skip to navigation skip to content

Reasons why

 

Think the market is irrational?

Research from Cambridge predicts investors with confidence and knowledge will profit.

2016-reasonswhy-irrationalmarkets-883x432

Don’t trust an investor who says he has never succumbed to irrationality. It may be the sector’s dirty word, but even the best, most level-headed and analytical investors can get sucked into an irrational market. It takes courage to pull against the crowd. So how can you tell when the market is irrational – and how do you survive it when it happens?

“Irrational markets are, quite simply, the result of irrational investors,” says Cambridge Judge Professor Raghavendra Rau. “Investors are irrational if they do not link changes to a situation to the fundamental change in a stock’s value. It’s not enough to just follow the market – you need to know if there are good reasons for a stock’s value to rise or fall.”

So far, so obvious. But as Professor Rau’s research has proved, thousands of investors do not follow that basic rule. In a paper titled A rose.com by any other name, examining the first dot.com boom, Professor Rau and fellow academics made the arresting discovery that mania around any association with the internet meant firms that changed their name to include “dot.com” consistently and significantly saw cumulative returns of 74 per cent over the 10 days following the name change announcement. The values of the new “dot.com” companies significantly outperformed those that did not – and here’s the killer – even if their business had nothing to do with the internet at all.

“It was completely irrational,” says Professor Rau. “If nothing else has changed and a name change affects their level of investment, that is irrational. It’s like me calling myself Brad Pitt and expecting that name change will make me more attractive to women. Many investors fail because they do not take the trouble to understand risk at all.”

So how can you spot an irrational market – and crucially, how can you survive it? Professor Rau, Cambridge Judge’s Sir Evelyn de Rothschild Director of Finance, offers the following tips:

  1. Be confident
    “It’s easy to follow the herd – and to follow them in the wrong direction. If you can see clearly and analytically a reason to head the other way, have confidence in yourself to invest in favour of something when everyone else is going against it.”
  2. Manage your bias
    “It’s okay to be biased – as long as it’s based on hard fact. In one of my programmes I ask participants whether they are an above average, average or below average driver. Eighty per cent say they are above average. That maths doesn’t work. They’re looking at what they fondly believe to be true rather than what actually is true. If your bias is not correlated with the changing value of the stock, your investment is more likely to fail.”
  3. Hold your nerve
    “For most of us the way to survive an irrational market is to buy and hold on – do not pay attention to the chaotic activity around you. That’s very difficult to do and you might think that you will risk missing out on a big return. But you don’t lose any money. In 1987 the stock markets around the world crashed 22% in one day. It was irrational – 20 years later we still don’t know either why it happened or, indeed, why most of that value had been recovered three months later. But what we do know is that if you didn’t panic, if you took a rational long-term view and held onto your stock, you didn’t lose anything.”
  4. Take yourself out of the equation
    “If you don’t make the decision to invest, your emotions and biases don’t get in the way. Hedge fund managers and mutual fund managers are smart enough to be more measured so you could rely on them – but remember even they have their biases and are trying to earn their bonuses. The best way to remove all bias is to invest with an automatic transfer – money that goes in every month regardless of what the market is doing.”
  5. Be a married woman
    “The most successful investors are married women. Next most successful are single women, then married men, then single men. It has been proven that married women tend to hang on to their stock and make more long-term investments because following and reacting to the market every day is not a natural priority. Single men, on the other hand, are poor investors because they tend to have more time and interest in regularly checking values. Many trade every day and are always looking for the next bubble, making them act and react – often too quickly.”
  6. Sign up for the Behavioural Finance programme!
    “Our programme studies financial disagreements and what kind of biases are at play and teaches students to assess if markets are rational, detect market inefficiency and how to deal with it. Behavioural finance has emerged as a vital new field of knowledge. This programme is an excellent opportunity to learn more about various behavioural decision traps and the biases at play – and how we can learn to spot and survive an irrational market.”