Visualizing History 

(Source: Global Financial Data)

From the Archives

Psychology of the Stock Market (1912)

Despite all the facts, figures, and statistics… so much of the stock market comes down to human behavior. As my boss, Jim O’Shaughnessy likes to say, “human nature is the last arbitrage.”  I recommend reading the table of contents, and reading the section that sounds most interesting to you. These primary sources, more than 100 years old, are an absolute treasure trove of insights and passages. Trust me, and take the time to read this:

‘MOST experienced professional traders in the stock market will readily admit that the minor fluctuations, amounting to perhaps five or ten dollars a share in the active speculative issues, are chiefly psychological. They result from varying attitudes of the public mind, or, more strictly, from the mental attitudes of those persons who are interested in the market at the time.’

My recommendations:

Sunday Reads


“All of humanity’s problems stem from man’s inability to sit quietly in a room alone”. 

It is difficult to argue with the above quote from 17th century French philosopher Blaise Pascal. While this maxim applies to many aspects of life and society, it is particularly poignant for investing. Many investors have a propensity for becoming their own worst enemy by either over or under reacting to stock market news. As Pascal’s quote suggests, these reactions and impulsive thoughts are often exacerbated when we are left alone with our thoughts and must “sit quietly in a room alone”. A study at the University of Virginia even found that some people will even shock themselves instead of sitting silently for 15 minutes.

“Most people are just not comfortable in their own heads, according to a new psychological investigation led by the University of Virginia. The investigation found that most would rather be doing something – possibly even hurting themselves – than doing nothing or sitting alone with their thoughts, said the researchers, whose findings will be published July 4 in the journal Science.

The researchers took their studies further. Because most people prefer having something to do rather than just thinking, they then asked, ‘Would they rather do an unpleasant activity than no activity at all?’ The results show that many would. Participants were given the same circumstances as most of the previous studies, with the added option of also administering a mild electric shock to themselves by pressing a button.

Twelve of 18 men in the study gave themselves at least one electric shock during the study’s 15-minute ‘thinking’ period. By comparison, six of 24 females shocked themselves. All of these participants had received a sample of the shock and reported that they would pay to avoid being shocked again.

‘What is striking,’ the investigators write, ‘is that simply being alone with their own thoughts for 15 minutes was apparently so aversive that it drove many participants to self-administer an electric shock that they had earlier said they would pay to avoid’.”

Well, in 2020, this idea of sitting in a room alone is all too familiar for investors around the world as the COVID-19 pandemic continues. That said, while much of the market mayhem this year has clearly stemmed from the economic fallout of COVID-19, I think that a significant portion of the wild swings and movements have resulted from investors being forced to sit quietly in a room alone (at home).

Coupled with our preference for action over inaction, we have witnessed some bizarre developments in markets this year like investors herding in and out of stocks that often offered no reasons for such bullish behavior (Hertz, etc.). While it has become a joke at this point, the transition of Dave Portnoy from sports gambler to stock market day trader is a perfect representation of human’s need to “do something”. Portnoy has frequently stated that the reason he started his day trading schtick was because we were all in lockdown and there were no sports to watch / bet on. As Jason Zweig recently wrote, these behavioral flaws do not only apply to retail investors:

“When you point your finger at somebody, make sure to step away from the mirror.

The professional money managers blaming individual investors and index funds for the phenomenal rise of speculative stocks should remember that.

Among this year’s hottest stocks, few are favorites of individual investors, and index funds aren’t their main buyers. Who’s driving them up? Professional stock pickers—the very people pointing the finger at everyone else. Let’s look at Zoom Video Communications Inc., ZM the teleconferencing company whose stock is up more than 660% so far this year. Given the popularity of its service and the stock’s scorching performance, you might expect Zoom is a darling among individual investors and traders.

Yet, on the Robinhood app used by millions of individual traders, Zoom was only the 49th widest-owned stock this week, according to the online broker’s tally of most-popular holdings. In fact, of the 25 stocks with market values above $10 billion that have the hottest returns so far this year, only two— Moderna Inc. and Peloton Interactive Inc. —are among the 25 most-popular stocks on Robinhood. They are up 278% and 362%, respectively, in 2020.

The biggest performance chasers? Big institutions, whose ownership of scalding-hot stocks has boomed this year, even as these shares become wildly expensive by traditional yardsticks…

Now let’s zoom in on Zoom. From the end of 2019 through September, institutions cumulatively bought almost 80 million shares, according to FactSet, while the stock price was rising roughly sevenfold. That took institutional ownership from less than 52% in December to 55% in September.

That includes index funds, those autopilot portfolios that seek to match the return of a market average. However, index funds accounted for only 19% of institutional buying over the period. Active managers, who purportedly work hard to analyze what companies are worth, did almost all the buying—even as Zoom was soaring far beyond conventional notions of where a stock should trade.

By this week, Zoom was priced at 690 times the company’s earnings over the past 12 months and 203 times what analysts are guessing it will earn in the next 12. Among the institutional buyers were three dozen “value investors,” whose mission is to find the cheapest stocks.”


Remarkable, right? ‘Value’ firms buying Zoom stock, which trades at 690x the previous 12 months earnings, because even these professional investors could not withstand the allure of Zoom’s eyewatering year-to-date return of 722%.

Now, obviously performance chasing is nothing new, but I do think that the pandemic and shelter-in-place mandates have exacerbated the already prevalent behavioral biases in investors. The perfect example is found in shares of Hertz rallying after the company declared bankruptcy, or shares of Nikola rocketing despite reporting only $36,000 of revenue in its first quarterly report. The depressing reality, however, is that many of the behavioral biases that plague investors today were recognized as far back as 1688 on the Amsterdam stock exchange. If we are still making the same mistakes that we did in 1688, human nature really is the last sustainable edge.

The First Behavioral Finance Book

History is an archive of human nature, highlighting all of our behavioral biases and mistakes. Through studying history, it is readily apparent that human nature rarely changes. As I referenced earlier, the first book on behavioral finance was published in 1688. Titled Confusion de Confusiones, the book is written as a conversation between an Investor in the East India Company, a philosopher, and a merchant. The majority of the discussion involves the investor explaining what the stock market is and how it works to the Philosopher. I could share the entire book here since there are just so many quotes fitting for investors today, but this excerpt below is one of my favorites, and most relevant after what we discussed earlier on human’s disposition for action over inaction. In this passage, the investor describes speculators as having “two bodies” that are often at odds with each other, and how nervous/restless the speculator’s behavior is. Remember this was written in 1688!!

I wish to describe the nervous condition of the speculators and the restlessness of their behavior at their business. I think that they have undoubtedly been given the name actionists because they are always in  action

When the speculators talk, they talk shares; when they run an errand, the shares make them do so; when they stand still, the shares act like a rein; when they look at something, it is shares that they see; when they think hard, the shares provide the content of their thoughts; if they eat, the shares are their food; if they meditate or study, they think of the shares; in their fever fantasies, they are occupied with shares; and even on the death bed, their last worries are the shares…

But what surpasses all these enormities… and what is hardly believable (because it seems to be complete fancy rather than over-exaggeration) is the fact that the speculator fights his own good sense, struggles  against his own will, counteracts his own hope, acts against his own comfort, and is at odds with his own decisions…. There are many occasions in which every speculator seems to have two bodies so that astonished observers see a human being fighting himself. If, for example, there arrives a piece of news which would induce the speculator to buy, while the atmosphere prevailing at the stock exchange forces him to sell, his reasoning fights his own good reasons. At one moment his reasoning drives him to buy, because of the information that has just arrived; at the other it induces him to sell because of the trend at the Exchange.”

It sounds familiar, right? I cannot overstate how important this book is for investors, and that everyone should read it. When recognizing the fact that human nature has changed so little since this book was written in 1688, investors should position their portfolios to both take advantage of behavioral biases in the market while also ensuring that their own investment process leaves little room for human error (via systematic methods, etc.).

For as the Confusion de Confusiones book states: “You will see that the stocks do not exist merely for fools but also for intelligent people.”

Now, let’s dive in!

Does Credit Affect Stock Trading? Evidence From the South Sea Bubble

One of the other common themes in terms of investor behavior across history is the increased risk taking when credit is cheap.

We study the relationship between credit, stock trading and asset prices. There is a wide array of channels through which credit provision can fuel stock prices. On one extreme, cheap credit reduces the cost of capital (discount rate) and boosts prices without trading or wealth transfers. On the other extreme, extrapolators use credit to ride a bubble and lose money. We construct a novel database containing every individual stock transaction for three major British companies during 1720 South Sea Bubble. We link each trader’s stock transactions to daily margin loan positions and subscriptions of new share issues. We find that margin loan holders are more likely to buy (sell) following high (low) returns. Loan holders also sign up to buy new shares of overvalued companies and incur large trading losses as a result of the bubble.’

As a general rule: When credit is cheap, speculators are a dime a dozen. For example, the chart below exhibits the Bank of England’s gross loan issuance in 1720, the year of the South Sea Bubble:

Looking into these loans further, the authors show that 79% of these loan holders were taking speculative positions in the popular stocks of that time: The South Sea Company, Royal African Company, and East India Company.

Knowing that there was rampant levels of speculation in 1720 London, this paper analyzes the behavior of speculators through an exciting new dataset:

‘We construct a novel database containing every individual stock transaction for three major British companies during 1720 South Sea Bubble. We link each trader’s stock transactions to daily margin loan positions and subscriptions of new share issues.’

Their results show that these speculative margin loan holders largely follow the herd by buying at the top, and selling out at the bottom. In addition, these loan holders were twice as likely to ‘buy new shares of overvalued companies’ at peak prices. We see similar scenarios unfold in modern times with retail investors piling into flashy but overpriced IPOs.

The outcome of all this is predictable: poor performance.

‘Even without taking returns on these share subscription positions into account, loan holders incur large trading losses. A margin loan holder realizes a 14 to 23 percentage point lower return than the average investor.

In short, margin holders buy and sell at exactly the wrong time, purchase new offerings at peak prices, and generated returns noticeably lower than the average investor. So who were these margin loan holders?

‘Less experienced individuals, investors who trade a lot and male investors are more likely to take margin loans. In the current finance literature, male investors and frequently trading investors are often associated with poor trading performance.’

The authors’ conclude the article by writing:

‘We collect every single stock transaction with buyer and seller identities for three large British companies during the classical 1720 South Sea Bubble. In May 1720, the Bank of England grants its shareholders the right to borrow cash by collateralizing their shares. Each investor can borrow up to the nominal value of the share and loans are recorded in the stock ledger books of the Bank. The meticulous documentation of the transactions allows us to link, on a daily basis, each investor’s share trading to her loan positions. Our data documents the daily equity transactions of about 50% of the British market capitalization over the course of the bubble and five years before.

We find that the marginal borrower displays speculative trading behavior. First, we document that a loan holder acts as an extrapolator by buying stocks that have experienced high returns in the recent past. Second, we find that borrowers realize lower returns than investors without a loan. Third, we find that margin loan holders are more likely to subscribe to new share offerings at peak prices. This strategy is extremely risky and we can ex-post determine that it leads to negative returns. Finally, we show that there is a positive relation between loan holder buying pressure and stock prices during the bubble.’

The Factor Archives: Momentum

If we assume that human nature rarely changes, and investors’ biases will persist, the next important question is how can we take advantage of this as a source of generating alpha? While there are multiple answers, this article that I wrote last year focuses on the Momentum factor. Instead of just recognizing the behavioral flaws in investors, the Momentum factor provides an investable strategy for arbitraging human nature.

“There are no certainties in investing, but one can be very confident that human nature will not be changing any time soon. Since shares first traded on the stock market in the 17th century, market participants and pundits recognized the fact that behavioral biases often cloud our investment decisions. Instead of simply recognizing this fact, however, investors can take advantage of these shortcomings to generate alpha through investment factors like Momentum.”

This article studies the Rubber Boom of 1910 as an example of the Momentum factor at work. What started out as a ‘justified boom’ in rubber companies’ shares quickly turned into a speculative mania as retail investors flooded the market, purchasing shares at increasingly higher prices. However, investors that had maintained a disciplined approach focused on buying companies at cheap valuations with good governance were able to reap the benefits of strong momentum in rubber shares. One outlet stated at the time:

“Now, with its many uses, there is little doubt that it will be more and more in demand. There would seem, indeed, to be method in the madness of the boom.

The persistence of Momentum is perhaps best exhibited by two articles issued by the same publication, over one hundred years apart:

“In 2011, The Economist described this gap as “the lag between beliefs and the new reality.” Over one hundred years earlier, in 1910, The Economist referred to it as “the point… at which prudent optimism ceases and is replaced by emotional enthusiasm.”’

To Err is Human: Rating Agencies and the Interwar Foreign Government Debt Crisis

As today’s post is all about human nature and human error, it only makes sense to include a paper aptly titled “To Err is Human”. This paper studies a seminal period in both financial history as a whole, and the credit ratings industry. In the carnage of the Great Depression, a department within the United States Treasury made the crucial decision ‘to use the credit ratings-based formulae to book the value of US national banks’ bond portfolios.’

This was crucial because it meant ‘from that point on, ratings became the main instruments through which regulators supervised banks’ risk exposures – which suggests that they were seen then as part of the solution, not as part of the problem.’ I found the charts below particularly interesting, as it gave a clearer picture of just how accurately rated these sovereign entities were:

This paper is also an interesting read because it offers ‘a useful perspective on what remains one of the most (perhaps the most) violent foreign debt disaster in financial history.’ For context, between 1931 – 1939, over half of the sovereign borrowers that issued in New York between Between 1920 and 1929 defaulted. In this paper:

‘We have gathered and analysed data on ratings and financial markets during the sovereign debt boom-bust cycle of the 1920s and 1930s. Focusing on foreign government securities listed on the New York Stock Exchange, we compare ratings’ reliability among different agencies and between ratings and market yields. We document a large degree of pro-cyclicality of ratings over the period. Perhaps more surprisingly, rating agencies do not appear to have performed particularly well relative to financial markets in forecasting the approaching mess: when we compare the predictive power of agency ratings with that of synthetic ratings based on market yields, we find little that suggests strongly superior performance. Our results leave open the reasons for the emergence of ratings as regulators’ preferred instrument, for superior performance does not appear to have motivated the initial regulatory use of ratings.’

Bubbles, Gullibility, and other Challenges for Economics, Psychology, Sociology, and Information Sciences

Andrew Odlyzko is one of my favorite financial history writers, and this excellent article demonstrates why. In this piece, he looks at the role of gullibility in bubbles, and our habit of getting ensnared by “beautiful illusions” during a bubble. This is a very insightful look at human nature and our gullibility.
“Gullibility is the principal cause of bubbles. Investors and the general public get snared by a “beautiful illusion” and throw caution to the wind. Attempts to identify and control bubbles are complicated by the fact that the authorities who might naturally be expected to take action have often (especially in recent years) been among the most gullible, and were cheerleaders for the exuberant behavior. Hence what is needed is an objective measure of gullibility.
This paper argues that it should be possible to develop such a measure. Examples demonstrate, contrary to the efficient market dogma, that in some manias, even top business and technology leaders fall prey to collective hallucinations and become irrational in objective terms. During the Internet bubble, for example large classes of them first became unable to comprehend compound interest, and then lost even the ability to do simple arithmetic, to the point of not being able to distinguish 2 from 10. This phenomenon, together with advances in analysis of social networks and related areas, points to possible ways to develop objective and quantitative tools for measuring gullibility and other aspects of human behavior implicated in bubbles. It cannot be expected to infallibly detect all destructive bubbles, and may trigger false alarms, but it ought to alert observers to periods where collective investment behavior is becoming irrational. The proposed gullibility index might help in developing realistic economic models. It should also assist in illuminating and guiding decision making.”

The Rise of the Popular Investor: Financial Knowledge and Investing in England and France, 1840-1880

“This article examines the knowledge frame in which financial investing became a popular, socially legitimate, and desirable activity in England and France in the nineteenth century. The empirical basis underlying the arguments of the article is provided by investor manuals, newspaper reports, advice brochures, stock price lists, financial charts, and novels from the period. The analysis focuses on the instruments and processes making possible a financial knowledge that could be legitimately acquired and utilized by separate, unrelated, individual actors dispersed over the territory.

The core argument is that this knowledge should be understood as an integrative social practice-that is, as a nexus of legitimating discourses, rules, skills, and cognitive instruments that transformed financial investing into a socially desirable activity. At the same time, they generated forms of financial knowledge that were no longer embedded in local conditions, but could be transported across various contexts. The dominant modes of evaluating financial securities include the new instruments of balance sheet analysis, problem solving, and charts. In this integrative nexus of discourses and cognitive instruments, financial activities became first and foremost an object of knowledge. The investor’s social and personal responsibilities became dependent upon his financial knowledge. This stance, together with the social desirability of financial investing and with the cognitive instruments provided to individual, dispersed actors, constitutes the ground for the expansion of financial investing.”

300 years of the Equity-Risk Premium

One of the most frequently repeated patterns in financial history is investors tendency to reach for yield and exhibit return chasing behavior when the yields on government debt are low. It’s a tale as old as time. This paper from Global Financial Data takes a look at three centuries of the Equity Risk Premium.

“The equity-risk premium (ERP) is one of the most important variables in finance. It tells investors how much a risky investment such as stocks returns relative to a risk-free investment such as government bonds.  Any history of the equity premium shows that its value is not constant.  It varies dramatically from one year to the next.  In theory, riskier stocks should provide a higher return than risk-free government bonds, but unfortunately, this has not always been true.

To help us understand how the risk premium has changed over time, I have calculated the 10-year return to stocks and bonds, then calculated the difference between them to determine the 10-year risk premium in the United States and the United Kingdom.  GFD has over 225 years of history on the return to stocks and bonds in the United States and over 300 years of history in the United Kingdom. This data allows us to analyze how the equity risk premium has changed over the past 300 years.”