Over the last ten years, the amount of research on behavioral finance — or BeFi — has exploded to the extent that anything said about the subject today seems almost trite.
To summarize: People are not perfectly rational economic machines when it comes to making financial decisions.
Now the fact that the decisions we make don’t match the mathematically optimal outcomes of traditional economic decision-making models isn’t a function of purely psychological factors. There are real physiological phenomena that occur that affect the decisions we make. The human nervous system is a complex network of cells that coordinates our actions using communication from sensory inputs from various parts of the body. This communication occurs directly through electrical synapses or via neurotransmitters.
In fact, research has begun to map behavioral finance concepts directly to specific neural pathways. For instance, loss aversion — where the psychological pain of losing is greater than the pleasure of gaining the same amount — has now been linked to activity in the ventral striatum, an area of the brain involved in processing dopamine, a neurochemical associated with rewards and pleasure. This research has shown less neural activity in this section of the brain among individuals who were less loss averse.
Other research has demonstrated that higher levels of cortisol, a type of steroid similar to testosterone, are correlated with more aggressive risk-taking behavior. Men with higher levels of this chemical in their system have been shown to trade more actively and aggressively than those with lower levels, and even more so than women. (Spoiler alert: The more aggressive the trading, the worse they did!)
And to be clear, such research shows behavioral impacts on areas outside of finance too. So we know that sensory input and how our neurological systems process that input are important drivers of decision making.
Since our physical world affects our nervous system and how we process sensory input, it makes sense that changes in our environment could also impact how we make decisions.
Seasonal affective disorder, or SAD, is a perfect example. SAD is a type of depression related to changes in the seasons. About 5 to 10 percent of people suffer from SAD, and symptoms include feelings of sadness and anxiety, extreme fatigue and lack of energy, trouble concentrating and loss of interest in many activities, and feelings of hopelessness or worthlessness in winter months.
While researchers don’t know exactly what causes SAD, lack of sunlight is known to be one of the main contributors. Sunlight helps regulate and stimulate the production of serotonin, a neurochemical that helps contribute to feelings of happiness.
Sunlight also helps produce vitamin D. And since vitamin D also encourages the activation and release of serotonin, having low levels of sunlight is a double whammy to those suffering from SAD.
One of the consequences of this depressive state and loss of interest in activities is a reduced risk appetite, and that has been documented across a variety of behaviors. Researchers from the University of Toronto looked at stock market returns across four markets: Stockholm, London, Frankfurt, and Toronto. While all of these cities have cold, dark winters, they are not equidistant from the equator. Some are farther, and hence darker, than others.
The researchers found that seasonal patterns in stock markets — such as excess returns in winter months, often called the Santa Claus rally or the holiday effect, and lower returns in late summer and early autumn — broadly matched the hours of sunlight in the different markets.
When they included South Africa and Australia — countries in the Southern Hemisphere, where the seasons are reversed — the authors found that the stock market patterns were reversed as well.
They concluded that the lack of sunlight contributed to a reduction in market participant risk appetites in winter months and the opposite in summer. Since decreased risk appetite requires a higher risk premium, and a higher risk premium leads to higher returns, these authors argued the strong link between distance from the equator, hours of sunlight, and market cycle couldn’t be due to chance alone.
However, recent research has linked market risk appetite cycles to another type of solar activity.
In a fascinating piece posted on LinkedIn, market research firm Focused 15 Investing details some of its work examining physics-based variables that correspond to its proprietary market-based measures of risk aversion.
First, the firm describes its model of risk aversion — a proprietary model developed nearly a decade ago that combines signals and trends. This model, which the firm calls the Micro Market Resilience Index, has been shown to do a pretty decent job of tracking cycles in public stock indexes like the Dow Jones Industrial Average.
Over the years, the firm has noticed recurring patterns in its risk-aversion cycles. And despite changes in demographics, communications technology, and economic externalities, these patterns remained relatively consistent over time.
Here’s where it gets interesting.
Hoping to improve its models, the firm turned to data scientists and mathematicians to uncover variables related to these regular patterns it had observed. Digging through reams of research, one paper in particular stood out: A Federal Reserve Bank of Atlanta working paper titled “Playing the Field: Geomagnetic Storms and the Stock Market.”
In this paper, a pair of Fed economists tied geomagnetic storm activity to stock market returns. Geomagnetic storms are disturbances in the Earth’s magnetic field caused by the eruption of plasma and radiation from the sun’s surface during a solar storm. Medical research had already connected geomagnetic activity to adverse effects on human health. In this case, higher levels of this type of solar activity — unlike direct sunlight — increase depressive states and decrease risk appetites.
The Fed paper explicitly demonstrated that unusually high levels of geomagnetic activity have a negative and statistically significant effect on the following week’s stock returns for all U.S. equity indexes. Additionally, the study also provided evidence of substantially higher stock returns around the world during periods of quiet geomagnetic activity. Higher geomagnetic activity led to lower stock returns, and vice versa.
Incorporating such data on solar activity and similar variables, Focused 15 was able to construct a physics-based risk model that does an even better job of leading changes in market prices. Further, all of the market lows in the sample occurred near or at risk-appetite lows based upon this solar model.
While I have to say I remain a bit skeptical, I am intrigued with this line of investigation. Perhaps in the not-too-distant future, we will see a cluster of new research in decision science examining how changes to the physical world around us can dramatically impact our investment decision making.
At the very least, perhaps it’s worth considering if it is your “gut instinct” telling you to liquidate your stock positions, or just an unexpected solar flare. Or maybe pitching a new and innovative strategy to your investment committee or trying to launch a first-time fund should be pushed back to sunny July or August instead of dreary December or January.
And maybe if that happens, I can lay claim to having been on the bleeding edge of introducing institutional investors to “PhyFi,” although that doesn’t have quite the same ring to it.
Christopher M. Schelling is the founder and chief investment officer of 512 Alternatives, a boutique consulting firm dedicated to helping wealth managers, family offices, and small institutions understand and access alternative investments.