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And so, following Sunday’s much-awaited Greek vote to endorse the Eurozone bailout of their country, the world has heaved a quavering sigh of relief as the threat of global financial Armageddon appears to have been postponed, if only to another day. Markets across the world, as a result, rallied at the start of the week, recovering some of the ground lost during the recent sell-offs.
Frankly, I don’t know about the rest of the market, but these constant, unremitting end-of-days predictions have started to wear thin. One day everyone is running around circles, wailing aloud “the sky is falling, the sky is falling – sell everything and run for the hills!” Then the following day, it’s all sunny skies and everyone acts as if nothing had happened beforehand.
That is the inherent nature of markets. It’s all naked emotions with not a single fig leaf of logic to hide behind. The market’s state of mind gets especially bad during a time of crisis or, transversely, during a period of good news and bullish expectations.
The market can be irrational, crazy, or inhaling the fumes of some illegal substance but there is no reason that the individual investor should be the same. The way to sidestep this emotional trap would be to do what people with emotional problems do: they visit a psychiatrist. Similarly, the individual investor must be able to step back from the market, turn introspectively and gaze critically at what the market is doing wrong and, most importantly, what he or she is doing wrong.
One bedrock tenet of the study of finance and markets consists of the “rational investor.” Theory depicts the rational investor as the person who avoids risk, i.e., risk averse, and would, when given the choice, prefer to earn the highest return possible given the least amount of risk. But in reality this is not necessarily how people act. They tend to take on a lot of risk to earn a potential minimal return. In local parlance, we call them “tsupiteros,” somewhat analogous to “day traders” in other markets.
The sources of irrational behavior in the market, the type of behavior that does not comply with the theoretical ideal of a “perfectly rational investor,” has become the subject of a relatively new field of study called “behavioral finance.” This fledgling field tries to use the theories from the science of psychology to explain stock market anomalies.
For instance, going back to how markets react to news. Markets and investors tend to “overreact” to the most recent headlines or news they have read. While this sounds like a trivial statement, it is in fact one of the most common ways that markets stray from the rational path.
In finance, “overreaction” is a market hypothesis that states “investors and traders react disproportionately to new information.” This overreaction will change stock prices dramatically, such that prices will not fully reflect their intrinsic, or inherent, value immediately following the release of the news. Such price swings will not last, and prices will soon enough return to their true values.
This overreaction may now be seen in the market’s kneejerk response to the news about the Greek vote. Just as relevant was the market reaction to the release of the Philippines’ first-quarter GDP growth of 6.4 percent. On the same day the government released the official numbers, the PSE index opened mostly unchanged from the prior day’s closing of 5,018, and traded defensively near 5,000 on the main for most of the day’s morning and afternoon trading sessions. But in the last half hour of trading, traders pushed the index to above 5,090, the highest closing in two weeks.
At the time, some fund managers and analysts raved about the fact that the GDP growth numbers were the second-best in the region and way beyond the consensus forecasts. They were actually guilty of irrational behavior.
The market, in fact, was underwhelmed by the GDP numbers, retreating a total of 200 points over the next two days after the news. As of this writing, despite the rally induced by the positive Greek vote, the market is trading at around 5,040, still below the high closing in the wake of the GDP news. If one were to hazard a guess, the market clearly does not see the 6.4 percent first-quarter growth being sustained the rest of the year. This will certainly settle down as the government gradually eases on the pump-priming pedal.
On the topic of irrationality, what do the psychologists say about the market’s initial reaction to the GDP growth number?
Psychologists have noted that when a person is faced with a decision, he or she would rely on the information or knowledge that is readily available, ignoring or overlooking other information, alternatives or procedures. It is always easier to recall the most recent information that we have received, and this leads to biases in our decision-making. This is the nature of people and this is how we normally learn and make decisions. This judgmental way of learning and decision-making is called “availability” in financial theory.
In the case of the GDP growth news, the investor already had an idea beforehand about the government’s pump-priming program and its rationale, which was to offset the shortfall in demand that would result from the deteriorating Eurozone situation. Growth expectations this year, as a result, would have to be tempered, as the Eurozone crisis is not the type of problem that will just disappear overnight. But when the 6.4 percent flashed on their Bloomberg screens, some investors appeared to have forgotten about this investment backdrop and just focused on the most recent news, which was the GDP number.
A related form of irrational behavior is called “narrow framing.” This is where people, when faced with a new investment prospect, would tend to evaluate the risks of this new prospect in isolation, instead of evaluating it in conjunction with the other risks he or she may already have in his/her portfolio. They would tend to reject the investment even if this would have had a positive effect on the overall return of their portfolio.
To put this in perspective, the theoretical ideal would be where the investor evaluates a new investment prospect by first mixing it with the other risks he/she already faces and then assessing whether the overall combination has an attractive return. More succinctly, the question should be: Would the investor’s overall wealth be enhanced by adding this new investment to his/her portfolio?
Why is this important? Because an investor who keeps narrow framing his investment decisions would forever miss the opportunities of buying when the market has dropped to cheap valuation levels. Just like the rest of the market, he/she would be selling when the market is dropping and buying when prices have already gone up.
The take-away that this piece would like to leave the reader is this: A better understanding of oneself as an investor, complete with the imperfections and irrationalities, can be the first crucial step towards better successful investment results. Investor, heal thyself.
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