I try to be skeptical of behavioral finance. I know stock markets are made of people and people have cognitive biases, especially when it comes to making market decisions; however people plays roles and the roles of the traders and analysts are to act as economic rationality calculators, and that rationality is controlled tightly through educational apparatus and institutional situations. (I’m speaking specifically of stock markets here, not you ordering dinner or at the mall.) I think limits to arbitrage born out of risk/reward and market structures are a good first model in causing bubbles and prices anomalies (which you could argue is behavioral, but that’s another thing); I also think the “heads-I-win/tails-you-lose” that is manifest in a lot of the rewards structure of our post-industrial economy can make managers look like they are acting irrationally.
That said, I think it’s important to look at stock puzzles in a lot of different ways, using all our tools. And I have a new puzzle! Here are two facts:
(a) On July 12th 2008, following word that Iran launched a missile that could hit Israel and that the U.S. was considering military action, oil prices jumped around $4.
(b) On December 3rd 2007, a NIE report was released that said that Iran had stopped its nuclear program in 2003, and the Bush team knew that for some time, making experts think that a war with Iran was not likely. It was a genuine news event, and the price of oil didn’t really go down at all, but let’s say it went down around 10 cents (which may have been noise).
When the likelihood of a conflict between the US and Iran goes up, oil goes up a lot, but when the likelihood of a conflict goes down, the price barely goes down. Why the difference?
1) Markets are efficient, and good news has diminished returns for future earnings while bad news grows the net loss exponentially.
2) Markets are behavioral in the sense that they overreact to certain types of news (bombs going off in the Middle East, photos of rockets in a desert) and under react to other kinds of news (the absence of an event happening).
3) To whatever extent markets are capable of processing large amounts of financial, accountancy, and macroeconomics data, they simply don’t have the expertise/time to try and work out a general free-floating risk factor in political relations across countries. Such a measure may be meaningless anyway.
4) The market knew that the NIE report would have no effect whatsoever on Bush’s policy to Iran.
5) Due to so much chaos in the market for oil, it is reasonable that Iran, as a producer of oil, would try and make the market more chaotic through its actions. As such, there is more uncertainty in the future.
6) The market for oil is controlled by “animal spirits” at this point, and people are bidding on it, at the margins, based on any noise that comes across the channel.
More to the point, see how difficult it is to tell the difference between rational/irrational? Between 1&2, and 5&6? The conflict between 3&4? What was rational and what wasn’t will only be decided in retrospect, and that’s a whole other ballpark of bias. Anyway, I’d be curious if anyone has better explanations than the hodgepodge I put up there for the difference between the two.