Market Psychology
Investment markets are driven by more than just fundamentals.
Investor psychology plays a huge role and helps explain why asset prices go through periodic booms and busts and why share prices can react in extreme ways to events. The key for investors is to be aware of the role of this investor psychology and its influence on them.
We don't have perfect information. We're making buy, sell, hold decisions around imperfect information about the future. And because there is uncertainty in that, we sometimes get those decisions wrong.
We as a species are predictably irrational.
The study of that, of course, is called behavioral finance.
Investor psychology plays a huge role, but it's often triggered by something positive or negative.
If you go back to the tech boom of the late 1990s, there was lots of reasons to be optimistic back then. That optimism propelled markets to excessive valuations particularly for tech stocks.
The market got ahead of itself as a result of investors piling in & pushing share markets higher.
Then we went through a severe correction in the early part of the 2000s as investors got in a rush to get out.
There's a combination of investor psychology traits that drive this.
One of the big ones is this tendency for investors to project recent strong gains or recent
sell offs into the future. If the current environment has been very positive, with lots of good news, people will assume that will continue. Then they pile into the share market pushing it to extremes. It it starts to feed on itself and then that eventually sets up a bust.
So how do we counter this behaviour?
This requires operating in a manner which is contrary to the crowd around you.
"buy when others are cautious, and sell when others are greedy" to paraphrase Warren b
Warren Buffett is perfectly happy to be contrarian.
He's got a long-term time horizon. I guess his mental makeup was such that he can resist the crowd, so to speak.
But for most of us we listen to and act on what those around us are talking about at dinner parties.
If everyone else is getting in, you want to get in, too. And likewise, at the bottom, it works in reverse.
You could aim to be a contrarian, but you may not get the timing right.
It's kind of hard to time the top and the bottom.
So what are the theories of investor psychology ?
These are my favourite papers all of which won Nobels for behavioral finance.
1. Herbert A Simon's 1978 Nobel win for his pioneering research
into "the decision-making process within economic organizations”.
Classical and neoclassical economic theories assume that people are perfectly rational and strive to optimize economic outcomes. Simon argued that human rationality is constrained, not perfect, and that people seek satisfactory rather than ideal outcomes.
Eg: you can argue with your kids to clean their the room.
In theory, the room should be perfectly clean, but they stop as soon as it looks
less messy and mom won't shout anymore? That's a concept of satisficing.
In theory we should be scouring the stock market for the very best places. But most of us being human don't. We look around until we find the very first thing that looks good enough and then that's what we buy or sell.
2. Allais Paradox
French economist Maurice Allais was awarded the Nobel Memorial Prize in
Economic Sciences in 1988 for his pioneering contributions to the theory of markets
and efficient resource allocation.
While he received the prize for his general equilibrium work, he is most famous
for the "Allais Paradox," a decision-making puzzle that challenges expected utility theory.
In the case on one of the shares I own (ASX JIN) which is a software gambling stock
the number of people buying lotto tickets is determined not by the outcome of likely win, but by simply the prize money on offer. Those that offer bigger prize money with worse odds have more participants than those with a greater expected value but have smaller winnings.
This is completely irrational.
3. Daniel Kahneman 2002 Nobel prize
Daniel Kahneman was awarded the 2002 Nobel Memorial Prize in Economic Sciences
for pioneering the field of behavioral economics, specifically for his groundbreaking
work on decision-making under uncertainty.
He developed this research in deep, decades-long collaboration with
cognitive psychologist Amos Tversky.
They talked about an S-shaped preference curve.
The idea here is that we treat wins and losses asymmetrically.
It explains phenomena like "loss aversion," where the psychological pain of a loss feels roughly twice as strong as the joy of an equivalent gain.
This partly explains bubble behavior.
As the market goes up, we become less and less risk averse about the fact that it
could crash, which is exactly the wrong thing to do.
Kahneman & Tverky showed, what matters is not did we win $10. It's how much did we think we had before we made that gamble.
The more wins we have, the less we value future wins.
4. Fallacies & Bias
Keep at the back of your mind the concept of
a) narrative fallacy,
b) confirmation bias
c) endowment bias.
a) Narrative Fallacy
This is the idea that we as humans really want to assign a story and
a reason to things that happen even if they're random.
Want to assign stories to random events which then can have the risk of
becoming self-fulfilling. So a great example is a company may have no
news on it. Its share price rises two or three days in a row. Now that's just
standard probability. You know, flip a coin three times,
you can get three heads in a row. And yet very quickly within the market, there
will be article after article writing about why the share price has risen and
why that is an indicator that this company is actually really good,
which feeds further share price rises because more buyers come
in the market. And the story takes on a life of its own.
We get caught up in that that sort of behavior of crowds, but it's one you can
really easily solve. All you ever need to do to avoid falling into the narrative
fallacy go and look at the underlying data and ask, is it true?
Is there any evidence from the company itself that that's occurred?
A simple sense check will often save you.
b) Confirmation Bias
That's that idea that if we hear a piece of information that confirms what
we already believe, we treat it as true. And if it disagrees with us, we think
it's wrong.
You see this in politics all the time.
Trump can say something and people who are on Donald Trump's
side hear it as confirmation and those of us with perhaps a slightly more
cynical view of Trump here it is negative .
Again you can stop yourself falling into that trap by just being aware of it
& looking up the facts.
c) Endowment Bias (existing ownership).
We as humans immediately value something more just because we own it.
So once you've made a decision to own something, whether it's a stock,
a house, a car, a managed fund, be conscious of the fact that you will
prescribe more value to that asset than you ever did before you owned it.
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So how do we acknowledge this irrationally and rationally evaluate the market?
Puts vs Calls are one method.
What's the ratio of puts versus call options looking at?
Because if you've got a a low level of puts but lots of calls then maybe um that
could be a sign of uh excessive optimism and so on.
Use the principles of value investors... ROE, PE ratios, earnings growth, chart analysis, .....the methods available are endless.
I think important to go beyond just understanding market psychology.
& to understand your own psychology.
At the end of the day you are managing your own money
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