How to Outsmart Your Investing Instincts

Merryn Talks Money

In this episode of Merryn Talks Money, host Merryn Somerset Webb interviews Professor Alex Edmans about his new book, The Madness of Markets, exploring why even sophisticated investors consistently fall prey to

Key takeaways

• Stock markets systematically decline following national football defeats due to collective investor sentiment, despite zero fundamental economic impact from sports outcomes.
• Neurobiological research by John Coates shows traders experience cortisol surges during high-stakes market events, physically altering their risk assessment and decision-making.

Main topics

• Behavioral finance and market psychology
• Herding, overconfidence, and loss aversion

Notable quotes

"If you're early and right, you are plain wrong."

Conclusion

Understanding behavioral biases allows retail investors to avoid costl

Transcript preview

Speaker 3 (0:00) AI is entering its most consequential phase where scale, safety and sovereignty will determine who leads and who lags. Join Bloomberg Tech in London on November 2nd and 3rd as global leaders across business, finance and policy examine the defining trade-offs shaping the future of AI. Thank you to our presenting sponsor, Salesforce, and supporting sponsors, IDA Ireland and Schneider Electric. Learn more at BloombergLive.com slash Tech London. Speaker 4 (0:32) Bloomberg Audio Studios. Podcasts. Radio. News. Speaker 5 (0:48) Welcome to Merrin Talks Money, the podcast in which people who know the markets explain the markets. I am Merrin Somerset Webb, and this week I'm speaking with Alex Edmonds, Professor of Finance at London Business School and author of the new book, The Madness of Markets, Why Smart Investors Make Crazy Decisions and How to Exploit Them. And here it is. I want to speak to Alex today because we've had him on before and we had a fascinating conversation about his previous book, May Contain Lies, how story statistics and studies exploit our biases and what we can do about it. But in this conversation about this book, we talk about why even the smartest fund managers still invest irrationally, the link between football results and stock market performance, how luck and skill influence how we perceive investment performance, and much, much more. Alec, thank you so much for joining us today. I really appreciate it. Thanks, Speaker 2 (1:35) Melvin. It's great to be back. Speaker 5 (1:36) As I say, I love this book. I thought it was absolutely great. But you know what? If I was a bookshop owner and I was looking at this and I was going, hmm. Where should I put this in my bookshop? I would find myself hovering between whether to put it in finance and investing or in self-help. Because it does what self-help books do, right? It tells you, well, this is the way the world is supposed to be. And oh dear, it's not that way. Your life isn't working out as you thought. So here's how it should be. Here's how it really is. And here's what you should do about it. And that's basically how all self-help works. So that's why I'd be hovering. But in this case, when we look at the bit about how the world should be, and we're talking about investing, it's supposed to be efficient. It's supposed to be about fundamentals. And it's supposed to be about fundamentals all the time. The market is supposed to know everything. The market is supposed to be based on discounted cash flow, on dividends, on P ratios, on press-to-book ratios. But your starting point is that it demonstrably isn't. And the idea that anyone still believes any version of that is absurd. Speaker 2 (2:43) That's correct. And that's what motivated writing this book. So I did my PhD at MIT in finance. I looked at what drives the stock prices. My professors were saying it's fundamentals, forecast future cash flows and discount rates with some hopelessly complicated model. But I had spent a couple of years at Morgan Stanley in London and also Morgan Stanley in New York. And I saw that even really sophisticated people, yes, they did use equations and quantitative factors, but they are human. They are affected by emotions. And then one of my earliest papers, I looked at, can the market be affected by something as crazy as a football result? So why do I look at football? Well, there's other things that drive national mood, such as a lockdown or a plane crash. But if you found the market fell after a plane crash, that could be just economics. It could be that there's going to be less travel and more restrictions. Yeah, Speaker 5 (3:30) and there aren't quite enough as well to really... Fortunately, there are not quite enough plane crashes in countries with Speaker 2 (3:37) big Speaker 5 (3:37) liquid markets to make this a reasonable way to look at it. Speaker 2 (3:40) Exactly. So when you have a small sample size, it could be due to some confounding factors. But what my co-authors and I were able to look at was 1,150 football matches. And the idea is that football doesn't affect profits or dividends or non-farm payrolls. But we found that the market systematically fell the next day after a defeat. And this was interesting and surprising to us because most people will agree, yes, my emotions are affected by my sports results or my family situation. But when I get into the office, I'm going to put my game face on. I'm a professional. I'm going to forget about this sentiment. But again, you're human and a human will be affected. Your judgment might be clouded by some of these extraneous factors. And then this led to the open the door to the wider measures of sentiment that can be affecting your emotions, your decisions. And that's what's in the book. Speaker 5 (4:27) Yeah, there were two other little interesting things on that football story, which I found fascinating. One was that there's a rise in death after a football loss, a rise in heart attacks. So, you know, the market is relatively minor next to the fact that a football loss actually increases the number of heart attacks. And also that after a win, the market doesn't go up. So the market, in terms of sentiment, feels misery more Speaker 2 (4:50) than it feels joy. Yeah, sadly, these are quite depressing findings. So let's go through them in turn. The effects of emotions, yes, I feel sad if England gets knocked out or if my local team loses, but you might think, well, this is just going to lead to some just minor mishap. However, people have died. So in England, heart attacks went up when England were knocked out of the 1998 World Cup. If you cross the pond, you go to Canada, suicides rise when people, when the Montreal Canadiens get eliminated from the ice hockey. And while in Canada, people kill themselves. In America, people kill each other. So sadly, murders go up in the local city after the NFL team is eliminated from the playoffs. And you might think, well, on the flip side, what happens when you win? Are you jubilant? Do markets rise? Sadly, no, it's only a negative effect. And this could be because of loss aversion. So a win hits positively much less than a loss hits negatively. And also, it could be that supporters are overconfident about their team's chances of winning. So for... 60 years now, England have gone to every men's World Cup thinking this is the year. And if you think you're Speaker 5 (5:55) going Speaker 2 (5:55) to win, you do win. You're not too surprised. But if you lose, you're bitterly disappointed. Speaker 5 (5:59) We'll Speaker 2 (5:59) get Speaker 5 (5:59) to overconfidence later. But there was another idea you used about sentiment, and that was the weather, which I thought was quite interesting. I'm sure you've read these studies as well, but they may still be coming out. I don't know, but 20 years ago or so, people were constantly telling us that the stock markets moved with the moon. Moved with the lunar cycle, and that was to do with serotonin in the brain. And now you tell us that, in fact, markets move with weather. Speaker 2 (6:23) Yes. And this was actually the inspiration for my football paper. And this was taught to me at MIT by somebody who believed in efficient markets, actually to argue why markets were efficient. Because he said, yes, there are studies which show that weather affects stock returns. But how do you know this is not a spurious correlation? You could correlate stock returns with... cloud cover and rainfall and snowfall and wind and so many other factors. And if one of them just happens to be significant, you show this to everyone and you hide away the results that don't work. And he was saying, and I think there is some truth to it, is there a really convincing reason why the weather will affect your trading behavior? Yes, you might feel upset on the commute to work if you're being rained on, but you are working from an air-conditioned, heated office. that should be something you're able to put aside. And so this is why I decided to look at football results, is that you have a much stronger effect than you do of the weather. Nobody has died or had a heart attack because of weather conditions. And also it's correlated across the country. So it could be sunny in New York, but cloudy in Chicago. And maybe it's Chicago fund managers who are making the trade, so New York weather should be irrelevant. This is why I looked at international football rather than the Premier League, because if England lose, the whole of England is depressed, and this may drive the market down. Speaker 5 (7:39) There's another bit, a bit later in the book, that I looked at, and it was about watching traders when they're watching the Fed to see what an interest rate decision is going to be, for example, and what happens to their body. And it shows that their hormones, you look at cortisol, a couple of other things, show that their bodies change. And the phrase you used was, they're like a predator waiting for a kill. Speaker 2 (7:59) Yeah, and this was really surprising to me because you might think is sentiment just about fluffy feelings, but no, it affects the hormones that seep through your body. So this was a study done by John Coates, who was a trader turned neurobiologist. So he would explore traders in action a bit like David Attenborough, but on the trading floor rather than in Antarctica. And he would measure their hormones and they would just be coursing through the body. And when you have so much of, say, cortisol in the system. that has to be something which affects you. So just like people may have committed some crimes based on some serotonin in Speaker 5 (8:35) the Speaker 2 (8:35) body or lack of serotonin, it may well be that you take some pretty devastating decisions based on the hormones in the system. Speaker 5 (8:42) Let's talk about some of the things you've picked up in the book that explain, well, describe rather than explain how people behave. So one of those is, well, actually there's loads. Speaker 5 (8:54) And there's herding, which is the obvious one. Speaker 2 (8:56) Yes, absolutely. It's talk about herding. And behind any crazy behavior, there is a grain of truth behind it, which is why such crazy behavior can perpetuate and why even smart people can exhibit this behavior. So what is the idea of herding? It's that, well, I want to be open-minded. I want to listen to other opinions. And maybe there's some smart people and I can learn from what they do. But sometimes we are learning from other people who are also being based on psychology and emotions rather than fundamentals. So it may be that I see that other people are investing in cryptocurrency and I see that they've made a lot of money. But there's a couple of issues with this. Is what I'm seeing a selected sample? So my five friends who made crypto thousands, it could be there were 95 other people who also invested in crypto and they're keeping quiet about it. Speaker 5 (9:41) I'm very glad about that. So that's a combination of herding and extrapolation, because that's one thing that investors do constantly. In fact, we see it all around us at the moment, don't we? Extrapolation of something that's happened over the last few years into the future without thinking about whether it's really sustainable or possible. Speaker 2 (9:56) Absolutely. And this is why I think these biases are so difficult to shake, because they are not specific to financial markets. We see this all the time. So over extrapolation from little bits of data we see everywhere. Go to any football stadium in the weekend. If the manager's lost three games in a row, then