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Search for the Holy Grail: Demystifying the Stock Market

The most basic features of the stock market continue to puzzle economists.

Research by Nicholas Barberis

Financial economists have labored for decades to develop a successful model explaining the workings of the stock market. Despite all their efforts, that model remains elusive.

Two concepts stand out as particularly vexing. The first and better known is the issue of the "equity premium," or the historically higher returns delivered by the stock market compared to the bond market.

Economists have been hard pressed to explain why the stock market has outperformed the bond market by as much as 6 percent per year over the past century, according to some estimates.

Less recognized but equally problematic is the issue of volatility. Simply put, economists have had difficulty explaining the erratic ups and downs of stock prices over the years. During the 1920s, 1960s, and late 1990s, price to earnings ratios reached astonishing heights. Then during the 1973-1974 crash, they plunged to great depths.

In a paper entitled "Prospect Theory and Asset Prices," Nicholas Barberis, associate professor of finance at the University of Chicago Graduate School of Business, Ming Huang of Stanford University, and Tano Santos of Columbia University turn to behavioral psychology to uncover some answers.

According to Barberis, the psychology of loss aversion may be one way of explaining the historic premiums paid by the stock market versus the bond market, as well as the stock market's volatility.

Stocks vs. Bonds

The standard view of the stock market holds that investors think of stocks as riskier than bonds, and therefore insist on higher average returns as compensation for this additional risk. The problem is that it hasn't been easy to fit this view to the facts.

"By any standard measure of risk used by economists, stocks do not appear to be that much riskier than bonds," says Barberis. And certainly, stocks don't appear risky enough to warrant an annual premium as high as 6 percent vis--vis bonds.

To resolve this problem, Barberis proposes an innovative departure from the traditional view of investor behavior. In the past, economists have typically sought first to determine what it is investors care about or get enjoyment from. Investors were believed to allocate current assets in order to derive as much enjoyment as possible from their lifetime consumption. But this approach cannot explain the great differential in returns between the stock and bond markets, nor the high volatility of the stock market.

Barberis argues that these earlier models may not capture investors' feelings accurately enough. He says that what drives investors is not only the enjoyment of consuming goods and services, but also the ups and downs of the stock market itself. When the stock market goes up, investors feel good because the gains affirm their belief in themselves as savvy investors, giving them an achievement to boast about at parties and in conversations with friends and family.

A large amount of research has shown that "loss aversion" is an important feature of this kind of psychological enjoyment. Simply put, it means that people are much more sensitive to losses than they are to gains.

Loss aversion is a simple way of resolving the equity premium puzzle. Investors focus on the gains and losses of their stock market investments, but the potential for losses looms larger in their thoughts than does the potential for gains. Their perception is therefore that stocks are much riskier than bonds. As a result, they conclude that they can justify holding stocks only if those stocks earn much higher average rates of return than bonds.

"We agree with other economists that the equity premium compensates investors for the greater risk of stocks," says Barberis. "We're simply proposing what we think is a more plausible measure of risk, and one that fits the facts better."

Explaining Ups and Downs

So what then causes stock prices to climb so high or fall so low in the first place? The simplest explanation for these dizzying swings is that prices reflected investors' expectations of future earnings. However, as Barberis points out, market peaks haven't been followed by substantially higher-than-average earnings growth, nor have market bottoms been followed by significantly lower-than-average earnings growth.

To explain the historic volatility of the stock market, Barberis draws on psychological experiments. These experiments demonstrate that not only are people loss averse, but the pain of losing depends to a large degree on prior gains and losses.

For example, people who had won substantial money on earlier bets demonstrated less fear of future losses. Gains they had accumulated softened the potential blow of subsequent losses. Their apparent reasoning was that it didn't matter whether they lost a little of their gains, because they would still be ahead overall. Gamblers frequently take more chances when they're ahead because they're "playing with the house money," or money already won from the casino.

But the experimental literature in psychology also suggests an asymmetry. After losing on prior gambles, people found the thought of any additional losses more painful than usual.

Similarly, Barberis argues that the effect of prior outcomes on subsequent actions may help explain why stock prices have traditionally been so volatile. When the stock market goes up, investors become less concerned about future stock market fluctuations, and feel their cushions of gains will soften the pain of small drops in the market.

In a sense, investors view stocks as being less risky than before. Accordingly, they buy stocks in even larger quantities, propelling the stock market still higher and continuing the cycle. And when the stock market falls, they view stocks as being more risky than before, leading them to sell stocks and push the market still lower.

Recent Trends

More importantly, Barberis's findings agree with market movements of the last few years. After the huge run-ups of the late 1990s, many analysts pointed out that the market seemed to recover easily after small dips. One plausible explanation is that because most investors had enjoyed substantial prior gains, they didn't find the dips very painful. "I'm still up relative to '97," they might have argued.

But when poor earnings reports on NASDAQ stocks resulted in steep drops in that tech-laden index in 2000, many investors knew their earlier gains had been erased. Suddenly, the stock market appeared much riskier than before, and investors began reducing their holdings en masse, precipitating additional declines. This might explain why once the NASDAQ began falling, its decline accelerated, resulting in a plunge of thousands of points in that index in a single year.

"I think that loss aversion is a plausible explanation for the higher historic average returns on stocks," Barberis concludes. "I also think that loss aversion is something that's very hard to shake off, which leads me to believe that over the long term, stocks are going to continue to outperform bonds."

Nicholas C. Barberis is associate professor of finance at the University of Chicago Graduate School of Business. "Prospect Theory and Asset Prices" was awarded the 2000 FAME Research Prize by the International Center for Asset Management and Financial Engineering.