The Mistakes We Make

The best definition of the stock market I know of is from Ray DeVoe, a market commentator with Spencer Trask in the 1970s and subsequently other firms, who said, “The stock market is only indirectly related to economics.  It is a function of human fear, greed, and apprehension all overlaid on a business cycle.”

We like to think of ourselves as rational creatures, analyzing income statements and balance sheets, comparing valuations of companies and then making balanced decisions. Well we do do this but we also act a lot like the chart below, letting our emotions rule and buying at the wrong time and selling at the wrong time.

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Today markets are quite calm and investors are taking on more risk. Negative news has been taken in stride. Even when it was announced that GDP had fallen in the first quarter, investment markets barely budged. On the bond side, spreads between high quality bonds and lower quality ones have narrowed considerably indicating buyers are showing more confidence.

One thing we know for sure is that investors as a group, will always swing from excessive optimism to excessive pessimism. Behavioral economics is the study of economics and the psychology of investors. We are emotional beings and there are a number of human traits that make it difficult for us to operate as calmly and unemotionally as Warren Buffett. Here are four traits to watch out for.

1. The Endowment Effect. Some say this is the most common fault of professional investors. It is the idea that you ascribe more value to things that you own than things that you don’t own. If you have made a lot of money in a stock, for instance, you are often reluctant to sell it even if there are good reasons to do so. You fall in love with your successful ideas, you value them more highly than the market does and often you get stuck, fearing that if you sell and the price moves higher, you will experience painful regret.

2. Anchoring. This is the tendency to focus on one piece of information at the expense of others. For instance, we often focus too much on what we paid for an investment. If the stock is at a loss, then maybe we feel we don’t want to sell until we get back to our cost regardless of the fundamentals. And if we are at a gain then the endowment effect kicks in and we assume the stock has a value higher than what the market thinks. A good exercise is to look at your investments without looking at the cost. I realize there are capital gain costs to consider but separating cost from market gives you a clearer picture of value.

3. Overconfidence. This is a big one. What do they say, 80% of people think they are above average drivers. Most of us are overconfident in our abilities. This is especially true on Wall Street where you have so many very intelligent, highly motivated, Type A personalities. It is important to remember, “Take not thyself too seriously.” Contrary to what we would like to believe, there is not that much we know for certain about the future. Keep confidence in check.

4. Group Think. When I started in the investment business back in the 1970s there were a number of high quality, established growth stocks, the Nifty 50, which sold at extreme valuations. The conventional wisdom was it didn’t matter what you paid for these stocks, even if you paid too much you would still get bailed out by their exceptional growth prospects. Well it didn’t work, the prices were too high and in most cases the exceptional growth didn’t materialize. As Julie writes in Some Less Familiar Investment Classics, you need to think for yourself in the market and question conventional wisdom. It gets very lonely at times especially when conventional wisdom is right for long periods of time. But as the saying goes, ‘The trend is your friend, except at both ends’. Understand where group think is and be prepared to follow your own path when necessary.

Where does market psychology stand today? To my mind greed is not rampant and neither is fear. We are at one of those in between places. But rest assured we will get back to periods of extreme emotion and when we do you will want to avoid as best you can the behavioral traps that we all fall into.