Daily Speculations

The Web Site of Victor Niederhoffer & Laurel Kenner

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01/03/05
The How and Why of Investment Decisions, by Steve B.

Have you ever wondered why you often change your mind about how you feel about an investment? Feelings start when you are about to purchase a security, the attachment becomes stronger after the purchase, and then over time you come to have mixed feelings, and finally you become pessimistic and sell the security to find better opportunity elsewhere?

The one major impact that we cannot escape is that group dynamics, often referred to as the majority, will tempt us to move with the crowd to one degree or another.  That pattern is always revealed in the performance of stock indexes. We have heard the expressions Over-Optimism, Outcome Bias, Prospect Theory, Hindsight Bias, Self-Attribution, Conservatism and Confirmatory Bias, and our favorite, Gamblers' Fallacy. The importance of these theories is not how good they are at explaining biases but how they reveal how people continue to make investment mistakes. It is the mistakes that people make that separate poor trades from good trades. In investing, the difference between poor traders and good traders is a lot less about how smart one is than about how well one is able to capitalize on the mood of the crowd.

The above theories are all valid but we need to avoid the Curse of Knowledge and accept theories as a truth and not be able to see the world otherwise. We should not come to the conclusion that others think as we do and they will draw the same conclusions about an investment. Even when two people have read the same information they are more than likely to draw different conclusions. If however we know how others are reacting to the same information we are likely to behave in a similar manner. Perhaps this is the reason that most analysts estimates are close together (perhaps they are placing more weight on leaders in the group) and that economic predictions such as GDP and inflation are closer than one would expect in a random situation.
People make investment decisions based on other people's decisions. Children learn by doing and as adults we learn to base our decisions on others, therefore we can blame them for our losses but take credit when we are lucky. To be able to generate a profit from others decisions we need to be able to act after the crowd reacts but before the majority of the crowd reacts. You can view this as a 20/80 rule we are looking to react after 20% of the crowd has already made a decision it is irrelevant what part of the investing community this 20% is composed from. Many times this 20% crowd will be wrong (they were eager beavers) and there enthusiasm will fail to catch on but when they are correct we are counting on gains approximately twice as large as losses that we may have previously had. Our 20% rule is definitely not fixed as there are times when the market is more susceptible to a move (i.e. periods of increased volatility) or when securities start to drop. It is just easier to move a crowd to the exit doors than the entry doors. Good investments are the result of mistakes made by others.

Lets follow the decision making process of an individual:

1) The individual or institutional investor is complacent with his holdings whether it be stocks, t-bills, bonds, currencies, ADR's, derivatives, or cash. Then there are items that make his question his holdings, as there is opportunity elsewhere of there may be negative news regarding his holdings. The source of this negative news may be in the form of word of mouth, CNBC, internet chat rooms, fundamental news directly from the company, analyst revisions, technical signal, or what have you. The idea here is that information is always coming in and we can not dismiss that it may be true, as individuals we are able to hold vast amounts of information even when that information may be contradictory.

2) We begin to open our eyes more on information that is contrary to our holdings, there begins to be doubt. This is often a function of price as the price is a daily reminder of our hopes, desires and sorrow. The hardest thing for individuals to admit is an error and nowhere is this more true than in investing, how will they tell their friends, colleagues and most importantly themselves that they were wrong in their assessment of a security. The individual continues to hold their beliefs or standing firm in the face of oncoming change. The unwillingness to change at this point has helped randomly in the past and we recall those events to commit ourselves to our current positions. This is the hope that things will change and we will eventually be proven correct. The risk management is generous in to the early adapters but to those who are late it is painful.

Irrational Exuberance, Shiller (2000) "A fundamental observation about human society is that people who communicate regularly with one another think similarly. There is at any place and in any time a Zeitgeist, a spirit of the times .Word-of-mouth transmission of ideas appears to be an important contributor to day-to-day or hour-to-hour stock market fluctuations " (pp. 148, 155)

3) At this point many investors have started changing positions (we have arbitrarily used a 20% rule) and the news about the new security begins to gain steam. The new acquiring holders are more vocal in the future prospects of their newfound security than the current holders. The exponential growth of the news begins to put doubt in the mind of holders of other financial instruments. This however presents a problem for the individual as the new information is at odds with his current held beliefs. In order to make the switch he must be able to reconcile his current information with his new found beliefs? Evolution is at the heart of the way we think, the quants may have figured out some strange relationships with their fancy math but deep down they will still be monkeys. As monkeys they will be subject to the impact of those amongst them.

4) At this point the individual is able to make the connection between his current beliefs and the new information that has been presented to him. We do not want to speculate what could have finally made the person decide to make the move to the new security; it is suffice to say that all the factors had an impact on the individual. As individuals we are subject to the different market forces and are not exempt from the pull of the majority. Investors have developed all types of models and strategies to deal with the impact of financials, stock prices, and economic growth to deal with the complexities of the markets. However, the pull of the majority has given us the feelings of comfort and we can not place a price on that intangible.

Is it any coincidence that most funds hold most of the same stocks within their asset groups.