According to the theory of efficient markets, where independent news flows freely and markets are fairly valued, it is impossible to “beat the market” through expert stock selection. Left to their own devices, markets would probably be nothing but rational, with trading wholly justified by universally available information.

However, there is a gap between what should be and what is, concerning decisions made in a theoretical marketplace that seek to optimize a rational outcome and decisions made by human beings—with all their fear, greed, vulnerabilities, egos, and weaknesses.

Out of this gap was born a body of research on behavioral finance by psychologists Amos Tversky and Daniel Kahneman who won the Nobel Prize in 2002 for the study of the effects of human biases and emotions on market participants.1

The irrational investor

The emotions that may lead human beings to believe they can outperform the market are the same emotions that may also unconsciously lead them to make poor investment decisions. Consider the example of hypothetical experienced investors James and Marilyn Larson, who managed their own investments. They thought they were doing quite well, until a closer look at the performance of the mutual funds they’d invested in showed that the returns they had earned were less than the funds’ actual returns. This situation is not unusual.

To better understand the disconnect between actual fund and investor returns, see Figure 1, which shows there is a high correlation between stock market returns and assets flowing into and out of stock funds. When stocks have declined significantly over the past 12 months (the orange line is deeply negative), fund flows (in gray) have been deeply negative for the past six months. This suggests that, as the market is bottoming, investors have sold more than they are buying (presumably out of fear and a desire to cut losses). It appears the opposite is also true, for when stocks have appreciated significantly (the orange line is positive and peaking), investors end up chasing performance, buying more as the market approaches its peak. Put another way: Emotions often wag the investor dog.

The tendency to buy high and sell low is nothing new. Investors are just as vulnerable today as they were 300 years ago. Take, for instance, when the COVID-19 pandemic accelerated in March 2020, the S&P 500 fell more than 20% over a span of 16 trading days, making it the fastest bear market decline in history and officially ending the 11-year-long bull market that began in the wake of the financial crisis. The index would only fall further, before bottoming on March 23 after a 34% decline in total. While fear was certainly understandable at that time, investors who had stayed put would have enjoyed a 98% rebound in equity values by August of the following year.

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