Malkiel would be shocked...
As we noted previously, one of the bedrock notions in modern finance is the “Random Walk Hypothesis”, which essentially says that every day is a new one. Markets are like Buddhist monks in this paradigm, waking up with nothing and taking their begging bowl into the streets to see what fate brings. If markets are up 5 days in a row, the sixth day may be up or down in line with long term trends. And long term here means the life span of a Galapagos Island tortoise.
After +6 years of a bull market in U.S. stocks, it’s hard to remember about “Random Walks”, but another market paradigm can help fill the void – something called the “House Money Effect”. This is newer than the “Random Walk”, which was popularized by Burton Malkiel in his 1973 book “A Random Walk down Wall Street”. The seminal work on “House Money” is a 1990 paper by Richard Thaler and Eric Johnson, and it showed that gamblers change their attitude to risk based on prior wins and losses. Get on a winning streak, and you bet more heavily since you are playing with the “House’s money”. Hit a bit of hard luck and you pull in your horns (except when given the chance to break even, when you grasp at any passing chance). It shouldn’t work that way – every spin of the proverbial wheel has its own independent outcome – but in practice the “House Money Effect” is measurable.
If there is one single argument for why investors have stuck with risk assets like U.S. stocks in the last few months, the “House Money Effect” is as good as any. After all, the domestic economy has slowed and not even the Federal Reserve is sure whether that is seasonal, secular, or the result of lousy measurement tools. Corporate earnings haven’t matched those of a year ago. And U.S. stocks are not cheap by any objective measure. Yet, after a long run of gains, it’s the house money on the table. And we know that’s more risk-prone capital than what investors may consider their own. That also explains the remarkably low levels of both actual price volatility and the CBOE VIX Index.