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Volume 15, Number 3: Faculty Focus
March 2009

Listen to a 4-minute interview with Professor Steve Foerster on investing   Listen (3.4MB)   Subscribe

In the past 18 months we have seen some once-in-a-lifetime events in equity markets around the world with some markets losing more than 40% of their value. The volatility in the markets has reached record levels. How can we make sense of the behaviour of investors?

Finance Professor Steve Foerster has researched capital markets for over 20 years and his recent research has focused on investor behaviour and why investors may not be as savvy as they think they are. In this Q&A he delves into his recent research as well as the conventional and latest schools of thought on investing.

Q. What has been the conventional approach to modelling how investors behave?

A. The traditional approach assumes that investors always behave rationally. That means, for example, that when investors receive new information about a stock they correctly update their beliefs, and given these beliefs they make choices solely on the basis of what we refer to as maximizing their expected utility. In such an environment, stock prices will always reflect what we call their true intrinsic value, which is also the discounted value of expected future cash flows. This is what we refer to as an efficient market and the key implication for investors is that there is no free lunch; in other words, no investment strategy can earn above-average risk-adjusted returns. So if you are an equity investor, you should simply buy an index fund.

Q. What is the latest school of thought on investing?

A. The latest school of thought is what is known as behavioural finance. It assumes that not all investors are rational. Behavioural finance has two key building blocks. One says that there are limits to arbitrage and in practice it is often difficult to correct the mispricing of irrational investors. The other says that there are psychological factors that describe the kinds of deviations from rationality that we actually observe. For example, investors tend to be overconfident in their abilities. They are often excessively optimistic. They hold their beliefs for too long. And they often defer realizing losses in order to avoid regret. The key insight is that irrational investors may not be as smart as they think are and they may end up losing money based on their investment decisions. As well, if we are aware of these irrational behaviours, we can avoid being disappointed by our decisions.

Q. What does your most recent research tell us about investing?

A. My research study is called “Double Then Nothing: Why Individual Stock Investments Disappoint.” I focus on how investors might behave and what the outcomes might be from investing in two different samples of stocks: one sample consists of stocks that have doubled in price in the last four years or less and the other sample consists of stocks that have not doubled in price. Investors often base their decisions on past performance and get excited over strong past performance, even though we always warn them that past performance is not necessarily indicative of future performance. In fact, I show that if you only choose from among stocks that have not doubled in the past four years, you probably have a good chance of at least doing as well as the overall market. However, if you only choose from stocks that have doubled, you may end up under-performing the market by as much as 30% over the subsequent four years. I also show that the faster a stock has risen in the past, it is more likely to fall further in the future. So the key message for investors is: don’t let your emotions get in your way.

That was Steve Foerster, professor of Finance, at the Richard Ivey School of Business.

Click here to link to the free download of the working paper from SSRN.