Behavioral Finance

Nobel Laureate Robert J. Shiller found in his early research that historical dividends can be modeled as a relatively smooth time series. Moreover this function can be used to interpolate (predict) future dividends with great accuracy. This is depicted in the graph below by the function “PDV, Constant Discount Rate”. The graph is taken from the Journal of Economic Perspectives, Volume 7 Number 1, published in 2003.

Fundamental Value of Stock Prices

What is so significant about this? Well, our 101 finance course tought us that the value of a stock is the discounted value of all future dividends. Those seem to be quite stable according to Shiller’s findings. However the stock market, S&P 500 in Shiller’s research, oscillates like the mood of a manic depressive patient around the mean / fundamental value of dividends.

Despite some criticism towards Shiller’s methods in this piece of research it appears that some other forces are at work than rational behavior of market participants. Does that mean that market participants are irrational? It does to some extent. The psychologist Daniel Kahneman found in his pathbreaking research how and when human decision making is prone to errors and biases. His book “Thinking Fast And Slow” is an excellent summary of his lifetime insights into this field.

Our interpretation of Kahneman’s insights is the following: We tend to get influenced by our environment especially regarding diffuse topics. Basically it means that we may get brainwashed into believing something we cannot entirely understand.

How does this relate to the valuation of the stock market for example? Well, if the stock market increases and trusted friends tell the average household how great of an investment stocks are, it is quite likely that some are going to believe the story and buy into the direction of an increasing trend. This may be trend enforcing and spread out like a snowball across other friends and relatives especially after having successful feedback with one’s own investment.

Robert J. Shiller and George Akerlof explain in their book “Animal Spirits” how they view that psychological factors ultimately drive the economy. They emphasize on feedback processes that ultimately drive prices, economies, and may even result into bubbles. A few research publications support their view. Positive feedback experiments in laboratory setups were able to reproduce price equilibria distant to their fundamental value. However we should keep in mind that the world we live in is way to complex to be plugged into any research with all relevant aspects.

We do believe nevertheless that psychological factors can explain to a great extend valuation excesses whereas traditional economics fails do do so. We believe that those factors were at work during the tulip mania in Netherlands, the pyramid schemes in Albania, or the south sea bubble. The future will bring new excesses in areas we probably do not expect today!

Technical Analysis