Irrationality, trend-following, and cats

By M.C.K. | WASHINGTON

ARE investors rational? One of the most robust findings in the empirical finance literature is that people who buy assets when discount rates are high do much better over time than those who buy when discount rates are low. In other words, when investors in the aggregate “expect” high returns, they get them. This suggests that the markets behave pretty sensibly. But according to a provocative new paper by Robin Greenwood and Andrei Shleifer, these implied “expectations” are not connected to what real people actually think or do. In fact, actual people basically do the opposite of what rational expectations models suggest they should do.

Mr Greenwood and Mr Shleifer measure investor expectations for the stock market by looking at the results of six separate surveys, as well as the flows into and out of equity mutual funds. They find that all of the surveys are strongly correlated with each other. Unsurprisingly, they also find that there is a strong relationship between equity fund flows and investor optimism:

In other words, when people expect to stock prices to go up a lot, they buy more shares.

But what determines these expectations? According to rational expectations theory, investors should become increasingly bullish as dividend yields rise (roughly). Yet it turns out that survey respondents are astonishingly bad investors who buy high and sell low:

[The] evidence is inconsistent with the view that expectations of stock market returns reflect the beliefs or requirements of a representative investor in a rational expectations model...Investor expectations tend to be extrapolative: they are positively correlated with past stock market returns, as well as with the level of the stock market (i.e., they are positively correlated with the price-dividend ratio).

Some financial economists dismiss the value of these survey results, even going so far as to say that respondents do not understand what they are being asked. The authors have little sympathy with this view:

Perhaps when investors report high expectations of market returns, they mean high expected growth of fundamentals, in which case their true expectations of market returns are low. This conjecture seems inconsistent with the obvious fact that respondents in the surveys we cover are active investors, and even CFOs, and they are asked directly about their expectations of stock market returns, not changes in fundamentals. The conjecture is also inconsistent with the high correlation between investors’ reported expectations and their actual behavior, as measured by the flows that retail investors direct into mutual funds.

What can we learn from this? As a first approximation, you should avoid trying to time the market. Unless you are a hedge fund superstar, you are probably buying high and selling low, just like everyone else. You would be better off letting a cat manage your money. As a second approximation, you may want to try to test out an investment strategy based on discount rates. *We are not actually endorsing this strategy. Please do not blame us if it fails to work out for you.* Finally, the paper presents us with an interesting puzzle: why do discount rates do a good job of predicting asset returns despite their complete disconnect from investor expectations? One possibility raised by the authors is that companies respond to over-eager investors by issuing more shares, but this is not fleshed out. It seems like an interesting area for further research.