Investing Money

An Introduction to Investment and Personal Financial Planning

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The Psychology of Investment - Fear and Greed

The price of any particular investment is equal to the sum of its discounted future earnings. Simple, right? Apart from the little word future, which means that in assessing how much to pay for a particular investment we must employ powers of precognition!

As there is no algorithmic model for foretelling the future, psychology plays a major role in investment price determination. Human nature is often driven by fear, greed, or both, and it is these twin demons that need to be guarded against in the context of investment, as witnessed by numerous booms and busts over the centuries including Dutch Tulipmania, the South Sea Bubble, the dotcom fiasco etc etc etc.

When we see everyone clambering to jump aboard a bandwagon we feel we must be on board too, at whatever cost. We are driven by greed inspired by relentlessly climbing prices, and fear of missing out. The effect is that prices climb ever higher, supported not by any fundamentally rising worth, but by human psychology.

One day someone admits that prices now far exceed any rational valuation and, like the story of the emperor's new clothes, so does everybody else. Fear now takes over and the rush is to the emergency exit sending prices into free fall. Now, a lot of people actually made big bucks from tulpimania, the south sea bubble and dotcoms, it's just they were the ones who'd already sold out before the crash.

The key to successful investing is to realize that all of us are influenced in varying degrees by both our heads (logical reason) and our hearts (emotion and intuition). There is a place for both, but we should be able to distinguish what each is saying to us. Ideally both head and heart should agree (or at least neither should strongly disagree) on a course of investment action. Or to put it another way both head and heart should have the power of veto. If the numbers seem good, but instinct says no, then don't do it. Likewise, if the emotions say yes but the figured don't add up, then best let it pass.

We also need to be aware of bubbles waiting to burst, the kind of disasters waiting to happen described above. Once any investment becomes a bandwagon whose price exceeds any fundamental justification, it is best avoided.

Efficient Markets or Random Walk

The efficient market hypothesis states that financial markets efficiently process all publicly disclosed information in order to arrive at correct prices for all commodities (stocks) at all times. Thus, if efficient market hypothesis is true every stock on the market is priced correctly and it is impossible to pick up any bargains. That is it is impossible to consistently beat the market.

Efficient market hypothesis is something of a paradox. If it is true then there is no point in traders and investors making any effort to beat the market. They may as well just buy every stock in an index and spend their time doing something else. But, it is only the fact that many individuals, and many of these highly intelligent graduates using state of the art computer models, do try extremely hard to beat markets that makes them efficient.

Markets ARE efficient. The actions of so many people, informed by an unprecedented volume of timely information, and mediated by instantaneous technological platforms mean that prices really do reflect just about all there is to know about a particular stock and the wider conditions in which it operates.

BUT... Markets are not perfectly efficient. Prices do not conform to some well-defined mathematical formula, but instead reflect to a considerable degree the psychology of market participants. Consider market crashes that have occurred throughout trading history. Can a stock be correctly priced at one level today, and also correctly priced at half the price or less tomorrow?

An alternative to efficient market hypothesis is random walk theory. This says that while markets may not be perfectly efficient, it is still not possible to consistently beat them because they are inherently unpredictable. Much like a drunk trying to find his way home they follow a random walk.

Whichever theory is true - efficient markets or random walk - the corollary is that it is impossible to consistently beat markets even with perfect knowledge and perfect analysis. This means that managed funds should be bad for your wealth, ie after deduction of the manager's fees they will actually UNDERPERFORM the market as a whole.

Of course, a few fund managers can point to consistently above average performance. Is this down to skill? Not necessarily, more likely luck. If you sit enough chimpanzees at typewriters and get them to bash away, one or two might actually produce intelligible words. However this is just due to the law of averages, rather than the linguistic ability of the subjects. In any case if someone really were able to beat the markets don't you think they'd be doing it for themselves rather that altruistically using their talents for others? Unless of course the fees they charged were more than the profits they could produce.

An example of this is reported by the U.K. Daily Mail (Oct 25, 2006) - "Research from independent advisers Bestinvest shows that over the past three years 73pc of actively managed funds nvesting in UK companies to increase your capital have failed to beat the FTSE All Share Index." (our emphasis)

As a further example, Clive Briault of The United Kingdom Financial Services Authority says: "Our research shows there is no evidence, on average, over time, that actively managed funds outperform tracker funds if you take into account the difference in charges between the two." (The Mail on Sunday, Financial Mail, January 28, 2007)

For more on this fascinating topic see Burton Malkiel's excellent A Random Walk Down Wall Street.

So, it's better to simply invest in a low-fee tracker fund (or several, if you wish to spread your investment across different regions/sectors). Trackers mean you miss the excitement/headache of stock-picking (depending on your point of view) but will yield healthy growth in the long run. You still get to choose which index(es) to invest in. At the core of almost everyone's portfolio should be the major companies (blue chips) of their home country. Beyond that, why not follow your instincts by gaining exposure to some specialized indexes of your choice.

If you really want to have some fun then rather than trusting your hard-earned cash to a faceless manager, why not pick some stocks of your own. Do some research by all means, but remember the market price probably already reflects what you find (and more). At the end of the day if you are going to beat the market you need to rely on your intuition, that little voice within that tells you a stock is right for you.

Further Reading