Fool's Eye View

[ February 29, 2000 ]

The Irrational Market

By Nigel Roberts (TMFNigel)

Chippenham, Wiltshire -- We all like to imagine that the stock market is rational, where the share price of a company reflects its potential. Of course over the short term this could not be further from the truth. The stock market is just that; it is a market that matches buyers and sellers, and the price that is placed on the shares in the short term is determined by supply and demand. When more people want to buy the shares than sell them the share price will rise; when more want to sell than to buy the share price will fall.

So what is it that drives investor behaviour? I am sure that we all think that we make our investment decisions on a rational basis, and I am also sure that we believe that all those "other fools" out there are the ones being irrational. A lot of the research conducted by economists into the stock market seems to adopt the efficient markets hypothesis -- where it is assumed that all information that can possibly be known is known, and that everyone takes careful account of all the available information before making investment decisions.

It is pretty clear to me that this is not true! People behave in strange ways. Last week I was discussing with one of my investment clubs what we should be doing with one of our most successful investments, Baltimore Technology (LSE: BLM). We bought this share just a couple of months ago at £30 and now it is trading at over £100 a share. The question was: should we be selling any of these shares now? Most of the members believed that we should not; the consensus was that the price would go higher. On that basis, I asked if anyone would like to buy some more shares now. The answer was an almost universal NO! The reason was that after such a large rise in a short period of time, the members saw the share as being "expensive". This seems to be contradictory, but to me it showed that most of us are emotional investors. We value the shares we actually hold more highly than a rational approach would probably merit; we set a higher value on shares that we own than we would actually be prepared to pay to acquire them now -- we become attached to them.

A similar situation seems to occur with shares that turn out to be losses. It seems that we investors hate to admit our failures, and if we buy shares in a company, and they subsequently fall in value, we are often very reluctant to sell the share and admit our mistake. This often leads to investors hanging on to their losers longer than they hang on to their winners -- the old adage that a long term investment is a short term investment that went wrong rings very true!

Investors also seem to like to follow trends; they will often jump onto "bandwagons" rather than going against the market. Contrarian investing is very hard to do, as you have to believe that you are right and everyone else is wrong. If you adopt a contrarian approach and it goes wrong you only have yourself to blame; if you go with the crowd and it goes wrong at least you can live with the knowledge that you were not the only one to suffer.

The phenomenon of investors following trends means that the market tends to overreact to both good and bad news. If a company announces something that is taken as good news by the market, investors often pile in without thinking, driving the share price above what would be considered rational. If there is bad news and a company goes out of favour investors will desert it in droves, and so drive the price well below what would be sensible.

The same situation can be seen in the market as a whole. During a bull market investors become more and more confident and put a bigger proportion of their money into equities, driving the value of the market as a whole up. Success encourages more investment, which drives up prices, which leads to greater success. It becomes a self-fulfilling formula. The same will happen during a bear market. When prices fall investors will panic and sell shares, this will cause prices to fall and even more panic and more selling.

Can investors exploit these trends? Contrarian investing is one way, and Stephen Bland (TMFPyad), who sees himself as a value investor, is probably the Fool's most ardent contrarian investor -- he seems to relish going against the crowd and buying shares that no one else seems to want. He tries to take advantage of the market's overreaction on the down side: if you can find shares that have been unfairly "marked down" and buy them before the market as a whole recognises this, then you can win when the share price returns to a more "logical" level.

Another way of exploiting the trends seems to have been discovered by Paul Marshall (TMFJonnyT), who devised an investment strategy based on relative strength. It has been shown that shares that have grown significantly in price, relative to the rest of the market, have a tendency to continue rising for some time. Paul's relative strength strategies aim to exploit this fact by highlighting the best-performing shares as a buy, but more importantly they are bought with a fixed holding period -- 12 months or 6 months -- which makes the sell decision an unemotional one. Selling shares, as most investors know, is one of the hardest decisions that you have to make. One way of looking at why this strategy works is to consider that it takes advantage of the market's overreaction on the upside. If a share price has gone up it will tend to continue to go up, but to profit from this you need to get out before the share price starts to fall!

Investor behaviour plays an important part in the stock market -- never forget that it is individual people who make the market. Whether they are fund managers or private investors the decisions of individuals drive share prices. What about trying to use investor behaviour to predict bull and bear markets, and in particular predict when a market crash is likely to happen? Well, as we have said above, the market tends to overreact to good or bad news, and crowd behaviour would suggest that in the if the market is going up it will tend -- in the short term -- to continue up, and when it is going down it will tend to continue to fall.

So what happens when everyone is very, very bullish about the future direction of share prices? You would naturally expect that the market would continue to climb. Well, let's bring a bit of rational thinking into this and suggest that the opposite is probably true. If everyone was truly bullish then they would tend to have a large proportion of their money already invested in the stock market. If you have most or all of your money invested, you don't actually have any money left to invest in buying more shares, and so the only real option available to you is to sell.

I think this is what has happened to the market over the last couple of months since it hit a high in January. Most people were very bullish about the future and were pretty much fully invested. In particular, they were bullish about the prospects for the Internet revolution and the tech stock bonanza. In order to get money to invest into the tech stock sector they have had to sell shares in the more traditional sectors of the markets.

I am sure that we are currently seeing an overreaction on the up side in "tech stocks", and an overreaction on the down side in the rest of the market. That does not mean that all tech stocks are overvalued; just that some of them probably are. The question is, if this is true, can we exploit it to our own advantage?

Answers please to the Fool's Eye View message board.

Related links:
• Stephen Bland on the psychological aspects of value investing
• Alan Oscroft on bubble psychology
• Alan Oscroft on Imperfect Markets
• Relative Strength by Paul Marshall