Andrei Shleifer’s Inefficient Markets: An Introduction to Behavioral Finance — KCR’s Key Lessons from a Legend in the Field

Behavioral Finance In the Markets: Are Markets Efficient or Inefficient?

In 2000 Andrei Shleifer published “Inefficient Markets.” The book brings together some of the best research in Behavioral Finance. Dr. Shleifer’s “Acknowledgements” section notes the tremendous contributions of other pioneers in the field. The list includes luminaries such as Joseph Lakonishok, Robert Vishny, Brad De Long, Larry Summers, Robert Shiller and Richard Thaler.

We believe this book, like Seth Klarman’s Margin of Safety, is a landmark. The work connects academic research around financial behaviors with the typical investor. The “Acknowledgements” section is a reminder that its contents are not just the views of one brilliant mind. The book draws on the work of many of the greats in Behavioral Finance.

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Academics are often dismissed by practitioners as a homogenous group that believes in the Efficient Market Hypothesis (EMH). Our team hopes this paper helps correct that error. Embracing rationality and perfect arbitrage, EMH states that securities prices reflect all information, making it impossible for stocks to be under or overvalued.

Prices in financial markets today are, in our view, a testament to the alternative approach to the study of financial markets offered by behavioral finance. Various types of herd behavior can send speculative asset prices to extremes. Finance and economics are dominated by the emotions of people take ESG and cleantech stocks for instance.

The lessons we share below do not do the book justice. In no way are they a substitute for actually purchasing your own copy of Dr. Shleifer’s book. As always, we encourage subscribers to take us up on our offer for a free copy of any book we have discussed.^[1] excluding A Margin of Safety.

Our Notes on “Inefficient Markets”:

Chapter 1: Are Financial Markets Efficient?

Quote: Moreover, new studies of security prices have reversed some of the evidence favoring the Efficient Market Hypothesis EMH. … behavioral finance has emerged as an alternative view of financial markets. … systematic and significant deviations from efficiency are expected to persist for long periods of time. –page 2

• The Efficient Markets Hypothesis (EMH) rests on a three-legged stool:
  • fully rational investors trade so securities prices in financial markets must equal fundamentals
  • when they are irrational their trades cancel each other out or…
  • arbitrage eliminates pricing anomalies as arbs trade against canceling out irrational traders
• History, theory, and empirical research present major challenges to EMH
• Researchers like Kahneman, Riepe, Tversky and others have presented theoretical rebukes based on abundant evidence that investors’ attitudes to toward risk, probabilities and forecasting are irrational
• One of the most basic premises of EMH is that, to the degree investors are irrational, they are randomly irrational and so this irrational behavior tends to cancel itself out
• Psychological evidence from Kahneman and Tversky suggests irrational behavior is not random and humans deviate like lemmings as our emotional biases drive collective investment decisions
• Published in 2000, the book notes that this herding effect is amplified when people act “…socially and follow each other’s mistakes by listening to rumors or imitating their neighbors (Shiller 1984).”^[2]
• Could you make up a more aggressive “strain” of this behavior than what we have seen in the social media forums driving investors today?
• EMH assumes irrational investors’ trades will be met by arbitrageurs who cancel out the inefficient behavior – Shleifer cites a large number of studies both from theory and data showing that arbitrage is not riskless as perfect substitutes are not readily available and what is irrational can become far more irrational – arbitrage is risky business!

We are going to stop here to make the following pitch: if you are a subscriber and have not read this book, please contact us and let us send you a copy of the book. Fantastic and timeless. If you don’t subscribe, please go buy a copy of Dr. Shleifer’s book.

The 27 pages in chapter one, is in our view, worth many times the price of the book. We cannot do it justice. The stock market today is a carnival of behavioral economics in our view as investor infatuation with finding fast growing stocks to invest in is reaching a crescendo. One could almost suggest a financial plan requires a rough understanding of the concepts covered in this book.

Chapter 2: Noise Trader Risk in Financial Markets

Quote: In this chapter, we explore some of the basic risks associated with arbitraging two fundamentally identical assets – the near textbook case. –Page 28

• Arbitrage is risky business even when you happen to have perfect substitutes
• The example used here is Royal Dutch and Shell in the context of Long-Term Capital Management
• There is a bunch of really fancy math here that validates the point being made – we are going to give it a crude summary as follows:

Royal Dutch and Shell represented ownership in the exact same stream of cash flows but were traded on two different exchanges. According to the Efficient Market Hypothesis theory they should always have traded at parity. They did not. Long Term Capital Management saw that there was a perfect arbitrage and bet it would close. Instead, the spread got wider. LTCM would then add leverage seeking to amplify their return when the spreads between the shares closed. Instead, the spread continued to widen, wiped out LTCM and the Fed got involved. Arbing even perfect substitutes can be very hazardous to one’s health!

• Citing research by Baker and Wurgler, Shleifer notes that aggregate issuance of stock and bonds is elevated during bull markets
• He further notes that new issues tend to be bad purchases precisely because they are overpriced…. we think that is a timely note so we included it here
• Market prices are often driven by irrational behavior that is often collective
• No one can know for sure just how severely markets can become detached from fundamentals
• These factors make arbitrage risky and are compelling evidence that EMH has serious flaws

To reiterate our point above: this book is so good, we hope you will get a copy and read it.

Chapter 3: The Closed End Fund Puzzle

Quote: Few problems in finance are as perplexing as the closed end fund puzzle. –Page 53

• Closed end funds are a near perfect method of exposing how irrational investors are
• The funds inexplicably trade at a premium when they are issued and then, shortly after, drift to substantial discounts and, when they are liquidated or moved to open-ended status they trade back to parity
• For long-time investors familiar with closed-end funds those facts are familiar, but if you really think about it, they make no sense
• If a closed end fund owned 10 securities worth $100, but the fund traded at $90, you would expect an arbitrageur to short the 10 stocks and buy the fund and repeat that until the two were at parity
• Data shows that doesn’t happen because the only way for the gap to close is for the fund to be liquidated or moved to open-ended status, and these funds have a long history of fending off such efforts by owners
• The closed-end fund “puzzle” is an incredibly compelling piece of evidence that investors are not rational
• Buyers of closed-end funds knowingly overpay for an asset they could easily replicate on their own even though they know that these closed-end funds frequently transition from premium to discount
• One of the most fascinating notes in our view is the simple observation of how, when and where closed end funds are launched
• Summarily these products tend to be in “hot” asset classes or, in some instances, to allow people access to “…so called ‘celebrity funds’ (funds managed by well-known money managers) …”^[3]
• Can anyone think of some funds that resemble this today? [ETHE, GBTC, ARKK, etc.]

Chapter 4: Professional Arbitrage

Quote: When, … the arbitrageur manages other people’s money, and his investors do not know or understand exactly what he is doing, they only observe him losing money when prices move further out of line. They may infer from this loss that the arbitrageur is not as competent as they previously thought, refuse to provide him with more capital, and even withdraw some of the capital although the expected return from the trade has increased. -Page 89

• We believe this is one of the most incredibly succinct means of saying what any investor with gray-hair knows to be true: money tends to abandon the best opportunities at precisely the wrong moments
• This creates a capital constraint for arbitrageurs – they have the least money and the least ability to actually provide offsetting liquidity to mispricing precisely when such mispricings are at their widest
• Referring to such situations as “performance-based arbitrage”^[4] Shleifer makes the point that this phenomenon actually means arbitrageurs can exacerbate mispricings
• As capital allocators, looking at past returns, begin systematically withdrawing capital, they create a self-reinforcing cycle of redemptions forcing arbitrageurs to buy what they were short (overpriced stocks) and sell what they were long (value stocks), amplifying the pricing error
• This effect is so severe it can spill over into other asset classes causing systematic pricing errors to widen across different strategies
• This strikes a serious blow to advocates of EMH who assume that people allocate money based on expected future returns – precisely the opposite of real-world observations
• The chapter ends with a discussion of the Long-Term Capital Management unwind and how this is a very real and tangible example of how the exact people that EMH assumes will arb out irrational behavior can, when given too much leverage and not enough time, present vast systematic risks

Chapter 5: A Model of Investor Sentiment

Quote: The underreaction evidence shows that security prices underreact to news such as earnings announcements. If the news is good, prices keep trending up after the initial positive reaction; if the news is bad, prices keep trending down after the initial negative reaction. –Page 112

• That technical language is merely a way of saying that the EMH cannot be true because markets spend a long time incorporating old information into prices
• The chapter goes into an exploration of what happens based on the “overreaction evidence”^[5]
• In the interest of brevity, we will compress an entire field of brilliant financial study into a crude observation: When some stocks have a long string of consistently good news, investors then think the good times will keep going forever and value that stock too highly, and that valuation eventually suffers mean reversion
• The evidence shows that this type of behavior takes place over periods of three to five years
• Citing work by Tversky and Kahneman in 1974, Shleifer refers to this as a mistake called “representativeness”
• Representativeness is a behavioral mistake where human beings start to disregard probability theory when making forecasts; they extrapolate a string of good news as if it could never end, even though that is entirely inconsistent with either theory or practice
• The full scope of behavior can be looked at through the lens of underreaction to overreaction – and we will use a real-life example from our business to make the point here:
  • When we started this business in 2010, we were bullish on a company called Microsoft – the stock was cheap, its cash-flows enormous relative to price and, due to a confluence of factors, the firm kept disappointing investors.
  • At less than 10x earnings people told us that Microsoft was a lost cause and obsolete. Eventually the news flow turned, new management entered, results began to outperform investors’ expectations.
  • In the beginning analysts and investors were skeptical and thought the good news temporary. Fast forward to 2021, and, after a long string of consistently good news, there is no multiple too high that investors will pay for Microsoft and the shares currently trade at 30x projected future earnings that are 20% higher than the all-time record earnings the firm earned in the last 12 months^[6]
• Shleifer notes that the volume of evidence supporting this behavior is “enormous”^[7] which we think is funny, because absolutely no-one is paying any attention to this stuff right now
• This entire chapter is a great way to learn about Post Announcement Earnings Drift and many other behavioral errors that our research models seek to exploit in a systematic and easy to digest manner

Let’s pause and catch our breath. This book is so prolific we cannot do it justice. We believe that behavioral finance is driving the massive price dislocations we believe exist today (November 2021).

We believe this book, written in October 2000, explains the future resolution of today’s pricing errors with the analogs between 2000 and today as obvious as they are plentiful. While over 20 years since first published, we believe the lessons within the book’s pages are as relevant today as they were in 2000.

Chapter 6: Positive Feedback Investment Strategies

Quote: While underreaction to news is well documented empirically, it may not describe some important instances of momentum. These are the so-called price bubbles, in which prices go up and up without much news just because noise traders are chasing the trend. –Page 154

• This chapter documents the fact that many investors are often just chasing trends
• When prices go up, they assume that they will keep going up and hence just keep buying
• When prices fall, they assume that they will keep falling and begin to sell indiscriminately
• The chapter explains that because this phenomenon is well understood by many, there is an entire class of arbitrageurs who seek to amplify mispricing pushing prices farther beyond their fundamental value expecting others to chase the price move they created
• The chapter connects the research to the behavior of George Soros who saw irrational investors chasing conglomerates and so, rather than betting on their eventual collapse, he stimulated the activity by joining the fray only to later sell at higher prices
• Dr. Shleifer then examines Bagehot in 1872 who stated that people seeking fast profits crowd into assets with rapidly rising prices ever more aggressively for “easy” profits
• On page 169 Dr. Shleifer goes into the “Anatomy of a price bubble” and we think this is absolutely critical reading for anyone investing in markets today
• Specifically, the book summarizes 10 of the world’s most famous price bubbles starting with the Dutch Tulip Mania in the 1630s
• Over 100s of years, we engage in remarkably similar patterns of behavior that takes an idea, turns it into a mania, which leads to losses and recriminations

Chapter 7: Open Problems

Quote: Behavioral finance has provided both theory and evidence which suggest what the deviations of security prices from fundamental values are likely to be, and why they persist over time without being eliminated by arbitrage. In many cases, behavioral theories have also met the “scientific” standard of issuing new testable predictions that are subsequently confirmed. –page 175

• This chapter is a summary of how behavioral finance has offered a sharp theoretical and empirical rebuke to the proponents of the Efficient Market Hypothesis
• Dr. Shleifer asks readers to ponder the idea that, in 1998, large stocks in the US were trading at 32x earnings or roughly 2x the post-World War II average and asks, “Are we in a bubble and if so, why?”^[8]
• Consistent with all the evidence presented in the book, not only were markets in a bubble, the bubble was driven by virtually all of the evidence Dr. Shleifer presented
• As we all know now, that bubble would rage on from 1998 until early 2000 as already exorbitant levels of speculation were taken further than any time in history
• Value investors were fired by allocators precisely when their opportunity was greatest and arbitrageurs in the world of “long/short” found themselves facing redemptions with people proclaiming the end of short selling immediately prior to an 80% collapse in the Nasdaq
• The chapter cites work by Campbell and Shiller that the required growth in earnings extrapolation implied by excessive valuations had never materialized in US history
• We hope our readers ponder this with market valuations higher than they were in 2000
• Even more problematic for investors, survey research shows that when stocks are priced to deliver the worst future returns due to long periods of price appreciation, which is precisely when investors expect the highest future returns
• Our human instincts guide us to some of the worst possible behaviors when it comes to investing

Closing:

The chapter notes the disastrous returns of buying IPOs vs. just buying the index and discusses some of the possible social implications of the research. We are going to avoid that and just draw our readers attention to one of the most recurring themes in every piece of literature we have reviewed: all the authors highlight the need to avoid IPOs. It is the easiest investor mistake to avoid, and we highlight it here again as we are in a world besieged by SPACs, IPOs and other forms of “issuance” that all represent market ebullience that is entirely consistent with some of the worst periods in history to buy such instruments.

We reiterate our view that this book should be read by every serious investor interested in identifying and exploiting systematic mispricing in markets.

Today everyone is infatuated with mutual funds that focus on innovation that have beaten the market recently. The collapse of risk aversion, short horizons and agency problems have rendered the idea that market prices represent fundamentals comical in our view. The idea that people are rational or because arbitrage is balancing things out, markets must be efficient, strikes us as a strenuous claim in today’s environment. Our piece explaining what high volume in stocks means today stands out as an almost perfect repeat of the dot.com mania Dr. Shleifer was explaining in his book.

We fear long-term future returns will be far lower than many expect. One could almost retitle Dr. Shleifer’s work “Behavioral Finance, The Book” in our view.