Behavioral Finance Series

Behavioral finance incorporates elements of psychology to explain the actual behavior of investors and the subsequent effect on markets, in contrast to traditional finance which posits purely rational investors and efficient markets. In a series of OTMI posts, we will go over the most common behavioral biases investors fall prey to and put them in the context of current market events.

Coming into 2020 – against a backdrop of steady and stable economic growth, along with a positive earnings outlook – many investors were worried about the market highs reached over the last few years; and while markets have been extremely volatile since the early months of 2020, the S&P 500 is effectively at the same level it was when the year started.

What is framing? 

Framing bias occurs when decisions are influenced by the way information is presented. The way identical facts and information are displayed can lead to completely different judgements or decisions. Examples of framing are common in marketing campaigns to consumers, but in financial markets, framing around earnings reports or the time horizon used to analyze markets can also affect investor decisions.

Framing around the equity market

What level of returns should we expect from equity markets? The answer changes depending on the time period – when investors allow an incomplete picture to influence their decisions, it is an example of framing. While it appeared the market had climbed to untenable highs post-GFC (Exhibit 1), if we take a slightly longer view, the overall market return was actually flat between 2000 and 2012. During that time period, the market had an average annual total return of 0.6% per year and a cumulative total return of 6.8% - effectively a sideways market. 

Contrast this with the very different picture if we frame the time period to only consider the recovery from March 2009 to March 2020 – posting astonishing average annual total returns of 18.3% per year. Interestingly, these market dynamics, characterized by multiple new market highs each year and strong returns is, in part, the reason we have seen so many new investors flock to markets through online brokerage apps over the last 6 months, as declines were viewed as the market being “on sale”. 

To change the framing yet again, Exhibit 2 shows that over multiple decades periods of sideways markets are typically followed by periods of sustained upward movement (often referred to as Secular Bull markets), with the last being in the 1980’s. With the power of perspective, a long term market view further bolsters the notion that we must be invested for the long run – this is how we can most consistently transform income to wealth through investing.

The framing effect explains how we alter our decisions depending on the way information is presented to us. Being aware of this bias is the first step to overcoming it and as an investor it is paramount to always challenge the framing. The data in Exhibit 1 and Exhibit 2 are the same, yet we see completely different dynamics, showing that framing matters.

Exhibit 1: Stock market since 1996

S&P 500 Price Index 

Source: FactSet, FRB, Robert Shiller, Standard & Poor’s, Thomson Reuters, J.P. Morgan Asset Management. Price to earnings is price divided by consensus analyst estimates of earnings per share for the next 12 months as provided by IBES since July 1995, and FactSet for June 30, 2020. Current next 12-months consensus earnings estimates are $143. Average P/E and standard deviations are calculated using 25 years of IBES history. Shiller’s P/E uses trailing 10-years of inflation-adjusted earnings as reported by companies. Dividend yield is calculated as the next 12-months consensus dividend divided by most recent price. Price to book ratio is the price divided by book value per share. Price to cash flow is price divided by NTM cash flow. EY minus Baa yield is the forward earnings yield (consensus analyst estimates of EPS over the next 12 months divided by price) minus the Moody’s Baa seasoned corporate bond yield. Std. dev. over-/under-valued is calculated using the average and standard deviation over 25 years for each measure. Guide to the Markets – U.S. Data are as of June 30, 2020.

Exhibit 2: Stock market since 1900

S&P Composite Index

Source: FactSet, NBER, Robert Shiller, J.P. Morgan Asset Management. Data shown in log scale to best illustrate long-term index patterns. Past performance is not indicative of future returns. Chart is for illustrative purposes only. Guide to the Markets – U.S. Data are as of June 30, 2020.

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