By Richard Carter, PhD, Full-Time Faculty, Purdue Global
As an investor you may have realized within minutes after the August 24, 2015, Dow Jones Industrial Average (DJIA) opening bell that the DJIA dropped by 1,000 points. By the end of the trading day, the DJIA closed down 588 points or 3.57%. Prior to this date the DJIA has trended up for 6 years.
One cannot offer a rational theory that would support a claim that on this date the intrinsic value of blue chip stocks such as General Electric, Pepsi, and Costco lost 12% to 20% of their value.
Violations of your rational investment decision behaviors have come to be the cornerstone of behavioral finance, which is best described a school of economics that believes that your psychological behavior influences financial markets to a larger degree than expected.
John Maynard Keynes and Robert Shiller offer insights.
You Follow the Crowd
John Maynard Keynes’ General Theory of Employment, Interest, and Money (1936) is a cornerstone of economic theory. This work reflects the underlying factors causing the Stock Market Crash of 1929. Keyes suggests that you, as an investor, will eventually create an investment strategy reduced to a shallow and uninformed urge to action simply to outwit the investors today. You’ll fall victim to the consequences of the mass’s spontaneous optimism and invest as the result of animal spirits—an urge to action—rather than inaction.
It is interesting to note that an October 22, 1929, New York Times headline declared that “Prices of Stocks Are Low!” Two days later, the stock market crashed, and by the end of November the New York Stock Exchange was down 30% from its peak.
You Are a Media Junkie
Robert Shiller’s Irrational Exuberance (2006) offers evidence to substantiate that the history of speculative bubbles begins roughly with the advent of media. Given the media’s obsession to produce “news alert” market reports coupled with investors’ reliance on financial commentary has evolved as a tool for day trading.
Inevitably the collapse of the 1990s irrational exuberance and internet stock pricing bubble took place in 2000. Of the 280 stocks in the November 2000 Bloomberg Internet Index report, 79 were down 90% or more from their 52-week high. Another 72 were down 80 to 89% from their 52-week high.
Anomalies: Not Trends
Behavioral finance suggests logical trends do not exist in investment markets. Anomalies, however, seem to exist. Consider the following:
- The January Effect: Rozeff and Kinney (1976) documented evidence of higher mean returns in January as compared to other months.
- The Weekend Effect: French (1980) analyzed daily returns for 1953-1997 and found a tendency for returns to be negative on Mondays and positive the other days of the week.
- The Weather Effect: Saunders’ (1993) work suggested that the New York Stock Exchange index tends to be negative on cloudy days. According to the anomalies, sell out of the index when returns are high in January, and hold investments on a cloudy Monday.
Richard Carter is a faculty member at Purdue Global. The views expressed in this article are solely those of the author and do not represent the view of Purdue Global.
French, K. R. (1980). “Stock returns and the weekend effect.” Journal of Financial Economics, 8, 55-69 Retrieved from http://www.iijournals.com/doi/abs/10.3905/jpm.1988.409156
Keynes, J. M. (1936). The General Theory of Employment, Interest and Money. London: Macmillan.
Rozeff, M., & Kinney, W. (1976). “Capital market seasonality: The case of stock returns.” Journal of Financial Economics, 3, 379-402 Retrieved from http://econpapers.repec.org/article/eeejfinec/default3.htm
Saunders, E. (1993). “Stock prices and Wall Street weather.” American Economic Review, 83, 1337-1345. Retrieved from doi.10.1037/1089-26220.127.116.11
Shiller, R. (2000). "A More Current Theory: Irrational Exuberance" Irrational Exuberance. Princeton, NJ: Princeton University Press. p. 223. Retrieved from http://press.princeton.edu/chapters/s6779.pdf