ANSWER TO PIER: (Nathanael)
RE: Week 5 Discussion 2
I certainly thing that human mistakes can aggregate and influence financial markets. Psychological biases and heuristics are often wide-spread and these decision-making processes can affect entire corners of the market. I have long wondered about the geography of decision making and whether there were noticeable patterns in the ways people invest depending on their geography. For instance, living and being from Florida, I do tend to favor companies who are based here. Additionally, I tend to think of Florida as a more business friendly state, and when business is good here, I assume it is good in other places to. This could cause me to assign too much confidence to the broader business environment and make me think that additional risk is permissable since the environment is so favorable. However, we know that state economies are not correlated, and that when one state’s business environment is doing well, it does not always translate to other state economies or the broader national economy. Yet, we also know that returns of stocks from a particular state can be anticipated based on the sophistication of it’s investors and the economic environment of that state (Korniotis & Kumar, 2013). Our lecture notes even suggest a potential trading strategy of buying stocks in states with depressed economies and shorting stocks in states with booming economies, playing on the fact that unsophisticated investors would have sold too much or bought too much in the respective states and thus misaligned fair value for the securities (Kumar, 2015).
Other human biases can also play an important role in the way investors approach the market. Recalling results from our Week 4 Presidential Puzzle project, as well as Addoum and Kumar’s paper on political sentiment, returns for certain industries and politically sensitive firms can be anticipated based on the current and predicted political environment (Addoum & Kumar, 2015). As an investment manager, I can anecdotally say that this true. In the late autumn of 2019, many politically conservative clients were asking about how to shift their portfolio should certain democratic candidates win the democratic primary and potentially win the White House. They saw the economic policies of these candidates as unfriendly to investors and to certain aspects of their respective portfolio. Meanwhile, many politically liberal candidates were quite excited by the prospect and were asking about plans to broaden their investment plans in anticipation of a strong business environment. This goes to show just how powerful political narratives are in today’s world, and those political narratives undoubtedly play a role in the minds of unsophisticated investors.
I do not believe that human error persists forever in financial markets, as I like to think there are enough intelligent investors out there to recognize opportunities of mispriced securities and take advantage of them. However, I also believe that these mispricings are not always short-lived and that our own biases and flawed decision making processes can create great distortions.