My definition for what I call "Funny Money" is this: money that irrationally gets invested into outperforming high valued equities, and then gets dumped at the very bottom of a stock decline when valuations are actually attractive and the stock is under performing. To me, exploiting funny money or understanding emotional trading and behavioral finance can put you a leg up on everyone else and ensure that you are making smart investing decisions that will be profitable in the long run.
I've eluded to emotions in trading back in Lesson 30, and how avoiding emotions over the long run can ensure effective compounding returns during that same time period. However, I'd like to talk a bit more in detail around behavioral finance and how investor emotions can drive securities up or down.
Investors can simply either be rational or irrational. Depending on the level of rationality or irrationality can dictate how markets react to publicly shared knowledge, and forecasted equity performance. Rational behavior will tend to see markets moving in a direction that is expected, or in other words, leave very little room for arbitrage. On the other hand, irrational behavior can see markets moving in all kinds of directions that is uncorrelated to expectations or to what public news and knowledge is suggesting, leaving huge opportunities for arbitrageurs to profit from mispricing, which will eventually force prices back to proper valuations.
Irrational investor behavior has 2 categories:
1) Limited processing and understanding of information
2) Behavioral Biases
Let's briefly look at limited processing first.
Having a limited understanding of information can influence how people invest and the types of investing decisions they do. This limited understanding can simply stem from previous experiences, both good and bad, or by placing too much importance and attention on previous equity performance, resuliting in forecasting errors.
"Oh my goodness, Netflix has gone up 50% in 1 month. I must buy this now because it will go up another 50% in the next month!"
This leads to a common misconception about stock prices, and well statistics in general, in that historical trends set the stage for future performance. Just because I showed up to work late today does not mean I will show up to work late tomorrow. Just because Richelieu Hardware (RCH.TO) was up 4% today does not indicate a future increase in the stock price tomorrow.
Another precursor to limited understanding is that the majority of investors are overconfident in their forecasting estimates. There was a study that was done by a Swedish psychology journal called Acta Psychologica that found that 93% of American drivers think they are better than the average driver. Obviously this can't be the case because 50% have to be worse than average, and 50% have to be better! The same thing applies to investors, where the majority feel that they can outperform the market or do "better than average" in terms of annual returns. However, this is quite the opposite where many studies have shown that the average equity investor earns a much lower return than the average return on the S&P 500 on an annual basis.
Now let's look at behavioral biases.
Behavioral biases exist and there are many factors that influence this state of mind. The first factor is around how an investor interprets a question around risk aversion or profit and loss, or in other words, how a question is framed or asked. Suppose your friend tells you that you pay $10 dollars to flip a coin, and that you have a %50 to win $10 on heads, and %50 to win nothing on tails. Suppose the same friend asks you instead whether you'd like to pay $10 dollars to flip a coin, and that you have a %50 chance of losing nothing or a %50 of losing all your money. Both statements are correct, and both scenarios have an expected return of $5 (50% x $10 + 50% x $0), which sucks either way because you paid $10. However, the first statement worded in a way of "winning" sounds more attractive than the statement around losing.
The second factor has to do with mental grouping of decisions, where investing decisions are placed into different "risk accounts". For example, an investor may be more hesitant to buy $5000 of Stock X with his cousin's money instead of using his own $5000. Retail investors (aka you and me) are more inclined to take on risk with their own money instead of someone else's money. Investors are also more likely to take risks in investing their gains than with their principal amounts. This is similar to a gambler in a casino playing roulette for example. If Jim plays roulette and bets $50 on black and he wins, he's much more likely to be more careless with this extra $50, or "house money", than he is with his initial $50. This seems silly since all $100 are his anyway.
The third factor is called "regret avoidance" where an investor will be harder on oneself in the event where they lose money on a risky investment, and be less upset when losing on a less risky or conventional investment. Terry may blame herself more for investing in FitBit when its inevitable demise and bankruptcy filing comes, as opposed to investing in Google right before it drops 10% at its next quarterly earnings release.
The last factor of behavioral bias is something called "Prospect Theory". Prospect theory suggests that a person's utility is tied to wealth. Simply put, money equals improved utility (happiness or satisfaction). Conventionally, utility typically depends on how much money or wealth one has accumulated. However, from a behavioral standpoint, Prospect theory suggests that utility depends on the change in wealth, where satisfation increases when one becomes wealthier, and satisfaction decreases when becomes poorer. However, utility is not linear with wealth changes. Consider this example. I love donairs. I'd probably say that it's one of my favorite food items. If you give me one donair, my utility goes up. I'm happier. If you give me a second donair, I'm likely somehwat full after the first, but I'd still be happy. After the 50th donair, the increase in my utility from that 50th donair is much less than my incremental utility from when I got my first donair. The same can be said for wealth. Earning $1M today would be fantastic. After earning $1M for the hundredth time (i.e. I now have $100M), the increase in my satisfaction is much less than when I earned that first $1M. The utility function for changes in wealth under Prospect Theory is shown below in Figure 1:
Figure 1: Utility Function Under Prospect Theory
The trend of the graph suggests that investors are risk adverse in investment gains, but risk seeking when experiencing investment losses. Again, this can be related back to Mr. Jim the roulette player. If Jim loses his first $50 because the ball landed on red, he's much more willing to keep playing and slap another $50 bill down in an attempt to break even and get his original $50 back. However, if Jim had won $50 the first time around, he may be less inclined to bet his original $50 because he'd like to lock in some "gains" after his win.
Irrational behavior exists daily in the stock market, and can drive market prices in unanticipated directions. However, being a smart investor means taking advantage of these arbitrage opportunities to buy equities at attractive valuations and hold for the longer term, or to sell positions at overbought and high priced overvalued levels to lock in profits in the hope to buy back in at a later point in time under more reasonable valuation conditions. Don't be a funnel to the funny money. Let the funny money do its thing and run its course so that you can capitalize on market opportunities that will benefit you in the long run.