How well do you know yourself? It’s an odd question to introduce an article on investing — or weather, for that matter — but knowing your own tendencies can be as important as understanding fundamentals and valuations.
One piece of evidence for this assertion: Over time, the stock market tends to perform better when the sun is shining, and it underperforms on days when it’s cloudy.
You can pass that off as nonsense, but it actually reveals how individual investors’ mood can play a role in their decision-making processes … and it provides a measure of the role emotions play in market performance.
The correlation between sunshine and rising markets might be hard to believe at first, but a convincing analysis of the anomaly is set forth by Mitra Akhtari of the University of California, Berkeley, in a paper titled “Reassessment of the Weather Effect: Stock Prices and Wall Street Weather.”
Akhtari’s paper posits that investors who are in a favorable mood are more inclined to take risk, while those in a worse frame of mind tend to be more risk-averse.
This is where weather comes into play.
Since sunshine elevates our mood while cloud cover depresses it, weather can actually be a factor in an investor’s appetite for risk on any given day. In her study, Akhtari performed a regression analysis to assess the relationship between weather conditions in New York City and the daily returns of the market, represented by the Dow Jones Industrial Average. Her conclusion: NYC sunshine and daily market performance were indeed positively correlated from 1948 to 2010.
There’s more to the story, however.
The relationship between weather and stock market returns isn’t constant over time. Instead, it tends to rise at the times when individual investors — or as Akhtari calls them, “average Joes” — are most active in the market. Akhtari writes that higher participation by “non-rational investors,” whose decisions may be governed more by emotion than those of the pros, tends to bring with it an increased correlation between weather and stock market performance.
The obvious question is how could the mood of individual investors have any meaningful impact on performance in the current era of globalization and high-frequency trading? The answer is that the actions of even a small subset of investors can lead to mispricing.
Further, the concentration of local trading agents and the financial media in trading centers — in this case, New York City — serves to exaggerate the impact of weather conditions near the exchange.
Does this mean investors should buy puts when the forecast is calling for a rainy day? Of course not. But knowing how having a positive or negative attitude on a particular day can impact investing decisions can aid in the process of self-analysis.
In addition to asking questions about a stock’s fundamentals, valuation or technicals, investors should also consider how their own frame of mind is playing a role in their decisions. Or as Akhtari puts it, “(Recent research) suggests that supposedly rational investors are affected by feelings, which are at times induced by unrelated events in their surroundings, and the effect of feelings on behavior influences investment decisions and market outcomes.”
In short, a risk-reward proposition that appears favorable today might not look good tomorrow. This is the hallmark of the non-rational investor. And it’s an easy trap, since most individuals (unlike professionals) don’t have anyone looking over their shoulder.
You won’t see a discussion of the “weather effect” on the stock market in Graham & Dodd or one of Warren Buffett’s annual letters, but for individuals, the lesson is clear — learn to master the psychological aspect of investing, or you’ll always be one step behind the pros.