Alex Edmans on Market Irrationality

Belief in ‘markets’ among the financial elite at time can at time border on the theological, with approaches like the efficient market hypothesis or the invisible hand cited, unironically, as dogmas. But finance professor Alex Edmans of the London Business School would like to have a quiet word with Mr. Market; Edmans would like to tell him that he’s a bit, well, irrational.

That’s not the dig it might appear in normal discourse. As Edmans explains to interviewer David Edmonds in this Social Science Bites podcast, the dominant idea in economics was that financial markets were rational, that they already knew everything and trying to outsmart them was generally foolish. By calling markets irrational, Edmans is saying they are inefficient. In short, they don’t know everything. And that opens up many doors for enterprising investors, as he datils in his latest book, Madness of Markets: Why Smart Investors Make Crazy Decisions – And How To Exploit Them.

Edmans started his career as a banker and trader for Morgan Stanley before joining the faculty at the Wharton Business School two decades ago. He moved to London Business School in 2013. Among his many honors and affiliations (including his first stint on Bites in 2024) he is president of the Western Finance Association; a fellow of the British Academy, the Academy of Social Sciences and the Financial Management Association. He also serves as a non-executive director for Morgan Stanley, Novo Nordisk and Royal London Asset Management.

Right click on this link to download the episode. The transcript appears below.

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David Edmonds: What connects yesterday’s football match, today’s weather and how business leaders sign documents? The answer is that they may all be linked to the price of shares. Alex Edmans, professor of finance at London Business School, is the author of a new book,The Madness of Markets. Alex Edmans, welcome to Social Science Bites.

Alex Edmans: Thanks so much, Dave. It’s great to be back.

David Edmonds: We’re talking today about market irrationality. When I was at university, I was taught by an economist who was a leading expert in rational economics. A rational economist believes that the market price has full information. You can’t beat the market. The market represents everything there is to know about the value of a company.

I take it that you’re not a rational economist.

Alex Edmans: I am not. And I was also taught by a rational economist, Steve Ross, one of the great minds of neoclassical economics. I guess most of us were. And this is why neoclassical economics has pervaded for so long. So why is it that I believe that markets are inefficient? Just look at the data.

One of Dick Thaler’s papers, which contributed to his Nobel Prize, said that if we were to stand here and look at all stocks in the UK stock market and see how they did over the past three years, if I buy the loser stocks and sell the winner stocks and hold them for another three years, then we have reversal. So the losers end up becoming the winners in the future, and the winners end up becoming the losers. That suggests that the market is overreacted and is a contrarian strategy.

And just look how inefficient the market has to be for that strategy to work. You don’t need to know the name of the companies. You don’t need to know the industry they’re in or the products they make. Just look at past performance, and that can be enough to put on this contrarian strategy.

David Edmonds: OK, I want to get into some of the details of this. But let’s start with a story that you write about, where I guess you had an epiphany. And that was the moment I think France was playing Greece in the quarterfinals of the Euros. And there was a great shock. Greece won that football game. What happened as a result?

Alex Edmans: Yes, I was on the trading floor of Morgan Stanley back then. And this was Morgan Stanley, New York. And that football match was in the European Championships.

And you might have thought, well, in America, people do not care about the Euros. They care about baseball and ice hockey and basketball and American football. But in the trading floors of Morgan Stanley and Broadway, people were really reacting to this.

And it may well be because some of them had European ancestry, as you could see from their last name. But this was something which really affected people’s emotions. And after that France defeat, one trader stormed off and didn’t return for days.

And this was a professional person who was managing billions of dollars of money. And so when I returned to MIT later that fall, and I was taught another class on neoclassical finance and rational markets, I thought, “Well, was this just one isolated incident? Or is this something which is there in the data?” So I looked at a seemingly crazy question, can football matches affect the stock market?

David Edmonds: And the answer is?

Alex Edmans: Yes! So what I did is I took 1,150 games across not just the Euros, but the World Cup and the Copa America and the Asian Cup, and my co-authors and I found that controlling for everything else happening in the world market, after a defeat, the market falls significantly the next day. To put some figures on it, after a World Cup elimination, it’s half a percent, which if you apply that to the UK market is £13 billion wiped off.

David Edmonds: But if France play England in the World Cup, and France lose, England win, why isn’t that a balancing effect?

Alex Edmans: Unfortunately, we found that the effect was only negative. So losses led to the market declines, but wins don’t lead to the market increasing.

And why is this? A couple of reasons. One could be loss aversion, the idea that the positive effect of a win is much less than the painful effect of a loss.

And second could be the asymmetry of the competition format. So if you lose, you’re instantly eliminated. But if you win, you still have to play more rounds.

And so this is something that we found actually not just in football. We found this in other international sports such as rugby and basketball and cricket. So it was something which was pervasive across sports, suggesting there’s an asymmetry there in terms of reaction.

David Edmonds: The logic would seem to be that before the World Cup, you should sell your shares because somebody’s bound to lose. And if only the loss has an effect, the market is bound to fall as a result of a big sporting occasion like the World Cup.

Alex Edmans: That is correct. So if England were playing France, you don’t know who’s going to win. But if you were to short both national indices before the game, then the one that does lose, the market goes down. So you gain on your short position.

The one that wins, the market will be flat. And so you don’t lose on that position. So if you were to take the paper, literally, you could put on a trading strategy.

And indeed, a follow-up paper did look at how to exploit this result. What they looked at was shorting just the U.S. market before each World Cup. So their idea was that the U.S. market is correlated with all the national markets.

And so if you just shorted the U.S., you would have made money over the, I think, 12 World Cups they studied. Now, even though I would love this to be true, I didn’t fully believe the result. Why? Because there were only, I think, 12 tournaments in their sample, whereas my original data had 1,150 games.

So I knew that it was unlikely to be a fluke. Maybe what they found in their study was something just lucky among those 12 World Cups. But the broader point of my paper was not necessarily to find a trading strategy that you could literally put on, but instead to show that the market is affected by emotions rather than fundamentals.

And then if the market overreacts to something as irrelevant as a football match, then the contrarian strategy found by Dick Thaler and his co-author is something that has a lot of weight. The market may well overreact to information, which leads to the profitability of a contrarian strategy.

David Edmonds: So the market’s affected by emotion, by mood. One of the things that affects our mood is whether the sun is shining. Does weather affect the stock market?

Alex Edmans: It actually does. And this was actually the inspiration for my football paper.

So I was in this neoclassical finance class, and the first week was telling us about good habits in research. And so the professor was going through some papers that he thought were weak and were problematic. One was a paper on weather.

So this paper initially found that when the day is cloudy in New York City, the market tends to go down. When the day is sunny, the market tends to go up. The professor was very open-minded with this.

And so while he was skeptical, he said, well, the best antidote to this is to check, is this true around the world, or was this just a fluke in New York? And so what he said you should do is an out-of-sample test to check whether this is true in other countries. And then he showed a paper by David Hirshleifer, who’s one of the big figures in behavioral finance, and Tyler Shumway, which replicated this across the world. They found that this was actually a persistent effect, and so that was a good way to try to convince people who were skeptical that there was an effect really there.

Now, even though this was a robust effect globally, one concern still remained is that, well, weather is very local. It could be sunny in New York, but it could be cloudy in Chicago, and how do we know it’s Chicago fund managers that are not actually trading? So this is then what gave me the idea to look at football. This is correlated across a country.

If England lose, the whole of England is upset, and this is also why I looked at the World Cup rather than the Premier League, because if Manchester United win and Arsenal lose, for example, some people are happy and some people are happy, and so it’s hard to see what’s going to happen overall.

David Edmonds: Is the idea just that if the sun is shining rather than if it’s raining, you’re feeling more optimistic, so you’re more likely to buy?

Alex Edmans: It is, and this might seem bizarre to some people, because you might think, yes, my emotions are affected by the weather, but when it comes down to work, I will put my game face on and I will shut those things aside. I will be a professional and forget about my emotions, and what is interesting is that there has been research by other people showing that even among professionals who should be putting their emotions aside, they are affected by sentiment.

For example, when the Louisiana State American football team lose, then judges in Louisiana give harsher penalties. While they might just be in a worse mood, and even though they should be unbiased, they are still human, and so the broader message here is perhaps as a trader, as a professional, be kind to yourself. You might think, okay, I’m affected by maybe the weather, maybe a football result, but maybe by some family situation, or maybe I had an argument with my wife, or somebody is sick, but I’m human, so don’t think, oh, I should just soldier on.

I might be affected by this when I’m making decisions, so delay the decision to another day, or chew my decision with the rest of my team. Make sure that we are not being overly swayed by sentiment.

David Edmonds: Let me inject a note of skepticism in this data finding about the weather.

We’ve recently been through some heat waves, and when I wake up in the morning and I know it’s going to be another 32 degrees, 33 degrees or whatever, I don’t think, “Oh, wonderful. I think, oh, my God, this is the end of days.” I feel pessimistic, even though the sun is shining, and presumably the data is not picking up on those subtleties.

Alex Edmans: Correct, so the study which did this was based on data to, I think, around 2003, and so that was before we had more extreme weather conditions. So what they looked at is more subtle changes in weather is maybe you end up being 25 degrees rather than 20 degrees. However, more recently, one of my former PhD students at London Business School, Darcy Pu, he did a study on extreme weather situations and found that extreme weather is negatively correlated with returns, which makes sense, and what this suggests is like many things in life, things are not linear. It’s not that the warmer the day is, the better it is in terms of mood, because when it gets too hot, as some people will have experienced this summer, then you might have a negative effect on sentiment. And so given now, unfortunately, we have more extreme weather events than Hirschleifer and Shumway did 20 years ago, this was something that Darcy was able to pick up.

David Edmonds: So this is all about mood. Sporting victory can affect mood. Beautiful sunny day can make us more optimistic sometimes.

How does this play into the idea of bubbles in the stock market? We get rises in the price of shares and sometimes we feel there’s over-exuberance. What’s the relationship between mood and bubbles?

Alex Edmans: This is a great question because it gets to the bigger picture about my study. So one might argue it’s crazy for MIT to give a PhD for a paper about football because why do we care about the effect of football on the stock market? But instead, what we were about was the broader question of whether the market overreacts. To show that the football result that then opens the door to other types of overreaction suggests that sentiment does matter.

So let’s give an example. So in 2000, Cisco overtook Microsoft to become the world’s most valuable company.

And why? Well, Cisco made routers and switches and these were the fuel for the internet and we were going to go into an internet world. However, even though the internet was the future, the market just got overly excited and overreacted to Cisco’s prospects. So Cisco’s nosebleed valuation would have been justified if it grew sixfold within the next five years.

And indeed Cisco did grow sixfold, but it took 25 years rather than five years to get there. So often the market gets the direction right, but the speed or the magnitude wrong because it gets overly excited. And we can think about this with more modern-day examples, maybe with electric vehicles. Yes, that will be the future given climate change, but the speed of adoption might be slower because we don’t yet have the charging infrastructure. Maybe AI right now, some people think, well, this will absolutely be the future, but there may be some people who are not comfortable with having an AI robo-advisor.

So this is a mistake we see many times, which is why bubbles are so frequent.

David Edmonds: We might then be in an AI bubble at the moment. How do we know? Because it’s possible that the market’s got it right. And if the market’s got it right, we want to be on that journey.

Alex Edmans: So in order to try and diagnose a bubble, there’s a couple of indicators that you can look at. And just to look at one in isolation won’t be sufficient. So one indicator, which I referred to earlier is to look at the stock price performance over the past three years.

And if we were to do that, we might say, “OK, we are in an AI bubble because the market has run up over those last three years.” But exactly as you’re asking, well, maybe that run up was fully justified by AI being the future and the adoption of AI has been quite rapid. So another thing that you can look at is a valuation multiple.

So that compares the value of a stock to its fundamental what it’s worth. So when you buy a house, you look at price per square foot, and that’s a measure of whether something’s overvalued to other houses in the area. And within stocks, you look at the price-to-earnings ratio.

And so in 2000, Cisco’s price earnings ratio was 190. That was three times Microsoft’s, it was four times Intel’s. So even back then, even without hindsight, it was reasonable to think that there was a bubble for Cisco.

But right now for AI, it is not as clear because the PE multiples, depending on what index you look at, they tend to be about 30, 35. Now, one could argue that’s because the E, the earnings, are inflated. Why? Because there’s been massive spending by the hyperscalers, which is going to scale back, or because some of the earnings have been the gains and the stock price of some of these AI firms.

But at least on the face of it, it is not as easy to call it a bubble, which is why you see sophisticated people on both sides of the trade right now, some saying there’s more room to run and others saying it’s overinflated.

David Edmonds: Let’s assume we are in an AI bubble, we may not be. But even if we are in an AI bubble, as an individual investor, presumably what I want to do is be inside the bubble until just a moment it bursts and then get out.

Is there a way of strategizing that? Is there a way of working out how I can stay in the bubble until everybody else identifies it as a bubble and the bubble bursts?

Alex Edmans: Unfortunately, it’s very difficult. But if you’re an individual investor, actually, you don’t necessarily need to call the very top. And this is one of the great things about being an individual investor.

You are managing your own money. And I might have a 40-year investment horizon. And so I might be sitting on a lot of AI and tech gains right now and be quite happy with this.

And I might think, well, let me sell now and lock in those gains. And even if I miss the top, even if it goes up for another six months, I’ve still done really well. In contrast, let’s say I was a professional money manager.

There, my concern is that I’m investing clients’ money. So if we go back to the tech bubble, we have Tiger Global Management, founded by Julian Robertson, one of the legendary investors. He thought, correctly, we are in a tech bubble. So he exited from this. And then it kept rising. And then his own investors said, “Well, you’re crazy. Everybody else is making money on this bubble. You’ve exited.” So they all withdrew their capital. His fund got liquidated in March 2000. And then shortly afterwards, the tech bubble did crash. And Julian was right, but he was not around to enjoy the victory.

And so this is really interesting because we often think, “Well, the professionals have an advantage.” And obviously, they have greater information and they have greater teams to process that information. But one thing that an individual investor may well have is just a longer runway.

We might buy in the dip, as I did in the depths of the global financial crisis. We might sell when we think the market is frothy, even though we don’t know it’s at the very top. And we don’t need to get the timing exactly right because we don’t have end investors to be concerned about.

David Edmonds: I can see how if your share is going up, it’s easy to lock in gains. If you own a share that’s declined in value, I can imagine it’s less easy to cut and run.

Alex Edmans: You’re absolutely right, Dave.

And this is another big mistake that people make with trading. This is known as the disposition effect. This is the idea that we anchor onto our purchase price, even though that should not be relevant.

So if I bought a stock at £100 , it’s now 120. I want to rush to lock in that gain. But if it’s gone down to 80, I refuse to take that loss, even though I might know it’s got downward momentum and it might be south to 60 or to 50. It’s just really hard to take a loss. We have to then admit to ourselves this was a bad decision. It’s a bit like if you go to a casino and then you lose £100, you will not exit. You’ll keep gambling more and more until you get back into the black.

And the reason why this is so crazy is that another phenomenon in the markets is short-term momentum. Earlier when I talked about the three-year strategy, that was long-term reversal, stocks that did badly over the past three years tend to now become winners.

But if we looked at the performance over the past six months, we actually have last six months losers stay losers and the last six months winners stay winners. So in fact, what you want to do is you want to hold onto your short-term winners and you want to sell your short-term losers because they’re continuing to decline. But what we do is the opposite.

We rush to lock in our gains and we don’t rush. We actually hold on to our losers. So it’s a bit like cutting our flowers and watering our weeds. It’s betting on gravity to reverse. But the reason why we do this is just psychologically it’s so difficult to take a loss yet we want to lock in a profit.

David Edmonds: I want to mention a couple of wonderful correlations that you’ve identified. And I wonder if you can tell us a little bit about assessing the value of a stock according to where the annual meeting is held, and also, according to the type of signature of the chief executive officer.

Alex Edmans: Thanks for asking about this, Dave because this is one of my favorite chapters of the book. So the CEO is important for two main reasons.

Number one, he or she has more information about their company than anybody else there inside it. And you’d like to read whether their information is truly positive or negative. But the difficulty is often their press releases, their public statements are spin. Even if they are truly nervous about a company they might say lots of positive things.

So what you want is the equivalent of a poker tell. A subtle signal which suggests to us that actually all is not well in the state of Denmark. And one of these signals is where the CEO chooses to hold the annual general meeting. So why? At an AGM there’s a lot of routine staff, voting on routine activities. But then there’s the wild card which is the Q&A session.

And that can get quite embarrassing. So sometimes shareholders can ask really aggressive questions. Now if you’re a CEO and you’re confident about a company, you don’t mind questions.

Even negative ones because that gives you the chance to set the record straight. But if you know that you don’t have good answers, you will try to hold the meeting in as remote a location as possible. So there was a company based in Detroit, Michigan which held its meeting in McAllen, Texas. So to get there you cannot fly. You have to fly to Houston and then drive for 300 miles. So this is painful for the CEO. So the only reason he would want to do this is if he wants to make sure that shareholders don’t go either.

So that was a great signal. And indeed if you were to sell a company after it holds its meeting in a weird location, a remote location, the market typically falls by 7% over the next six months.

Now the second reason why the CEO is important is not for their inside information but for their character. So some CEOs really try to create long-term value for shareholders and society. But other CEOs run the company like their own personal plaything. They want to pay themselves a lot and enjoy all of the trimmings of being a CEO and use it to bolster their reputation.

And one thing that you can look at is the CEO’s signature size. So in an annual report there’s the shareholder’s letter at the start and you sign this particularly if you’re the chairman as well. And some have just really large signatures and you might think well this is a crazy measure doesn’t it depend maybe on just the space that they have.

But no there is quite strong correlations and just as a simple example Rupert Murdoch’s signature is loud and flashing and large which is consistent with what people think about his character. And what people found was that CEOs with larger signatures — they will tend to have much more aggressive capital expenditure, much greater volatility in terms of the stock price, also earnings being restated in the future. So that suggests that they may have pumped up their earnings and those earnings are actually not backed up by real fundamental improvement.

David Edmonds: This whole interview is about the irrationality of the market. So when it’s sunny the market might go up, but these are short-term effects right. If I’m a long-term investor as opposed to somebody going in and out of the market, can I expect that these irrational climbs and falls will work their way through the system. I can ignore them in effect.

Alex Edmans: Actually no. So you would be correct in terms of some short-term overreaction.

So the overreaction to sports and weather that may well correct. But what we’ve just discussed is underreaction to particular important signals. So the location of an annual general meeting is a key signal. So might be the signature size and other measures of CEO character. So might be intangible assets. So the value of a company’s corporate culture.

And these are things which are not fully incorporated into the stock price for many, many years. So one of my own studies found that employee satisfaction takes four to five years to be incorporated into the stock price. And so yes, the market does get it right in the long term. But as John Maynard Keynes said in the long run we are all dead.

So yes maybe if you waited four to five days you might say well the market is not that inefficient even four to five months. But four to five years suggests that if you are a long-horizon investor you might still want to pay attention to these intangible hidden signals because they are ones that the market gets wrong for a long time.

David Edmonds: Can I ask you about the macro value of this research? There’s you and I. Let’s say we’re both investing in the market. You’ve studied all this. You know where the irrationalities are.

So you take advantage of it and I don’t. You win and I lose. But it’s a zero-sum game, isn’t it? What’s the benefit overall to understanding that the market is irrational in this sense?

Alex Edmans: This is a really important point and often people think the market is indeed a zero-sum game. There are winners and losers but they all cancel out this is not something which affects wider society. And then this goes to questions as to why do traders get paid so much? They’re doing something where they’re just betting with each other. They’re not adding social value.

But in fact, there are implications for wider society. Why? Because the stock price has many effects on the real economy. For example, if the stock price is really high, this can allow companies to raise a lot of capital and then engage in a lot of investments.

For example, in the US a shale oil boom the prices of oil companies was really high and this allowed there to be a lot of expansion and billions of dollars were wasted. Why? Because people thought that investment opportunities were really positive taking the stock price as a signal when in fact they were not. Similarly, in the dot-com bubble many companies were raising money on just inflated prospects, taking advantage of the fact that they were able to sell at high valuations.

On the flip side, if the market is too low, then it is difficult to raise capital even if you have truly great opportunities. And one concern that people have about stock markets is that they are short-termist. You might be a company with fundamentally great long-term prospects and it’s hard to raise money.

And so this matters in both directions and so if you are a trader who is trading on fundamental information which would involve buying companies with strong fundamentals and intangibles you’re actually helping society because you’re pushing up the stock price making it easy to raise capital and if you’re shorting companies which might be fraudulent or which might be over-inflated you are also adding value. So I know that short sellers get a lot of bad rep and there are some short sellers which are manipulative, but if you short sell a company such as say Valeant Pharmaceuticals, which was engaging in unsustainable strategies, then this is actually better because this makes sure that those companies don’t keep getting more capital and then employees don’t keep flocking to those firms.

David Edmonds: But you’ve published all your research if these irrationalities exist ,why doesn’t a clever hedge fund just move in and take advantage of your findings?

Alex Edmans: You might think so and I often will make a big thing about the fact that these are really rigorous studies published in the top academic journals, but that might backfire because if everybody puts their trust in it why doesn’t everybody put on a momentum strategy or contrarian strategy or even the employee satisfaction strategy.

So indeed there was one really influential paper which looked at what happens to these strategies after they are published in a top academic journal. Now the returns of these strategies go down — but only by a third. And so why don’t they fully go down all the way? Well for a couple of reasons, the number it might not be that not everybody reads The Journal of Finance it may well be that people are investing based on intuition and gut feel. Number two it might be it’s really difficult to put on these strategies because it goes against our biases.

For example, to put on a momentum strategy involves you selling your losers and running your winners which goes against natural human behavior for the reasons that we’ve discussed. One could also say that there’s great scientific research about how to live a longer healthier life so try to avoid chocolate cake or excessive drinking and try to exercise, and even though that research is very respected it is hard to operationalize, so just like other types of rigorous research might not be followed it is the same which is true in investing.

David Edmonds: What about you though? I mean we’re conducting this interview in a lovely room in the heart of London, but why aren’t we doing this interview on your private island in the Caribbean that you’ve bought because you’ve made so much money from buying and selling shares?

Alex Edmans: So indeed, based on this research I have changed a lot of my own individual behavior so it’s tempting for me to think I’m a finance professor I’m really knowledgeable about finance and therefore I should be day trading individual stocks. But what I realize is that when I’m trading, I’m trading against sophisticated fund managers who have access to information that I don’t have. They have teams of individuals to help them and they’re able to spend 12-16 hours a day on this whereas I spend most of my day either writing books or giving talks or teaching students. So this is actually something quite difficult for individual people to do who don’t have the access to information all the time.

But then what I can do is I can put my money with fund managers who I trust who I think are putting on these strategies so one of my earliest investments was in the Parnassus Workplace Fund, which invests in companies with strong corporate cultures based in part of my research and those things have done decently. So it’s true that I’m not on a private island but I don’t think that should be the goal one of the final messages of the book is get rich slowly but get rich.

I think one of the biggest things that we should be doing is just to play the game, to be in the market the fact that stocks over any reasonable time period do much better than cash, and so while you might not become a millionaire overnight in the long term, you’ll be able to your and your family’s future.

David Edmonds: Well, it’s an excellent book so I hope the royalties alone will enable you to buy a private island. Alex Edmans thanks very much indeed.

Alex Edmans: Thanks so much Dave really enjoyed the conversation.