When the market gets volatile, maybe it’s time to put it on a couch and think like a psychologist.
Levelheaded long-term investors hope for nutty markets. That’s when bargains abound or when panicky investors thrust profits into the hands of the patient. But aren’t markets rational? If we think back to even high school economics classes, all investors are expected to coldly make investment decisions that maximize their expected returns.
Investors are allowed to make mistakes, but they’re expected to be random. Some investors will be overoptimistic and others too pessimistic. Once all those errors in different directions and degrees are added up, they should, in theory, cancel each other out, and what’s left is an accurate market price, or at least the closest we can get without knowing the exact future.
But that rational market theory flies in the face of experience. Why do companies miss earnings expectations by miniscule amounts and their stocks instantly crater? What drives growth stocks to wildly high prices? Why do clearly dirt cheap stocks languish? If markets are rational, why would the stock market move wildly up or down, only to quickly reverse itself?
First, there’s some logic behind some moves. Small changes in growth rates can justify big changes in stock prices. There are several calculations that can prove that (net present value is one), but we can summarize them by saying that getting a little more one year is very different from getting that same amount for the rest of your life.
In the same way, markets should pay less attention to one-time occurrences – or at least the stock price won’t change drastically once the market adjusts to the news – unless they imply the future stream of profits will change or the company’s assets are less valuable. Fans of rational markets explain away prices that are too high or too low as random error that will eventually correct itself or that everything driving the price isn’t yet understood.
Other investors take almost the opposite approach. They think the “true” price of an investment or market is unknowable, so they only focus on the investment’s price behavior. If it’s trending up, those investors will assume that trend will continue until there’s enough evidence to suggest otherwise, say if it breaks a 200-day moving average. Some may assume the market frequently overreacts and look for extremes and sell when everyone buying or vice versa. Those investors assume we’re driven mostly by impulsive fear and greed instead of thoughtful estimates of value.
But, as a billion GIFs keep asking, “why not both?” Let’s assume markets are rational most of the time but human nature and mass hysteria can play a part as well. That’s a fair way to characterize human behavior. We are rational in most of our daily lives, but can be stubborn, impulsive or emotional too, but only occasionally. Our default assumption most of the time should be that markets are as close to on the money as we can get.
But when we accept markets can be irrational, we can be better prepared to profit from mass hysteria. In next week’s column, I’ll list a few indicators that might tell us when to pull out the psychologist couch.
Evan R. Guido is the founder of Aksala Wealth Advisors LLC, a 2018 Forbes Next-Gen Advisors List Member, and Financial Professional at Avantax Investment ServicesSM. Evan heads a team of retirement transition strategists for clients who consider themselves the “Millionaire Next Door.” He can be reached at 941-500-5122 or email@example.com. Read more of his insights at heraldtribune.com/business. Securities offered through Avantax Investment ServicesSM, member FINRA, SIPC. Investment advisory services offered through Avantax Advisory ServicesSM, insurance services offered through an Avantax affiliated insurance agency. 8225 Natures Way, Suite 119, Lakewood Ranch, FL 34202.
This article originally appeared on Sarasota Herald-Tribune: EVAN GUIDO: Levelheaded investors hope for nutty markets. Here’s why