The annual ‘Black Friday’ phenomenon is well known for producing some unusual human behaviour. Consumers rush to take advantage of lower prices, displaying the classic biases associated with group dynamics: myopia, and a fear of missing out. We often see people in a crowd doing things that few would consider in the cold light of day.
But even this can be far more understandable than some of the behaviour we see in apparently rational investment markets.
At least Black Friday shoppers are rushing towards lower prices.
Financial markets are often different
Before the term ‘Black Friday’ became popularised the other famous ‘black days’ in modern history were often associated with financial markets.
This year marked the thirtieth anniversary of ‘Black Monday’. David Harding at Winton has produced an excellent retrospective (including a very cool video) which also highlights the fact that even quantitative strategies are not immune from the impacts of human emotion. On that day, US markets fell around 20%.
In the heart of this storm there was huge panic. Instead of rushing in – elbowing competitors out of the way – to take advantage of the 20% discount as we would for a new TV, investors rushed to sell.
Now, markets do periodically fall in such a manner with genuine reason. Real fundamental events can take place which mean that your asset wasn’t worth what you thought it was.
But in 1987, very few had a real sense of what had actually changed relative to the day before, except for price.
We cannot know the counterfactuals, but it seems likely that fundamentals hadn’t actually changed, and were in fact strong. Ultimately, the total return on the S&P 500 in the calendar year 1987 would be 5.2%, and for the five years from 1987 to 1992 – including another noteworthy crash in 1990 as many developed markets entered recession – it would be an annualised 15%.
Going with the crowd
While the behaviour in our shops today and the behaviour in markets in 1987 seem diametrically opposed, they come from the same source: human beings’ in-built compulsion to go with the crowd. A colleague made the analogy this way: “Say you open your front door to find a huge crowd running down the street. Even if you don’t know why they are running, you aren’t likely to go in the opposite direction.”
This is a great strategy for survival. But in financial markets the crowd can get us into trouble. On another ‘black’ day (Tuesday this time) in 1929, the Dow Jones industrial index dropped 25%. But this wouldn’t prove to be much of a buying opportunity.
In this case it was again true that the fundamentals hadn’t changed from one day to the next; they just hadn’t been strong enough to justify valuations to begin with. Investors had been beguiled by the crowd again; this time liking assets more and more as the prices had gone up.
Apparently rational investors could benefit from being more like the ‘irrational’ Black Friday shoppers and think about the price they are paying for an asset in the same way as we do for a widescreen TV. They just need to avoid the crowd psychology that can go with it.