Explain Behavior In Financial Markets

Since the late 1980's, economists have been worrying that efficient market theories don't explain behaviour in financial markets. Numerous studies provide evidence that individuals can be expected to demonstrate behavioural biases. There are two types of investors in the market; they are the sophisticated investors (i.e. equity fund managers), and individual investors. Some journals refer to sophisticated investors as “arbitrageurs” and “rational speculators” versus all other investors, or “noise traders” (Schleifer and Summers, 1990: 20). There is a popular theory that sophisticated investors tend to take advantage of the individual investors. This essay will explore this theory and outline the common mistakes that less sophisticated investors tend to make. It will then prove that sophisticated investors are not always immune to making the same mistakes themselves. Lastly, this essay will illustrate the phenomenon of high-frequency trading and how it has been putting individual investors at a disadvantage.
Individual investors often tend to display irrational behaviours. One of these behaviours is the disposition effect, which is “the tendency to sell stocks that have appreciated in price (winners) sooner than stocks that trade below the purchase price (losers)” (Dhar and Zhu, 2006: 728) One reason they may do this is because they want to take on more risk, despite having suffered losses; they also may have difficulty admitting mistakes by taking losses. Individual investors also tend to be close-minded, and invest in stocks that are familiar, close to home, and have management speaking the same language, even though neither strategy increases returns. (Grinblatt and Keloharju, 2001). The frequency of their trading is also too high, due to overconfidence about the quality of their information. “Noise traders on average are more aggressive than the arbitrageurs—either because they are overoptimistic or because they are overconfident—and so bear more risk.” (Summers, 1986: 599) Lastly, individual investors often buy attention-grabbing stocks (such as stocks frequently in the news, or stocks with a unusually high trading volume.) “When alternatives are many and search costs high, attention may affect choice more profoundly than preferences do.” (Barber and Odean, 2008, pg. 812) It is complex to demonstrate that sophisticated investors are able to outperform the market as a result of exploiting these inefficiencies. Some studies indicate that fund managers are just as subject to irrational behaviours as individuals. For example, fund managers tend to display herd behaviour. “Professional managers will follow the herd if they are concerned about how others will assess their ability to make sound judgements.” (Scharfstein and Stein, 1990: 465) Fund managers would rather make a mistake with the herd rather than by themselves, that way they can receive less of the blame. Herd behaviour can also explain stock market volatility. “By mimicking the behaviour of others, rather than responding to their private information, members of a herd will tend to amplify exogenous stock price shocks.” (Scharfstein and Stein, 1990: 477).
On balance, there is evidence that more sophisticated investors are less prone to irrational behaviour and can out-perform noise traders, after adjusting for riskiness. Kosowski and Timmerman (2006, p.60) find that a “sizable minority of managers pick stocks well enough to more than cover their costs. Moreover, the superior alphas of these managers persist.” Stock alphas are a measure of performance on a risk-adjusted basis; therefore, mutual fund managers can outperform individual investors. Furthermore, if mutual fund managers were only “lucky”, they wouldn’t be rewarded for their services. “If all performance were due to luck, there should be no reason to reward it.” (Berk and Green, 2004: 1270) Not only do sophisticated investors outperform individual investors, they also “spend time and money

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