Investors are happy to follow the herd

PUBLISHED : Sunday, 06 December, 2009, 12:00am
UPDATED : Sunday, 06 December, 2009, 12:00am

How do you make investors happy? This may seem like an easy question because people who have made money should feel happy. But investors can be a perverse lot.

It turns out that those who have made a profit are not necessarily happy with their gains. On the other hand, when a loss is incurred, investors are not necessarily moved to unhappiness. This happens when, for example, they incur a loss as a consequence of a general market depression. Investors have greater tolerance for such collective losses as opposed to a loss made as a consequence of an individual decision.

Here lies the key to much of the sentiment that pulsates through the world of the personal investor. Investors' sentiments are heavily swayed by the fortunes of others, which in part must be seen as a verdict on their own ability as money managers relative to other investors.

Thus if, say, an investment in company X yields a profit of HK$100 while investment in company Y, which is in a related business, yields a profit of HK$120, investors in X will not rejoice in having gained a profit of HK$100 but sulk that those in Y have gained more. X investors feel they have incurred a 'loss' of HK$20.

The reality is that they have made no loss at all, merely forgone a potential gain. Somehow it is difficult to persuade the dissatisfied investor that this is the case.

At the beginning of this year, investors made spectacular losses in stock markets throughout the world, almost certainly more than would have been incurred in the course of normal trading. However, the fact that these losses affected more or less everyone else in the market went a long way to mitigate the pain.

Moreover, it was common to find equity investors talking about the losses they had made, although these 'losses' were purely illusory as no trades were undertaken. All that had happened was that the value of their assets had diminished, whereas a real loss would only be realised if these assets had been sold.

The flip side of this comes from investors who insist they have 'made' stupendous profits as the market has risen although, again, not a cent has actually been made until a trade has been completed. Most investors are not stupid and understand this, yet what motivates them and stimulates their mood swings are these false perceptions of profit and loss.

Unfortunately, these mood swings are responsible for intemperate action by investors, many of whom sell in panic when the market goes bad and cling tenaciously to their shares as the market rises, in anticipation of further rises.

Nathan Rothschild, one of the most famous investors of all time, once said: 'I never buy at the bottom and I always sell too soon.' This was a modest way of saying he did not spend his time searching for the elusive peaks and troughs of the market but contended himself with looking for good value and taking profit when he felt the time was right.

The perversity of investors is not merely confined to the strange practice of wishing to buy when prices are high and sell when prices are low. They also display remarkable hostility to views that contradict widely held opinions about the state of the market.

The stockbroker Roger Ward Babson is famous for being reviled in the wake of the 1929 crash for having predicted it two years previously - the 'logic' being that his prediction was part of the reason for the collapse.

Investors like conventional pundits and they prefer their fund managers to follow market trends rather than to defy them. As John Maynard Keynes put it: 'Worldly wisdom teaches us that it is better to fail conventionally than to succeed unconventionally'.

This is why there is so much herding among professional investors and a tendency to crowd into certain types of investment. Once the herd has decided that, for example, energy stocks are hot; the price of these counters will predictably surge and overshoot most reasonable extrapolations of value based on earnings or even asset base.

But the herd is fickle, and sentiment can turn on a dime as new information, real or imagined, comes to light and the next hot issue looms into view. Small investors are generally laggards in discovering the latest best thing, not least because they are often tied up in funds as opposed to easily tradeable stocks, which make switching cumbersome and costly.

This begs the question as to where information comes from. Investors are bombarded by information to the extent of finding new investment tips regularly bleeping out of their cellphones. However, a number of studies, notably research in 1986 by John Pound and Robert Shiller, found that an overwhelming majority of investors were motivated to make investment decisions based on information derived from personal communication - be it from a friend, business associate or whatever.

It is easy to see how information delivered in this manner is influential, but hard to identify its source, as it has passed through so many channels. Everybody likes to think they are in receipt of a hot tip or some kind of privileged information, so if it is contained in something like a newspaper, it is deemed to be less valuable than information conveyed on a one-to-one basis, even though this very same piece of information may well have originated in a newspaper.

When processing information, a strange form of collective amnesia descends on investors, who view the past as a distant country. They refuse to accept that one of the greatest lessons of investing history is the cyclical nature of investment trends: booms are followed by busts and that kind of thing.

Instead, they choose to believe the mantra of 'this time it will be different'. We are hearing this kind of nonsense now in regard to China's overheated markets which, we are informed, are different from other markets and will perform in new and more exciting ways.

The bottom line is that those likely to do best as investors are the people who understand market psychology and are prepared to go against the herd as it plunges forward almost blindly.