IT USED TO BE gospel in academia that markets are rational. Now academics do systematic studies of how loony investors can be. Maybe they can explain the surge in volatility.
It's A Mad, Mad, Mad, Mad, Market
forbes.com
By Scott Woolley
The growing democratization of the stock market is a good thing, right? Individuals can easily access free information and trade cheaply, getting in on the action once reserved for the big shots. The number of households holding stock has jumped from 19% in 1993 to 50% today. Retail trades now account for two-thirds of Nasdaq volume.
But this democratization of trading, and the reduction in frictional costs, has an ominous side. It has sped up the pulse of the market, making wild swings wilder and faster. How do you explain a stock like Hikari Tsushin, see("Rocket Returns to Earth Orbit"), up tenfold in the space of a few months, down by a factor of ten a few months later? Or Certicom, see("Fainting Spells"), whose pre-IPO price dropped from $150 to $50 in two days, with scant change in its prospects?
For decades finance professors have talked about the "rational markets hypothesis," the notion that a stock price accurately reflects all available information about the company's prospects. Many talk differently now. A growing body of academic research--in fields ranging from psychiatry to anthropology--explains market behavior in terms of irrational urges. The Journal of Psychology and Financial Markets, the first academic journal devoted to investor psychology, warns in its March debut issue: "People do not behave as gas molecules," namely as independent actors making individually random movements that are collectively predictable. No, investors act more like herds of agitated animals.
One big question on market psychologists' minds: How will the millions of newcomers to the stock market--the ones who didn't experience the 1973-74 crash--react to prolonged or very deep corrections? We know how they react to short, sharp shocks: They buy on dips. That explains the quick recovery from the August 1998 spill. But what if stocks fell 50% and sat there for three years? A rerun of the 1970s, predicts Brian Bruce, a money manager and former Southern Methodist University finance professor who studied market psychology, will send a lot of folks bolting from the market.
Researchers have also simulated trading with test subjects--ordinary people, not pros. It was like putting the greater fool under a microscope. A recent compilation of 150 such experiments found reliable patterns: Bidding frenzies get going for no other reason than that others are buying. And the ability to buy on margin helps inflate prices. Rather reminiscent of the market's recent tech mania.
One intriguing avenue of inquiry in market psychology: so-called thought contagion. This explains how ideas get transmitted and gain force the more they circulate. Concepts like this may explain fads like Hula Hoops and they may explain some of the outlandish multiples seen in Internet-related stocks. Aaron Lynch, an independent researcher studying the phenomenon, says the Internet (as a communications vehicle) spreads delusions about the Internet (as an investing sector). People who used the Internet a lot, says Lynch, were easily excited by its potential, and acted on wild notions with their investment dollars. They'd e-mail each other or post chat-room opinions about the latest hot stock. Next thing you know, this crowd was pouring money into businesses with little or no profit, like MicroStrategy (at 150 times sales) and Ivillage (at 50 times sales).
Or, as Lynch puts it in academic-speak: "Armed with an enriched concentration of good electronic communicators, the shareholders of Internet companies may routinely outdo the shareholders of other young companies in belief transmission."
The stock that gets talked about on the Net isn't Ford Motor, despite its strong sales and large cash position, ripe for a huge dividend payout. Lynch found that Ebay was mentioned in 5,900 documents on the Web in 1998, Ford in only 1,300.
Here's another market-psych term: recency. That is, the investing public has no historical sense and pays attention only to the most recent events. Remember yesterday's 5% advance? Yeah, let's do it again. Remember the 1997-98 Asia meltdown? Uh, no.
Now, don't think that the new market psychologists exempt professional traders from the ailment of emotional behavior. The pros may know more about the market, but they are heir to human folly as well.
Dr. Richard Geist, a former Harvard Medical School psychology faculty member, just left teaching after 29 years to be a consultant to institutional investors, helping them identify the emotional issues that lead to bad decisions.
One money manager came to him right after she bought a stock for $20 and watched it climb to near $30, then fall back to the low teens. The fall was triggered by a company announcement of a sales force restructuring. She was confident the market was just spooked and that the stock would soon shoot back up. Despite all that, she wanted to sell in the teens.
Why? Says Geist: "One of the emotional convictions she followed is that when something good happens, something bad is sure to follow." Since the stock had briefly shot up, making her feel good, she subconsciously expected the fall, and felt she deserved it. Fortunately, after her session with Geist, she held onto the stock and it rose again.
For sensible investors, the upside of widespread investor irrationality is the opportunities it presents to capitalize on other people's missteps. The bad news: The chances of your acting rationally are very slim. >ggg<
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