By LARRY SWEDROE
The basic hypothesis of behavioural finance is that behavioural biases lead to markets making persistent mistakes in pricing securities. An example of a persistent mistake is that markets under-react to news — both good and bad news are slowly incorporated into prices, leading to the momentum effect. Another well-documented phenomenon is recency bias, the tendency to overweight recent events/trends and ignore long-term evidence, which leads investors to buy after periods of strong performance and sell after periods of poor performance. The academic literature demonstrates that recency bias impacts both the security markets and sports betting markets. We’ll examine recent studies on both security and betting markets.
Recency bias in sports betting
Kevin Krieger, Justin Davis and James Strode, authors of the study Patience is a Virtue: Exploiting Behavior Bias in Gambling Markets, published in the October 2021 issue of the Journal of Economics and Finance, analyzed the influence of bettor behaviour in sports gambling markets. Their hypothesis was that recency bias (another version of the “hot hand” theory) could create pricing anomalies with recent impressive (unimpressive) performance by a team, causing some bettors to over-react (under-react). Their database was betting markets from National Football League games that took place between 2007 and 2019.
Krieger, Davis and Strode found that bettor decision-making is erroneously influenced by recent performance of teams, creating profitable betting opportunities for those less subject to recency bias — teams that had outperformed (underperformed) the point spread by a wide margin in the prior week were overvalued (undervalued). They found that betting on games where the reversal spread was between 10 and 19.5 points for the two teams won 54.4 percent of the time (statistically significant at the 5 percent confidence level), and betting on games where the reversal spread was between 20 and 29.5 points won 53.5 percent of the time (significant at the 10 percent confidence level).
Surprisingly, the researchers also found that bettor perception often helps create greater inefficiency in the days leading up to a game — sophisticated bettors (“wise guys”) were unable to arbitrage away the mispricings. Thus, a winning strategy (due to the “vigorish”, the charge taken by a bookie or a gambling house on bets, a strategy must actually succeed more than 52.4% of the time in order to prove profitable, net of fees) was to use a reversal strategy that wagers on teams that performed relatively poorly in their prior games compared to their current opponents — betting against the hot hand. This last finding goes completely against standard market efficiency theory, which posits that time and exposure to scrutiny will eliminate any mispricing of a particular asset.
In other words, in the same way that bubbles can appear in stock prices (such as the dot-com bubble of the late 1990s, when sophisticated hedge funds were unable to correct mispricings), the public-driven consensus of which team is good or bad in an upcoming contest can build a huge volume of pressure that swamps the expertise and cash reserves of the sophisticated investors who would otherwise correct mispricings.
We now turn to a recent study on how recency bias impacts equity prices and returns.
Recency bias and equity markets
Nusret Cakici and Adam Zaremba, authors of May 2021 study Recency Bias and the Cross-Section of International Stock Returns, calculated a chronological return ordering (CRO) variable and analyzed its importance for the cross-section of returns for global equity markets (23 developed markets and 26 emerging markets) over the period 1990-2020.
The CRO measure relies on the correlation between the historical stock returns and the number of days that have passed since the return realisation. The interpretation of CRO is intuitive and straightforward. Low CRO numbers indicate relatively low distant returns and high recent payoffs. Conversely, high CRO values indicate relatively high distant returns and low recent returns. Hence, low CRO values should imply low future returns, and high CRO scores should signal high future returns.
Cakici and Zaremba found that, globally, the value-weighted (equal-weighted) decile of stocks with the highest CRO outperformed the decile of stocks with the lowest CRO by 0.91 percentage point (0.63 percentage point) per month, and that the phenomenon exists in the U.S. and across developed markets. However, the picture of emerging markets differs dramatically, as there was no CRO anomaly — neither average returns nor alphas in the long-short portfolios produced any significant profits.
Cakici and Zaremba found that two variables play a critical role in the CRO effect: individualism (linked in the literature with overconfidence and self-attribution biases) and investor protection. The third of countries with the highest individualism score outperformed monthly CRO long-short strategy returns by 0.26-0.40 percentage point (depending on the measurement approach) than the most collectivistic countries. And the CRO spread portfolios in the top third of markets with the highest anti-self-dealing index outperformed their low-investor-protection counterparts by 0.27- 0.45 percentage point per month. This observation accords with the supposition that stronger investor protection attracts retail investors, who are typically considered less sophisticated and more prone to behavioural biases than institutional players.
The researchers also found that CRO profits are more substantial during periods of elevated market volatility — positive and significant coefficients were observed for both historical and implied volatility measures. This observation complies with the reasoning that high volatility tends to impede arbitrage activity. And they found that market crashes augment the global CRO-driven mispricing. The anomaly was particularly pronounced following extreme volatility and significant down markets—outside these difficult periods, the profits on global CRO portfolios hardly differed from zero.
Of interest is that the lack of CRO evidence in emerging markets perhaps can be explained by the finding that countries with the highest individualism scores showed the highest CRO — developed countries tend to be more individualistic. The result is that individualistic investors focus on short-term performance, and they also tend to be overconfident and sensitive to extreme returns. Thus, the differences in cultural dimensions may explain the differences in the CRO anomaly between developed and emerging markets.
The findings from the two studies we reviewed highlight the impact of psychological and behavioural factors on common betting/investing behaviour. Thus, the takeaway is that bettors and investors should avoid the mistake of recency bias, as the research demonstrates that teams that have recently underperformed expectations, and companies with comparably low recent returns and high distant ones, significantly outperform their counterparts (teams that recently outperformed expectations and companies with relatively high recent returns and low distant ones).
Bettors and investors alike should be particularly careful to avoid getting euphoric because when something is highly popular, it runs the risk of being bid up in price and thus is prone to disappoint.
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LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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