Even stock market pros let emotions overcome rational decision-making
NEW YORK » Many Wall Street professionals see most people in the market as a herd. If the herd is heading one way, they say they'll head the other.
As a result, they can't get enough polls gauging how people feel about stocks. If the majority of investors love stocks, the pros take that as a strong sign to sell. If most investors hate stocks, that's a reason to buy.
The smart money says it will do the exact opposite of what everyone else is doing, because logic and experience dictate that investors who stay with the herd often get trampled.
But history shows that investors -- both professional and amateur -- too often let emotions drive their investment decisions.
More on that later. First, let's look at market sentiment indicators, Wall Street's chief measure of which way the herd is heading.
Sentiment polls are a mini-industry. Strategists at firms including UBS AG, Citigroup Inc. and Wachovia Corp. look at sentiment indexes. There's the UBS Index of Investor Optimism, Citigroup's Risk-Love Indicator and the Ned Davis Crowd Sentiment Poll, which Wachovia uses. There are enough polls that Schaeffer's Investment Research throws a combination of polls into an algorithm that tries to time the top of the polls.
"I probably have 30 or 40 market timing indicators that are sentiment based," said Chris Johnson, manager of quantitative analysis at Schaeffer's.
In looking at the polls, the strategists try to stay one step ahead. "Think of the investor polls as a crowded theater," Johnson said. "If the polls are telling us everyone is in the market, then, if the smallest thing happens, everyone tries to run though one door."
Said Whitney Tilson, a value investor and founder of Tilson Capital Partners, "My guess would be that for every 100 people looking at the polls, maybe nine are using it to pile in." The rest use it as a contrarian indicator.
In recent weeks, sentiment has been high. Yet, stocks have been rising, a sign the pros aren't fleeing the market.
When it comes to outsmarting the market -- or almost anything else -- Tilson has argued that we all suffer from overconfidence. In a popular presentation, he says that 82 percent of people say they are in the top 30 percent of safe drivers; 82 percent of Harvard Business School students say they are better looking than their classmates and 68 percent of lawyers in civil cases believe their side will prevail.
"Much of economic and financial theory is based on the notion that individuals act rationally and consider all available information in the decision-making process. However, researchers have uncovered a surprisingly large amount of evidence that this is frequently not the case," Tilson wrote in a paper called "Psychology & Behavioral Finance."
One problem: We're too emotional. A study published in "Psychological Science" co-authored by professors at Stanford University, Carnegie Mellon University and University of Iowa pitted people with normal brains against people whose limbic systems, the brain's emotional center, were impaired.
The paper asks whether a neural systems dysfunction that curbs emotion can lead, in some circumstances, to more advantageous decisions. The answer, in terms of investing, was yes.
Subjects were given $20 in play money to invest, $1 at a time. Determining whether the investor won or lost was done by coin toss. Heads, they won; tails they lost.
Losers lost the dollar they had invested. Winners had $2.50 added to their account. The rational thing to do, since there's a 50-50 chance of the coin coming up heads each time and the returns for winning were greater than the returns for losing, would be to invest in every round. But people with normal brains did not behave rationally. They became more conservative when they lost. People with impaired limbic systems did not.
"Medical study confirms brain impairment helps improve investment returns," Ajay Singh Kapur, chief global equity strategist at Citigroup, wrote in a summary of the study.
He uses the study as an argument for fighting instinct and getting into the market when investment sentiment is most negative and exiting when investor sentiment is high.
It's a rational argument. But think back to the last bubble: Big time money-managers took just as many lumps as day traders in boxer shorts. Most pros didn't stay ahead of sentiment. Most pros didn't bail out when it became clear valuations were irrational.
Following the crowd or running from the crowd isn't as solid a strategy as buying good stocks at cheap prices and waiting for them to rise, Tilson said.
"Contrarians, value-oriented investors, they look at intrinsic value," he said. "They don't play games with sentiment, because that's inherently a short-term game."
He is currently investing in McDonald's Corp., Wal-Mart Stores Inc., Costco Wholesale Corp. and Microsoft Corp., stocks that have been overlooked in recent months because most investors have been hunting for bigger gains from riskier stocks.
Yes, he and his firm are making a bet against the general consensus, he said. "That being said, we're just doing stock picking."
His paper wraps up with a series of quotes. One of them is, "The human mind craves clairvoyance, but anyone's ability to see the future is extremely limited."