IL54: Why Smart Investors Keep Making Crazy Decisions ft. Alex Edmans

Alex Edmans (0:01)

I'm not so worried about missing out on perhaps future gains by not selling at the absolute top, because I know that it had had a really good ride. What I want to avoid is if we are in a bubble, we are in a big market dilution, and the whole market then turns south, as it did for electric vehicles, in sort of 2020-2023.

SPEAKER_2 (0:24)

Welcome to Top Traders Unplugged. In markets, success doesn't come from predicting what happens next. It comes from being prepared for what you can't predict.

In each episode, we go deep with some of the world's most thoughtful minds in investing, economics and beyond, to understand how they think, how they prepare and how they decide, and the experiences that shaped how they see the world. No noise, no shortcuts, just real conversations to help you think better and invest with confidence.

Kevin Coldiron (0:58)

Welcome everyone to Top Traders Unplugged. My name is Kevin Coldiron and I'm host of the Ideas Lab series where we talk with authors of new books that help us understand and navigate the global economy. Our guest today is Alex Edmans. He's a professor of finance at London Business School and a leading expert on market psychology. You may have read about his research in the FT or the Wall Street Journal, or you may have read one of his books. He's the author of May Contain Lies, which was an Amazon number one bestseller, and also Grow the Pie, a Financial Times Book of the Year.

Alex is here today to talk about his new book just out in September called The Madness of Markets, Why Smart Investors Make Crazy Decisions and How to Exploit Them. Alex, thanks so much for joining us and welcome to the show.

Alex Edmans (1:48)

Thanks so much for having me on, Kevin. It's great to be here.

Kevin Coldiron (1:51)

First of all, shout out London Business School. That's where I studied finance and got started using a lot of the ideas you actually talk about in your book. So, I wanted to maybe start off with what you say. You say that mood matters, that sentiment impacts markets in surprising ways.

Perhaps we can start off with a couple of stories from your own research. I mean, you became well-known early in your career for a paper that looked at the impact of sporting results on markets. And then later, you looked at the impact of music on markets. And you use that as kind of an illustration to show us that markets are not just driven by raw fundamentals, their sentiment matters a lot. So I was wondering, perhaps you could tell us those stories.

Alex Edmans (2:46)

Certainly. So while you learned finance at London Business School, I learned it at MIT in the US. I did my PhD there. And MIT being MIT, all the professors and my classmates, they were looking at rational quantitative factors. So the price of a stock depends on future dividends and growth rates and inflation, and all of that stuff. But I had just been in the real world. So I was at Morgan Stanley between undergrad and my PhD. And while people are really smart and they're able to devise big Excel spreadsheets, taking those into account, they're also human.

I wanted to show that psychology and emotions and sentiment also matters. Now, showing that sentiment affects the stock price is quite difficult because many factors that affect the mood will also affect fundamentals. For example, if there's a plane crash, yes, people are unhappy, but the stock market might go down not because people are unhappy, but instead because it's bad for the economy. So this is why I looked at crazy things such as soccer results. Why? Because if England lose, that should have no effect on profits or dividends or inflation, except in a few sectors like replica merchandise. But it does cause a huge effect on national mood. And what I found long story short is that when a country gets knocked out of the World Cup, the market falls significantly the next day.

To put some numbers on it, it's about half a percent, even when you control for the broader world market movement. And when applied to the UK stock market, that is over 10 billion pounds wiped off the market on a single day.

And so why is that so profound? Because you might think, yes, emotions matter. Yes, certain things make me happy or unhappy. But when I am trading, I become rational. I shake that off. I'm a professional who puts my emotions to one side. But what my data shows is that's not the case. You are human and you are affected by emotions even when you're in your job. And therefore we need to be very careful when making investing decisions not to be swayed by these extraneous factors.