The Many Errors Investors Repeatedly Make in Choice of Investment and Timing
Applying a strategy is more than just deciding when to buy and when to sell according to some predetermined notion. Most importantly, itís about having the right mental approach. From a psychonomic perspective, two sides of the coin, financial criteria and approach, need to be integrated for you to be an effective investor. Hence, the strategies that are the most profitable are a result of successful investors being able to accept any behavioral tendencies they have and trade accordingly. And this is where it can all go to pieces. You may start out using a strategy with the best of intentions, but irrational motives, misperceptions and beliefs can lead to poor decisions. Here, therefore, is a summary from the findings of investment psychology and behavioral finance of systematic errors to learn to avoid.
Watching out for systematic errors
Overall, these errors really have only one effect: that is, you take a financial decision that lacks accuracy. And these errors are strongest when uncertainty, inexperience, attitudes and market pressures come together to undermine your decision-making ability. The way to get round this problem is to implement a good strategy - because good strategy is about taking the right decision, in the right way, at the right time.
Can you use contrarianism to overcome errors?
To be contrarian just for the sake of it is like the guy who always wears a scarf whether the climate is cold or hot; it smacks of obstinacy. To go against accepted wisdom, and implement an active strategy - such as a particular type of value strategy - there must be some good evidence that your decisions are valid.
One of the strongest findings of behavioral finance is that, in a three to five-year period, there is a tendency - remember this is not an absolute - for previous poor performers to begin to do well and for previous good performers to begin to perform less well.
In other words, value stocks turn into glamour stocks, and glamour stocks turn into value stocks. The value stocks are those that have low ratings; for example, low price to earnings ratios Ė the market price of a companyís stock divided by its earnings - while glamour stocks, or growth stocks as theyíre also known, have high ratings because theyíre sought after by investors.
Equating Ďwinnersí with glamour stocks and Ďlosersí with value stocks, this idea was tested by Werner De Bondt of the University of Wisconsin and Richard Thaler of the University of Chicago Business School, who formed a portfolio of Ďwinnerí and Ďloserí stocks. They found that the thirty-five Ďloserí stocks in their portfolio subsequently outperformed the Ďwinnerí stocks, during the next three-year period, by twenty-five percent.
What this means is that investors who specialize in buying Ďloserí stocks may profit. Essentially, because these are good quality stocks but their price is dependent on misperception, they move up and down in a cyclical manner.
Nevertheless, you donít know at what stage in the cycle youíre at, so buying what you believe to be a value or Ďloserí stock with great potential may mean you have to sit on it for a long time - and thatís hard, especially when you see opportunities that youíre missing. If you mistime it, could you really wait five years on just a hope?
In the same way, investors believe the stories and the market hype surrounding glamour stocks. They buy and keep buying; again overreacting. Eventually, the price rises to a level above what is financially realistic and investors finally see that it has become too expensive.
The fact that investors are slow to come round to a true assessment of stocks is what drives prices up or down to the extent of overreaction or underreaction. It is a result of the difficulty many people have in giving up a firmly held belief. Often too, they have a vested interest in maintaining their holding. Their thinking is dictated by a failure to admit that a changed situation necessitates a change of action. As a result, they wait too long to trade. So, for example, they keep revising their trading limits. ĎIíll sell when it rises another 15c.í or ĎIt canít drop much more, Iíll hang in there.í Many people also hate to sell a stock if it falls below the level they bought it. This is sometimes referred to as the disposition effect. So, investors donít cut their loss until later when the price has dropped even further. The strategy of these investors is unformed and they are buffeted around the market by the actions of the herd, never truly making their own systematic investment decisions.
Though initially there may have been a good reason for the downward price re-rating, as time passes and the company puts its affairs in order, the real outlook changes. But, real facts are overlooked. Once investors have perceived the stock as a bad bet, the price falls. With minimal news hitting the market - itís no darling of the analysts and rarely focused upon - investors become discouraged and keep trading out, pushing the price ever lower. Investors have again overreacted by being slow to respond to changed conditions. This provides the opportunity. Using a value strategy, clued-in investors buy stocks that are weak in the hope theyíll eventually become strong. Itís a long-term view. But, when the price begins to rise, their approach is proven correct.
If youíve ever pulled up sharply in a car and felt the seat belt cut into your shoulder then youíve experienced momentum. In a physical sense, it is the tendency for objects to keep moving when theyíve been previously moving but the force that propelled them has stopped.
If XYZ Industries has recently been a poor performer, investors believe it will remain a poor performer until there is a weight of evidence to convince them otherwise. Similarly, if XYZ Industries has performed exceedingly well in recent months, investors often believe it will continue to do so. Their thinking is by momentum. All this may fly in the face of sound evidence to the contrary. For example the PE ratio may be way above the sector average and the projected earnings may not justify the high price investors are paying. Momentum strategies that take advantage of this systematic error have become more popular in the last ten years.
Investors, it appears, can be overly cautious when confronted with situations that call for clear thinking. Hence, they wait too long to act and miss the best opportunities for profit. And, in the same way, once the investment is on the move, they plough in. Itís the Barn door closing effect, where investors are saying to themselves: Hey. Wait a minute, this is a good opportunity. Iíve got to be quick though, otherwise everybody else will get in and Iíll miss the chance to make any money. An example of this is in mutual funds when performance improves above around ten percent and is publicized. Suddenly, new money entering the fund increases. But, projections about the fundís future performance donít have this effect. Furthermore, once in the fund, investors are slow to react to information suggesting poor performance is just around the corner. At the extreme, they fudge the information, misinterpreting the facts, and again failing to act. They do this because they donít want to admit to themselves that they couldíve chosen a bad mutual fund. Overall, investors delay taking action.
You have to be alert to catch the best momentum stocks
Within this behavior lies opportunity, as the interesting finding by Josef Lakonishok, professor of finance at the University of Illinois and partner in LSV Asset Management, has shown. High momentum stocks - based on their previous six months gains or by dazzling earnings surprises - outperform low momentum stocks by eight to nine-percent in the following year. In other words, the momentum behavior of investors, coupled with a swift appraisal of new information, is used to signal which stocks are starting the upward phase of their cycle.
The longer you wait, however, the more other people will have spotted the opportunity and the more expensive the stock will become. Very soon it isnít a momentum stock anymore but a growth stock. As investors catch on though, the higher premiums paid for momentum stocks are justified because they donít have to wait so long for improvements compared to highly underrated value stocks.
Nevertheless, for many of these stocks, it still isnít easy to identify which ones are on the move but undervalued by the market. Besides using financial yardsticks, like performance ratios or relative strength, which are discussed in the next chapter, spotting these types of undervalued stocks can be done using published forecasts, such as the consensus earnings forecasts of the S&P 500 Index. You then need to figure in where you believe this stock is going to go. If, however, the forecast is more than thirty percent above what it was a year ago, then it may have already peaked - but then again, you donít know for sure. This is where an informed guess based on instinct, experience, and psychonomic rationality comes in.
Strategies that look for value stocks on the basis of momentum rely on the fact that out-of-favor stocks have begun to turn around, as other investors have spotted their potential. Investors are buying stocks when they are already moving in the hope they will move even more. In the medium term it can be a highly profitable approach if you trade at the right times. But itís important to remember that this strategy is not dependent on the stock itself but on investorís perception of the stockís future value. To paraphrase Finance Professor Robert Vishny, You donít necessarily make money by buying the best stocks in the market this way but by buying stocks everyone thinks are going to be the best.
A profitable momentum edge
Momentum effects also work on combinations of stocks. Research on portfolio returns by Andrew Lo and Craig Mackinlay, showed there was a correlation between one weeks return and the next, where about four- percent of the price change of next weeks return could be predicted from this weeks return. When the constituents of the portfolio were altered to contain small capitalization companies, rather than an equal amount invested in each stock of the New York Stock Exchange, the effect was enhanced to around ten- percent. Though the effect only works for portfolios, not for individual stocks, and only in the short-term - that is, daily and weekly returns - there appears to be an observable lead/lag pattern. Which means, big stocks lead little stocks. For example, Microsoft goes up dramatically and a few days later thereís a price jump in other computer software manufacturers.
Consequently, a contrarian investment approach where investors buy second line stocks - mid caps and small caps - in a sector believed to be ready for a re-rating sometime in the near future, and then sit on their investments patiently, can work very well. Though money can be made from momentum, my preference here is for a portfolio thatís financially sound and less likely to be buffeted around by volatility once it moves. In other words, youíre pitting your wits against market sentiment, where investor perception alone has decided these stocks are unfashionable, not against fundamental financial determinants and economic realities.
Adapted from Profits Without Panic: Investment Psychology For Personal Wealth © Jonathan Myers 1999