You may remember Eugene Fama from Econ 101. He argued that in an efficient market that includes equally well-informed and rational investors, securities will be appropriately priced to reflect all available data.¹ The rejection of the theory is represented by another breed of market analyst who believes markets are inherently inefficient, and prices are not always an accurate reflection of the intrinsic value of securities.

Enter behavioral finance, which seeks to understand how investor psychology influences decisions and which might better explain anomalies like bubbles and crashes.

A common bias that affects even the most seasoned investor is anchoring^,2 or placing too much emphasis on one factor or trait when making a decision. Loss aversion³ is a typical example of anchoring; investors get anchored to their cost basis and are so intent on breaking even, they lose focus on whether the security is still a good long term investment. Inevitably, they may lose out on a better opportunity while waiting for “their” stock to fight back.

Confirmation bias, or seeking out information that supports one’s own view, undermines the rational decision making process. In this scenario, bullish investors seek out positive data points, whereas bearish investors find negative data points.⁴ Similar to confirmation bias is herding behavior, which is most often characterized as both irrational and driven by emotion. Periods of panic- buying or -selling are examples of extreme market sentiment in which there is a clear disconnect between prices and fundamentals. These are, in our opinion, the critical times for investors to recognize the psychology of the markets and to avoid the pitfalls of emotional decision making.

The “recency effect”⁵ refers to investors placing greater relative importance on events that have occurred in the recent past. In our view, the crash of 2008 has spawned a cottage industry of bubble hunting, even though a repeat of a wholesale market drawdown of a similar magnitude is unlikely, statistically speaking. Linked to this bias is herding behavior⁶: for example, investors who overreact and shift completely out of an asset class, e.g., equities, to protect against a disastrous loss instead of looking at the potentially greater risk of inflation. This leads investors to irrationally prepare for a devastating event with a 5 percent probability of occurring and to ignore the more mundane 50 percent event.

Last, we draw attention to the concept of money illusion.⁷ For example, let us say an avid movie fan invested in a bond 10 years ago that pays $5 interest per year to purchase one ticket. Fast forward 10 years. Our fan is stuck watching matinees because his $5 interest payment no longer covers a primetime movie. He did not lose any money, but in real terms, he lost purchasing power.

The CMF Group continues to stress the importance of taking in all available information when making decisions and structuring tactical portfolios with as little emotional overlay as possible. We believe this is the best way to avoid the biases that can stand in the way of prudent and thoughtful active management.

¹http://www.dimensional.com/famafrench/2009/08/fama-market-efficiency-in-a-volatile-market.html, Journal of Finance, May 1970: Efficient Capital Markets: A Review of Theory and Empirical Work; ²Tversky, A. & Kahneman, D. (1974), Judgment under uncertainty: Heuristics and biases. Science, 185, 1124-1130; ³Kahneman, D., Knetsch, J., & Thaler, R. (1990), Experimental Test of the Endowment Effect and the Coase Theorem, Journal of Political Economy 98(6), 1325-1348; ⁴Zweig, Jason (November 19, 2009), How to Ignore the Yes Man in Your Head, Wall Street Journal (Dow Jones & Company), http://online.wsj.com/ article/SB10001424052748703811604574533680037778184.html, retrieved 2010-06-13; ⁵Murdock, B.B., Jr. (1962) The Serial Position Effect of Free Recall, Journal of Experimental Psychology, 64, 482-488; ⁶Markus K. Brunnermeier, Asset Pricing under Asymmetric Information: Bubbles, Crashes, Technical Analysis, and Herding, Oxford University Press (2001); ⁷John Maynard Keynes, Fisher, Irving (1928), The Money Illusion, New York: Adelphi Company.
Nancy Cooley, Falisha Mamdani and Jason Friedman are Financial Advisors with the Wealth Management division of Morgan Stanley in New York, NY. The views expressed herein are those of the author and may not necessarily reflect the views of Morgan Stanley Smith Barney LLC, Member SIPC, www.sipc.org. Morgan Stanley Financial Advisor(s) engage Worth to feature this profile. Nancy Cooley, Falisha Mamdani and Jason Friedman may only transact business in states where they are registered or excluded or exempted from registration. www.morganstanleyfa.com/thecmfgroupsb. Transacting business, follow-up and individualized responses involving either effecting or attempting to effect transactions in securities, or the rendering of personalized investment advice for compensation, will not be made to persons in states where Nancy Cooley, Falisha Mamdani and Jesse Friedman are not registered or excluded or exempt from registration. The strategies and/or investments referenced may not be suitable for all investors.