Stockmarket volatility and the gamblers fallacy

Sharp market sell-offs look like the ultimate irrational investor behaviour.  It is hard to understand why share prices of banks and other big companies should drop more than 10% in days, despite little change in the economic background.  May’s volatile stockmarket seems bizarre, contradicting any concept of market efficiency.   But it provides a real opportunity for behavioural finance to shine.

 The often dramatic end to trends reflects contrasting investor perspectives.  It would be wrong to dismiss this stockmarket volatility as simply herd behaviour.  In fact, investment analysts and private investors typically behave differently, particularly in the way they view trends and market patterns.    Private investors tend to extrapolate trends, which can be smarter than it seems.  As 2009 progressed, private investors continued to climb aboard the rally without needing to wait for company results to confirm recovery.   Waiting for a rational analysis may mean missing out, and trends often last longer than most expect.

 Analysts, however, rely more on research, and they can show one particular behavioural weakness; the gamblers’ fallacy.  This describes the belief of many experts that trends must reverse.  After watching a coin land heads ten times in a row, the expert typically calls tails; whilst many others would predict heads again. Both calculations may be wrong, but these differing perspectives on how to interpret information have an impact on the stockmarket.  Many investment professionals take pride in being contrarian – their longer term perspective on how market moves should average out is seen as wise.  In contrast, amateurs can find the crowd more comforting. 

 This perspective of investment professionals can drive them to “buy the dips”, dismissing a sell-off as irrational and relying on previous information and analysis. Yet, the world might really have changed in ways that are not obvious in analysts’ reports.  A new political landscape or widening credit spreads are not readily captured in company research.  In this environment, misplaced belief in models and traditional ratios can lead professionals astray.  The result was evident in 2008’s bear market.  The underlying truth about the banking sector took a long time to appear in stockbroking research.

 Those who believe the market knows more than they do are sometimes right.  Echoing what happened in 2008, there is now much misleading public information from governments and banks.  When a bank says not to worry – that its exposure to Greece is less than 1% – it is not the whole truth about the likely balance sheet damage. And, when politicians suggest that the crisis is purely a creation of aggressive bond market speculators, it misses the real issue. European governments do not like the message that credit markets are delivering and are intervening to stifle the market.  Currently weak share prices for banks and insurers, and wider credit spreads, might not simply be panic.  It could reflect the knowledge that a few have about the true underlying position. 

 If private investors see this as a new trend reflecting crowd wisdom, they will raise liquidity.  For a time they may be matched by others “buying the dips”.  Market turning points are usually characterised by higher volumes – not a feature of the last 12 months, but a warning signal we should look out for.  If activity picks up we know that there is a real two-way pull that could be resolved dramatically. 

 Behavioural finance tells us that much of what goes on in turning points reflects competing types of investors, not individuals who change their minds.  That may come later.  By failing to move smoothly from one pattern to another, the market may not be efficient, but that does not mean that raising some liquidity now is irrational.

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