Hot Features
Premium
Register for streaming realtime charts, analysis tools, and prices.
We humans evolved to cope with complex environments. One adaptation is to take mental short cuts. While these can be very useful in many situations, e.g. it’s good to instinctively prepare for flight if you see something out of the corner of your eye that may be a predator, in financial markets cognitive short-cuts can lead to errors – not all the time, but sometimes.
Positive feedback and extrapolative expectations
Stock market bubbles may be, at least partially, explained by the presence of positive-feedback traders who buy shares after prices have risen and sell after prices fall (this problem is exacerbated by the growing significance of index funds in the share market).
They develop extrapolative expectations about prices. That is, simply because prices rose (fell) in the past and a trend has been established investors extrapolate the trend and anticipate greater future price appreciation (falls). This tendency has also been found in shares as well as house prices and in the foreign exchange markets.
George Soros describes in his books (1987, 1998, 2008) his exploitation of this trend-chasing behaviour in a variety of financial and property markets.
Here the informed trader (e.g. Soros) can buy into the trend thus pushing it along, further away from fundamental values, in the expectation that uninformed investors will pile in and allow the informed trader to get out at a profit.
Thus the informed trader creates additional instability instead of returning the security to fundamental value through arbitrage.
Regret
Experimental psychologists have observed that people will forgo benefits within reach in order to avoid the small chance of feeling they have failed. They are overly influenced by the desire to avoid feeling regret.
Thus we find investors at certain points in time become overly fearful and therefore risk averse, e.g. in 2009 few people were buying shares because of the financial shock and yet, with hindsight, we see that 2009 was a great time to buy, with returns of over 100% since then.
This fear will occur again, investors will go on a buying-strike again – and are likely to do it at the wrong moment, again. They say things like “I’ll just wait until things look a little more certain. If shares fall more I’ll just kick myself”.
The true investor examines the business behind the shares, estimates intrinsic value, and then waits until the market price falls sufficiently below intrinsic value to give a margin of safety, and then buys.
Thus, if before 2009 you had estimated intrinsic value for some companies but had not bought because prices were too high, you were then ready to jump when Mr Market went into a depressed state of mind.
Personally, I’m really hoping for a market crash soon, so that I can buy when others are selling.
………………To read the rest of this article, and more like it, subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
