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Psychology - Essential for Professional Investors

January 06, 2012 | About:
Federico Flom

Federico Flom

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Many investors make silly decisions by chasing stock prices. What can be done about it? The answer is in psychology.

The fascinating field of psychology is no longer limited to human behavior in social settings. In recent years, behavioral finance has focused on the psychology of stock prices and financial decisions by market participants. Essentially, two main forces affect stock prices in the market: the fundamentals of the company and human behavior. However, a combined knowledge of the two should make a more powerful foundation for making intelligent decisions in the stock market than relying on fundamentals alone.

It is widely known by even the ordinary man that the price of a stock can deviate substantially from its basic value because market participants may betray a herd instinct in their behavior. When people do not understand a company well, they follow the crowd: They chase the winners and dump the losers indiscriminately.

Because of this herd mentality, individual stocks — and the entire market — may go up or down dramatically. When interest rates rise or when there are fears that an important country’s economy will fail, world markets react substantially. It is extremely difficult to time the market or to forecast events that make markets move dramatically. The lesson to learn is that when the market does go down significantly, prime buying opportunities may surface.

The most common phenomenon is that people feel like buying a stock when its price has recently gone up or when the market has gone up. If anyone does so, he or she is herding. However, if the investor carefully examines the company, he will not be herding because the intrinsic value of the stock was analyzed before making the final decision.

Investors often extrapolate evidence from recent trends and then decide to buy or sell. If it were easy to pick stocks based on recent price trends alone, mutual fund managers would be able to beat the market indices. But most of them don’t. For every trend that continues, there is probably another one that does not.

The best antidote to herding lies in knowledge and in focusing on the long run. Buffett’s suggestion of buying only what is known may help avoid following the herd. In addition, concentration on fundamentals is important.

How can one determine how to make decisions? When analyzing with others what one does to make decisions one comes to the conclusion that what one is doing and that is wrong, is very common. One starts to notice that is affected by price, that one gets excited to buy when a merger is announced, when a new product is launched, etc.

In the short run, one notices that no attention is given to the incorrect decisions made. One also realizes that long-run results are usually not related to what happened to the stock price right after one bought the stock. But one is paying more attention to the stock immediately after having purchased it, when more attention should be placed on the stock before purchasing.

There are of course other techniques to learn more about decision making. One can separate the months when the market went up and the months when it went down. One can also find out whether one was a net buyer or seller, according to the brokers' statements, etc.

It is essential for a good investor to know who he or she is. Self-reflection can be challenging but very rewarding to an investor.

George Soros points out that the outcomes in social sciences such as economics arrive from a different process than the processes in natural sciences. In natural sciences, one set of facts follows another without interference. The scientist does not influence the process.

In finance the relation between earnings and prices in the short run depends on participants’ perceptions and actions, not on fundamentals alone. Investors often want to get rich quickly when the market is rising, and they want to protect their investment value when the market is falling. In a rising market, initial price changes may lead to further price changes as investors pour in, which then makes the market overvalued. On the other hand, when prices are falling, more sellers come to the market to protect their investments and the market becomes undervalued.

Market trends leading to overvaluation and busts do not last forever; they finally reverse. There are several implications for an average investor. First, an overvaluation usually starts in one sector of the economy and then spreads. Second, relative valuations may often not be a good guide for investing. After the initial rise of the high-tech stock prices during the Internet bubble, most other stocks also became overvalued. Third, it seems impossible to tell how long a bull or bear market will last. Finally, to take advantage of these bull or bear markets, one should buy or sell a stock only after intrinsic value has been objectively computed.

Many psychological studies show that the human decision-making process is imperfect. In particular, individuals deviate from economic rationality. For example, they make different choices depending on how a given problem is presented to them.

However, simply because some investors place a lot of weight on psychological factors and less weight on fundamentals doesn’t mean everyone should follow the idea that the financial markets are crazy. In general, if both optimists and pessimists trade in the market, there may not be any destabilizing effect

In general, when a psychological explanation of movements in the market appears, it must be read carefully and rationally evaluated because there are many biases that may affect decision-making. Let's take overconfidence. Overconfident people tend to overestimate themselves. Financially speaking, there are those who have confidence and no ability in the market. Thus, they select stocks randomly. Some of them will underperform but others will outperform. Something similar happens with an overconfident person who has some skills. Not all his picks may do well. The result will depend on his overall ability to find undervalued stocks, not on his level of confidence in them. On average, if one is able to pinpoint undervalued stocks, it does not matter whether one is highly confident or not so confident.

In some situations, biases may indeed be destructive. One common bias is that of not selling a stock at a loss. But one thinks that the stock is overvalued, then one should sell even if the current price is below expected cost and this will bring a loss.

Another bias is comparing the stock market to a casino. If one can do well in gambling at a casino, there is more possibility to be wrong than right. The stock market becomes a casino when one tries to time the short-term price movements. In that case, beliefs may lead one to trade excessively, and trading costs will harm performance.

Everyone has biases. However, it is necessary to think how they will affect behavior and whether that behavior is harmful. Where do these biases come from?

Why do people believe that a trend in prices will continue? Probably because of their own experiences with a wide variety of charts since childhood, they naturally see patterns even when there are none.

Likewise, why do investors follow others into investing in companies when it is well known that past successes generally do not predict the future? Once again, they are probably reacting on the basis of their experiences with patterns in life in general.

Biases are formed on the extrapolation of knowledge from past to future events, from one field to another. However, what is important is to reduce biases.

The purpose of understanding psychology is to reduce the irrational component in decision making. To apply psychology in stock buying and selling decisions, the first thing is to explore the primary reason for making that decision.

In any case, systematic thinking will help determine what one knows or does not know and overcome psychological biases. When one does not know the answer, a judgment call needs to be done.

The ultimate question should always be, “Is this rational based on all that I know?” A set of basic questions about the stock and psychology will help everyone do well in the stock market.

Overall, knowledge of fundamentals should help estimate the company’s long-term future, and knowledge of psychology should help inject rationality into decisions.

The more knowledge someone may have on psychological biases, the better the person can function in the volatile stock market. The entire market may be influenced by psychological reasons, not by fundamental reasons alone. From an investment perspective, the bottom line is that the market will continue to fluctuate and give solid opportunities every so often. Value in the long run is determined by fundamentals, while short-term gyrations reflect market participants’ psychological weaknesses, such as herding. Knowledge is the best antidote to making wrong decisions.

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