Market Review: Greed and fear: Psychology of markets

Efficient markets require that all known information is built into share prices on a rational basis. Experience and observation tells us that market participants are human and that all the weaknesses that affect our daily lives will also affect our investment decision making.

In fact, it is not hard to see the seven deadly sins at work: pride in not accepting a wrong decision; greed in wanting higher capital gains; envy at others achieving rewards out of a bull market; anger at not recovering bad positions; power (lust) in building empires; avarice in over- extending/borrowing to achieve excess riches and sloth in not being diligent and allowing bad positions to deteriorate further.

When added to the pursuit of the 'free lunch' – reward without risk - the fear of being unpopular or embarrassed by failure, plus the emotional attachment to favourite stocks it is little wonder that mispricing of stocks and markets occurs. This mispricing can present an opportunity to the disciplined investor.

Under-priced stocks

Opportunities to invest in undervalued securities arise when the market or stocks are influenced by emotion rather than priced according to an objective analysis. At times a stock traded at the margin in light volume can be priced well below its intrinsic value (the fundamental value assessment of a rational investor).

This paper focuses on the emotion of markets that creates opportunities for investors such as Tyndall. A few examples may help to illustrate this:

• A security that has a minor exposure to a large public bankruptcy is marked down, well below the possible impact on the stock.
• A highly public fight in the boardroom of a company, that has little impact on its operations, marks down the share price.
• The distraction of investors into ‘bubble’ type stocks, leaving the traditional companies behind, often with the view that ‘this time it’s different’.

Many of these kinds of events have a high immediate media profile. However, tomorrow there are new stories to be pursued and as yesterday’s news fades, then rational thinking recognises how a share has been under priced. Investors return to the affected companies and push prices back to reasonable levels.

The fear of investors is often justified. Can management be trusted? Are there further problems to be made public? Is this the start of a downward spiral?

Events that under price a stock due to market sentiment, are not confined to ‘value’ style companies (generally characterised by having a low price to earnings multiple). They can equally apply to ‘growth’ style companies (high price to earnings multiple). For example, adverse media comment might cause a company's share price to fall below its intrinsic value (that includes a premium for growth potential), even though it is still believed to be attainable by analysts.

History repeats

The psychology of markets was well documented in the book ‘Extraordinary Popular Delusions and The Madness of Crowds’ by Charles MacKay in 1841. An extract from the Preface to the 2nd Edition in 1852 says:

Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one”.

MacKay’s recount of Popular Delusions were based on ‘bubbles’ over the centuries and we have experienced recent periods of madness – history is bound to repeat itself – as in the last ‘tech boom’. This is the greed or envy of markets, to create unsustainable over-valuations, eventually to burst with severe consequences.

Not all participants suffer, such as those clever enough to exit an over priced market before the collapse. In fact, a rational investment strategy can be used to take advantage of the momentum in rising markets, based on the ‘greater fool’ theory. That is, there is a greater fool to buy you out at the peak of the market. However, no one rings a bell to indicate the top of the market and the risk is to be left holding the overvalued stock when the inevitable collapse occurs.

In the modern age when markets are global and new information is instantaneously available through the electronic media, then perhaps the time taken for investors to recover their senses is far shorter than in MacKay’s days, as evidenced by the 1987 sharemarket and 2000 ‘tech boom’ crashes.

Herd mentality

An important feature of market psychology is the herd instinct. If others believe, then it is safe also to believe. This occurs in market upside rallies as well as market falls. The hardest decision, whether at the level of over-pricing or under-pricing of a market or security is to take a view that is contrary to popular opinion.

The temptation is to go with the crowd and not be criticised for holding stocks that appear to be unworthy. However, popular stocks are usually fully or over-priced and, when ever they do not live up to expectations, there is a disappointment reaction that reduces the share prices, sometimes severely.

Advice and Accountability

The herd mentality is fuelled by market commentators, who, because of their own business objectives, are required to talk up the market or stocks. The short term focus of their commentary is at odds with the longer term investment horizon of most investors.

Another common behaviour covered in this paper is for investors to not fully account for performance by detailing actual results against market benchmarks. That is, biasing their success on the number of wins, discounting their losses or opportunities not taken.

Moreover, like gamblers, investors with successive wins can assume a certain arrogance of invincibility that encourages larger ‘bets’.

The above theories attempt to explain behaviours observed of investors. There are many examples, from purchasing shares in a company because its products are well regarded through to buying because 'Sir John' is on the Board. Both examples demonstrate inadequate thinking by investors.

Reversion

There is a market phenomenon known as ‘reversion to the mean’. Essentially, it says that as markets go in cycles, there is a long term average or mean that the market reverts towards. If, for example, the long term valuation of the share market is a price earnings multiple of 15 times, then as the market moves over cycles there can be reversion to this valuation. There are other measures such as risk premiums, value of money, risk/return payoffs etc that can set market norms.

Should these assumed values be skewed on the upside or downside, then there is a high probability of ‘reversion to the mean’ in the future. This can assist investors to avoid the herd mentality.

Summary

In the 'art and science' of investment decision making, the skill is to know when markets and stock prices are rational and when opportunities can be available. This skill combines common sense with signposts to provide profitable outcomes.

To see how the numbers stacked up for various markets around the world in the past month and over the year, visit our Monthly Market Review here

Anthony Quirk is the managing director of Tyndall Investment Management New Zealand Limited (Tyndall).

Anthony Quirk is the managing director of Guardian Trust Funds Management.

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