Saturday, October 19, 2013

Thoughts to You from Yours Truly - ( TYYT ) - ( 91 ) - Erratic Investor Behaviour

Thoughts to You from Yours Truly - ( TYYT ) - ( 91 ) - Erratic Investor Behaviour


Most notorious stock market crashes such as th Wall Street Crash of 1929 and 1987 did not betray themselves with any extraordinary signs before the disasters struck. Once the price falls started, they snowballed at lightning speed and became a cascade in the blink of an eye. Analysts can always attribute specific and concrete reasons and factors to the disasters with the benefit of hindsight. Many of their elaborate reasons were eagerly accepted by the investment community because as Friedrich Nietzche said :- “ First principle : any explanation is better than none.” For the October, 1987 crash, most analysts attributed the disaster to computerized trading which was subsequently restricted. Could the drastic fall of 22% of the market value in a single day be so easily explained by just one lone factor ? Again, the 1929 crash was explained by excessive borrowing at the time. Are the real reasons that simple ? Everybody knew that financial institutions routinely lent money to borrowers. Otherwise, how else can they make a profit with all the money in their hands deposited by their account holders ? Financial analysts have no choice but to insist that the investors are rational beings because they are the very reason for the analysts' own existence. The market trends are subject to some basic dynamics capable of expression in some laws thus making any forecasts meaningful. Of course, both of these assertions must be true or there would not be any need for the analysts in the first place. So, they keep on upholding the assertions. But do these assertions stand up under vigorous scrutiny ? I am afraid the answer is no. The scientist Alfred Zauberman has his own sarcastic law about any economy in general. It goes like this :- “Zauberman's Law : The worse the economy, the better the economists.”

For the same reason as the example given above where the throwing of darts and applying high power computer analysis on share prices come out even handed, I totally support the views proposed by the Theory of Chaos and the Science of Networks concerning unpredictability and information cascades.There cannot be any hard and fast rules for predicting investor behaviour. Now let us look at some reliable scientific research on the subject of investor behaviour to see what the results can tell us.

Everyone agrees that our personal opinion can be influenced by other people and additonal information even though the latter may be purely promotional in nature. Take going to the movies for example, we seldom have a completely independent choice. Most of us usually know which one to see before we actually go to see it. Through advertisements in the media and comments from our friends who have already seen the same movie, we have most probably come to a definite opinion on the movie before going to watch it in the cinema. This is a decision based on our emotions and impulse rather than a rational and systematic decision making process. Of course, there is the Coercive External Effect at work. If everyone else has seen the movie and is talking about it, how can I afford not to see it for fear of being isolated socially. Therefore, it is easy to realize how human beings can influence one another irrationally in their decision making process.

In 1999, the economist Thomas Lux of The University of Bonn and the engineer Michele Marchest of the University of Cagliari conducted a reaserch into investor behaviour to investigate the validity of the orthodox investment theory of rational investor behaviour based on changes in the economic fundamentals. Their alternative theory was fluctuations in share prices were mainly the results of “mutual interactions of participants “. The researchers' model was a very simple stock market with just one kind of stock and a population of investors who buy and sell the stock. The population was divided into three different categories of investors. The first group were the Fundamentalists who were the rational ones basing their decisions on economic fundamentals as proposed by the Orthodox Investment Theory. The second group were the Optimists who believed the market was on an upward trend purely by blind faith and wanted to buy. The third and last group were the Pessimists who consistently felt that the market was at a down turn and wanted to sell.

The researchers also put some authentic value on the stock and tied it to some basic economic fundamentals. The price changed as the fundamentals changed. As in real life, it was the interactions between the different groups and the changes in the fundamentals that finally determined the price. So far, the scheme followed the orthodox view of the stock market. However, the researchers added one more assumption to enable them to test their own theory and that was the participants could influence one another. This new parameter proved definitively to be the volatile factor that rocked the whole boat. The minds of both the Optimists and the Pessimists are not fixed permanently so that changes in the moods of some members of one group can lead to a overall inclination of the market towards either camp. This will result in the optimistic and pessimistic outlooks being propagated throughout the market on a cycle of swings between the two moods. The researchers also found that these two groups very often organised themselves until they reached the critical state for the system as a whole when slight changes in the moods of just a few of its members could lead to a change of the overall optimism or pessimism in the market. Once such a point was attained, a cascade could easily occur in the market trend towards one mood or the other so that huge fluctuations of varying magnitudes would ensue. These upheavals would continue in a self-perpetuating chain of actions and reactions until it came to an end and then the trend could reverse itself and so on. 

What happened to the fundamentalists in this model ? Well, they did the best they could in using past data and changes in the economic fundamentals to make their investment decisions. They were understandably frustrated because their so-called rational behaviour was upset by the erratic mood changes caused by the other two groups. Decisions based on the orthodox method mostly turned out wrong as common sense was not allowed to operate freely because of the presence of irrational moody behaviour of the Optimists and Pessimists. Finally, even they, the rational ones had to succumb to market pressure and had to go along with whatever mood that was influencing the market at a particular time. Particularly, when the cascade effect took hold of the market even the Fundamentalists acted in accordance with the prevailing mood. So in effect, the Fundamentalists were eventually converted to either the Optimists or the Pessimists by the end of the game through Coercive Externalities of other members of the network. Only during very calm and gentle ups and downs in the market could the Fundamentalist sentiment be detected. There were bulls and bears or runs and rallies and moods just like the real world scenario where slight glimpses of hopes and doubts can be magnified totally out of proportion to the apparently insignificance initial disturbances in the market. Such minor disturbances can be real like some changes in the economic fundamentals or simply rumours like the impending resignation of the CEO of certain big corporations. The researchers had conclusively proven that the biggest volatility in the stock market arises not on account of the basic economic fundamentals or rational investor decisions as predicted by the Orthodox Investment Theory. Instead, it is the inherent unpredictability of the “ mutual interaction of the participants “ that is the main driving force behind this market volatility.

If all these sound familiar, it is because we have come across such phenomena in the Theory of Chaos and Complexity in connection with the occurrence of natural disasters like earthquakes and forest fires which follow the Power Rule. It will be recalled that for systems where the Power Rule applies there are no such things as typical behaviour in any aspect of the networks or systems in question. In other words, there is no such thing as a normal peak or normal trough in the investment graph. In short, there is no normal fluctuations, period. This may seem to be both a sarcastic and pessimistic view of the investment market but such conclusion is justifiable by research results as well as sound scientific theory. Does this imply that we should not invest in the stock market ? The answer is a resounding negative. So long as we are aware of the ultimate unpredictability and volitility of the system and not to put all our eggs in one basket in terms of the form of investment, we should be on home ground. The smart thing to do is to diversify into different forms of investment other than equity while holding only a fraction of your stakes in stocks as an aggressive component of your portfolio for growth and to beat inflation. However, you should be psychologically prepared and not to feel devastated should disaster really strike for no apparently good reason.

Sometimes, you cannot ask why ? This is equally true with life. It serves you better to rally your efforts and find the courage to start all over again in life than to lament over your misfortunes. Why waste time in re-living your painful moments by trying to ask why it happened over and over again whereas, in fact, there may not even be any sensible answers. Very often, one thing leads to another and all the causes and effects are madly jumbled up. There is this telling historical question. What killed Abraham Lincoln ? The short answer is, of course, the assassin's bullet. This is only the immediate reason. The broader analysis would have to include the political situation, the misguided racist view against negroes, the technology that led to the invention of the assassin's pistol and so on and so forth. The true and complete answer is all these and other unknown factors working in unison in a Network that is the human society up to that fateful moment in history that killed the great and honourable President Lincoln. It is the complicated mechanics ( mostly human in this particular case ) working under various principles of the Science of Networks that actually killed the great man. So, as the saying goes :-“ Don't cry over spilt milk.“ Whatever tragedy hits you, it is to your advantage to look at it as a challenge and learn something from it. Bring out the Mr. Q's attitude within you and face your tragedies with humour and, if possible, defiance. That is how you can manage to win in every instance in life. If tragedy actually strikes, there is no way you can prevent it. This is a fact of life. Rather take an indifferent view, if you can, because lamenting over it would only weaken your resolve to combat the tragedy. It is an uneconomic proposition because it represents a waste of resources and energy. Life has been and always will be an uphill battle against the odds. We have already learned this in chapter (ii) on the origin of life. However rich and powerful you are age will inevitably catch up with you. Tragedy of one kind or another will and must strike. Therefore, be positive and have faith in yourself. Look forward to your future, with a little help from luck and you will be alright. A positive attitude cannot ensure your success but a negative one can surely guarantee your failure. After all, what better can you do if you have already done your best !

The kind of lucrative returns we usually obtain from investing in equities precisely reflect the workings of one of the most sacred laws in the investment market. This golden law, so to speak, is that risks and return always go hand in hand. The greater is the expected return the higher are the related risks. What we have learned from the Science of Networks regarding investor behaviour is that when disaster does strike do not blame yourself on your bad judgment as everyone traditionally does because there is no sure way at all to read the ominous signs as there may not be any. If there really were observable signs and viable predictions based on past trends the computer would have been king of the investment jungle ! 

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