How to Outsmart Your Investing Instincts

Alex Edmans (0:02)

Bloomberg Audio Studios, Podcasts, Radio, News.

Merryn Somerset Webb (0:17)

Welcome to Merryn Talks Money, the podcast in which people who know the markets, explain the markets. I am Merryn Somerset Webb, and this week I'm speaking with Alex Edmans, Professor of Finance at London Business School and author of the new book, The Madness of Markets, Why Smart Investors Make Crazy Decisions and How to Exploit Them. Here it is. I want to speak to Alex today because we've had him on before, and we had a fascinating conversation about his previous book, May Contain Lies, How Stories, Statistics, and Studies Exploit Our Biases and What We Can Do About It. But in this conversation about this book, we talk about why even the smartest fund managers still invest irrationally, the link between football results and stock market performance, how luck and skill influence how we perceive investment performance, and much, much more.

Alex, thank you so much for joining us today. I really appreciate it.

Alex Edmans (1:04)

Thanks, Melvinda. It's great to be back.

Merryn Somerset Webb (1:06)

As I say, I love this book. I thought it was absolutely great. But you know what? If I was a bookshop owner, and I was looking at this and I was going, where should I put this in my bookshop? I would find myself hovering between whether to put it in finance and investing or in self-help.

Because it does what self-help books do, right? It tells you, well, this is the way the world is supposed to be, and oh dear, it's not that way. Your life isn't working out as you thought. So here's how it really is, and here's what you should do about it.

That's basically how all self-help works. So that's why I'd be hovering. But in this case, when we look at the bit about how the world should be, and we're talking about investing, it's supposed to be efficient. It's supposed to be about fundamentals. And it's supposed to be about fundamentals all the time. The market is supposed to know everything. The market is supposed to be based on discounted cash flow, on dividends, on P-ratios, on press to book ratios. But your starting point is that it demonstrably isn't. And the idea that anyone still believes any version of that is absurd.

Alex Edmans (2:14)

That's correct. And that's what motivated writing this book. So I did my PhD at MIT in finance. I looked at what drives the stock prices. My professors were saying it's fundamentals, forecast future cash flows and discount rates with some hopelessly complicated model. But I had spent a couple of years at Morgan Stanley in London and also Morgan Stanley in New York. And I saw that even really sophisticated people, yes, they did use equations and quantitative factors, but they are human. They are affected by emotions. And then one of my earliest papers, I looked at can the market be affected by something as crazy as a football result?

So what do I look at football? Well, there's other things that drive national moods, such as a lockdown or a plane crash. But if you found the market fell after a plane crash, that could be just economics. It could be that there's going to be less travel and more restrictions.

Merryn Somerset Webb (3:00)

Yeah, and there aren't quite enough as well to really, fortunately, there are not quite enough plane crashes.

Alex Edmans (3:06)

Fortunately, there are not.

Merryn Somerset Webb (3:06)

In countries with big liquid markets for make this a reasonable way to look at the road.

Alex Edmans (3:10)

Exactly. And so when you have a small sample size, it could be due to some confounding factors. But what my co-authors and I were able to look at was 1,150 football matches. And the idea is that football doesn't affect profits or dividends or non-farm payrolls. But we found that the market systematically fell the next day after a defeat. And this was interesting and surprising to us because most people will agree, yes, my emotions are affected by my sports results or my family situation. But when I get into the office, I'm going to put my game face on. I'm a professional. I'm going to forget about this sentiment.

But again, you're human and a human will be affected.

Your judgment might be clouded by some of these extraneous factors. And then this led to the open the door to the wider measures of sentiment that can be affecting your emotions, your decisions. And that's what's in the book.

Merryn Somerset Webb (3:57)

Yeah, there were two other little interesting things on that football story, which I found fascinating. One was that there's a rise in death after a football loss, a rise in heart attacks. So, you know, the market is probably minor, next to the fact that a football loss actually increases the number of heart attacks. And also that after a win, the market doesn't go up.