Everybody knows that markets aren't anywhere near as efficient as classic financial theory suggests. If they were, there'd be no point in ever trying to beat them.
Markets are created by the actions of human beings. Human beings are complicated things. We panic. We get greedy. And sometimes we do apparently irrational things, such as selling a perfectly sound asset, for rational reasons because we're getting divorced, say.
It's impossible to model the range of factors that affect human action, and therefore the markets. That hasn't stopped the whole financial industry, from academia to central banks to Wall Street and the City, from basing their business model on the flawed idea of market efficiency.
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However, the good news is that science is gradually turning the tide against the efficient market theorists. In this morning's Financial Times, Gillian Tett looks at a fascinating study by a trader-turned-neuroscientist that shows how traders' hormones move markets.
But as a private investor, how do you take advantage of this? And how do you stop yourself from being dragged around by your own hormones?
The 'greed and fear' hormones
The whole field of behavioural economics' is a classic case of science scrambling to catch up with what people already know: that when it comes to investing, we are often our own worst enemies.
This afflicts professional' investors too. Gillian Tett tells the story of John Coates, a neuroscientist and former trader at Deutsche Bank and Goldman Sachs. In short, Coates thinks traders' hormones are a real problem in financial markets.
Here's the short version. Testosterone is associated with aggression and risk-taking. Traders already have higher testosterone levels than most people. When they get on a trading floor, that goes even higher.
Testosterone can be good. Making money as a trader involves taking risks. They should be calculated risks, of course. Just as you wouldn't climb Everest without checking weather conditions, you should know your maximum downside before you trade. But it's an adrenaline sport, and you need nerves of steel to do it well.
Trouble is, too much of it affects your judgement. Coates calls it the irrational exuberance hormone', but you could just as well label it greed'. It makes investors get cocky, and take too many risks. In a rising market, that feeds on itself.
On the other side, there's cortisol. This "regulates our bodies' "fight or flight" reactions," notes Tett it's the fear' hormone. When there's too much of that, you panic, and get scared to invest.
Coates is so convinced of the impact of this on financial markets, that he thinks it would be worth installing "heart monitors, or blood tests in banks, to spot hormonal swings". He also thinks more women and older men should be employed on trading floors. "A better biological mix will mean fewer swings in testosterone and cortisol, and thus fewer market dramas."
Profiting from market mood swings
They're nice ideas. But I don't see them taking off. On the first point, if we're going to start monitoring people's mental state at work as a matter of course, I'd rather start with people who are making genuine life or death decisions.
The fact is, I don't really care if a trader at Goldman Sachs is taking a testosterone-fuelled epic bet on Apple or the Japanese yen. I do care if the surgeon who's about to operate on my loved one is feeling careless with the scalpel because he's a bit stressed about his house move.
On the second point, a better mix on the trading floor sounds good. But this comes down to a more fundamental culture change. The traders aren't there to be sensible. They are there to make short-term profits. To use ex-Citigroup chief Chuck Prince's infamous phrase, it's their job to keep dancing until the music stops. So you need to address that. If you do, a better biological mix will probably follow.
The good news is, you can take advantage of all this. Benjamin Graham, the father' of value investing, always described Mr Market' as being very up and down. When he's in a good mood, he'll pay you generous prices for your stocks. When he's feeling gloomy, he'll sell you his stocks at any price he can get them away for.
So the key is to know the stock (or asset) you want, and the price you want to pay for it. Then wait until Mr Market offers it to you at that price. If it wasn't for these hormone-induced mood swings, value investing wouldn't exist.
Your best investment yet a notebook
Sounds easy. There's just one problem. You're human too. And if you've ever invested (or ever indulged in spread betting or playing high-risk small caps), you'll recognise all these emotions.
There's the part of your brain that thinks rationally, for want of a better word. It knows' what you should do when you invest. It knows you should have a plan. It knows you should ride your profits and cut your losses. It knows you shouldn't over-trade.
But then there's the other part. Let's call it your gut to save confusion. Your gut thinks it knows best. It doesn't. Your gut panics when it sees a stock you're thinking of buying going up. It wrestles the controls from your brain and makes you hit the buy' button.
When the same stock is plunging days later, it's your gut that will tell you to ignore it, because it's bound to rebound. When it fails to do so, it's your gut that will panic and tell you to sell it just at the point of maximum loss.
In short, your gut is the enemy. How do you beat it? You need to slow your investing process down. I've found that the best way to do that is to take the time to write down your trades. It sounds dull. But it works.
Firstly, it forces you to consider your trades properly, so it stops you from taking impulsive bets, which are the ones most likely to go wrong. Secondly, if you write down why you are buying, and why you are selling, you'll start to spot where you are going wrong.
So get yourself a notebook and a pen. I'm going to look at the sorts of things you should be writing down in more detail in a future email. But for now, merely getting into the habit of physically writing down what you're buying, how much it costs (including dealing charges), and a one-line sentence on the rationale, will help keep you from making the most damaging mistakes.
This article is taken from the free investment email Money Morning. Sign up to Money Morning here .
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