Explaining Market Swings with Behavioral Finance

After the worst start to a year in U.S. stock market history, markets have spent the last five weeks bouncing strongly. The S&P 500 is 13.06% off of its lows, and the MSCI Emerging Markets Index has soared an eye-popping 23.51% since Jan. 20. Oil has recovered more than 38% since bottoming on Feb. 11.

It was only five weeks ago that I was reassuring investors not to exit the market altogether. After all, studies have repeatedly shown than we tend to exit at precisely the wrong time.

Today, that advice looks like it has proven correct once again.

Putting Mr. Market on the Couch

Market mavens such as Warren Buffett know that much of the “current state of the market” is one giant psychological Rorschach test.

What we see says more about us than what is actually there.

Whether you’re Goldman Sachs or Harry Dent, most of financial punditry is about shoehorning real world events into pre-existing rational explanations — and then justifying them after the fact with the benefit of 20/20 hindsight.

It’s an exercise that Nassim Nicholas Taleb, author of the classic book “The Black Swan,” calls a “narrative fallacy.”

Although investors do this on a daily basis, today we know that there is real science behind Mr. Market’s mood swings.

And it’s science that trumps even the Nobel Prize-winning intellectual tenets of modern finance.

Tell a street-smart trader that you’ve just learned that the market is driven almost entirely by fear and greed, and I’m willing to bet he’ll look at you with a combination of pity and disdain.

After all, traders do little else than pay attention to the market’s mood swings.

Academics have labelled this “Behavioral Finance” — the discipline based on psychological experiments done in cognitive science and the psychology of decision making.

Here’s the basic message: Humans have natural decision-making biases that make it difficult to win in the markets.

See if you recognize yourself in any of these categories:

Confirmation bias — You have the tendency to search for or interpret new information in a way that confirms your own preconceptions. You avoid information and interpretations that contradict your prior beliefs.

Gold bugs read gold bug newsletters; tech mavens stick with “story stocks” that offer a limitless future; doom-and-gloomers always seek facts to confirm that the world is on the precipice of economic collapse.

Need-to-Understand Bias — You have to understand what is going on with the markets better than the guy next to you. All that you need now is to buy that new secret “system” and you’ll gain the insight that you need to become a market guru. And since there are thousands of systems out there, it’s just a question of finding the right one. Just keep trying.