Fund managers are only human
Optimism and greed are ingrained in the City psyche - but they can be refocused, says Cass's champion of behavioural finance. Nick Mathiason examines a discipline that is finally attracting a serious following.
For much of her career, Gulnur Muradoglu, Professor of Finance at Cass, has been at odds with the mainstream of intellectual finance and economics. But not any more. In fact, the Turkish-born academic is today acknowledged as one of the world's leading experts in behavioural finance - a theory that, post-crash, has come of age. Behavioural finance is about understanding markets through a human lens. This relatively new school of thought rigorously analyses the nature and quality of financial judgments and choices made by individuals to assess whether investment strategies are misguided. Professor Muradoglu says one key question she asks is: "Do fund managers have any systematic biases when they make investment decisions?" Where once she and a small collection of academics ploughed a lonely furrow, now blue-chip investors increasingly commission Professor Muradoglu and her team at Cass to help them unpick how their fund managers and clients make decisions.
It marks a significant sea change as, until very recently, behavioural finance was regarded as something of an academic backwater. In January 2008 Professor Muradoglu established the Behavioural Finance Working Group which she leads and Cass hosts. It was a well-timed move. This school of thought now appears to be challenging and perhaps has even usurped the efficient-market hypothesis which once held unquestioned sway. In 1978 Michael Jensen, an American economist who is now emeritus Professor of Business Administration at Harvard Business School, declared: "There is no other proposition in economics which has more solid empirical evidence supporting it than the efficient-market hypothesis." The hypothesis underpinned market fundamentalism, a position that largely attributed market instability to governments rather than those who worked the trading floors.
The efficient-market theory dates from the beginning of the 20th century but it came into its own in the early seventies. Eugene Fama, Professor of Finance at The University of Chicago Booth School of Business, defined its essence: that the price of a financial asset reflects all available information that is relevant to its value. As the 1944 Bretton Woods Accord on rule-based financial regimes gave way to neo-liberal deregulation, an unbridled faith that markets were the ultimate judge of value emerged. It took the most catastrophic banking failure the world has ever seen to realise that this faith was misguided. Professor Muradoglu identifies four triggers that caused global financial meltdown. First there was globalisation, which allowed cancerous US sub-prime problems to infect the rest of the world. Second, high leverage, not just in housing but across the corporate sector. Third, inadequate and opaque accounting systems that amplified volatility and created false, not fair, value. And, finally, "the underestimation of risks, not only in newly issued assets but also in corporate sector leverage ratios" - in short, the behavioural trigger.
"Part of the process that led to the crisis was over-optimism," Professor Muradoglu says. "Look at the television programmes that dominated the schedules: Location, Location, Location; A Place in the Sun; house makeover shows. The whole assumption was that you couldn't lose in the property market and that reinforced the bubble. Part of this was due to optimism. The lesson of the crisis is that we need better regulation and that regulation has to take into account human behaviour." William N. Goetzmann, Professor of Finance and Management Studies at Yale School of Management, argues that analysis of housing prices systematically generated forecasts for long-term price growth and underestimated the possibility of extreme price decline. "Such optimism is fuelled by the extrapolation of past trends into the future," wrote Professor Muradoglu in her paper published last year, The Banking and Financial Crisis in the UK: What Is Real and What Is Behavioural? "Why were the fundamentals not recognised? Optimism is in human nature and cannot be avoided. Greed is in human nature and cannot be avoided."
Fusing psychology, finance and economics, Professor Muradoglu places the decision-making process at the heart of assessing whether investment decisions are made on optimistic, over-confident criteria or based on cultural assumptions that in reality are flawed or unnecessarily narrow. She said: "Fund managers all have benchmarks and trading strategies but if there's an element of a systematic bias within that, you have to acknowledge it. These people are well trained. If they recognise something, they change it immediately. That's the fun part of working with finance professionals." During the nineties, Professor Muradoglu experimented with stock market professionals' trading strategies to reveal whether they exhibited over-confidence and optimistic tendencies. Experiments continue to provide the basis for asserting that markets have an inherent weakness built into them. The questions posed to professional investors and casual traders are simple and boil down to predictions about specific stock prices. Professor Muradoglu and her team gather traders' projections at various intervals and assess the basis on which predictions are made.
After the dotcom crash and Enron collapse, a paper by Professor Muradoglu, Portfolio Managers' and Novices' Forecasts of Risk and Return: Are There Predictable Forecast Errors?, concluded that professional traders tended to predict share prices more accurately in the short term but non-experts' medium-term predictions proved the better performers. "Experts are, in general, more optimistic than novices," she wrote. "However, they hedge their optimism better." Critics of behavioural finance suggest it is not a coherent theory but rather a patchwork of various strands. Perhaps, says Professor Muradoglu, this says more about the reductive, simplistic need by critics to come up with one over-arching principle to explain the way markets work. "I think you can come up with more than one theory. We have a pragmatic realistic approach. The idea is to examine how people behave. If you don't know the virus, how can you cure it? If you are a banker and if you acknowledge you are optimistic or over confident, then you have a chance to address this. If you are a regulator then you have a chance to make markets better." Andrew Lo, Professor of Finance at the Sloan School of Management at the Massachusetts Institute of Technology, sees merit in both the rational and behavioural views. He has tried to reconcile them in the "adaptive markets hypothesis". The Economist recently characterised his thinking as assuming that "humans are neither fully rational nor psychologically unhinged. Instead, they work by making best guesses and by trial and error. If one investment strategy fails, they try another. If it works, they stick with it."
Professor Muradoglu agrees. "There is no harm in using the efficient-market hypothesis as a benchmark," she says. "It is one representation of reality. But the danger is having faith in efficient markets." Such a pragmatic, nuanced viewpoint has brought Professor Muradoglu to the attention of a number of financial institutions. "I received a lot of invitations during and after the crisis. Most of them were related to the difficulties people had understanding what had happened. If the efficient-market hypothesis was true, then markets weren't supposed to overshoot." She suggests that global finance requires a profound regulatory overhaul. She argues that the system has its roots in the 1934 Securities Exchange Act which was a reaction to the Crash of 1929. Then, 90% of securities were held by individuals. Today, 70% are traded by institutions. "The financial markets are not sterile," Professor Muradoglu says. "They are places in which people openly communicate and we can't think about markets without thinking about people. There are ways of understanding people through behavioural psychology. My focus is on how people behave."
It seems that her philosophy, while perhaps not an explanation for the way markets operate, gets us close to the truth. After all, markets are made up of humans interacting. "I'm Turkish. When you see volatility you think this might be because of national institutional markets related to issues in an emerging market. But then you observe them in mature markets. When I first read papers on behavioural finance as a PhD, I was thrilled: volatility has to be because of human beings. We assume people are rational but they're not. We assume they're rational in the financial domain but they're not." The rule applies throughout myriad asset classes, extending even to foreign direct investment. What else explains why funds managers or businesses from one country invest only in specific jurisdictions outside their borders? Behavioural finance is still in its infancy and remains a work in progress. But the financial crisis has undermined old certainties. The past 30 years have produced a procession of financial crises encompassing the US savings and loans collapse, the internet stock "pump and dump" scandal and the destruction of the global banking system requiring trillions of dollars of publicly funded bailouts affecting billions of people worldwide.
Professor Muradoglu is convinced that an element of brash optimism and over-confidence lurks behind every stock market crash, from 17th-century Tulip Mania and the 18th-century South Sea Bubble to the Wall Street Crash and the present malaise. The task of behavioural finance is to isolate and then identify the intellectual frameworks such attitudes are built on so they are acknowledged and remedied. Professor Muradoglu wrote with three other academics in 2009: "It is clear that if academics are to succeed in understanding financial institutions and actors, and if the agents themselves, as well as policymakers, want to make wise decisions, they must take into account the true nature of people, that is to say their imperfections and bounded rationality." There is an obvious need for a shift in the theoretical framework of finance. To carry on as if nothing happened is not tolerable. Behavioural finance must be part of that shift.
Nick Mathiason is Business Correspondent at the Bureau of Investigative Journalism, a not-for-profit news organisation based at City University London.