Tyler Cowen: belief

Transcript context

…There are a number of them. One hypothesis is I’m really not very convincing at all. Another is more people do it these days and I’ll admit I think the strategy is going to survive that, but it’s a concern. It is not something every investor can do. I get this question from clients sometimes and I go, “Are you going to do it?” and they go, “no.” I go, “That’s why.” With that said, I think it is a fairly unintuitive idea. To some, it’s very intuitive. Just buy what’s going up. To someone who studies markets, particularly for Gene Fama like I did, the idea that you can beat markets — and we do more than just momentum. (Tyler, he’s promised me he’ll get to that.) But it’s a very unintuitive idea if you think markets are anywhere near highly efficient. I think that dissuades some. It nowhere nearly works all the time. One thing I should really be careful about. I throw out the word “works.” I say “This strategy works.” I mean “in the cowardly statistician fashion.” It works two out of three years for a hundred years. We get small p-values, large t-statistics, if anyone likes those kind of numbers out there. We’re reasonably sure the average return is positive. It has horrible streaks within that of not working. If your car worked like this, you’d fire your mechanic, if it worked like I use that word. I think it is harder than you might guess, even if something works long term, to have it go away because a lot of investors can’t live through the bad periods. They decide why it’s never going to work again at the wrong time. I think of you as doing a kind of metaphysics of human nature. On one side, there’s behavioral economics. They put people in the lab, one-off situations, untrained people. But here it’s repeated data, it’s over long periods of time, it’s out of sample. There’s real money on the line, and this still seems to work. When you back out, what’s the actual vision of human nature? What’s the underlying human imperfection that allows it to be the case, that trading on momentum across say a 3 to 12 month time window, sorry, investing on momentum, will work? What’s with us as people? What’s the core human imperfection? This is going to be embarrassing because we don’t have a problem of no explanation. We have a problem with too many explanations. Of course, we can observe the data. The explanations you have to fight over and argue over. I will give you the two most prominent explanations for the efficacy of momentum. The first is called underreaction. Simple idea that comes from behavioral psychology, the phenomenon there called anchoring and adjustment. News comes out. Price moves but not all the way. People update their priors but not fully efficiently. Therefore, just observing the price move is not going to move the same amount again but there’s some statistical tendency to continue. Take a wild guess what our second best, in my opinion, explanation for momentum’s efficacy is? It’s called overreaction. When your two best explanations are over- and underreaction, you have somewhat of an issue, I admit. Overreaction is much more of a positive feedback. It works over time because people in fact do chase prices. So if you do it somewhat systematically and before them you make some money. One of the hard things you find out in many fields but I found out in empirical finance is those might be the right explanations but they’re not mutually exclusive. Remember the movie Highlander? You and I talk about sci‑fi.…

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