Investment psychology
An absurd influence on the market
It’s all very well to keep abreast of current events but, as investors, we can easily be distracted and even overwhelmed by news reports. This post will describe the problem and then provide a set of gap-to-edge rules to: firstly, help us avoid the behavioral gap caused by our own foibles; and secondly, take advantage of Mr. Market’s pathological focus on the here and now.
The most recent past
Let’s start off with a quote from Barton Biggs. He formed Morgan Stanley’s investment management division and served as its chairman for 30 years. He was ranked as top global strategist from 1996 to 2003. He later formed Traxis Partners, a hedge fund. His book Hedgehogging was published in 2006.
Biggs puts it this way: “All investors by nature are conditioned by their memories. If they have only been investing for a short period of time and don’t have a lot of combat experience, they are particularly vulnerable to what has just happened to them. It is very important not to fall into the attractive trap of extrapolating the most recent past into the future. If you do, it is like steering a sports car up a mountain road, with a steep drop on one side, by peering through the rear-view mirror.” (Biggs, Hedgehogging. 2006) p.167. (Emphasis added)
Markets overreact to current events
In 1985 WERNER F. M. De BONDT and RICHARD THALER published a paper titled: Does the Stock Market Overreact?
Their conclusion was that Investors “tend to overweight recent information and underweight prior (or base rate) data.”
Base rate data is simply the real weight to be given anything based on the long term as opposed to the current overreaction to recent events.
In the paper De Bondt and Thaler note: “One of the earliest observations about overreaction in markets was made by J. M. Keynes:“ … day-to-day fluctuations in the profits of existing investments, which are obviously of an ephemeral and nonsignificant character, tend to have an altogether excessive, and even an absurd, influence on the market”. About the same time, Williams noted in his Theory of Investment Value that “prices have been based too much on current earning power and too little on long-term dividend paying power”. More recently, Arrow has concluded that the work of Kahneman and Tversky ‘typifies very precisely the excessive reaction to current information which seems to characterize all the securities and futures markets’. “
Recent events and vivid memories
Overreacting to recent events is related to another overreaction problem humans have. That is the overreaction to vivid memories. The latter is our reaction to things like plane crashes or mass shootings. Our overreaction to both recent events and vivid memories are examples of what Kahneman calls the availability heuristics. He tells us that we react based on how easily and graphically something comes to mind.
In my last post I explained what Daniel Kahneman calls risk policies. I also explained that I have created risk policies for investors that I call gap-to-edge rules. What follows are some simple rules we can adopt to help us overcome the problems described above.
Gap-to-edge rule: Educate yourself about the pervasive impact of our human tendency to overreact.
As with so many behavioral biases and cognitive errors, the road to salvation comes from a combination of study and hands on experience. The problem with the Availability Heuristic, as with many other behavioral biases, is that they work without us realizing it. Reading Kahneman is a good start.
The first thing to truly take to heart is that we as individual investors tend to overreact. The second is that Mr. Market is also highly prone to overreacting. So, if we can deal with our own propensity, we can overcome the behavioral gap and at the same time take advantage of Mr. Market’s overreaction.
Gap-to-edge rule: Always take time to step back and get perspective – frame broadly.
Perspective is a good word to describe the best antidote to this bias. It is the same as broad framing we discussed in relation to long term thinking.
We need to ensure we have enough information to reach well supported conclusions. With experience, investors will learn to see how Mr. Market is overreacting to current news and dramatic events so as to be able to take advantage of other investors’ weaknesses caused by the Availability Heuristic.
Gap-to-edge rule: When evaluating management don’t be fooled by very recent success or some high profile win.
Gap-to-edge rule: In evaluating companies study the long term business prospects of companies you are considering investing in and purposely underweight the ‘vistas immediately behind you’.
Gap-to-edge rule: When looking back at the record, underweight a few good years or a few bad quarters.
Gap-to-edge rule: Avoid focusing too much on negative news in bad times;
Gap-to-edge rule: Avoid focusing too much on good news in good times;
Gap-to-edge rule: Avoid allowing the media to shape what is important for you;
Gap-to-edge rule: Realize that Mr. Market’s overreaction shapes what media are interested in;
Gap-to-edge rule: Be alert that the media can unwittingly generate a cascade effect.
Kahneman puts it this way. An availability cascade is a self-sustaining chain of events, which may start from media reports of a relatively minor event and lead up to public panic and large-scale government action.
Gap-to-edge rule: Ignore ‘doom and gloom’ and ‘new age’ pundits completely.
Gap-to-edge rule: Recognize the fact that purely random data can produce what looks like a pattern or a trend even though no pattern or trend in fact exists.
Gap-to-edge rule: When you have had a few recent successes – that is the time to be more cautious.
Gap-to-edge rule: When you have had a few recent failures that is the time to learn from your failures and not lose heart. That may be a time when opportunity knocks. A few recent failures don’t make you a bad investor.
Conclusion
If we are not careful, the here and now will control our lives. Sometimes we can’t see the forest for the trees. Most current events are of little consequence. Hopefully these gap-to-edge rules will help readers keep things in perspective.
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Other posts on investment psychology
This post is part of a series. Readers are invited to read Investment psychology explainer for Mr. Market – introduction This will give you a better understanding of some of the terms and ideas and give you links to other posts in the series.
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You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
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You can also use the word search feature on the right hand side of this page to find references in both blog posts and also in the Motherlode.
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There is also a Table of Contents for the whole Motherlode when you click on the Motherlode tab.
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