The Hidden Influences of Your Brain: Part 3 – Market Impacts
posted on December 11th, 2015 by Bellmont Research Team
This is the third of 5 posts that will show you how to use insights about your brain to become a better investor. In the first two posts (post 1 and post 2) we discussed behavioural biases as they impacted Mark & Meg’s decision to buy a car, and as they made a number of investment decisions. In this post we will examine some market impacts that result from underlying behavioural biases.
When Mark went ahead and purchased Ivoprotein shares, the investment he considered in post 2, he contributed to the “value effect”. As a small investor in a $200 million market cap company, Mark’s purchase was unlikely to have much impact on Ivoprotein’s share price by itself. However, by following a biased decision-making pattern that he is likely to share with other investors, the aggregate effect may be material – pushing Ivoprotein’s share price above fair value.
Ivoprotein is not alone, of course. The same price inflation effect will be true of other stocks that have high expected future growth, stocks that engage our emotions with likeable characteristics and compelling stories. The effect is likely to be strongest if these messages are amplified by media exposure, broker recommendations, IPO promotional material or the like.
But what goes up tends to come down. Long-term studies confirm that these stocks (“growth stocks”) tend to underperform their less lovable cousins (“value stocks”).
Value stocks can be identified by a number of quantitative measures, such as a low relative price to earnings (P/E) ratio, or a low price to book (P/B) ratio. Some investors also apply a qualitative overlay to identify the types of characteristics that might cause them to be irrationally loathed. They may not feel like good investments, but they are likely to outperform over the longer term. This effect highlights that rational investing is not necessarily comfortable investing – a topic we will return to in later posts when we consider approaches investors can apply.
In post 2 we discussed how Mark sold his Tintop shares and was potentially subject to the disposition effect. Because Tintop has performed well over the past few months, many other investors will probably have unrealised gains like Mark does. Some of those investors will experience a similar apparent compulsion to sell, dampening Tintop’s share price growth. However, over time, as the impact of these investors diminishes, we should expect it to rise towards fair value. This creates a pattern of short-term momentum – share price rises followed by more share price rises.
However, momentum investing strategies come with a warning. Over longer periods, the momentum reverses.
In post 2 we saw how Meg was affected by loss aversion – overweighting losses relative to gains. We also discussed Mark’s perception of probability – how he may have overweighted the possibility of Ivoprotein’s success. When these two effects combine they can become very powerful. That occurs when we think about salient, low probability events that lead to losses. In the real world this may be seen when consumers take insurance to cover the risk that a new TV breaks down after the warranty period, even though the probability of such a fault is very low. In the financial world, in trying to protect themselves against these losses, people bid up the price of put options* more than they should. This leads to potential investment strategies that we discuss in the next paper.
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Simon Russell, Director, Behavioural Finance Australia
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* Put options are a financial instrument that allows you to cap your losses