THE IRRIGATION SIDE OF MARKET
A thesis presented to the faculty of IICSE University
...a liberal arts education.
In partial fulfillment of the requirements for the degree of PhD of Doctoral of Business Administration
By Abdul Rahim Wong08/2022
CERTIFICATION OF APPROVAL
THE IRRATIONAL SIDE OF MARKET
By Abdul Rahim WongAcknowledgements and Dedication
Thanks to all the information researched through out this thesis. Dedicated to the field of behavioral economics.
It is not hard to understand the way the market is supposed to work. In theory, the investment process is quite logical. Find stocks that are good values or set up well technically and then hold them as the market discovers their true value. News like the crisis or economic issues may cause some volatility along the way but ultimately the market is logical and functions as a discounting mechanism that will eventually reward astute stock selection.
That is the theory. The reality is that the stock market is wildly irrational at times. Valuations become meaningless, trends climb to the sky and it seems like the dumbest investors are rewarded for their lack of rigorous analysis.
These periods of irrational action are the nature of markets. They occur regularly and they will always eventually come to an ugly end. They almost always last longer than seems reasonable. It is the herd mentality at work and a stampede of hungry bulls doesn't usually end too abruptly.
Credits
All the information researched within the knowledge spheres
Irrational market action offers some of the greatest profits but many people squander their chances by proclaiming that the market is irrational. The market will always be irrational. The best way to deal with it is to embrace reality.
Investors’ cognitive biases – such as over-confidence in their ability to forecast; using rules of thumb in investment allocation; using historical “anchors” as benchmarks; or alternatively, an excessive reliance on recent past performance – are well documented. Finance academics and commentators use these psychological traits to “explain” irrational anomalies such as herd behavior or speculative bubbles and crashes.
Unfortunately, it has not been straightforward to incorporate these irrational investor traits in standard rational-agent finance models to assist portfolio allocation, option pricing or the identification of arbitrage opportunities. After all, the typical investor’s behaviour is most likely a potpourri of psychological traits. Some combinations of cognitive biases reinforce a particular valuation error, other combinations are contradictory and may even lead to a valuation that is perfectly indistinguishable from the rational investor solution.
A Ponzi Scheme mentality is in play. Ponzi schemes work as long as the participants are confident that someone else will come along and pay an even higher price than they just paid. Eventually, those buyers fail to show up and the scheme collapses. In the stock market, the traders that are trading super momentum stocks have this belief that a new supply of buyers will continue to show up and pay even more. They use a variety of arguments to justify valuations but mostly they just count on momentum. When there is a high level of liquidity in the market like there has been in 2020, that money keeps coming into stocks because there just aren't any alternatives that are providing sufficient returns.
It will last longer than you think is reasonable. One of the reasons that irrational action can last so long and go so far is that there is a huge crowd of people that are betting against it. They think that the market is going to suddenly appreciate all the compelling reasons for a collapse, but the more skepticism there is the easier it is for stocks to keep running higher.
All runaway markets have key themes or sectors. Most of the irrational action in the market is in a relatively small group of stocks. Traders gravitate toward the fastest moving groups and they stick with them until they start losing money. The internet bubble is the classic example but at other times it has been groups like the FATMAAN stocks, or high beta technology that are favored. Currently, it is IPOs and SPACs that are favored. There is some sympathy action in other stocks but it is the theme plays that become very crowded that work best.
The primary focus is on stock picking rather than the indices. While the indices may make some very strong moves during these periods, it is individual stocks that offer the most opportunity. Stocks that double in a few days are not rare and that is where the most aggressive money will flow.
Be ready to lose money. The key to trading during these irrational periods is to build up a cushion of profits and then to be ready to give some back when the turn comes. You will not know in advance when this action will end. When it does end you will take some hits unless you have been sitting on the sidelines doing nothing. I contend that the opportunity lost of trying to time a top is generally much higher than the risk of loss that you will suffer when there is a turn.
Trends don't die easily. Strong irrational market action creates a huge supply of people that have missed out. They are determined to not miss the next run and they will be ready to aggressively buy the first few pullbacks and corrections. It is only after they have been burned several times that they give up on the dip-buying approach.
Irrational action works to the downside also. Markets go down much differently than the go up but the opportunities in irrational selloffs can be even greater especially if you focus on counter-trend trading.
Don't obsess over market timing. Stay focused on individual stocks and let them determine how much exposure you have. When your individual stocks start to falter then sell them and only make new buys if you find the right setups. Your stocks will do your market timing for you. You don't need to study macroeconomics or Elliot Wave Theory. Sell stocks that are breaking down and if you can't find new buys then you will be ready for a bear market.
Prices, the best approximation of intrinsic value, and won a Nobel Prize for his work on his Efficient Market Hypothesis. Markets assimilate all known information about a stock/bond/diamond, constantly. If people consistently pay for assets at prices greater than they're worth, they'll lose money. If those people keep losing money, they will exit the market. Only people willing to pay the 'right' price at least some of the time will remain.
Perhaps markets can be both irrational and efficient? prices reflect all available information of a security, but this does not imply that people are rational, or prices are always right. Since we are irrational, we will still create markets with bubbles and busts, marked by our greed and fear.
Markets can absolutely be irrational
Although short-term mis-pricings can and do occur, they do not happen in predictable patterns that can lead to consistent outperformance. In the long-term, markets do get the price right.
Market efficiency implies that it is very difficult to beat the market, and this has proven to be true.
Market prices represent the decisions of millions of investors - this is inherently more consistently accurate than the efforts of any of us single humans
What is the science behind irrational consumers?
There are n-number of factors affecting a person’s choice and decisions while buying a product. There are few factors causing behavioural changes as in consideration with economics:
A. Emotions
The deep bond between decisions and emotions form in such a way that it remains strong and defies any logic crawling into your head.Consumption by itself can definitely also mean a way to an end when it comes to regulating emotions or affirming our image. We also buy things which might not be necessary but showing-off your highstandard comes into play.
Why did I buy this? Did I really need it?
These few questions arise a number of times but your rational-self might disagree but emotions start echoing and says “It’s okay, you deserve this”Getting influenced by discounts or statements like “Hurry up!! Only a few left” triggers the buying capacity within you. Consumers also fear to face words like “sold out’ and hence finish their transaction as soon as possible.
B. Context
Most decisions made by the consumers or buyers are because they are extensively influenced by situational factors. This can include anything ranging from environment, pat decisions or any other alternative factor.For instance, we can consider the application a basic and a premium plan. Adding a buying option with lesser advantage and more expense obviously shift the customer’s attention to premium plan.
To decrease the choice overload, we tend to incline toward products tagged as “Bestseller” or “top-pick” etc.
C. Time
The Marshmallow test is a good example for this.
The test clearly presented how children waited for an extra minute to receive more candies than to receive one single candy at the moment. Influencers and celebs carried out this test with their kids and posted videos on Instagram.Waiting for sale or waiting to avail discounts on each and every product is a very common trait within us.
When setting the cost or price take into consideration how customers really take their decisions. Many customers already have a brand of chosen products to buy, and then are too satisfied to switch the brands.
Customers often like the idea that they will not change products or suppliers for any minimal price differences.Hence, when you try them your products, you should lower the worth or get hung up on matching their level of low price.
It must be a priority in economic sector to spend your time focusing on development of products or provider loyalty.Ensure that the quality you provide or the service that you are reciprocating should not be disappointing. If all these points are taken into thought, customers will be much less worried about the price.
Complex buying behaviour
Consumers are intensively involved in the product when its expensive and bought infrequently. The factors of the product being risky and highly self-expressive kind of attracts the customer.In such cases, the consumer does not have proper knowledge about the product category and must learn about it first.
When we take an example of a person buying a computer, he/she may not know what attributes to look for. Main features which usually constitutes in making it successful like memory, disk storage, screen resolution etc carry no meaning to them due to lack of technological knowledge.
This buyer must go through a learning process characterized by developing beliefs about the product, its attitude, the attributes and then come to a proper personal choice as required. The marketer of such high-involvement products must make the consumers understand the information. They must notice the evaluation behaviour of such highinvolvement consumers.
The marketer must expand the level of strategies to assist the buyer.
Dissonance-reducing buying behaviour
Many a times it so happens that consumer is highly absorbed in a purchase, but notices minute differences in the brands. This high involvement again pushes us to the fact that the purchase is infrequent, risky and expensive.
In such cases, the buyer will go around and shop while also learning about it. This will make them buy the products fairly quickly because differences in the brands are not yet
pronounced. There underlie high chances for the buyer to respond quickly to a good price or shopping conveniences.
After finishing the purchase, consumer might experience dissonance that peeps out from noticing certain dissatisfying features about it or just inclining towards other brands providing extra features. The consumer will now be more alert to information that might change decisions.
He/she will now take an action or will just change behaviour and attitude towards buying.In this case, communications should focus to supply beliefs and evaluations and give surety about satisfaction so that consumers feel good about the brand choice.
Habitual buying behaviour
There are n-number of brands which go out of trend due to lack of attention and customer preference.When we take brands of salt as an example, people such for one specific brand and want only that. This happens due to the repeated using of the same brand since years and not due to brand loyalty.
There is good number of evidence that buyers have very low involvement with low-cost products. In these cases, the behaviour of consumers does not pass through normal attitude or behaviour or belief.Consumers do not go about extensively looking for information about the brands or their characteristics. There is not much involved in making a weighty decision on which brand to choose.
What is Rational Purchase?
Rational purchases demand a considerable amount of extensive research ad comparisons with different ranges of products. Companies like Amazon or other pricecomparison portals specialize in offering a wide range of retail and consumer products and detailed information about the products available.
Generally, rational purchases involve research, information and bulk of extensive knowledge. Most of the times, these products require higher investment of expenses and a proper level of dedication. Savings in operating cost is one of the main factors in a rational purchase.
Emotional and rational purchases are often related to the fact that even if we make an emotional choice, we are adamant that we made a rational decision. Here we are led by emotions more than being logical.
In comparison to Zalando and Amazon, the brand Sugarbearhair uses a proper emotional approach. Their website is easily accessible and does not offer a huge number of products, but a very limited one which makes it easier to choose.
The compact product information and fixed price of each product is listed. Because of the offering of only one single product of a kind, consumers do not have the option of evaluating alternatives.This fact also guarantees that consumers will find a way to the desired product in a short period of time and rapidly move towards check out without any issues upcoming in the path of purchase.
What is the approach to be taken?
The approach to be taken not only depends on what product you are choosing but also on the audience who are going to buy it. If we wish to evaluate which approach works best for us, the target group can work as a good decisive factor.
Many at times it is argued that women are more prone to emotional marketing criteria than any other gender. Other brands targeting both male and female customers are more into the development of emotional relationships.
For younger people or kids in fact, purchase is done on the basis of emotions and instinct rather than thinking logically or waiting for the correct time.
Irrational exuberance
Breaking Down Irrational Exuberance
Irrational exuberance is widespread and undue economic optimism. When investors start believing that the rise in prices in the recent past predicts the future, they are acting as if there is no uncertainty in the market, causing a positive feedback loop of ever-higher prices.
It is believed to be a problem because it can give rise to bubbles in asset prices. But, when the ultimately bubble bursts, investors quickly turn to panic selling, sometimes selling their assets for less than they're worth based on fundamentals. The panic that follows a bubble can spread to other asset classes, and can even cause a recession. The investors who get hit the hardest — the ones who are still all-in just before the correction — are the overconfident ones who are sure that the bull run will last forever. Trusting that a bull won't turn on you is a sure way to get yourself gored.
● Irrational exuberance is unfounded market optimism that lacks a real foundation of fundamental valuation, but instead rests on psychological factors.
● Irrational exuberance has become synonymous with the creation of inflated asset prices associated with bubbles, which ultimately pop and can lead to market panic.
For decades, economists have speculated, theorized and argued about the "rational actor"—a completely logical creature who always makes the sensible financial choice. Now psychologists are weighing in, and they're finding that real people often don't act that way. "Psychology has a story to tell about investing, and it's different from the one economics tells," says Princeton psychologist Daniel Kahneman.
Average investors are full of irrationalities and inconsistencies, according to the field of study known as behavioral finance. Some of their characteristics:
Too self-confident. Investors often ignore the role of chance, preferring to preserve an illusion of control by exaggerating both their own skill and the importance of that skill.
Too bold. Professional and amateur investors alike tend to have an "optimistic bias," believing that their chances are better than the next guy's. "This bias is the foundation of the whole stock-trading industry," says Kahneman. "Traders know that 50 percent of them must be below the median, but they all think that they're above average."
Too timid. The average investor makes bold forecasts, but he is also risk-averse and makes timid decisions. His choices are unstable and he is quick to bail out of a situation.
Too afraid of loss. How much a stock costs shouldn't affect your decision to sell it, according to the traditional model. But for real investors, how much they paid is very important. People hang onto their losing stocks because they don't want to feel the pain of admitting that they were wrong.
Too quick to trade. Kahneman reports that a study shows that when an investor sells one stock and immediately buys another, the one that was sold does better by an average of 3.4 percent in the following year. People like to feel that they're actively bettering their financial situation—but, as Kahneman says, "if you hold onto a stock for a while, your chances of making money on it are greater."
Behavioral finance is changing the way the actions of entrepreneurs as well as investors are viewed.
Methodologies
Methods for analysis
Who is the irrational consumer? We all are! As consumers, don’t always do what we say. We sometimes don’t make purchase decisions that seem very logical. This is a fact that market researchers have to wrestle with during the design phase of any research project.
Behavioral economics has been drawing attention to the inadequacy of the rational choice theory. This assumes that consumers have perfect information about all the alternatives and weigh in pros and cons before making a purchase decision.
Sometimes this may be true for product categories with which consumers are engaged for a variety of reasons. However, it is often the case that consumers often:
Make decisions with incomplete information. Skip the evaluation of options and make impulse purchases
Simply go with what is available
As behavioral economists have pointed out, actual behavior doesn’t always match the rational approach to decision making.
Our Irrational Buying Decisions
You may not want to admit it, but you have been an irrational consumer, without realizing it. More often than not, we all make purchase decisions using at least one of these approaches.
Rules of thumb
We rely on heuristics or rules of thumb as shortcuts to decision making. The irrational consumer doesn’t take into account all possible options, as economists expect him or her to do.
Consequently, we may not make optimal decisions, but our decisions are “good enough.” This may be due to information overload, too many options, time constraints, financial situation, and lack of category involvement, among other factors.
Emotional arousal
The irrational consumer also makes purchase decisions influenced by his or her emotional state. When you are calm, you are more likely to think through your purchase decision.
However, if you are experiencing strong emotions (positive or negative), you are more likely to succumb to impulse purchases without much thought of the long term consequences.
Framing
The context often influences purchase decisions in ways we may not be aware of. For example, we often compare products to others that are present, particularly on price. Therefore, the same product may look like a good value at one store or terribly expensive at another, depending on competing alternatives and our expectations.
Store atmosphere, layout, music, scents, in-store advertising can invite or discourage us to buy. For online retailers, the website design, layout, navigation path, graphics, type and amount of information, and trustworthiness indicators, among others, provide a context that influences our decision to buy from a particular online retailer.
Cognitive biases
Overall, we tend to overvalue items we own (the endowment effect) or have invested in (the sunk-cost fallacy) and feel losses more intensely than gains. This may explain why for some, paying for shipping feels worse even if the cost of shipping may be compensated by a price discount.
While we often assume that others think like us, we are also influenced by the decisions of others (e.g. recommendations by word-of-mouth).
Moreover, we also seem to be wired to think short-term and have a hard time resisting instant gratification. Subsequently, this may interfere with rational decisions that would be more beneficial to us in the long run.
Segment Audience
In order to tackle this problem from a research perspective, we first need to understand how consumers make purchase decisions in a particular product category and identify potential segments with different decision-making approaches.
For instance, a consumer may consider laundry detergent a commodity and buys whatever brand is on sale at the time of purchase. Another consumer may browser the detergent aisle, opening bottles to check for fragrance, and reading packaging labels searching for harmful ingredients for herself or the environment. The key is segmentation within product categories based on purchase decision approaches.
Go Deeper
To capture the nuances and situations influencing purchase decisions, we can’t rely only on traditional concept tests or focus groups. We need to combine these with methods that go deeper.
The goal is to understand consumer emotions, purchase context, cognitive biases, and rules of thumbs. Here are some of the research techniques that are useful for these purposes.
Adaptive Choice-Based Conjoint Analysis
In ACBC, we ask consumers to build their own products based on a set of criteria. We use this information to understand the rules they use to choose products (must-haves and unacceptables) and to present relevant alternatives they would actually purchase.
Shop-Alongs
We go along with consumers in their shopping trips and observe how they make purchase decisions, what the motivators are, how the context influences their decision, the role of emotions, etc.
Mystery Shopping
Consumers participate in shopping occasions and report back their personal experience with different aspects of the purchase occasion.
Journaling
Consumers report about their experience with products and services in a journal format using text, video or pictures as the experience progresses.
Ethnographic Interviews
We interview consumers as they carry on different tasks or use products in real-time and environment.
Mobile Surveys in Real-Time
We ask consumers about their immediate and current experiences, feelings, and opinions via text messages.
On-Site Observation
Acting like a fly on the wall, we can watch how consumers buy and use the products and integrate them into their daily life.
In-Depth Interviews
We delve deeper into purchase drivers, cognitive biases, situational factors, etc. We can use projective techniques to uncover motivators, not consciously recognized.
Neuromarketing Research
We use neuroscience, psychology, and other cognitive science techniques to study consumer responses to marketing stimuli and products. Some of the responses measured include eye-tracking, heart rate, electroencephalography – EEG, functional magnetic resonance imaging – fMRI, galvanic skin responses, etc.
In conclusion, if you want to understand the gap between what consumers do and say, don’t rely only on one research methodology. In other words, each research method provides data that reflect only a few facets of the consumer.
Discussion
The irrational consumer refers to situations in which consumers' actual behaviors don’t match the rational approach to decision making. We should consider various approaches to uncover the drivers of such behaviors.
When markets are irrational, can either do something or can do nothing. When the market is irrational on the downside, can buy or do nothing. When the market is irrational on the upside, you can sell or do nothing. For most people, especially longterm investors, doing nothing is best.
Irrational markets feed irrational investors and feed on irrational investors. Don’t become the prey. Use market inefficiencies to your advantage, both in terms of staying safe and reaping greater rewards.