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What myths do markets generate and what mistakes do investors make under their influence? Dmitry Muravyev, Associate Professor of FInance at Michigan State University and NES graduate, discussed these questions in an episode of the "Economics out Loud" podcast. Just before it was recorded, the continuos rally at the US stock market was interrupted: August proved its reputation of being one of the worst months of the year, and the market turned bearish. Is it possible to predict a decline after such growth? And is it worth trying to seize the moment and try to enter and exit the market on time? GURU shares a summary of the podcast episode.
Filipp Sterkin and Nadezhda Grosheva
Financial markets are great simply because they always give reasons for a discussion: they grow, they fall, and they create fears of a bubble. And there is always market uncertainty that we try to reduce, because of our natural desire to make life more predictable. We want to foresee the movement of the market, and we think that if it has been growing steadily for a long time, then there will definitely come a decline. This is a typical gambler's fallacy: if we toss a coin and get tails many times in a row, then we increasingly believe that we are about to get heads.
Although there is still a little less casualty in the market than when tossing a coin, one should not look for the iron laws of nature in it. Asset prices move freely and can go in any direction. And this has always been the case, as was shown by a research of William N. Goetzmann, Professor of Finance at the Yale School of Management, who studied stock market bubbles of the past several centuries starting with the Dutch tulip mania in the first half of the 17th century. It turned out that the market can grow strongly and for no reason for a year or two, everyone would wait for a fall, but the market can with equal probability both fall and continue its growth. Predicting the market is extremely difficult, because, as the efficient markets hypothesis teaches us, the current asset price is basically and on average correct and reflects the available information. Therefore, it is impossible to systematically beat the market.
It is in attempts to eliminate this uncertainty and simplify the world that myths about markets are born. For example, the myth of the puppeteer who runs the stock market. Usually this role is given to the US Federal Reserve System, which allegedly pulls the strings, and investors, like puppets, follow its signals.
Both the growth and the fall of the market give rise to different myths. For example, market growth attracts new investors, who believe that this growth will continue, and often take on too many risks. They listen to stories about people who sold everything, invested in bitcoin and made a fortune. Is it worth following their example? The answer is no. In finance, you can do some things "wrong" and still earn something, but it would be an exception. The rule is simple: those who accumulate mistakes eventually pay for them. Luck can let you earn in a short run, but in the long term, mistakes will lead to losses on average. Same is true in everyday life: you can meet people with a lot of bad habits who reach the age of 100 years, while others lead a healthy lifestyle and die young. But it does not mean that bad habits are not harmful, does it?
It seems to me that myths about investments can be divided into myths about expected returns and about risks. The former is somewhat simpler: investors just do not understand the expected profitability of certain instruments and assets, it seems to them that it is possible to get a large return without any risks. They are like fairytale characters who do nothing but still get something if not much. But market returns are always associated with risk.
Risks are a more complex matter, because their assessment depends on what scenarios have been drawn up and how we assess the probability of their realization. The most common myth here is that you can time the market, i.e. predict when it will fall or rise. We have studied the behavior of the market, identified patterns of the past, and it seems to us in hindsight that everything was predictable. We believe that these patterns will continue in the future, while this is not true. People underestimate the factors of chance and luck. In fact, the timing of the market can only slightly – not dramatically – increase the expected profitability (in reality you can get any profitability).
There are also more serious mistakes than an incorrect risk assessment. Yes, it is very painful to lose a lot of money on investments in cryptocurrencies. But a much more fatal mistake is underestimating the infrastructure risk, because of which you can lose everything. This happened to many people during the collapse of FTX, one of the world's largest crypto exchanges, or when investments of Russian investors in foreign assets were frozen.
Another wrong belief is that one should start investing if everyone else is doing it. It is associated with such a key for the market psychological phenomenon as the fear of missing out (FOMO). People think: "The cryptocurrency has grown, and for some reason I'm not in it! I need to buy it quickly, while it is getting more expensive. The market is volatile, there is a chance to make money on it".
One of the key myths is the one about the complexity of investing: people do not dare to invest and lose a lot in income because of this. Or they are too risk-averse. American investors keep a lot of money in a bank account and earn about 0.1% per annum there. It means that their capital does not work.
This excessive risk aversion is also characteristic of professional investors, especially those who have lived through crises. For example, it is difficult for financiers who remember the losses of 2008 to take risks. Therefore, experienced fund managers hire young and inexperienced analysts.
A very important lesson can be learnt from the history of university endowments. For the most part, they used to choose a very low-risk strategy: 80% of the investment portfolio was held in government bonds and only 20% in stocks. Therefore, the volume of the endowment remained pretty much the same, because you can't earn a lot on government bonds. And then a man from Wall Street, David Swensen, took over the management of the Yale endowment. He considered it strange to invest almost all the money in bonds, while portfolio managers advise even individual investors to keep 60% of the portfolio in stocks and only 40% in bonds. He suggested changing the proportion to 80/20 or even invest everything in stocks. People took his advice, and now there are tens of billions of dollars in university endowments. Yes, keeping money in the bank seems to be a safe strategy, but in fact it is more risky for the general welfare, because it doesn't give profit.
Another mistake is that too active trading increases transaction costs. They have declined significantly in recent years, but there are still markets with high transaction costs, such as the real estate or options markets. Ignoring them is a guaranteed way to lose money. There is research showing that funds that trade too much lose more money.
To try to avoid these mistakes you need to understand why you are investing and what you want to get. Why are you buying certain assets? Let's say Elon Musk says you need to buy Dogecoin, and you buy Dogecoin. Why? Is it because you've come to the conclusion that this is a good deal? Or you want to be part of a big game, to follow Elon Musk. Or why did you short-sell GameStop? (Retail investors inflated the value of this company through social media, but then its shares collapsed.) Isn't it because it's a cool story to tell friends and students about?
Many investors came to the market in 2020 simply because they were bored of sitting at home and decided to have fun. And if they are aware that they are buying some assets not only for the sake of earning money, but also to play like a kind of computer game, then they will act more consciously, assess the risk more adequately and limit losses.
At the beginning of my career, I was very passionate about psychology research, cognitive distortions, behavioral finance. I understood that scholars consider investors rational and markets efficient, but we all make mistakes. And some of these mistakes are common to all investors, which means that markets change under their influence. However, over the years I have come to the conclusion that although, of course, we all make mistakes, but systematically it does not make the markets ineffective, it does not allow us to constantly predict the market movement.
There are so many distortions that they have become like a zoo. They cannot be ordered. A well-known economist, John Cochrane, proponent of the efficient markets theory, wrote that the identification of these distortions began to resemble a fishing expedition: you cast a fishing rod and fish out another distortion, then another one. But since they cannot be ordered, they all do not have predictive power. However, they need to be taken into account, of course.
Meanwhile, a rational approach allows you to concentrate on just a few ideas. On average, the markets are efficient. When are markets inefficient? It happens when you have some advantage in relation to other investors – for example, access to information or, say, an advantage in the government contracts market. Or when there are structural barriers in the market and when competition is imperfect. For example, in the 1980s, the US market was more or less efficient, and those investors who went to foreign inefficient markets managed to make money there. The market of direct, venture investments is based on the availability of advantages for those who know more than others.
You need to clearly understand that in order to make money in an inefficient market, you really need to have a competitive advantage. If in a organized market you are offered a unique product with a yield much higher than the market average, then most likely you are being deceived. For example, if you are offered a deposit with a very high interest rate, then someone is probably trying to sell you not a deposit, but a structural product for which you may not get anything at all. Yes, you won't earn much in a competitive market, but you won't lose everything on mistakes either.
An extremely interesting trend is the growing influence of social media on the markets. Information is now spreading in real time, and we recently observed how a phrase dropped on a social media platform about problems of Silicon Valley Bank led to a classic bank run. In the past, some could have questioned whether Bernie Madoff had built a Ponzi scheme and could take away their money, but this did not lead so quickly to everyone taking their money at once, and therefore Madoff could continue his scheme. Today, news and rumors spread instantly and individual mistakes can instantly become shared.
