Behavioral Finance – Here’s Why Nobody Understands The Markets

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Behavioral Finance – Here’s Why Nobody Understands The Markets by Jared Dillian, Mauldin Economics

I used to be a big astronomy nerd when I was a kid, locked up in my room, reading space books. I actually was once interested in planetary science. Now I study finance. How depraved.

Nassim Taleb is right—finance actually is depraved. If you study finance, you study money, of course. But why is money interesting?  Because it doesn’t sit around in static piles that you shuffle and count. It can grow asymptotically, or else simply disappear.

This is true not just of stocks and bonds, but also of currencies, which are supposed to be worth something, and even commodities, which are really supposed to be worth something.

Then you have gold, which is totally useless from a practical standpoint and whose value fluctuates dramatically.

Funny thing about money exploding or disappearing is that it’s so hard to understand that we hire physicists to figure it out.

And then they come up with these really mundane solutions, like an options pricing model that doesn’t work, or a way to forecast future volatility (that also doesn’t work).

None of this ever comes close to figuring out why money explodes or disappears.

Human Behavior is Unquantifiable

The reason we aren’t any closer to the answer is because we keep using the wrong methods.

You can get the math geeks to come up with equations to describe human behavior, but then human behavior changes or does something new, and you are back to square one.

The study of money is the study of people, and people behave in sometimes predictable, but often unpredictable ways. Just when you think you have a rubric (like Nate Silver with elections, a related field), along comes a Trump who blows apart the whole model.

I’ve always felt that finance is a very qualitative discipline. You are no worse off hiring English or history majors. It’s no accident that all the heavy hitters in this business are also really great writers.

The quants are starting to catch on, and a lot of the algorithmic traders are writing programs to mimic and predict human behavior… though it’s really just technical analysis and trend following in a computer program. Technical analysis has an uneven reputation, but when you can quantify and backtest it and it works, the reputation gets markedly better.

Hard to argue nowadays that even weak-form EMH holds when you have a cottage industry of very profitable systematic strategies.

Of course, there is a lot of math behind the quant stuff, and the guys doing it are mathematical geniuses, but the best of them are also very sharp market folks with a nose for when trades start to get crowded.

The quant blowup of 2007 happened because all the smart quants were in all the same ideas. So even in the world of high-level mathematics, you still have to deal with unquantifiable stuff: human behavior.

When someone like hedge fund manager Bill Ackman sees his portfolio get slaughtered by about 20% in 2015 and then double digits in the first month of 2016, that’s not just bad stock-picking. This is what happens when crowded trades become un-crowded.

Computers may be computers, but the people who program the computers are just human and utterly fallible.

Why I Believe in Behavioral Finance

When I taught my college finance class last semester, I’d say the most consensus long among the students was Disney (DIS) because of Star Wars.

Of course, I had been doing a bunch of work on the short side for months.

Disney has some serious problems like declines in sports viewing and superhero movies and cable industry trends—secular stuff that’s completely out of their control.

Suffice it to say that by the time the MBA students in South Carolina get bulled up on a stock, it is probably pretty close to the end.

That’s behavioral finance in a nutshell.

This is what I do for a living. I watch the market, not the stocks, if that makes any sense. I am always collecting data. Every person I talk to on the phone, every chart I look at, every tweet or article I read, it all goes into the soup, and from that soup, I am trying to gauge sentiment.

Sentiment tells you everything. Cheap things get cheap, and expensive things get more expensive. Markets are alternately rational and irrational because people are alternately rational and irrational. Seems like a crazy way to allocate resources, but it works better than all the alternatives.

If you want to read more about my investment process, you can choose between the monthly version or the daily.

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