The irrational element of investing

It hasnot been in my nature to forecast the future but I would like to indulge in a bit of future gazing.

The debate continues to rage around the risky nature of equities. As an aside, the fixation with the riskiness of equities I equate with the slavish belief that property is the only way for people to accumulate wealth. Both are equally irrational.

The book that prompted my thoughts was BeyondFear and Greed, understanding behavioural financeand the psychology of investing. Three of the issues raised related to heuristic-driven bias, frame dependence and market inefficiency.

Heuristic refers to rules of thumb that people develop by trial and error. But, like all ‘back of the envelope’ calculations that may sometimes come close to the right answer, heuristics often involve bias. Examples of bias have afflicted many analysts in the US.

A study in the US found that stocks that were extreme losers over the preceding three years do much better than stocks that were extreme winners. Despite this, security analysts’ forecasts were biased in favour of recent success, suggesting they were much more optimistic about recent winners than they were about recent losers. The press has recently reported some examples of this extreme bias by US security analysts.

Frame dependence, as its name suggests, requires that decisions are made through a frame that is transparent, not opaque. When a person has difficulty seeing through an opaque frame, the decisions will typically depend on the frame that is used. The best examples of this are the studies that show that people are about two and a half times more sensitive to a loss than a gain of the same magnitude.

Finally, we are told that markets are efficient and yet, when it comes to investment decision-making, people who display less than rational characteristics make markets. The question as to whether markets are efficient or inefficient remains one of the most hotly debated questions in finance.

Having given a less than satisfactory synopsis of this fascinating book, what does it all mean?

The Nasdaq index in the US is now down over 80 per cent from its peak. My prophecy is that it will take a long time to see that level again. I further suggest that in years to come, commentators will point out the length of time it took the Nasdaq to get back to its original peak of over 5,000. This will be used as another example of the long periods of time where the share market doesn’t perform and is therefore ‘risky’.

In a similar vein, we are constantly reminded of the ‘crash’ of 1987. I have no doubt that the Nasdaq meltdown will similarly enter the annals of history and become part of the ‘heuristic’ associated with our propensity to feel the downside more than the upside.

The fact that the Nasdaq rose meteorically prior to this correction is never considered in this one-sided debate. Nor is the fact that not everyone participated in this madness. Sensible investors continued to make money during this period, as they have during most periods of market turmoil. Indices only ever tell a part of the story.

Allow me to examine in a little more detail the events of 1987. The hot numbers during this period were the entrepreneurial stocks and speculative mining stocks.

A fund, which shall remain nameless, was quoted in theAgenewspaper on Monday, July 20, 1987: “The Fund has produced areturn of about 300 per centfor investors in the 16months since it was launchedin February last year.”

The fund manager was about to release a mark II version of this fund and provided the following insights. “Some sectors have becomeexpensive, however, thereare still opportunities especially in the emerging goldstocks which have been neglected...”

The rest of the story we know: the market corrected a few months later by around 50 per cent. Driven by all the above emotions and most of all by the catchcry of all periods of irrational exuberance, “this time is different”, we have seen history repeat itself. The Australian sharemarket rose by almost 100 per cent in the 12 months prior to the 1987 correction. The Nasdaq rose by 105 per cent in the 12 months prior to its correction and a whopping 213 per cent in the 18 months prior.

From my heuristic, frame dependent position, I consider the spectacular rises to be the irrational element in both instances. The subsequent corrections were a perfectly rational response to an ‘inefficient’ market. But in our over sensitive reaction to loss, we remember the modest downturn as the frightening element. A rational person should have been frightened and horrified by the overwhelming speculation that preceded these corrections.

The length of time that it will take the Nasdaq to recover to its previous peak will not record a period of poor performance, it will simply calibrate the sheer stupidity of the irrational exuberance that preceded it.

Peter Thornhill is principalof Motivated Money.