Overreaction is probably the most popularly known effect of human behavior
on market prices. All things being equal, in a rational market the fundamentals of a company should determine its market price, and there should be a clear relationship between the two. However, research - as well as a casual glance at CNN's stock-ticker on any given day - shows that this relationship doesn't necessarily happen as expected.
Investors regularly overreact, often wildly, so pushing prices up too high or pushing them
down too low against their fundamentals. Not only is the market, therefore, not wholly
rational in reality, but the effect cannot be attributed to any financial or company-based
factor. The most likely reason for the anomaly appears to be the way investors perceive,
and react to, earnings surprises or news items, or indeed other investors' actions. This
overreaction occurs across the stockmarket and gives rise to several investment
strategies.
Contrarian Strategies
The overreaction effect is highly pronounced when comparing 'out of favor' (contrarian
stocks) against current 'favorites', or what are also known as value and glamour
stocks. 'Out of favor' stocks are not stocks that are bad quality stocks, simply ones that
are not attractive to the market, for whatever reason that might be. The interesting thing
is, however, that over time the 'out of favor' stocks will, in general, outperform the
'favorites'. Then, when the 'out of favor' stocks become the 'favorites' due to increased
buying the effect is reversed and the process is repeated in a cyclical manner, while only
minor changes may take place to the stock's fundamentals. 'This occurs,' says David
Dremen, who researched the effect with a portfolio of stocks over a ten year period,
'because these stocks will tend to reverse over time as investor expectations change'.
Premiums paid for high growth stocks become too expensive while 'out-of-favor' stocks
begin to represent greater potential gains. The effect is reminiscent of regression to the
mean, a statistical effect where measurements will tend towards their average, and is in
fact nothing new. Scientists have known for several hundred years that this kind of effect
often occurs when human behavior is involved. What is new is that the effect has been
found to occur within a particular domain of stocks.
Whether a stock is an 'out of favor' or 'favored' stock is indicated by their ratios.
According to James O'Shaughnessy, whose extensive and well-researched findings were
published in What Works on Wall Street, these include: price to book value (P/BV),
price to cash flow (P/CF), and price to earnings (P/E). Stocks with the lowest ratios have
the most potential to rise, particularly on good news surprises, and are therefore the
ones, from this contrarian perspective, that should be sought after, providing they are
essentially good stocks.
Momentum Strategies
Contrarian investing would seem to indicate that making money in the stockmarket, over
and above the smaller but consistent returns from well-known companies like Microsoft or
IBM, requires buying only 'out of favor' or value stocks. However, this is not the case.
Indeed, if one were to take this to its logical conclusion no one would buy rising stocks
- that were on their way to becoming glamour stocks - and profitable opportunities would
be missed. In addition, value stocks take an average of five years to show a worthwhile
return. Clearly that is often unacceptable and research bears out, in fact, that momentum
pushes many stocks towards new heights regularly, and money can be made on these stocks
considerably faster than five years. This doesn't mean that you simply buy any stocks that
are rising away from their rational price due to market or behavioral influences. Such an
approach would be unsystematic and likely to result in a loss. Although, as Robert Vishny
points out, 'You don't necessarily make money on the best stocks in the market but on the
stocks everyone thinks are going to be the best'. The rider here, of course, is that you
still need to buy stocks that are good or potentially good, even though they may not be
the best. Inasmuch as this is true, and you can locate these stocks, there are two
momentum strategies that can be implemented.
The first strategy applies to combinations of stocks, and makes use of what is known as
the big stock effect. Research on portfolio returns by Andrew Lo and Craig
Mackinlay, using a mixture of small and large capitalization companies on the New York
Stock Exchange, showed there was a correlation between one weeks return and the next,
where around ten-percent of the price change of next weeks return could be predicted from
this weeks return. Though the effect only works for portfolios, not for individual stocks,
and only in the short-term - that is, daily and weekly returns - there appears to be an
observable lead/lag pattern. Which means, big stocks lead little stocks, hence the
name. For example, Microsoft goes up dramatically and a few days later there's a
price jump in other computer software manufacturers.
Consequently, buying second line stocks - mid caps and small caps - in a sector
believed to be ready for a re-rating sometime in the near future, and then sitting on the
investments patiently, can work very well. Though money can be made here purely from
momentum effects, my preference is for a portfolio that's financially sound and less
likely to be buffeted around by volatility once it moves. In other words, you are pitting
your wits against market sentiment, where investor perception alone has decided these
stocks are unfashionable, not against fundamental financial determinants and economic
realities.
The second strategy relates to Professor Joseph Lakonishok's intriguing findings which
show that high momentum stocks - as measured by their previous six months gains -
outperform low momentum stocks by 8 percent to 9 percent during the following year. Hence,
buying high momentum stocks can prove to be another useful method for increasing portfolio
returns. Again, though, the rider is that you still need to buy stocks that are good or
potentially good.
Joseph Lakonishok and his colleagues, finance professors Andre Shleifer and Robert
Vishny, don't just come up with interesting academic ideas. They run LSV Asset Management,
where they put into practice many of their research discoveries. Generally, they tend to
avoid choosing expensive growth stocks that have been given the momentum tag. Instead,
they use momentum signals - such as increased sensitivity and volatility to
earnings reports or news announcements - to reveal value stocks that are just beginning
the upward phase of their recovery. This is not an easy method of portfolio formation,
timing and stock choice are crucial, but just like the professors, you'll find it a lot
simpler if you have a specialized computer program!
Earnings Surprise Strategies
As far as momentum stocks are concerned, the trick in forming a portfolio is in using
accurate measures indicating the stock is starting its rising phase. This can be somewhat
harder than it first appears, even with a specialized computer program. Nevertheless,
besides looking at the stock's past six months gains, earnings surprises may also be used
as the deciding factor for stock selection.
One way of assessing the earnings surprise, suggested by the work of Victor Bernard and
Jacob Thomas at Columbia University, is by measuring the surprise against analyst's
expectations. If the surprise is not only positive but exceeds analyst's expectations
there is a greater likelihood of it being a potential winning candidate for your
portfolio. However, it needs to be remembered that it isn't always clear what constitutes
a useful positive earnings surprise, especially when it is considered whether the earnings
can be maintained or repeated in the future. One swallow doesn't make a summer! Has
the company actually changed at all?
Earnings surprises can also be affected negatively in the market by analyst's
evaluations and this prompts overreaction in the extreme, which again provides another
useful strategy. For example, Intel dropped a hugely excessive 20 percent in three days
when it had reported stronger second quarter earnings in 1995. These though came in at 4
percent under analyst's expectations, which was, behaviorally speaking, the impetus for
the drop. A change-around was inevitable though as earnings continued to grow. By the
spring of 1997 Intel's stock price had almost tripled. Anyone knowledgeable about the
company, rather than following the investment crowd, would have made money in this
situation.
A similarly striking example concerns Hewlett Packard, and it also serves to emphasize
just how extreme investors' reaction to news releases can be. Exploiting this overreaction
once again leads to a profitable investment strategy. In September 1992 the company
announced that earnings would be below analyst's expectations. By the next day, the price
had plummeted 18 percent. This reaction was totally irrational and disproportionate. In
real terms for an expected reduction in earnings during the following year of a few
million dollars the company's market valuation had plummeted in twenty-four hours by 3.5
billion dollars. Needless to say - if you've followed the thrust of this article so far -
it won't come as a shock to know that within three months the price had fully recovered
and then some.
With a profound insight into these types of behaviorally based pricing anomalies, born
out by his success, and taking the view that a good investor doesn't need to be constantly
trading, Warren buffet put it well when he said, 'Only look at the market to see if
anyone's done something foolish that day on which you can capitalize'.
Merger Strategies
Another way to make use of overreaction that cause pricing anomalies is to exploit
certain types of merger situations. For example, in 1907 an alliance was made between
Royal Dutch Petroleum and Shell Transport. These two companies agreed to merge their
interests on a 60 to 40 percent basis but remain independently incorporated in Holland and
in England. As things stood in the early 1990's, RDP was trading primarily in the US as a
constituent of the S&P500 and Shell was trading primarily in the UK as a constituent
of the FTSE100 (Financial Times Stock Exchange One Hundred index).
Even allowing for the passing of the years, a rational market dictates that the two
parts of the company should trade in the same, or similar, ratio of 60 to 40. Yet, recent
research has highlighted that this was not the case; stock prices of the corporation did
not reflect this ratio. On the contrary, after adjusting for tax, transaction costs, and
foreign exchange differences, the actual price ratio between RDP and Shell had deviated
from the expected ratio by approximately 35 percent.
Human behavior is again at work to cause the effect, which, apart from dealing in the
most potentially profitable part of the company's stock, can also be exploited with an
arbitraging approach. The strategy is long-term perhaps but for mutual funds or hedge
funds it can be an ideal method of investment.
Apparent High Risk Strategies
An apparent high risk strategy involves dealing in investments that are considered as
needing an extremely wide berth as they will lead to heavy losses. The rationale for this
strategy is that misinformation, a lack of knowledge about the investment, or market
pressures, are influencing investors thinking in some way and leading them to overreact.
Successful implementation of the strategy involves overcoming these factors and rationally
examining the proposed investment.
Junk bonds are one example here. These are high yield bonds with low ratings by credit
agencies, ie issues rated BB or lower. The general perception of these, strengthened by
the media coverage surrounding Mike Milken and Drexel Burnham in the late Eighties, is
that they are very bad and therefore exceptionally risky. But is that perception justified
or is it another case of investors overreacting to the information they hear rather than
making their own considered assessment? The fact is these bonds are still around so
someone is buying them - in actuality $178.45 billion worth was issued during the five
years ending in 1996 (source: Securities Data Co.). Indeed these individuals may well have
based their dealing decisions on a variety of reports and studies that demonstrate the
high performance of these bonds under the appropriate conditions. Notably that low grade
bonds on average yield 50 percent more than high grade ones and that defaults were not
substantially larger (the Hickman report looking at data from 1900 - 1945); that the
default rate, according to T. R. Atkinson, was actually 0.01 percent from 1945 -1965; and
perhaps most convincingly that even when the default rate rose to between 0.015 percent
and 0.019 percent by 1981, on a yield premium of 4 percent the risk was highly acceptable.
What this meant was that the possibility of a gain was over twenty times more likely than
against the potential loss on the default. But in the affected mindset of most investors
there wasn't any chance of a sure gain. Faced with the possibility of what they believed
were greater gains elsewhere in the market, and as prospect theory developed by
Daniel Kahneman and Amos Twerski predicts, investors steered clear of this opportunity in
favor of what they believed were safer stocks, such as the upcoming glamorous Microsoft
and Yahoo! The irony is that many investors would later get burnt on these stocks as their
ratings shot through the roof and then see-sawed.
Junk bonds are not for everyone, and certainly not for the novice; they take a high
level of knowledge to trade them successfully, they need to be in a diversified portfolio,
and they need to be good quality, which many still aren't. But what this strategy
demonstrates is that there are many investments that on close scrutiny are safer than
first appears. Human behavior, overreaction, overweights the importance of extraneous
information such as media hype and expert opinion, stopping investors from giving junk
bonds or similar apparent high risk investments careful consideration on their own merit.
A New Wave of Strategies
While overreaction can be exploited with a variety of strategies, as we've seen, so far
overreaction is itself difficult to measure as a causal factor in determining price
anomalies. Knowing this would give us a highly effective strategy. But, the scientific
jury is still out on what exactly constitutes overreaction. We know what effect it has but
what actually is it? For example, is it a market based or individual investor based
effect, or both? Can we know before we see its effects that the factors that promote it
are in evidence? Attempts at using a measure have produced mixed results, as ABN AMRO have
found with their behavioral finance fund which has lost about 27 percent since inception.
Much work needs to be done before we fully understand how human behavior functions in the
context of the stockmarket.
There is little doubt that a knowledge of human behavior can improve our
money-making chances when investing. Behavioral finance specialists, though, have only
just begun to scratch the surface of new strategies with a systematic approach to
understanding the processes involved and applying the findings. Many more useful
strategies are likely to materialize in the next few years. The field itself is only about
fifteen years old, a newcomer in the financial arena, and one that is only now beginning
to show its worth.
Jonathan Myers is an industrial psychologist specializing in behavioral finance, and the Director of Psychonomics.com
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