Chapter 10 Chapter 9 The Irrationality of Financial Markets

When the stock price fell, why did we still insist on holding it, and the result was a huge loss? The several investment strategies that can make you rich overnight explained in the last chapter are the core of which is to take advantage of special phenomena in the financial market to obtain considerable returns.It has been explained above that if all investors in the financial market are completely rational, those special phenomena are impossible to appear.However, in addition to the content seen in the previous chapter, there are various other special phenomena in the financial market, which are different from the assumptions in economics textbooks. In the real financial market, there are many irrational investors. , so there will be a lot of special phenomena.In this chapter, a few particularly interesting phenomena are selected to analyze their characteristics and the reasons for their occurrence.

Comparing the returns of stocks and bonds in the US financial market from 1889 to 1978, we can observe such a unique phenomenon.The calculation shows that the average annual return rate of stocks is 7%, compared with less than 1% annual return rate of short-term bonds.It is hard to believe that there is such a large gap between the returns of stock investment and bond investment. People engaged in financial investment will of course choose products with high yields as investment objects.Buying stocks when stock yields are higher and bonds when bond yields are higher is a natural thing to do.With bond yields falling to less than 1%, it is hard to say that anyone will invest in bonds.If people were going to make money, they wouldn't be investing in bonds.

The above-mentioned phenomenon is exactly the stock premium phenomenon, and the stock premium not only appears in the United States, but also exists in Japan, Germany, France and other countries.In the financial markets of all countries, the phenomenon of stock premium can be seen in almost all countries, which is already a universal fact. Our question is, why is the stock premium so prevalent?If you want to invest in both stocks and bonds, there can't be such a significant gap in yields.If a certain product yields higher returns over time, all investors will invest in that product. Obviously, people who invest in bonds will ask this question: Why have the yields of stocks remained higher for a long time?

An easy-to-think explanation is that because stock investment is more risky, it is reasonable for stocks to provide a certain degree of risk premium.The so-called risk premium refers to the higher rate of return obtained in return for taking on risk.Without this risk premium, it is clear that everyone would invest in bonds rather than riskier stocks. However, given the actual degree of risk, it is difficult to see such a large yield gap as an accessory to the risk premium.In other words, as compensation for the risk-taking of people who buy stocks, there is no need to have such a high rate of return.So, minus the part used to explain the risk premium, how does one explain the remaining yield gap?This question is the "mystery of the stock premium."

There are several explanations for the equity premium puzzle.However, no matter what kind of explanation can not completely solve our doubts.One of the most interesting explanations is that of behavioral economists.They believe that the answer to this mystery should be found in the behavioral characteristics that people exhibit. Behavioral economists have noticed that investors have the characteristic of loss aversion.They appear to be more sensitive to losses than to gains of the same amount, as explained earlier.Investors who buy stocks experience gains or losses based on changes in the price of the stock.Therefore, buying stocks requires exposure to losses more frequently than buying bonds.

In addition, behavioral economists also point out that it is important for investors to regularly evaluate how much return they have made on their investments.Under normal circumstances, the interval for evaluating how much investment income is also varies from person to person.For example, there are people who seem to have forgotten about it after buying stocks, and there are investors who look at the market every day and see it as a loss if they don’t make a profit; Stare at the computer screen and pay attention to the income every moment. For investors who are particularly averse to losses and pay attention to investment returns every day, stocks are not particularly suitable investment objects.Because they think that there are many times when they suffer losses, and every time they feel great pressure in their hearts.If you feel a lot of pressure every day after buying stocks, you will definitely not have the idea of ​​​​investing in stocks.

The fact that stock yields have long been trending higher compared to bond yields, and stocks are known as riskier assets, does not satisfactorily explain the premium. Generally speaking, for investors who are particularly loss-averse, the shorter the time interval for evaluating investment performance, the less likely stocks are an investment for them.Because the shorter the time interval between assessments, the more time investors think they will suffer losses, so such investors prefer bonds as an investment method.If you want them to buy stocks, you have to offer a higher premium. Now, we find a way to solve the mystery of the stock premium.Many investors are particularly averse to losses, and the time interval for evaluating investment performance is very short.For these people, stocks are not particularly attractive investments.

It seems plausible that behavioral economists explain the stock premium puzzle in this way.Still, it's hard to say that this explanation fully solves the mystery of the stock premium.Only with more research in the future can a more satisfactory answer be found. Who can be called the masters of stock investment?Those who can intuitively find stocks whose stock prices will rise sharply in the future must be masters.They can make a lot of money with stocks, which is predictable.But if you're not a born fortune teller, it's hard to pick a needle in a haystack of stocks that will rise in price.In any case, there are times when even the best investors will miss out and buy stocks that are falling in price and lose all their money.

From a practical point of view, the core condition that a master stock investor must possess is the ability to choose the timing of stock investment just right.Don't be obsessed with stocks that have no room for price rise in the future. You must have the courage to sell them before you can become a master.Even if a certain stock has suffered a huge loss, in order to avoid a greater loss, you should sell it without hesitation.This is the characteristic of a real stock investment master. However, the performance of real investors is far from the behavior of masters.Under normal circumstances, for stocks with no prospects and whose prices continue to fall, they still desperately hold on and refuse to let go.On the contrary, it can also be seen that some investors tend to sell stocks whose prices continue to rise prematurely.In a word, we focus on doing things that experts do not do.

Even for ordinary people, there is no reason not to know that the core of stock investment is to choose the right time to trade.However, if you are not a very rational stock investor, it is impossible to guess the best trading time.In their ability, it is impossible to know exactly when is the best time to trade.Therefore, most investors failed to find the right time to invest in stocks, so they took the approach of selling too early or too late. How do we judge between selling a losing stock too late and selling a winning stock too early?First of all, the method that can be used is to compare the selling ratio of each stock among the stocks held by investors.A low sell-off ratio for a losing stock means that investors are continuing to hold that stock.Conversely, a high sell-through ratio for profitable stocks indicates that the stock was sold prematurely.

Therefore, if you compare the selling ratio of winning stocks to the selling ratio of losing stocks, you can evaluate the timing of selling stocks.Analyzing actual stock trading data, we can see that the sell ratio of winning stocks always tends to be higher than the sell ratio of losing stocks.Looking at the results of this comparison, it can be seen that there is indeed a phenomenon that people tend to sell profitable stocks prematurely and, conversely, continue to hold losing stocks. But wait!Is selling a profitable stock quickly the same as selling "too early"?Needless to say, selling quickly and selling too early mean different things.Likewise, continuing to hold a losing stock cannot be said to be selling too late.The mere fact that winning stocks are sold more frequently than losing stocks does not mean that selling is not timed properly. Strictly speaking, selling too early means that you are better off holding on to it.Conversely, selling too late means you would be better off selling in time.So, how to judge what kind of stock is better to continue to hold, or it is better to sell it in time?As long as you make this choice, you can judge by observing how the stock price changes. Specifically, the answer to this question can be obtained through the following methods.For example, sell a certain stock, but the next year, the stock price rises sharply.If it's a high-yielding stock, we think investors would be wise to continue holding it.If you sell it without waiting for a higher yield, it means selling too early.On the contrary, continue to hold a certain stock, however, the stock price falls sharply in the next year.Since it is a low-yielding stock, continuing to hold it means selling it too late. At a certain point in time, it is decided to sell a certain stock or not to sell a certain stock. Whether this decision is appropriate can only be judged by comparing the earnings of the sold and unsold stocks with the next year.First of all, understand the return rate A of the sold stock for the next year. If the stock price rises, it means that continuing to hold that stock will have a higher return, and it was sold prematurely before. Next, find out the next year's rate of return B on the stock that you didn't sell. If its price becomes lower, it means that the stock should have been sold sooner, when in fact it was too late.As we can see now, selling profitable stocks too early and selling loss-making stocks too late, concretizing this situation, is a relatively high rate of return A and a relatively low rate of return B.Therefore, if it is judged that Yield A is higher compared to Yield B, it can be concluded that the investor mistimed the sale of the stock. If you use the stock market to derive these two prices, it will show that A is actually much higher than B.According to one study, A is 3.4% higher than B.If you had held on to winning stocks for a longer period of time and on the other hand sold your losing stocks earlier, you could have made a bigger profit, but people didn't do that.In reality, investors sell winning stocks too early and hold on to losing stocks for too long. This behavior has been well documented. What we are particularly concerned about here is the phenomenon that the loss-making stocks were not sold earlier and held for too long.What is the reason for investors to make such an irrational choice?A plausible explanation is that investors made this irrational choice out of ego.Although the price of the stock you bought fell and you suffered a loss, the loss did not really occur until you sold the stock.There's a big difference between just knowing the fact that a loss will be incurred compared to actually having it happen. At the moment of selling the losing stock and turning the loss into reality, the investor will truly feel that the choice of buying that stock was really wrong.Moreover, investors feel that they have done something that they regret, and their self-esteem has been greatly traumatized.Therefore, not turning losses into reality is likely to be trying to avoid losses and injuries.This kind of thinking can explain why investors continue to hold losing stocks. It is explained in economics textbooks that the fact that a loss occurs is as important as itself.A rational investor will correctly predict when this will happen, even if the loss does not materialize.Therefore, he believes that what matters is only the fact that the loss occurred, and whether the loss becomes a reality has no special relationship. However, from the perspective of behavioral economics, whether the loss materializes is very important.Because if it is an irrational investor, whether the loss really becomes a reality will cause a big difference in the psychological state.Even if the stock price plummets and suffers a large loss, he may remain silent until the loss materializes.Once he sells that stock, the loss will become reality immediately, and he will cry at that moment: "Ah, I bought the wrong stock and suffered a lot of losses." Is there a different attitude to this? When grilling meat, if it is turned too frequently, the meat will definitely become unpalatable.The meat will only taste good if you wait until one side is done and then quickly flip it over.The same is true for stock investment. People who buy and sell frequently cannot obtain high returns.There is no doubt that only those who choose the right time to invest in stocks can obtain high returns by observing the market situation and waiting patiently.It can be predicted that if it is a rational investor, it will invest in stocks in this way. There are such investors, once they buy a certain stock, they still insist on selling it no matter how much the stock price rises or falls when they sell it.On the contrary, there are also such investors who can't bear the slow change of the stock price, sell it too hastily, and then buy other stocks.Looking at it as a whole, it can be seen that the latter, that is, the number of investors eager to buy and sell stocks is greater.The irrational, hasty behavior of many investors is another particular phenomenon that has drawn our attention. If there are many investors who act too hastily, the visible trading volume in the stock market will unexpectedly expand.The accident here refers to a larger than normal transaction volume.So, what kind of trading volume is appropriate?In fact, it is difficult to put it clearly in one sentence.But that doesn't mean we can't do anything about it. The following is a method for judging whether the actual stock trading volume is larger than the appropriate level, that is, a method for judging profit and loss when investors conduct another stock transaction.If the result of that transaction is that the average rate of return on the stocks you hold falls, it will lead to a worse state than continuing to hold the stock, that is, you have suffered a loss on that transaction.If this is the case, it indicates that that investor is buying and selling too frequently, which also means that the trading volume is larger than the appropriate level. According to the analysis results of the actual trading volume in the stock market, we will find that the majority of losses are caused by additional transactions.Calculating the average rate of return since that transaction occurred, it turns out that the rate of return on the sold stock was much higher than the rate of return on the newly purchased stock.For example, looking at the average rate of return 252 days after that transaction occurred, the rate of return on the sold stock was 9%, compared to only 5.69% for the purchased stock, and the gap between the two is 3.31% %.After deducting the commission, the investor suffered a considerable loss through this transaction. Trade stocks too hastily like this, only to lose all your capital.Our question is, why do people show such impatience?Perhaps the first reason that comes to mind is that the staff of the securities company persuade investors to change investment products in order to charge more commissions.The more frequently investors trade stocks, the more commissions these staff earn.Therefore, the staff of securities companies tend to secretly encourage investors to trade stocks frequently. According to behavioral economists, investors' overconfidence is the most important reason.It has nothing to do with the persuasion of the staff of the securities company. In the case of trading stocks purely based on their own judgment, investors suffer losses in additional transactions.This can serve as very convincing evidence that investor overconfidence is a more important reason to act too hastily. Research in psychology has shown that, in general, people place too much faith in their own abilities or knowledge.No matter what happens, there are many people who say, "I already know that." This statement expresses a sense of self-confidence that has already surmised that something will happen.But is that really the case?Three-year-olds know it's not true.It's always something that happens and people react.The claim that something was known before it happened is nothing more than an unwarranted sense of self-confidence. Overconfidence is related to performance in picking investments.How do investors behave when they believe they have a superior ability to select investments that yield high returns, compared with others?He will certainly show a tendency to change investments frequently, expecting unrealistically expected returns on additional transactions. If it is a rational investor, it will first accurately estimate the expected return of additional transactions, and then make a decision.However, investors who believe too much in their own abilities and have unrealistic expectations can actually cause themselves to suffer losses.As you can imagine, the more such investors there are, the more realistically observed trading volumes will exceed the appropriate level.Investors' overconfidence induces frequent transactions, which leads to the reduction of investors' assets, which has been repeatedly confirmed in many studies. Today, with a high degree of internationalization, there is no need to only invest in the stocks of companies in one's own country.We have entered the era of economic globalization. If it can bring higher returns, it doesn't matter to invest in the stocks of companies in any country in the world.For example, rather than investing in Samsung Electronics, it may be better to buy the stock of Google, which can earn higher returns.In the past, there were various restrictions that made it difficult for investors to invest in the shares of companies in other countries. Now those restrictions have almost disappeared. If you look at the current situation, you can see that most investors still only invest in the stocks of companies in their own countries.Therefore, there is a phenomenon that almost all the people who own the stock of a certain company are nationals of the country where the company is located.For example, almost all the people who invest in the stocks of American companies are Americans.Similar phenomena do not only appear in the United States, but also in other countries. To be more specific, at the end of 1989, American investors held 92.2% of the stocks of American companies. Similarly, in Japan, the proportion was 95.7%, in the United Kingdom, it was 92%, in Germany, it was 79%, and in France, it was 89.4%.At the same time, it can be seen that among the stocks held by Japanese investors, the proportion of foreign company stocks is only 1.9%, and the proportion of American investors is only 6.2%. In summary, it is not a rational investment strategy to invest mainly in the stocks of your own country's companies like this.From an investor's point of view, maximizing risk diversification is a favorable investment strategy. Spreading risk means that if a loss is incurred on one side, it can be covered by profits on the other side. Let's take the example of moving eggs and explain in detail what it means to spread risk.There is a western adage: When moving eggs, don't put all the eggs in the same basket.For example, put all 100 eggs in the same basket and carry them. If you are unlucky and trip over a stone, in this case, all 100 eggs will be broken.Because there is no diversification of risk, if a risk occurs, it will lead to the loss of all the assets owned at once. If the eggs are packed in 10 baskets in groups of 10, they will be transported in multiple times.In this case, even with a fall or two, most of the eggs can still be handled in good condition.This method of moving eggs in many times is equivalent to the behavior of spreading risks.The same is true for stock investment. Risk diversification is a rational investment strategy. Investing only in the stocks of your own country's companies means that you have not spread your risks scientifically.If the economy of one's own country falls into an extremely sluggish situation and the stock prices of all domestic companies fall sharply, investors will suffer great losses.If you want to diversify your risk, you should invest in the stocks of companies from many countries in the world at the same time.Then, even if the economy of a certain country is in a recession, because of investing in the stocks of other countries that are in a good situation, they can still get more or less income.This is the purpose of risk diversification. If you are a rational investor, you will not invest all your funds in the stocks of your own country's enterprises at once.Obviously, they will objectively compare the stocks of companies in all countries and buy the most valuable stocks.If you want to maximize the spread of risk and obtain the highest possible return, there is no other way.Therefore, it is difficult for us to understand the behavior of investing mainly in the stocks of companies in our own country. This question is called the "mystery of home bias". Based on this phenomenon, economists have put forward an explanation for institutional factors. They believe that there are some institutional factors that make it difficult for investors to hold stocks in other countries, or reduce the returns they can get from stocks in other countries.The fact that this has not changed even with the recent apparent reduction in restrictions on holding shares in companies from other countries tells us that this explanation is not convincing. There is also such an explanation, because it is easier to obtain information about domestic companies, so investors prefer to invest in stocks of companies that are closer to them.For example, you can often meet the staff of nearby companies, you can easily learn about information, and you can also get important information through local newspapers.In contrast, because it is difficult to obtain information on companies located far away, and they are not very familiar with those companies, there will naturally be a phenomenon of reluctance to invest.Similar attitudes explain why investors invest primarily in their own country's corporate stocks. In contrast, from behavioral economics, we find such a reason, based on the psychological characteristics of preferring familiar things, investors have a home country bias.We have inexplicable fears of things we don't know much about.It can be quite unnerving when we look around in unfamiliar places.In addition, the first time you try an unfamiliar product, you will have the same feeling, and you will feel uneasy about the pros and cons of this product.Investors are likely to feel the same way about unfamiliar foreign companies. Generally speaking, when we make choices under uncertainty, not only probability, but also the degree of knowledge of the surrounding situation will also have an impact.Given the probability factor, we will judge which action is more advantageous to take, and once we are not familiar with the situation around us, we will adopt a negative attitude.On the contrary, if it is a situation that is very familiar to us, we will show an attitude of willing to take risks.This is why investors prefer to invest in the stocks of domestic companies that they are familiar with. If you want to diversify risks to the greatest extent while obtaining the highest return possible, you should objectively compare the stocks of companies in all countries and buy the stocks that investors think are the best.Even so, the behavior of mainly investing in the stocks of companies in one's own country appears. This question is a mystery of national prejudice. The failure to correctly judge reality due to overconfidence is not unique to stock investors.According to the observations of psychologists, people in many cases show a tendency to look to the future too optimistically.Looking to the future optimistically means being very confident.For example, there are many times when students expect higher scores before the exam than they actually get. In addition, there is also such a phenomenon that many people place infinite good expectations on personal development after the completion of the business administration course. Even the analysts of securities companies showed a tendency to be too optimistic.Only when they have made an objective evaluation of the company's profits can they be considered as fulfilling their duties.If you fail to make an objective evaluation, you will most likely lose your job.But comparing their earnings outlooks with reality often shows a tendency to be overly optimistic.There is not much difference between the so-called experts and the "layman" investors. If someone is too optimistic about everything, disappointment will follow in his life.Plus, because of overconfidence in doing things you shouldn't be doing, it's not hard to figure out that a lot of things are just wasting time, effort, and money.The loss of a lifetime of hard-earned money because of stock investment is an obvious example.If you don't have the confidence that you can make a lot of money, you won't invest that money in stocks. Humans have the ability to constantly adapt to their surroundings.Because without acclimatization, it is impossible to survive the struggle for existence.Then, this problem of overconfidence may also be gradually weakened with the accumulation of experience.If you have repeatedly experienced the disappointment of looking to the future with too much optimism, you may well develop the habit of looking to the future with a conservative attitude. However, in reality, we have not seen the phenomenon of adapting to the environment in this way. Not only is it difficult to find that compared with the previous generation, the next generation has a tendency to be relatively less optimistic, but it is also difficult to find that there is something wrong in a certain person. Tendency to gradually become less optimistic.A person who loses a lot of money on a gamble goes back to the gamble, which means that his confidence that he can win is not diminished at all. It's quite interesting to be able to bite the bullet and persevere even after paying a certain price due to overconfidence.Psychologists have discovered the fact that, in fact, people adapt differently than we might expect.One example of this is the method of self-soothing.When a disappointing outcome occurs, people will say to themselves, "It should be okay if it is this level". Another way to adapt is to find a suitable excuse for a disappointing outcome.If you lose a lot of money investing in stocks, you can justify that the overall situation of the stock market is not good, and you can't do anything about it, even if you choose the right investment varieties wisely at the beginning, it will not help.This example powerfully shows that the cause of failure is overconfidence.It is rare to see people who have experienced failure find reasons from their own faults, and people generally find a decent excuse. Interestingly, optimistic visions of the future have the nature of a partially self-fulfilling prophecy.In other words, looking optimistically toward the future actually has the potential for an optimistic outcome.According to psychologists' research, when one's own efforts may have an impact on the result, the possibility of getting one's wish is very high. If this is true, there is another good reason for people to continue to be optimistic about the future. . However, we should not be blindly optimistic about the future, and we should not overly believe that the future results will be good.Too much self-confidence will often lead to not working hard, and of course things will backfire.If you work harder, your test scores will be higher, and this kind of self-confidence will make your wishes come true.In addition, although optimism about the future can bring us benefits, it may not always come true. This point should also be paid special attention to. Psychologists point out that people are not moderately optimistic in all situations, and people will be blindly optimistic without any basis, which is also an important reason for the existence of human beings.I don't think many people would do such an impulsive thing like being blindly confident without any basis, and wanting to cross the river after just a few swimming training sessions.