Come the 19th of October it will have been 30 years since the 87’ stock market crash. It was the biggest market meltdown since the crash of 1929.
Over the last 30 years you’re probably often heard the repeated advice to never panic and always take a long-term view, be patient the Dow Jones Industrial Average recovered all loses within two years after the 87’ crash and the Warren Buffett’s golden piece of advice “Be fearful when others are greedy and greedy when others are fearful”.
They’re good advice but let’s dig even deeper and explore what really is driving our investment decisions.
Humans are Pattern Seekers
Not many individual investors can move share prices, unless you’re Carl Icahn, which creates this sense of lack of control and it increases our tendency for creating illusory pattern perceptions between unrelated stock information. That is the conclusion reported by Jennifer A. Whitson and Adam D. Galinsky, in their report for Science magazine in 2008. And they wrote;
‘Which we define as the identification of a coherent and meaningful interrelationship among a set of random or unrelated stimuli. Participants who lacked control were more likely to perceive a variety of illusory patterns, including seeing images in noise, forming illusory correlations in stock market information, perceiving conspiracies, and developing superstitions.’
The causes of forming illusory correlations in stock market information was identified as the individual’s ability to try to gain a sense of control perceptually, when they are unable to gain a sense of control objectively. What it means is when we are faced with a lack of control we turn to pattern perception, the identification of coherent and meaningful inter-relationship among sets of stimuli.
In one experiment Whitson and Galinsky tested the relationship between lack of control and illusory pattern perception in the stock market by using a standard illusory correlation paradigm.
Participants read news headlines that either stated ‘Rough Seas Ahead for Investors’ or ‘Smooth Sailing Ahead for Investors’, and read company reports of two companies A and B, with a even number of negative and positive statements, but company A had 16 positive and 8 negative statements, whereas company B had 8 negative and 4 positive statements.
When participants were given a choice to invest in either company A or B, only 25% of participants who read “Rough Seas Ahead for Investors” chose company B as compare to 58% who read ‘Smooth Sailing Ahead for Investors’.
The perception of a volatile market led to strong association between the negative information and company B. Most participants overestimated the frequently of negative statements about company B.
As the study suggests, during market downturns, as experienced during the 87’ market crash, investors will inform illusory associations based upon market volatile news headlines and the increasing number of negative statements in company reports, which will ultimately determine their investment decisions.
Today, more and more headlines are reporting low volatility in the market, and according to the study this leads to more investors playing down the seriousness of those negative statements released by companies.
What can we do ourselves?
If we all read the same news and company reports and accept them at face value then how do we gain any type informational advantage?
To gain an advantage we need to objectively question the news and negative company statements, putting them into a long-term perspective. Ask yourself if the news story is based upon fact or opinion? Is the negative or positive news story about this company bias in way?
Management have a tendency to downplay negative news, and you may have noticed that the first half of most annual reports look like a marketing feature, take Austria Solar as an example, they produced a blank annual report, but when put under the sunlight the wording comes to light.
But as Warren Buffett proved by beginning his shareholder letters with first admitting all his mistakes he has made over the last year: if you are honest about your mistakes and don’t sugar-coat the news it builds trust with readers.
Very positive annual reports should be viewed critically, everyone makes mistakes or misjudges how a plan will turn out, but do management fully explain what happened and why?
Howard Marks Two Pronged Approach
Howard Marks wrote in his book, The Most Important Thing, that the most important thing is to know where you stand. He wrote “As to the macro, including the level of the market, we never know where we’re going, but we sure as hell ought to know where we are.”
And he provides a two pronged approach to understanding of where we are heading, as it is not so hard to know where we are. Firstly, looking at valuations—price-earnings ratios, yields, yield spreads, transaction multiples, cap rates in real estate—and you ask yourself “are they high or low relative to history and relative to interest rates?” You gauge the appropriateness of valuations and that’s entirely quantitative.
Secondly, there’s the qualitative. How are people behaving? Are people euphoric or depressed? Are they sceptical or unquestioning? If a new fund comes out, is it oversubscribed overnight, or does it go begging? All these kinds of things. What are they saying on TV? What are the newspapers saying?
Take the temperature of the market. Look at the behaviour around us, that’s the key. Warren Buffett says, “The less prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own affairs.” In other words, when other people are carefree, we should be worried. When other people are panicked, we should turn aggressive.
Tell us in the comments section below, what are your thoughts on the market right now?