The Evidence that Emotion Dominates Market Pricing

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Last week, I introduced the concept of behavioral portfolio management (BPM) as a way to build superior portfolios.

BPM is built on the dynamic interplay between two investor groups and rests on three basic principles. I will discuss the first basic principle in this article, the second in a series of five.

What is BPM?

BPM posits that there are two categories of financial market participants: emotional crowds and behavioral-data investors (BDIs). Emotional crowds are made up of investors who base decisions on anecdotal evidence and emotional reactions to unfolding events. Human evolution hardwires us for short-term loss aversion and social validation, which are the underlying drivers of today’s emotional crowds. On the other hand, BDIs thoroughly and extensively analyze behaviorally driven price distortions and build portfolios based on these distortions.

Basic Principle I: Emotional crowds dominate pricing

BPM posits that the emotional crowd usually dominates the price discovery process. This means that prices infrequently reflect true underlying value. Even at the overall market level, price distortions are the rule rather than the exception.

For many market participants, this principle is uncontroversial. The chaotic nature of the stock market shows little outward signs of rationality. Prices swing wildly based on the latest events or rumors. For many investors, the contention that prices are emotionally determined is consistent with their market experiences. But it is necessary to examine stock price data to truly grasp the importance of emotions in the price discovery process.

There is considerable evidence that stock prices are not driven by fundamentals and that emotions play a major role. Robert Shiller highlighted excess market volatility in 1981 and it has been hotly debated since. But after 30 years of empirical efforts to explain excess volatility and prove the efficiency of markets, Shiller (2003) stood by his initial assertion:

After all the efforts to defend the efficient markets theory there is still every reason to think that, while markets are not totally crazy, they contain quite substantial noise, so substantial that it dominates the movements in the aggregate market. The efficient markets model, for the aggregate stock market, has still never been supported by any study effectively linking stock market fluctuations with subsequent fundamentals.