Behavioral biases and investing

The New York Times published a great piece by Nobel prize winner Robert Shiller (economist and professor at Yale). Shiller identifies several behavioral biases that confound making any short term market predictions.

As it pertains to the present, the Fed will release its decision about interest rates tomorrow (Wednesday) at 2 PM. It’s widely expected that the Fed will raise interest rates. Investors and traders will look to the written statement and to comments Fed Chairperson Janet Yellen will make in the Q&A discussion immediately thereafter.

At this point, even if I had perfect foresight and/or a transcript of this future event, I wouldn’t have any idea how to use this to predict how stocks will react.

Returning to the NYT article, I echo two behavioral biases that Shiller mentions. The first is nonconsequentialist reasoning – essentially that some events are so complex that we elect not to plan but instead react when the news occurs. The second is confirmation bias, in which people look to outside factors as evidence of the correctness of their positions. The stock market has been rising, evidencing (at least in people’s minds) that individual stock holdings (and perhaps the market or even the economy broadly) must have a good outlook. These biases lead to trend extrapolation, wherein it becomes hard to imagine a state of affairs other than the current one.

I think it is critical to be aware of these frameworks of thinking, but they are only partially applicable as it pertains to the Fed. In my humble opinion, the state of markets and even the economy will hinge as much on confidence as on interest rates. Small pieces of news have led to big moves in the markets. These news tidbits would go completely unnoticed in most circumstances. My own take is that markets are jittery. Markets are reacting out of fear of a big move until some semblance of a stable direction manifests. I don’t find this particularly healthy, for I prefer investors base decisions on expected cash flows, earnings, and even catalysts for companies themselves. I interpret big moves as possibly suggesting that investors generally have low confidence in the underlying value of their holdings. If one doesn’t ‘know’ the value of a holding, it’s easy to see how a person could become spooked and sell.

Returning to the markets, the pattern that establishes itself after the Fed decision is likely to play into confirmation bias. Market commentators will then explain the resultant market move by interpreting the data to fit the subsequent behavior. Confidence is a funny thing, though. It is fragile. Caveat emptor.



Sources: Don’t Assume a Fed Action Will Move Markets (The New York Times); Robert J. Shiller (Wikipedia)

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