BULLS & BEARS: Studying psychology can help investors earn money

April 3, 2006

In 1843, Charles MacKay wrote an investment book that even today remains a good-seller. It's titled, "Extraordinary Popular Delusions and the Madness of Crowds."

In it, he argues the crowd is always wrong and that its irrational and manic mentality pushes prices to extremes. Throughout history, we all have witnessed many examples of this irrationality.

The Holland tulip-bulb mania of the 1600s, various stock market crashes, and the willingness of kids to drain their piggy banks and frantically buy Pokemon cards are a few examples.

About 40 years ago, Eugene Fama, a professor at the University of Chicago, posited the efficient market theory in a series of papers and articles. Because of that work, he became known as the "father of modern finance."

The efficient market theory basically states that because people have access to the same information about the stock market, the price of the market reflects a rational assessment of all that information. In short, the market is priced at its true underlying value.

There may be short periods when prices are too low and likewise some when prices are too high, but on average the market is priced right and is efficient.

Acceptance of this leads you to throw up your hands, accept that overall the manic investors offset the depressive ones, and since you can't beat 'em, just join 'em and buy an index fund.

So which is it? Are there manias that can be exploited by going against the crowd or is the crowd ultimately right and worthy of following?

Maybe it depends on which crowd you are following.

A hot field today is "behavioral finance"-trying to exploit market inefficiencies by the study of investor psychology.

For example, we assume intelligence is fungible and that smart people who are experts in one field can be darn near experts in other fields.

However, any stockbroker can tell you the skills and knowledge to be a brilliant brain surgeon are really not what's required to be a brilliant investor.

Likewise, sometimes the people closest to an industry are a poor prognosticator of it.

Two famous examples are Harry Warner of Warner Brothers asking in 1927, "Who the hell wants to hear actors talk?" and Tom Watson of IBM stating in 1943, "I think there is a world market for maybe five computers."

This "expert" bias also can cause a security analyst to fall on his face. You would think a smart analyst who visits with a company's management could make the best assessment of the company.

Analysts with half the alphabet after their names feel their superior knowledge combined with the "touch" leads to the best decision, when in reality it often leads to overconfidence.

It's tough for you to admit you're wrong, especially if you are an "expert."

Behavioral finance takes data about what investors are doing today to try to predict what will happen tomorrow.

To some of you, this field may sound like a combination of technical chart reading and tarot cards. But if you can use data to try to separate mania from despair, it would be worth investigating.

In two weeks, after I finish my palmreading class, I'll be back to delve deeper into behavioral finance with you.



Gilreath is co-owner of Indianapolis-based Sheaff Brock Investment Advisors, money management firm. Views expressed are his own. He can be reached at 705-5700 or daveg@sheaffbrock.com.
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