Paul Kaplan: I'm Paul Kaplan, Director of Research at Morningstar Canada. Today I am talking to Mark J. Kamstra who's a Professor of Finance at York University's Schulich School of Business. Much of Professor Kamstra research focuses on investor and market behaviour through the lens of psychology. In particular Professor Kamstra has studied how psychological factors lead to seasonality in investor behaviour and market returns.
Professor Kamstra, thank you for talking to me today.
Mark Kamstra: Thanks for having me Paul, it's a real pleasure.
Kaplan: Why do you think it is important for economist, especially financial economist, to incorporate elements of psychology into their analysis.
Kamstra: Well I guess to start with, I mean we are humans, so we are affected deeply by our psychological biases and our kind of view of the world. So, this its not all just rational individuals responding in probably the best way possible. It's us coming with our hundreds of thousands of years of evolutionary behaviour and all these things impact the way we behave.
Kaplan: Behavioural economics in finance, once a fringe area has now garnered Nobel Prizes for two of its leading researchers, psychologists Daniel Kahneman and economist Richard Thaler. How has their work and the work of others in behavioural finance changed the way that financial economists view investors and markets.
Kamstra: I'm obliged to throw in Bob Shiller another recent Nobel laureate. So, I think of him – his most important work is being behavioural, although I love all of his stuff on GDP bonds and other things. I mean how is this work influencing the way financial economists and investors view markets? I think that this has highlighted the issue that when we look at market movements, we can't just pretend they necessarily reflect best response to given situation that sometimes is going to be behavioural effects, like hurting that can push prices around. Even if for short periods of time this can be a problem, and when they lift prices away from where we think they should be for long periods, like I would describe bitcoins having the price of bitcoin being pushed away from its fundamental value for a very long time. It misallocates resources, and this is a real problem for our society.
Kaplan: Now let's discuss your research on seasonality. First of all, please explain what you mean by seasonality, both in terms of investor behaviour and market behaviour.
Kamstra: The kind of seasonality that I focused on my research with collaborators Lisa Kramer, Mau Levi amongst others, is seasonality which is throughout the year you can't speak of seasonality being day of the week and other effects like that. But we've looked at really over the course of the year, our first work is on daylight savings. We are looking at two days of the year in particular where there is daylight savings time change. And then fall versus spring variation in mood which impacts us. Seasonal factor disorder is something that impacts all of us probably to some degree and some people tomuch greater degree and that kind of depressions have been shown by psychologists to be associated with serious changes in mood leading to changes in risk aversion. So, it changes risk aversion, it could change market prices.
Kaplan: What was your motivation for pursuing this line of research.
Kamstra: Well, honestly it was serendipity that led to this research. I came at this work thinking about market prices mostly from the point of view of market efficiency. Noticing some deviations, but noticing how a lot of the deviation could be accounted for at least in the long run by common sense or at least cash flow considerations. And it was a day on the campus of UBC that two of my co-authors started talking about the daylight savings effects that psychologists have noticed, and shortly thereafter the three of us started working on quantifying the impact on financial markets. From there we talked to psychologists because we were just fascinated by this. We found that the biggest impact on people in terms of psychology, the mass impact of seasonal effective disorder was larger than anything else. This is nice because it synchronizes all of us with our mood essentially.
So other effects divorce, death in the family is very idiosyncratic, its terrible it really effects an individual's mood, but is unlikely to impact markets. But if 10% or 20% of us are all getting a little nervous about taking on extra risk then this could dramatically impact markets. I come from Dutch farmers on my father's side and winters are long and hard in Holland. If you didn't get a little nervous in August and September and started putting away food for the winter, you might not make it. So, I think this evolutionary route to a little bit of nervousness and anxiety and depression in the fall has been very helpful for us as species. But it doesn't always help us as investors.
Kaplan: Please explain the research that you and your collaborators have done on seasonality in market returns.
Kamstra: The stuff we've looked at market returns are focused on large market economies although we did subsequent work that looked at a broader set of maybe 40 or 50 economies. We looked at far northern economies, southern-hemisphere economies, the U.S. of course and Canada, and what we've looked for was this broad overall pattern of asset prices being hit in the early fall by investors becoming more risk averse. And you know the way this works is first asset prices will fall or not rise as quickly when people become more averse to risk and then, if you hold through this period of anxiety, you get higher returns over the next coming period. So, we anticipated and found these lower returns in the beginning of fall and higher returns as you move through to spring. Similar to the sell and manufacture, I guess, but the timing is a little different and the motivation is not an ad hoc kind of noticing there seem to be patterns in returns, but rather something motivated by something substantial like a change in risk aversion.
Kaplan: Please explain the research that you and your collaborators have done on seasonality in mutual fund flows.
Kamstra: When we started thinking about the effects on returns of course we thought about quantities too. So, you've got flows from returns. You've got flow and quantity and if people really are becoming more risk averse, what we should see is some kind of pressure in flows. The first thing we thought to look at was mutual fund flows just because these represent mostly -- broadly 70% or 80% are held by individual investors as opposed to institutional investors. We imagine that institutional investors, guided by groups of people and professionals, would be less impacted by changes in risk aversion. They've got a portfolio strategy to follow and they follow it. And it's also little easier maybe losing other people's money not your own. But good fund managers in my perspective hold to their strategy, but individual investors can deviate.
So, we looked at fund flows, which would reflect in large part the flows of individual investors, and we found in the fall, indeed, people were moving out of equities -- presumably hedge fund and other professional investors were picking up that flow. And then in the spring they were moving back into equities. And the reverse happened with money market funds and other relatively safe asset classes for mutual funds. So, it was just a logical progression from looking at returns; an obvious question was to consider quantity of flow.
Kaplan: Is there direct evidence that individual investors undergo seasonal changes in risk preferences.
Kamstra: That's a great question too, we were asked that a lot by people when we first started this research strategy. Of course, it's hard to work on too many things at once. One of co-authors Lisa Kramer from University of Toronto's Rotman School she together with a colleague at Rotman School who is a social psychologist did a big survey of individuals. It gave them an incentive compatible task -- basically they could put their money in a safe asset or risky asset and they got payoffs from it. So, they have a fairly good funding I think they went and talked, surveyed maybe thousand or more people and they did this at three points: summer, winter and then summer again. And they found remarkable variation in mood according to standard psych questions on mood and kind of that sort of lean. And then they also found strongly statistically significant variation in willingness to tolerate risk. So, people are much more willing to tolerate risk in the summer than in the winter. And people who tended to be more affected by seasonal mood disorders, the effect was larger, more substantial, but it was in everyone they looked at. So, there is evidence from individual investors, actual incentive compatible choice, it's fascinating.
Kaplan: What lessons should individual investors learn from your research? Should they change their behaviour?
Kamstra: That's also a great question. I guess what I'd advise individual investors to do is have an idea of a strategy that makes sense for them that they are comfortable with and maybe not look at their portfolio too often. And probably the most important thing that I pay attention to is when I see news and it makes me nervous and I see the markets reacting, I also look at the time of year. So I know in the fall and winter people are going to tend to react more strongly to bad news and less strongly to good news. And so when I see the market really getting volatile in the fall I remember that part of that activity volatility is probably coming from people reacting differently because of their mood being in a more depressed state in spring. If markets are reacting really strongly to news I guess I sit up and I pay little more attention because I think this is people who are not so disturbed by any kind of mood disorder and therefore its more informative watching what's going on in the market.
Kaplan: Is there anything you'd like to add?
Kamstra: Well, diversify, try not to imagine you can time the market too much. I have played with timing the market myself occasionally, with my wife just looking to see if we can make trades on our daylight savings hypothesis and even sad, it's fun to play a little bit. I guess if you really want to play a little bit put some money aside, but the bulk of your savings probably I'd be a little more conservative and try to understand yourself.
Kaplan: Thank you Professor Kamstra for taking the time today to discuss your research and its implication for investors.
Kamstra: It's real pleasure Paul. Thank you for having me. Great to see you.
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