Practical analysis for investment professionals
28 January 2015

Markets Hitting Highs: Unseen Contaminants to Rationality

Suddenly, proponents of the urban myth that our drinking water is poisoned seem to be correct. Scientists have discovered traces of the harmful and addictive drug cocaine in the United Kingdom’s water supply even after it had been intensively purified. According to one newspaper headline, “Cocaine Use in Britain Is So High It Has Contaminated Drinking Water.

But this is small fry compared to the scale of contamination of US drinking water. With 10% of Americans now taking antidepressants and half on prescribed medications, “your tap water is probably laced with antidepressants” and harmful chemicals according to one report. Worse still, studies are blaming contaminated water for physical and behavioral changes, such as fish losing interest in their food, or even becoming “intersex” fish whereby male fish grow ovaries and start laying eggs. As markets hit new highs, we explore whether rational economic man, the bedrock of many financial theories and valuation models, is subject to unseen and adverse physiological influences.

Let’s begin with hormones. It has emerged that the stress hormone cortisol makes people more financially risk averse according to new scholarship from a group of nine researchers at the University of Cambridge and Queensland University of Technology Business School. Under replicated market trading conditions, the human endocrine system seems to magnify the effects of financial panics. Invisible subclinical levels of stress could hold a key to better understanding individual and collective risks in the financial markets.

Next, testosterone: A new study in the Journal of Accounting Research, titled “Masculinity, Testosterone, and Financial Misreporting,” suggests that firms whose CEO has a more masculine face (defined by a width-height ratio) experience a greater incidence of intentional financial misreporting. Facial masculinity appears to be linked with masculine behavior in males, namely aggression, risk taking, desire to cheat, and egocentric nature. The relationship stands true even in cases of insider trading and option backdating.

If investors are being poisoned by drugs and hormones, then this quite dents the force of many cherished assumptions about rational economic man that have been around since Adam Smith. In fact, there is a distinguished line of thinkers casting doubt on rationality, including Thorstein Veblen (Veblen goods), John Maynard Keynes with his description of investing as anticipating the judges of a beauty contest, and the Austrian school of economics, which stresses uncertainty and bounded rationality in the making of economic decisions. Following these luminaries, Daniel Kahneman and Amos Tversky developed prospect theory and founded the experimental discipline of behavioral finance. Beyond such thinkers, the fields of psychoanalysis and neuroeconomics cast many doubts on the empirical limitations of the homo economicus model in regards to investor behavior.

An accessible introduction to the irrationality within some investors (reviewed recently in Financial Analysts Journal) is Investor Behavior: The Psychology of Financial Planning and Investing, edited by H. Kent Baker and Victor Ricciardi, which looks more deeply into investor psychology. In Chapter 19, Richard L. Peterson’s essay “Neurofinance” takes the reader firmly by the hand through the science of brains and decision making. Peterson evaluates the impact of medications and drug abuse on financial risk taking which can be crucial in helping clients through their investment process but is something which is rarely discussed. Peterson has also shared some original thoughts for CFA Institute on “How to Deal with Irate Clients” as part of the Take 15 Series.

Inconveniently for rational investors, a recent study by Elroy Dimson of Cambridge University and Christophe Spaenjers of HEC Paris reviewed the long-term investment performance of collectible investments such as stamps. They find that these so-called emotional assets have actually outperformed government bonds, Treasury bills, and gold over the long run (although transaction costs can be hefty).

With the notion of a rational investor under such empirical pressure, where does this leave the asset management profession, particularly with US equities and bond markets at their current, rather elevated levels? Speaking at a recent CFA Institute conference in Seattle, Clifford Asness, chief investment officer at AQR Capital Management, said, “I believe that most individual investors are probably better off assuming that markets are perfectly efficient. It leads them to having a diversified, low-cost portfolio that they can easily rebalance and does not require them to do too much. A strong belief in the opposite view, that markets are completely inefficient, can cause financial ruin quite easily.” For Asness, “How markets are designed, how accounting systems are designed, and how regulatory systems are designed is extremely important.” Salutary words.

Writing in the Journal of Economic Perspectives, Nicholas Bloom of Stanford University examines economic uncertainty over time and highlights the changes in behavior that uncertainty triggers. Bloom reviews suitable economic policies to counteract these changes. Finally in, “Regulating Fraud in Financial Markets: Can Behavioural Designs Prevent Future Criminal Offences?” two authors from the University of Munich examine the recent cases of Bernard Madoff, Kweku Adoboli, and the LIBOR scandal. On an optimistic note they conclude that whilst social and physical environments can influence financial wrongdoing aligning performance incentives should help reduce misconduct.

Recent CFA Digest summaries and related resources for interested readers to research are summarized below:

  • Cortisol Shifts Financial Risk Preferences: Many leading models in economics and finance assume risk preferences are a stable trait, but researchers have found that a sustained increase in the stress hormone cortisol makes people more risk averse financially. The authors replicate the conditions of trading in a risky market, and their findings suggest that the human endocrine system may play an important role in magnifying the effects of financial panics.
  • Masculinity, Testosterone, and Financial Misreporting: The links among wrongdoing, senior management’s behavior, and senior management’s facial masculinity have been much debated. The authors argue that firms whose CEO has a more masculine face experience a greater incidence of intentional financial misreporting.
  • Investor Behavior: The Psychology of Financial Planning and Investing: This collection of articles by scholars in the field of behavioral finance encompasses a wide range of topics in the psychology of investing, focusing on academic work on financial planning. The book addresses a number of topics not usually covered in mainstream behavioral finance research.
  • Fluctuations in Uncertainty: The author discusses the history, effects, and current trends of economic uncertainty. Of particular importance are uncertainty’s effects during recessions.
  • Regulating Fraud in Financial Markets: Can Behavioural Designs Prevent Future Criminal Offences?: Reviewing three high-profile financial scandals, the authors study the favorable circumstances for their occurrence. The authors’ research leads them to consider measures that could mitigate fraud in the financial markets.
  • 21st Century Asset Management: Facing the Great Divide: The “great divide” in financial economics is where investment managers stand on market efficiency, Clifford Asness explains. On one side are those who believe the markets are inefficient and subject to behavioral biases, and on the other side are those who believe the markets are efficient. The reality is most likely somewhere in between the two extremes.
  • How to Deal with Irate Clients: Richard L. Peterson provides a medical and emotional description of irate clients and discusses techniques for dealing with them and how advisers should frame solutions.
  • Investing in Emotional Assets: Elroy Dimson and Christophe Spaenjers reviewed the long-term investment performance of collectibles and found that these so-called emotional assets have outperformed government bonds, Treasury bills, and gold over the long run. However, the costs of trading in these markets are high and an investor faces many dangers and pitfalls. Emotional assets are particularly attractive to some high-net-worth investors. The need for vigilance makes it hard to justify the inclusion of emotional assets in the portfolios of most institutional investors.
  • Fund Management: An Emotional Finance Perspective: To increase understanding of the real world of the fund manager, the authors apply principles from emotional finance. They report their findings from analyzing in-depth interviews of 52 traditional and quantitative-oriented equity managers. In particular, they examine the importance of storytelling in the manager’s ability to act in the face of uncertainty. The nature of the fund manager’s job requires them to cope with emotions that, particularly if denied, can threaten to overwhelm their thinking. (For those interested in further information, the complete monograph is also available.)
  • The Psychology of Decision Making: Three areas of “cognitive illusion” that violate basic assumptions of the classical economic model of decision making are risk attitudes, mental accounting, and overconfidence, Amos Tversky explains. Their existence indicates that the rational economic model is incomplete in a systematic way. The three phenomena also provide clues to many market anomalies and investor phenomena, and understanding these biases may suggest ways to exploit them in the market.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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About the Author(s)
Mark Harrison, CFA

Mark Harrison, CFA, was director of journal publications at CFA Institute, where he supported a suite of member publications, including the Financial Analysts Journal, In Practice summaries, and CFA Digest. He has more than 12 years of investment experience as a portfolio manager and securities analyst. Harrison is a graduate of the University of Oxford.

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