Game Theory, Behavioral Finance, and Investing: Part 3 of 5

In this post, I continue the discussion of behavioral finance with examples of some of the key behavioral biases and where they can be seen in recent market behavior.  The specific focus of this post is those biases that drive investment fads and bubbles.

Recency Bias

It is almost invariably the risk that we ignore that really hurts us.  The market today is, for the most part, discounting inflation risk.  Historically, inflation has been a major threat, especially to bond investors.  Today, with yields at historic lows, the implied inflation expectations are exceedingly low.  The process by which the market comes up with rationales as to why a risk, that has historically done major damage, no longer matters is at the heart of every bubble.  We have had the housing bubble (in which investors became convinced that houses were an infinite source of capital appreciation), the Tech bubble (in which investors decided that valuations based on earnings were irrelevant) and now the government debt bubble (in which investors are implicitly assuming that inflation risk is no concern).  The bubbles get out of control largely because people assume that what has worked recently will continue to work.

The belief that what has worked recently will continue to work is a key cause of under-performance by investors.  If you bought a small amount of Tech stocks in the mid- to late-90’s and saw the value of your investment surpass the rest of your portfolio, it would have been very tempting to increase your allocation to this sector.  If the strategy continued to out-perform, you might shift even more of your portfolio into this sector.  By the time the bull market in Tech stocks had run its course, you might find yourself with a very high exposure to losses.  The opposite of this bias is also evident.  Rather than buying stocks when they are cheap (after a decline), investors tend to assume that the decline will persist.  This effect is well-documented in the behavior of retail investors.  Analysis of investor sentiment by the American Association of Individual Investors (among others) shows that investors are most confident in equities right before a stock market decline and most bearish just before a rally.

Individual investors show clear evidence of recency bias in their timing.  DALBAR, a research firm that studies investor performance, consistently finds that individual investors buy high (after the market has gone up) and sell low (after the market has dropped).  In doing so, individual investors substantially under-perform the broad indexes.

Love of Lotteries

Gambling is one of the least-rational economic behaviors.  When people go to a casino, the odds of the games that they play are skewed in favor of the house.  Clearly, there are plenty of people for whom this is not a deterrent.  There is a literature that demonstrates that certain types of investments will attract people in the same way that people are attracted to gamble, even when the odds are stacked against them.  The small chance of a huge win is so viscerally appealing that people will play.  This tendency is clearly evident in the market.  How else can we understand the enormous attention visited on Groupon (GRPN) when it went public?  This is a company that has seen its value drop by 82% since it went public in November of 2011 and which is still worth more than $3 Billion, despite not being profitable as yet.  As recently as February of 2011, the stock was worth almost five times what it is worth today.

Source: Yahoo! Finance

Similarly, we can look at Zynga (ZNGA):

Source: Yahoo! Finance

People invest in these companies in order to take a gamble.  Sometimes it works out, but often the results are not impressive.  Investors have to be aware that they are taking a long-shot bet, but the potential for a massive win—however small—convinces people to take a swing.

Wall Street does a great job of selling IPOs, aided and abetted by the financial media.  The period leading up to recent IPOs reminds me of advertising for the state lottery.  Both the lottery and hot IPOs share the feature that they target an irrational belief that, against all odds, we might receive a windfall. 

Underperformance of Glamour Stocks

A more subtle effect than the ‘lottery ticket’ bias is the desire to own stock in companies that we admire.  The problem is that great companies are not always great investments.  Chipotle (CMG), for example, is a great company, but the fact that Chipotle makes a very good burrito does not necessarily mean that the stock is a good deal.  Chipotle stock was trading at $440 per share in mid April and recently (October 2012) closed at $243, a decline of about 45%.  The problem for the firm has mainly been that the expectations were far too high.  At the current price, the stock trades at a P/E ratio of 29.5, as compared to Starbucks (SBUX) at 25.4 and Panera (PNRA) at 31.3.  The recent massive decline in the price has brought the valuation down to the level of comparable well-known retail food and beverage chains.  Prior to this decline, however, investors were ignoring that the fundamentals did not justify the price, when compared to comparable brands.  Seeing a price in which investors ignore the fundamentals is a not uncommon trait of companies with well-known and well-liked brands.  These are often referred to as ‘glamour stocks.’

There is a long literature showing that glamour stocks, those that get a lot of attention and that have well-known brands, do not deliver attractive long-term returns.  Restaurant chains and other retail stores are often in this category because they have such high brand recognition and people want to be associated with these brands.  Facebook also falls into this category.  The company was heavily followed in the media and promoted powerfully via a constant stream of articles and, of course, a feature film.

Just so that I am not accused of hindsight bias, I will note that I see LinkedIn (LNKD) as a clear example of a glamour stock for which the price has gotten far beyond what the earnings will justify.  LinkedIn is a great tool, but its price assumes a rate of growth in earnings that is certainly a stretch goal.  The current P/E ratio is 900.  Amazon (AMZN) is another stock that I believe can be classified as glamour stock.  With a current P/E of about 3000, investors are simply enamored of the brand.  Amazon is an amazing company, but the growth necessary to justify this level of valuation is incredible.

What it Means

The behavioral anomalies that I have discussed here are the key drivers of investment fads.  When you combine the appeal of lotteries (love of lotteries) with a rally in a stock (recency bias), and you have a stock with a brand name that people admire (glamour stock), you have the perfect recipe for bad investing decisions.  I have been awed this year observing the sheer power of these biases when they are all combined, Groupon and Zynga are merely two examples.  I increasingly believe (with no evidence) that the people bringing these stocks to market are well-versed in these biases and exploit them very well.  The big lesson here is to recognize that stock in many companies may be pitched to investors in the same ways that other products are marketed.  The goal is to reach beyond the rational and to attract people based on visceral appeal.  In general, investors will receive far better returns if they steer clear of these pitches.

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One thought on “Game Theory, Behavioral Finance, and Investing: Part 3 of 5

  1. Pingback: Game Theory, Behavioral Finance, and Investing: Part 4 of 5 « Portfolio Investing Blog: Portfolioist

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