By ADRIAN LOWCOCK 16/10/2008
The UK has only experienced three recessions since the second world war and on each occasion markets rallied strongly the year after (1975 +142%; 1982 +29%; 1991 +20.7%). This highlights the extent to which equity markets look ahead of the economy and bad news is factored in early on. In trying to avoid losses in the short term, investors may well miss out on the significant rebound of the market and end up being behind the curve for any recovery.
The predominant economic and financial theories are based on the assumption that individuals act rationally and are able to absorb all available information when making an investment decision. This is a big assumption, and indeed researchers have discovered this is frequently not the case. Dozens of examples of irrational behavior and repeated errors in judgment have been documented in academic studies over recent years. As with any academic field there are several theories out there, below we list some of the main ones.
Regret theory
This is people's emotional reaction to having made an error of judgment and can occur when buying a stock that has gone down or not buying one they considered, which has subsequently risen. In these instances, investors may refuse to sell the holding that has fallen to avoid the regret and admitting they have made a mistake. Likewise, where they missed out on the rise of a holding they had considered, they may also find it easier to follow the crowd and buy it at the higher price even if it is not rational. If it subsequently goes down, it can be rationalised as ‘everyone else’ owned it. Going against conventional wisdom is harder since the possibility of feeling regret if decisions prove incorrect, is increased.
Prospect theory
This theory suggests that people suffer from loss aversion, which means they are willing to take more risks to avoid losses than to realise, gains even when faced with a sure win, most investors are risk-averse, but faced with a loss, they become risk-takers to try and recoup the losses quickly. Essentially people set a higher price on something they already own than they would be prepared to pay to acquire it.
Anchoring
Anchoring is a phenomenon which, in the absence of better information, investors will assume current prices are correct. Therefore in a bull market, each new high is 'anchored' by its closeness to the last record and its more distant history increasingly becomes an irrelevance. People tend to give too much weight to recent experience, and use recent trends to justify valuations which are frequently at odds to long-run averages and probabilities.
Over- & under-reaction
The consequence of investors putting too much emphasis on recent news at the expense of other data is market over- or under-reaction. Individuals show overconfidence, they tend to become more optimistic when the market goes up and more pessimistic when the market goes down. Hence, prices fall too much on bad news and rise too much on good news. In certain circumstances, this can lead to extreme events, and ultimately investors end up doing the reverse of what is best investment practice by selling low and buying high.
The Professional Investor
So do professional investors behave differently than individuals? There is evidence to suggest they do, because they are agents acting on behalf of the 'ultimate' investors. For example, professional investors do not have any emotional attachment to an individual holding. They do not suffer from panic selling or risk aversion. As such in the current climate profession investors will look at the underlying fundamentals of the investment and determine if there is an opportunity there. When they Identify weakness they will take advantage by investing.