Financial markets foundations

“One day in December 2003, when Saddam Hussein was captured, Bloomberg News flashed the following headline at 13:01: U.S. TREASURIES RISE; HUSSEIN CAPTURE MAY NOT CURB TERRORISM.

Whenever there is a market move, the news media feel obligated to give the “reason.” Half an hour later, they had to issue a new headline. As these U.S. Treasury bonds fell in price (they fluctuate all day long, so there was nothing special about that), Bloomberg News had a new reason for the fall: Saddam’s capture (the same Saddam). At 13:31 they issued the next bulletin: U.S. TREASURIES FALL; HUSSEIN CAPTURE BOOSTS ALLURE OF RISKY ASSETS.

So it was the same capture (the cause) explaining one event and its exact opposite.”

Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly Improbable

A feature of most daily news bulletins is a report on the performance of the local financial markets. “The ASX 200 is up 32 points.” “Shares in Acme Corporation plunged on the release of poor retail sales figures in February.” Unfortunately, as Nassim Taleb’s story above suggests, these news reports are little more than exercises in storytelling, as journalists desperately attempt to attribute causes to what might just be noise.

But these financial markets become more interesting and worthy of examination when we start to think of them as the aggregations of thousands or millions of individual decisions.

In the book Consumer Financial Decision Making I discuss how financial decisions are made by individuals and households. Individuals use heuristics and rules of thumb in their decision making that, while often powerful tools, can also lead to systematic error.

In this book, we will examine how those individual decisions manifest in financial markets, and what is the aggregate effect of the various market participants.

I will start with the basic economic approach. I will then layer onto that a series of anomalies that the traditional approach has difficulty explaining, and follow with the research in behavioural finance that gives us a richer picture of markets.