As the once universally-sacred Efficient Market Hypothesis (EMH) continues to fester unceremoniously in economic purgatory post-crisis, behavioral finance–which might tend to support the notion that short-term price action, far from being rational, is highly inefficient and emotional, continues to gain credence among economists and fund managers alike.  Speaking in 2005, Dr. John Porter of Barclay’s Capital in London for instance remarked that “psychology is by far the most important area in the markets.  Markets people want to be quantitative and model human behavior, but the problem is human behavior is not stable.  When people interact as groups, human behavior becomes subjugated to that of the overall group.”  Moreover, Robert J. Johnson, senior managing director at CFA Institute, noted in Monday’s FT that in fact behavioral finance is documented to have created profitable trading opportunities.  “At its core, the discipline of value investing is largely based on behavioral finance principles.  Implementing strict value-based or contrarian investment philosophy can require exceptional fortitude, especially in volatile markets where it might be difficult to convince investors of its wisdom.”

The burgeoning field seems particularly relevant, in my opinion, to frontier investing, which is defined in part by illiquidity and relative volatility.  Yet in his November 2008 research paper, “Investing in the Unknown and the Unknowable -Behavioral Finance in Frontier Markets,” Larry Speidell, founding partner, CEO and chief investment officer of the San Diego-based Frontier Market Asset Management, notes that the relatively large presence of neuro-based biases in frontier investing underpins the sector’s high risk premia potential as well:

“Behavioral biases and opportunities are abundant in frontier markets.  Foreign investors are prone to view them through the prism of personal prejudice and media hysteria, making it difficult for them to even travel to frontier countries, let alone invest in their markets.  Those professionals who do venture out on the frontier find it difficult to travel light, without the comfort of all the data that have made more developed markets so efficient.  Meanwhile, local investors are lacking in analytical tools and are prey to rumors, leaving the brokers to make fat commissions while their customers chase rumors.  Investors who can avoid the crowd, evaluate the asymmetry of knowledge, and deal with decision making under uncertainty have an opportunity in frontier markets.”

Behavioral-based volatility in illiquid markets can be a boon to long-term investors who are apt and able to lower their price base rather than rashly seek-out skeptical buyers.  The recent bank-kerfuffle continues to keep the Nigerian Stock Exchange into a kink, for instance, but prudent heads may yet prevail; as Silk Invest’s Baldwin Berges wrote in this week’s newsletter to investors, “Nigeria’s local investors remain nervous and have been putting more pressure on the market. We have to keep listening for that thud that will tell us we have reached the bottom. [But] when it turns, it will go fast…some patience may be required but we believe it is justified by the potential upside to be had in Nigeria.”

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