BEHAVIORAL FINANCE IN THE ERA OF GAMESTOP

BEHAVIORAL FINANCE IN THE ERA OF GAMESTOP

 

One of the hallmarks of classical investment theory is that markets are “efficient,” a concept for which Eugene Fama received the 2013 Nobel Prize in Economic Sciences. His research demonstrated that stock price movements are impossible to predict in the short-term, and that new information affects prices almost immediately, meaning that markets are “efficient.” These empirical findings led to the development of index funds, which today hold global assets of ~ $10 trillion. 

If markets are efficient, how does one explain the volatile price movements in the stock of an otherwise declining retail business such as GameStop? More specifically, the stock reached a 52-week high of $483 on January 27, 2021, before closing that day at $348 as shown in the graphic below. Over $30 billion of its shares were traded on the 27th, an amount larger than the annual GDP of Iceland. However, its share price began at $17.24, and closed February 19, 2021 at $40.59. In between these dates, its soaring market price seemed to defy any concept of market efficiency.

 chart photo

 

Now, return to the Nobel Prize in Economic Sciences awarded to Richard Thaler in 2017, and an explanation for GameStop’s stock volatility may begin to emerge. Thaler’s Nobel was for his contributions to the emerging discipline of behavioral economics, a field in which the Nobel Committee recognized his "contributions have built a bridge between the economic and psychological analyses of individual decision-making.” In short order, behavioral economics was adopted by the financial services industry, where it is now known as behavioral finance.

The table below displays some of the differences between the primary concepts of the efficient market and behavioral finance theories. A key one is that investors, portfolio managers, and stock analysts generally believe that they are making rational decisions, but unrecognized personal biases may intrude into their decision-making process.

 

Efficient Market Concepts Behavioral Finance Concepts

Markets and investors are perfectly rational

Markets and investors are normal, not rational

Investors always seek to maximize their utility

Investors are risk-averse, i.e. they value a $1 loss more than a $1 gain

Investors have perfect self-control

Investors have limits to their self-control due to individual biases

Investors are never confused in their decision-making by cognitive errors

Investors often experience cognitive errors which may contribute to wrong decisions

 

An understanding of some of these potential biases could aid investors, managers and analysts in their future decision-making, whether in finance or other life choices. While researchers have identified over 100 individual biases, let’s pare our assessment down to just a handful:

  • Herding instinct: a key driver of the GameStop mania, this occurs when investors tend to follow or copy what other investors are doing. They are influenced by emotion, social media pressure and instinct, rather than relying upon their own independent analysis. The fear of missing out on a profitable investment idea is often the driving force behind herding instinct. The dot-com bubble of the late 90s is directly attributable to this herding instinct, as is the explosive rise in just a few technology stocks today.
  • Loss aversion: this is when investors focus more upon avoiding a loss rather than making a gain. An example is when investors sell their winning stocks while they are still rising, but then hold onto their losing ones which lack any apparent source of price recovery. Whether for individual investors or portfolio managers, this bias leads to higher portfolio turnover, increased transaction costs, negative tax consequences and resultant underperformance with respect to a passive market index. When markets sell off significantly, it may even lead investors to forsake their long-term financial plan and begin aggressive portfolio trading instead.
  • Anchoring bias: this occurs when investors construct an initial mental reference point, usually in stock prices or valuation, upon which to make subsequent investment decisions without revisiting or revising their initial anchor. An example is when stock indices approach “round numbers”, e.g. Dow Jones Industrial Average at 30,000, which then impels some investors to adopt that number as their anchor for future investments without considering whether that index level is fairly priced.
  • Overconfidence and the illusion of control: this arises when investors and portfolio managers develop a false assessment of their talent, skills and intellect. As a result, they believe they can influence the outcome of uncontrollable events like future market performance. As an example, just 29% of active U.S. stock fund managers beat their benchmark index after fees in 2019, despite possessing extensive—and costly—research and analytical resources.
  • Narrative fallacy: this bias causes investors to view a series of unconnected events as stories, often constructed with logical chains of cause and effect. In fact, our minds often create more cause-and-effect links than exist in reality. Often, individual stocks become labeled as “story stocks”, because the narrative associated with their growth and superior price performance seems so intuitive. Unfortunately, some are found later to be fraudulent or having taken on excessive risk. Such examples include Theranos (breakthrough healthcare testing?), Volkswagen (innovative “clean diesel” technology?) and Wells Fargo (record customer product sales?).
  • Hindsight bias: often called the “I-knew-it-all-along-phenomenon”, this bias causes some investors to believe that, after an event has occurred, they could have predicted the outcome of the event even before it occurred. A minor example is that one supposedly knew—before the fact—that a specific stock was headed upward at a dramatic rate, e.g. Netflix or Tesla. Major examples include the number of investors who later stated that they had seen the dot-com bubble or the Great Recession coming before they occurred. Hindsight bias, by the way, often leads to overconfidence bias.
  • Confirmation bias: investors often seek out information which confirms their already held beliefs, and ignore or discard information which may be in conflict with those beliefs. This may lead to increased portfolio concentration risk, e.g. an erroneous belief that technology or cryptocurrency are the only sectors to invest in now, or to excessive reliance on a market pundit whose outlook may differ greatly from current market conditions. This bias is best summarized by Warren Buffett’s musing that “What the human being is best at doing is interpreting all new information so that their prior conclusions remain intact.”
  • Framing bias: this occurs when investors make decisions based upon the framework in which information is presented through different wordings, settings and situations, rather than just on the actual facts. Marketers of consumer package goods companies and financial services firms recognize and utilize this bias quite often. As an example, would consumers prefer a yoghurt which is “95% fat-free” or one which contains “5% fat”? They are equivalent, of course, but consumer surveys reveal that the fat-free product is the preferred one. In financial services, companies had experienced a ~ 37% participation rate for employees in their 401(k) plans when using an “opt-in” approach, i.e. sign up if you wish. When companies switched to an “opt-out” approach instead, i.e. you are in the plan unless you actively choose not to be, the participation rate then rose to 86%.

What can one do to minimize the effect of these behavioral finance biases? First, attempt to avoid reflexive decision-making as much as possible, which may be more prone to biases, emotions and social media influences. This means not “going with your gut”, which too often becomes the automatic or default option for investors. Instead, try to adopt a more reflective decision-making process, one which is both logical and methodical when approaching investment or life decisions. This approach requires a lot more effort and discipline, of course, but it enables an investor to focus on the process, and not just on the outcome. It will become the pathway to future decision-making if this approach is used more often.

The Mather Group, LLC (TMG) seeks to manage with unbiased financial planning, tax, and investment management professionals to help you achieve your financial and retirement goals. We always welcome your ideas and thoughts, which help us to maintain the currency of your financial plan. Please reach out to a team member of TMG if you have further questions which we will strive to answer with you. 

The Mather Group (TMG) is registered under the Investment Advisers Act of 1940 as a Registered Investment Adviser with the Securities and Exchange Commission (SEC). Registration as an investment adviser does not imply a certain level of skill or training. For a detailed discussion of TMG and its investment advisory services and fees, please see the firm’s Form ADV on file at www.adviserinfo.sec.gov. The opinions expressed, and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security. The opinions and advice expressed in this communication are based on TMG's research and professional experience, and are expressed as of the publishing date of this communication. TMG makes no warranty or representation, express or implied, nor does TMG accept any liability, with respect to the information and data set forth herein. TMG specifically disclaims any duty to update any of the information and data contained in this communication. The information and data in this communication does not constitute legal, tax, accounting, investment, or other professional advice nor is it intended to provide comprehensive tax advice or financial planning with respect to every aspect of a client's financial situation. Investing in securities involves risks, and there is always the potential of losing money when you invest in securities. Before investing, consider your investment objectives. Past performance does not guarantee future results

Sources: BigCharts Inc.; Bloomberg; CFA Institute; Charles Schwab & Company, Inc; Fidelity Investments; Financial Times; Investopedia; Journal of Marketing Research; Morningstar; Norwegian Nobel Committee; United Nations; Wall Street Journal


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