Tuesday, January 22, 2008

Investor psychology in action

Wow. We are witnessing a serious selling spree in the stock markets. Once the stampede starts, several factors tend to feed it:
  • Our "herd" instincts take over. (ie the instincts to be part of the herd, not the instincts of a border collie to organize the herd.)
  • People who have bought stocks on margin get a call to cover their margin, and have to sell good stocks to cover their bad investments. Selling pressures drop the price of good stocks, and the cycle reinforces itself downwards.
  • In golf, our worst fear after a bad shot is that it makes us believe that it will happen again, soon and often. Many people view a precipitous drop in the stock market as a sure sign that more drops are to come, and their instincts are to sell early. Those who don't sell early hang on bravely for a couple of days or weeks, during which the prices drop even further. Eventually, there is capitulation selling, which is necessary before a real reversal can occur.
  • When a beaten up stock recovers a bit, some will happily sell holdings to reduce the size of the loss that they have already resigned ourselves to.
  • Prudent investors who had stop limits set, say, 5% below the last closing were stopped out of their holdings before they had a chance to check the markets. This selling adds to the selling pressure
  • As we search for explanations, we turn to columnists and analysts who are human. Those who were doomsayers in the past have the chance to say "I told you so", which usually feels pessimistic. Those whose rosier projections now seem wrong may resort to exaggerating the shock and awe of the purported causes associated with the market drop, rationalizing their previous conclusions as not having accounted for the extreme events of the past couple of trading days.
  • We question why we ever bought stocks in the first place, and consider selling so that we can invest in, say, vacation properties, or just getting out of debt.
Markets may be generally efficient in the long run, but in the short run they distill and concentrate the basic emotions of fear and greed. Benjamin Graham, the father of value investing, writes of "Mr. Market" and his mood swings. When we are at the moment of greatest fear and discouragement, that is the time to buy good stocks that have been pulled down with the bad ones. When we are jubilant that our clever picks are doing better than we ever could have imagined, then it is time to sell. In both cases, the right thing to do is the opposite of what we feel like doing.

Tough game. At all stages of the cycle, just remember 'this too shall pass'. But we can't know the timing, the direction, or the size of the reversal in advance.

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