaching highs for the year, the new focus on market behavior offers a timely reminder of the importance of focusing on longer-term swings in the market instead of the day-to-day ups and downs in stock prices.
“I’ve sort of felt that with behavioral finance, I’ve found my niche,” says Clark.
Carol Clark’s journey is one of many signs that this field is wielding more influence in finance and investment circles. Economists Richard Thaler at the University of Chicago and Robert Shiller at Yale University are the most visible leaders in this rise.
Thaler and Cass Sunstein, a law professor who is now a White House adviser, wrote “Nudge,” a 2008 book about how people can make better choices. Shiller is credited with coining the phrase “irrational exuberance,” a reference to the bull market of the mid-1990s. He helped develop the Case-Shiller Index, which tracks housing prices and has become one of the most frequently cited measures of the economy.
Doubts about efficient market
For decades, the “efficient markets” theory prevailed in the highest echelons of academe and corporate finance. A central proposition of this theory holds that prices of stocks will “fully reflect” available information and thus steer capital to its most efficient uses. In short, the stock market is a pretty rational place that gets prices right.
Even today, Clark notes, the efficient markets theory remains embedded on college campuses and at the CFA Institute, the global nonprofit that manages the accrediting of investment professionals.
But the theory didn’t add up for Clark, who manages $600 million at Lowry Hill for 30 wealthy families. “I never believed it,” she says.
Nor did others looking out from the trenches of money management. Day after day, they got a dose of reality that didn’t square with the efficient markets theory being taught in so many MBA programs and economics classes.
“I do think markets are reasonably efficient most of the time,” Clark says.
But whew! What about those other times? They are hardly footnotes.
“We’ve set ourselves up for more volatility in the markets,” says Clark. She cites staggering increases in the assets of mutual funds, 401(k) assets and pension funds over the last 30 years and far greater trading in the market. Thus, when the markets get in a particularly bullish or bearish mood, mass psychology kicks in — more than in the past — to amplify the swings.
Not so tiny bubbles
The seesaws take investors up to the heavens and then back to earth again. Think the dot-com bubble and its subsequent bursting in 2000. Or last fall’s financial meltdown, which triggered a deep decline in the stock market, followed by this year’s considerable rebound.
Clark didn’t go to the University of Chicago, where economist Eugene Fama became famous as the father of the efficient markets theory. Fama and his disciples, who came out of the “Chicago School of Economics,” built elegant mathematical models which, they argued, showed that the market operates in a reasonably predictable way.
Instead, she went to William Woods University in deepest Missouri, halfway between St. Louis and Kansas City. The school has a strong equestrian curriculum, which drew her interest. Clark liked horses and was pondering a career as a veterinarian.
She graduated summa cum laude in spring 1983 with a business degree. Then she joined the Edward D. Jones investment firm in St. Louis. Her superiors there asked her to clip out obituaries from the newspapers, to help the firm identify and eventually solicit the business of well-heeled survivors who came into inheritances. Turned off, she headed back to her native Minnesota, to a job as a junior securities analyst at Piper Jaffray.
While at Piper, she earned her Chartered Financial Analyst designation, a lengthy and exhaustive process that exposed her to efficient markets theory.
Clark recalls an eye-opening experience during a particularly bullish day at Piper. She was standing near a trader who took a call from an East Coast money manager. “Buy me 5,000 shares of anything and then call me and tell me what you bought,” the caller told the trader. The thundering herd was buying mindlessly.
Spotting holes
“That was my first clue that there might be holes in the efficient market hypothesis,” she says.
In 1987, she moved to First Trust in St. Paul. She remembers clients there who held stocks for decades because of family traditions, despite solid evidence that they should be sold. “It doesn’t take you very long, sitting across the table from investors, to realize that most people are very emotional about investing,” she says.
In 1993, she joined Lowry Hill. In recent years, she has been delivering presentations and writing advisories that draw on advances in psychology, neuroscience and medical technology to describe how a grasp of behavioral finance can help investors.
Her presentations are laced with cartoons and colorful business magazine covers that illustrate the powerful force of mass psychology in pushing stocks up and down.
“We’re not really wired to be investors,” she says. “We want to run with the herd and run with the crowds.” She mentions surveys showing that up to half of the respondents knowingly gave wrong answers rather than go against the crowd.
Riding the emotional cycle
Clark cites a “cycle of investor emotions” that drives prices up and down even as the intrinsic value of an investor’s stock steadily rises: optimism, excitement, thrill, euphoria, anxiety, denial, fear, desperation, panic, capitulation, despondency, depression, hope, relief and back to optimism again. Euphoria is the time of maximum risk; depression, the moment opportunity knocks.
The public capital markets are organized “to bring out the worst in our ancient wiring,” she wrote in one recent advisory. “By their very nature, the markets are not predictable.
“We place a greater weight on the story that we just heard than on more verifiable or logical long-term, but distantly experienced evidence. We want desperately to believe that those we view as successful are experts, even if their advice does not make sense or is not meaningful to our specific situation.”
If only we would recognize our natural shortcomings, she says, we could then learn to deal with them. “Behavioral finance is fascinating, but sometimes it can be difficult to implement.”
Yet there are ways. Clark says we can short-circuit our innate wiring in matters of money by filtering out the deafening noise about the market — the meaningless predictions, the daily deluge of largely useless data, the endless media speculation, the unsubstantiated claims about why the market moved this way or that over the last day, hour or minute.
Investors can limit risk through sound allocation of assets. By thoughtful planning, they can exert some control over taxes, fees and costs. They should never forget that no bell rings to announce market tops or bottoms, and no magic box filled with fancy equations can banish risk.
Recent developments have showered her with fresh material, including a new book by Justin Fox — “The Myth of the Rational Market” — and more huge swings in the stock market. In October 2007, the Dow Jones Industrial Average peaked at 14,165. Just 10 months later, it was below 12,000 and by October 2008 (after the Lehman Brothers failure and the financial meltdown), it was down to 8,519. In March, it bottomed below 6,600. Then came a sharp rebound, which has boosted the average above 10,000 again.
As Thaler wrote in the Financial Times this August, the efficient markets theory that “the price is right … is in more trouble than ever.”
That’s no surprise to Carol Clark. She is ginning up a new presentation for her clients, recounting the many bubbles that have visited the financial markets over the centuries: “Bubbles and Busts, Mania and Panics: The Myth of Efficient Markets and Rational Investors” is her working title.
“If you look back,” she says, “you would have to say there’s something seriously wrong with the idea that investors are rational.”
Dave Beal writes about business and the economy. He can be reached at dbeal [at] minnpost [dot] com.
Interesting read. A couple of thoughts come to mind:
– In the pre-internet days, brokers and their proprietary in-house research were at the center of most stock transactions and stock ownership was most prevalent amongst the upper echelon of society.
Today, any person with a minimal amount of money to invest and access to the Internet can buy and sell at a whim for a price. Throw in a healthy dose of tweets, e-mails, blogs and 24/7 talking heads and one has to wonder if P.T. Barnum has found a new vocation. John Houseman has been replaced by an obnoxious toddler spitting up on a keyboard or lambasting his caddy. Louis Rukeyser has been replaced by Jim Cramer.
– Information sources were more limited in the day. You had four networks with nightly newscasts, plus daily papers. You followed daily changes in your stock by reading the morning paper with the day’s previous activity. Volume was in the millions–not billions of shares.
Today, in addition to having almost real-time data flowing during the trading day, you also have the ubiquitous “stock futures” number you hear before 9:30 am Eastern, and “after hours” trading following the 4:00 pm Eastern close. Or the ever-popular “volatility index.” Trying to sort the real information from the noise is challenging all by itself.
“A central proposition of this theory holds that prices of stocks will “fully reflect” available information and thus steer capital to its most efficient uses. In short, the stock market is a pretty rational place that gets prices right.”
If it doesn’t, what purpose does it serve? It becomes little more than a casino with better odds than Vegas, despite a group of insiders with their thumb on the wheel and cards up their sleeves.
I think part of the market’s volatility is caused by the fact that a lot of money is “passively” invested in index funds that follow the market, rather than setting it. The market setters are now a shrinking group of high-stakes gamblers and insiders. The more volatile the market, the more those folks make. They are always one step ahead of the passive investors, selling a little earlier when prices fall and buying a little earlier when prices raise.
The biggest problem is not that there is too much information, but that the markets are largely opaque. The price of stock is set by people with more information than the market and they are getting rich in the process. Even the guys at Lehman Brothers walked away from the company’s bankruptcy with to their mansions in the Hamptons.
Robert Shiller is often credited with coining the term “irrational exuberance” but he gives that credit to Alan Greenspan, though, more likely it was an anonymous Fed speech-writer. He does deserve credit for prompting Greenspan to use the phrase as they met shortly before Greenspan’s speech.
Also, unlike Greenspan who never seemed to take it seriously, Shiller had the wisdom to spot the phenomenon and write a book warning of it (and a second edition warning of the housing bubble). Both came out in time — that is before the bubbles burst.
This is an excellent article. Thank you. I enjoy watching a couple of stock prices over time and am always surprised that investors seem to ignore the most basic information such as income statements that show losses year after year. One wonders why investors are willing to drive up stock prices in such cases–apparently they like giving their money away. Investors who believe in fairy tales can and do often drive up such stock prices for a time but, over the longer term, the market does seem to be efficient. Those investors who love fairy tales lose money.
The spinners of fairy tales such as Madoff have often made off with the moola of the greedy and foolish. Petters too sang a pretty tune. Ah, the siren song of unlimited wealth and gold and silver.
The US economy carries about $20 trillion of excess debt. Until that debt is eliminated, the idea of a healthy boom is a mirage.