Behaviour and projections

Behaviour and projections
Published: 2009/04/29


This article intends to explore the behavioural side of those who make stock market projections

THE economic tsunami that has hit the world since late-2007 has left many wondering where it is heading, what to expect, etc. Experts as well as laymen make projections, mostly trying to predict when the stock market will hit bottom. Unfortunately, no one can really provide a definite answer. Setting aside the technical details of the various projections that have been and are being made as we speak, this piece intends to explore the behavioural side of those who make these projections.

Gambler Fallacy

According to Hersh Shefrin, in his book titled "Beyond Greed and Fear", research has shown that strategists and analysts are often caught in a behavioural phenomenon called "gambler fallacy"- the misconception that the law of averages can be applied to even a small sample size.

This is illustrated by a simple coin-tossing game. If five consecutive tosses of a coin come up heads, most people tend to think that the sixth toss should be tails, even though the probability of getting either heads or tails is 50/50. Going by this, some predictions tend to project inappropriate trend reversal as evident by a study done by De Bondt in 1991. Based on published predictions by Wall Street analysts, the study shows that the analysts are overly pessimistic after three-year bull markets and overly optimistic after three-year bear markets.

What does this behaviour mean to you?

It is especially important if you use the projections to make investment decisions. When dealing with a bear market that has yet to touch the bottom, using an overly optimistic projection would lead to the wrong decision. You stand to lose by buying certain stocks believing that their prices are low enough and the downtrend is going to reverse anytime soon, only to find that the prices continue to drop. By the time the market actually hits bottom, you may have already used up your resources.

Naive Extrapolation

Studies have shown that individual investors have the behaviour that is quite the opposite of what has been described above. The retailers in the market, for instance, have the tendency of doing simple extrapolation - projecting the future based on the recent past. As a result, they are overly optimistic during bull markets and overly pessimistic during bear markets.

Seasoned investors would always tell you to prepare to leave the market when you hear that people around you (especially those who've hardly ever talked about investing) start to be active in the stock market. This may indicate that the bull run is about to end. Unfortunately, new and inexperienced investors would naively think that the bull run would continue.

The time to look around hard is when no one is talking about buying stocks. Your golden opportunity in getting good stocks at a bargain surfaces when others steer clear of buying them. As Warren Buffett said, "Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can't buy what is popular and do well".

Overconfidence

Both the analysts and individual investors have something in common. They are overconfident when it comes to predicting the future. So, they often end up getting surprises. Interestingly, it has also been found that experience plays an important part here. Those who are inexperienced turn out to be the ones that have greater confidence in their predictions and therefore higher expectations in stock market returns. Seasoned investors and analysts, on the other hand, tread with more caution and are more conservative in their investment approach.

Less Predicting, More Reading!

The combined effect of the behavioural phenomena from the investors drives market sentiment. As an intelligent investor, learn to separate yourself from the herd effect and try not to fall into the biased behaviour described above. You need to be aware of the market direction, but don't waste too much time predicting when the market will bottom out. Instead, spend your valuable time reading more and doing your research on the companies of your interest. Understand the fundamentals well and learn from errors that others have made in the market.

Securities Industry Development Corporation, the leading capital markets education, training and information resource provider in Asean, is the training and development arm of the Securities Commission Malaysia. It was es tablished in 1994 and incorporated in 2007.