Analysis and News

Market Myths, Bubbles and the Psychology of Economic Man

Senior External Contributor: Saumya Poddar

Investing is grounded in profits and price movements; investors try to buy low, sell high andmake profits. They try to either estimate the value of an investment through fundamental analysis or predict the price movement through technical analysis. This is how traditional finance looks at the concept of investing; it assumes that investors are rational, i.e. they are risk-averse, self-interested utility maximisers (act in accordance with decisions made by homo economicus or rational economic man. 

The big assumption behind using traditional finance is that there exists a theoretic “true intrinsic price” and that the price of an investment will move to that price. This is in line with the Efficient Market Hypothesis which states that at any given time in a highly liquid market, stock prices are efficiently valued to reflect all the available information. The rationale behind this is that investors can calculate the intrinsic price and will trade according to it (buying if the market price is lower than the intrinsic price and selling if it is higher than the intrinsic price, thus pushing the price towards this apparent true price). 

It is unrealistic to believe that any investment asset will have one consensus intrinsic price. Markets move with supply and demand, which means that the price of the investment asset will move along with investor actions, towards the price believed in by most of the capital in the market. For instance, if a few small investors trading an aggregate of $1m believe that a stock is overvalued, but others trading an aggregate of $50m believe that it is undervalued, and all the investors trade in accordance with their beliefs, the stock will rise in value due to the increase in demand. This will happen regardless of whether the smaller investors were right or wrong in their valuation. Thus, what moves markets is the investors’ actions; this is ignored by traditional finance as it focuses on what the action of a rational economic man should be. 

Behavioural finance seeks to explain investor actions that go against rationality as per traditional finance. It addresses the limitations of traditional finance by incorporating psychology into investment analysis by providing an explanation for market movements where traditional finance fails, like market bubbles. 

Investopedia defines a bubble as an economic cycle that is characterised by the rapid escalation of market value, particularly in the price of assets. According to traditional finance, a bubble should not exist because as soon as the prices rise above the intrinsic value, investors, being rational, will sell the asset, therefore pushing down the price. If we take investor behaviour into consideration, a number of factors like overconfidence bias, herd behaviour, confirmation bias, etc. can explain the existence of bubbles. 

There are also various reasons in favour of participating in a bubble that will not be supported by traditional finance. During a bubble, traditional financial analysis would identify assets as overpriced, leading to investors having low or no allocations to equity during this time. Despite the risks, bubbles have given investors large returns before bursting. During the dot com bubble, between 1995 and 2000, NASDAQ rose from under 1,000 to over 5,000. An investor could identify a bubble and still cautiously participate in it to avoid the opportunity cost of staying out of it. Asset managers not participating in the bull markets during bubbles could very quickly lose clients. 

As compared to the rational economic man followed by traditional finance, a more realistic concept is Bounded Rationality which removes the assumptions of perfect information, fully rational decision-making, and consistent utility maximisation which is a more realistic scenario. This addresses the fact that there are limits to investors acting rationally. 

Incorporating behavioural finance into investment analysis and recognising that there are various factors in addition to the concepts explained by traditional finance could lead to better investment decisions. In the process of investment analysis, an individual investor should keep in mind that there is no absolute truth regarding the intrinsic price of a stock and be open to the idea that there exist behavioural biases in himself and the other market participants. Asset managers should actively try to identify the biases in themselves and their clients and be aware of them while making investment decisions, to minimise the effects of these biases on their investment activity.

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