Surprisingly some broadly held beliefs about investing are quite wrong according to academic research. Here are three of the major disconnects between how we might think the financial markets work and the real world. This is based on what academics have learned over past decades through research.
Financial theory suggests that return and risk go hand-in-hand. Want to dial up your return a little? Simply take more risk. However, there are a lot of situations where that situation simply does not hold or even runs in reverse.
One area that researchers have focused on are so-called lottery stocks. Stocks that see large short-term moves in price, and could be considered riskier, tend to underperform the broader market over time. You would expect the opposite. If those big swings in price signal that the stock is actually risky, then you should receive a slightly higher return, on average, for owning it. In fact, you receive less.
Similarly, firms which have a high risk of going bankrupt tend to lag the market, according to research. Again, if a stock has a risk of being totally wiped out by bankruptcy, which can easily occur, then investors holding that stock might enjoy a higher return in compensation for the risk. Again, that does not play out as we expect, on average.
As a result, there are various examples of risky situations, where you don’t appeared to be paid to take the risk. In fact, certain research suggests the opposite, by owning less risky and more conservative stocks, you can enjoy slightly higher returns. This is a strange outcome, but one that is supported by multiple studies.
It’s generally thought that a big move up or down in the markets, must be associated with some big positive or negative news that day. Academics have struggled to consistently find such a link. First off, on many days with big market movements it can be hard to find what’s actually moving the market despite academics scanning the headlines.
Perhaps the most obvious example of this is Black Monday in October 1987 when many markets fell over 20% in a single day. A historic crash. Researchers have been unable to find a major news event to justify such a major market move. Robert Shiller surveyed investors right after the crash and found that it was not news, but general investor panic that caused the mass sell-off. Mass panic isn’t a part of most financial theory. In fact, people are assumed to be rational, calculating machines for the purposes of their trading decisions.
Secondly, on days of historically major events with market impact such as election days, a Presidential shooting or assassinations or changing of the Federal Reserve chairperson, the markets didn’t move too much. Of course, news does have some role in driving market swings. Yet, upon examination the effect is less than you may imagine. The markets can often move more on days with no real news, than when a significant event occurs.
One of the simplest ways to analyze stocks is to look at historical price trends. This is so easy virtually anyone could trade on these sort of signals. Yet, trading on this information can, surprisingly, lead to positive performance. This is called momentum. Momentum is idea that recently strong performers tend to continue to do well, and weak performers continue to lag, at least over the short-term. Surprisingly, it seems to work.
Buying past winners and selling losers tends to beat the market over time. Or, at least, that’s been true for much of recent history. Again, it’s odd that such a simple strategy should be able to show such strong performance, especially when it’s one that has been well-research and discussed. It’s hardly a secret, but it seems to persist.
At times the markets are incredibly precise and almost awe-inspiring in their foresight. Yet, there are other times when we appear to observe elementary mistakes in the markets, or the market appears to get things almost exactly backwards. We are certainly making progress on our understanding of market dynamics. However, we still have much to learn. It seems the markets are sometimes more representative of human weaknesses than we would care to admit.