A year has gone by since we witnessed the unexpected. An institution which was considered too big to fail eventually failed. The fall of Lehman Brothers on September 15 led to unprecedented events that have seen millions of jobs lost, negative investment returns and, above all, lack of trust and confidence. Numerous stimulus packages and government guarantee schemes were structured just to achieve one target: regenerate trust and confidence in the markets. Who would invest in an asset if s/he cannot trust the counter-party?
Investing is not just the economic activity most people think it is. It is a web of human behaviour and emotions that directs the rises and falls of the markets and investors. Though hardly ever thought of as such, the stock market is a hub of human behaviour and thought patterns.
At the other end of the transaction is another human being: a human being with emotions, someone who is experiencing feelings that could range from optimism to over-confidence, greed or fear. A human being, whose personality and mood affects the stock market. And that is what creates the psychology of investments. This is more commonly known as behavioural finance.
When investing, the pendulum swings between two basic groups of emotions: optimism and greed, and fear and caution. When fear is created within the stock market, investors start to sell shares to avoid losing their savings. It takes self-discipline on the part of the investor or stockbroker to look beyond the initial feeling of fear to judge its rationality. A falling market can fall even further due to fear.
Another psychological trend in the markets that affects emotions is the herding mentality. Stock market bubbles and crashes are great examples of the herd mentality. A herd mentality in general tends to begin and end with extremes of emotions; frenzied buying to cause a bubble and then selling in a panic to trigger a crash. In this scenario, one will encounter otherwise sensible people who act against their better judgment; individuals don't want to be left out and rush with the crowd into and out of the market.
Kahneman and Tversky (1979) introduced a new class of utility evaluation where investors weight losses more heavily than gains. This is called the "Prospect Theory". Psychological studies have repeatedly demonstrated that the pain of losing money from investments is nearly three times greater than the joy of earning money. Investors often have more trouble selling than buying. If a stock is heading up, investors wait, hoping to increase their gains. If it is heading down, investors wait too, hoping to recoup their losses. Of the two, the latter is the bigger problem. This suggests investors do not prefer to "cut their losses".
On the other hand, the concept of positive feedback trading refers to a trading strategy in which investors buy after prices rise and sell after prices fall. This type of trading can result from herding or high expectations. Investors tend to become more optimistic when the market goes up and more pessimistic when the market goes down. Hence, prices fall too much on bad news and rise too much on good news. Investors may avoid selling stocks that have gone down to avoid the regret of having made a bad investment and the embarrassment of reporting the loss. They may also find it easier to follow the crowd and buy a popular stock: if it subsequently goes down, it can be rationalised as everyone else owned it.
The possible fear of regret is a factor driving some investors' behaviour.
This factor is most likely to dominate where investors are not confident of their information, or ability to process it. Investors may use financial consultants as scapegoats thereby reducing their responsibility for poor investment decisions.
To succeed in stock markets, market discipline is indispensable. Investment time horizons should be set and followed. Unfortunately, in a rising market, investors have long time horizons: they are not only thinking of the future, they are willing to plan for the future. They look at their investment returns over three-, five- and even ten-year periods. Conversely, in a declining market, investors shorten their time horizons dramatically.
Mr Mangion is managing director of MPM Capital Investments Ltd.
alexmangion@mpmci.net