Market Make Believe
Jonah Lehrer has a great post up about the ridiculousness of virtually all market news (you know, the daily, “The Dow rallied today on news of an abundant Australian salmon harvest— wait, it tumbled because I’m not sure if Australia has any salmon, and it probably doesn’t” stories).
Here’s Lehrer on why we need so desperately to believe that the market acts rationally and predictably (despite the fact that if it did, we’d all be multimillionaires):
Similar stories appear on every single news site (and fill 12 hours of airtime on CNBC), as reporters and talking heads deftly try to explain the erratic movements of Wall Street. I think such explanations are especially popular in times of rampant uncertainty, which is where we are now. After all, if we understand the movement of the financial markets then we have a modicum of control – we know when to buy and sell – and people love control. In one classic 1975 study led by Ellen Langer, male undergrads at Yale were asked to predict the results of coin tosses, a cliched example of a random event. Nevertheless, a significant number of the men believed that their performance improved through practice – they got better at calling heads or tails – and that distraction would detract from their performance. How did they justify this wishful thinking? As Langer notes, the men engaged in some sly cognitive filtering and consistently “overremembered past successes”.
Is Wall Street any different? The market, after all, is a classic example of a “random walk,” since the past movement of any particular stock cannot be used to predict its future movement. Given this inherent stochasticity, it’s silly to attempt to explain the daily movement of the market: such an endeavor is like analyzing a series of flipped coins, or trying to explain the payout patterns of a slot machine. We can construct theories – and some of these theories might even sound intelligent – but they’re ultimately futile attempts to stave off the flux.
The problem, of course, is that this leads people to think they actually have some idea what the market will do — just as the guys in the experiment believed they could get “better” at predicting a coin toss.
There’s even experimental evidence that more information (at least more financial news) makes us make worse investing decisions. Back to Lehrer, quoting from his new book How We Decide:
In the late 1980’s, the psychologist Paul Andreassen conducted a simple experiment on MIT business students. (Those poor students at MIT’s Sloan School of Mangament are very popular research subjects. As one scientist joked to me, “They’re like the fruit fly of behavioral economics”.) First, Andreassen let the students select a portfolio of stock investments. Then he divided the students into two groups. The first group could only see the changes in the prices of their stocks. They had no idea why the share prices rose or fell, and had to make their trading decisions based on an extremely limited amount of data. In contrast, the second group was given access to a steady stream of financial information. They could watch financial news on television, read The Wall Street Journal and consult experts for the latest analysis of market trends.
So which group did better? To Andreassen’s surprise, the group with less information ended up earning more than twice as much money as the well-informed group. Being exposed to extra news was distracting, and the “high-information” students quickly became fixated on the latest rumors and insider gossip. (Herbert Simon said it best: “A wealth of information creates a poverty of attention.”) As a result, these students engaged in far more buying and selling than the “low-information” group. They were convinced that all their knowledge allowed them to anticipate the market. But they were wrong.
The lesson, as always, is don’t believe in your own ability to pick stocks (you think you’re really smart, 99.9% chance you’re not). Invest in a large basket of stocks, diversify, hold for a long time, and don’t ever think you can “time the market.”