The AMP’s chief strategist, Dr Shane Oliver looks at the role played by investor psychology in investment markets and what it means for investors.
He says investment markets are driven by more than just fundamentals. Investor psychology plays a huge role and helps explain why asset prices go through periodic booms and busts.
Up until the 1980s the dominant theory was that financial markets were efficient – in other words all relevant information was reflected in asset prices and in a rational manner.
While some think it was the Global Financial Crisis with its collapse in credit markets and consequent 50% fall in global shares that caused faith in the so-called Efficient Markets Hypothesis (EMH) to begin unravelling, this actually occurred in the 1980s.
In fact it was probably the October 1987 crash that drove the nail in the coffin of the EMH as it was virtually impossible to explain why US shares fell over 30% and Australian shares fell 50% in a two month period when there was very little in the way of new information to justify such a move.
It’s also hard to explain the 80% slump in the tech heavy Nasdaq index between 2000 and 2002 on the basis of fundamentals alone.
Sure, there was an economic downturn and slump in IT demand at the time – but this is normal and should have been allowed for in setting share prices.
Study after study has shown that share market volatility is way too high to be explained by investment fundamentals alone.
Something else is obviously at play, and that is investor psychology.
Investor psychology
Several aspects of investor psychology interact in helping drive bull and bear phases in investment markets, including individual lapses of logic and crowd psychology.
Individuals are not rational
Numerous studies by psychologists have shown that people are not rational and tend to suffer from various lapses of logic.
The most significant examples are as follows.
Extrapolating the present into the future – people tend to downplay uncertainty and assume recent trends, whether good or bad, will continue.
Giving more weight to recent spectacular or personal experiences in assessing the probability of events occurring.
This results in an emotional involvement with an investment strategy – if an investor has experienced a winning investment lately he or she is likely to expect that it will remain so.
Once a bubble gets underway, investors’ emotional commitment to it continuing steadily rises, thus helping to perpetuate it.
Overconfidence – people tend to be overconfident in their own investment abilities.
This is particularly the case for men.
Too slow in adjusting expectations – people tend to be overly conservative in adjusting their expectations to new information and do so slowly over time.
This partly explains why bubbles and crashes in share markets normally unfold over long periods.
Selective use of information – people tend to ignore information that conflicts with current views.
In other words they make their own reality.
This again helps to perpetuate a bubble once it gets underway.
Wishful thinking – people tend to require less information to predict a desirable event than an undesirable one.
This may partly explain why asset price bubbles normally precede crashes.
Myopic loss aversion – people tend to dislike losing money more than they like gaining it.
Various experiments have found that a potential gain must be twice the potential loss before an investor will consider accepting the risk.
An aversion to any loss, particularly in the short term, probably explains why shares traditionally are able to provide a relatively high return (or risk premium) relative to “safer” assets like cash or government bonds.
The madness of crowds
As if individual irrationality is not enough, it tends to get magnified and reinforced by “crowd psychology”.
Investment markets have long been considered as providing examples of crowd psychology at work.
Collective behaviour in investment markets requires the presence of several things:
A means where behaviour can be contagious – mass communication with the proliferation of the financial media both in print and electronic form are a perfect example of this.
More than ever, investors are drawing their information from the same sources, which in turn results in an ever increasing correlation of views amongst investors, thus reinforcing trends;
Pressure for conformity – interaction with friends, monthly performance charts, industry standards and benchmarking, all help result in herding amongst investors;
A precipitating event or displacement that gives rise to a general belief that motivates investor behaviour.
The IT revolution of the late 1990s or the growth in China and emerging markets are classic examples of this on the positive side.
The demise of Lehman Brothers and related events setting off investor panic is an example of such a displacement on the negative side; and
A general belief which grows and spreads – eg, share prices can only go up or alternatively shares are a poor investment – this helps reinforce the trend set off by the initial displacement.
