Financial Happenings Blog
Wednesday, May 11 2011
Dr Shane Oliver is the Chief Economist at the AMP and is a regular commentator on the economy and its implications for investors. I do not always agree with his conclusions but I do think he is able to clearly articulate economic theory.
His latest contribution is an explanation of investor behaviour in an article written for the ASX - Why markets are irrational
You may think that it is strange that I refer to this article as this firm's investment philosophy is seemingly built on the backbone of the efficient market hypothesis and Dr Oliver clearly does not believe in this theory. However it is not that issue that I think is most useful in this article, it is rather the explanation of investor behaviour and concepts such as irrationality, the madness of crowds and why bubbles and busts occur. Dr Oliver, as do I, believe it is crucial for an investor to understand these concepts and act accordingly.
The concluded implications for investors from the article are:
The approach taken by this firm is focussed on points 3 & 4, getting the strategy right from the outset and remaining disciplined to that strategy. A major reason for this approach is to protect clients from themselves and letting emotions dictate decisions. If you can achieve this discipline around a strategy developed on strong principles you are streets ahead of the game.
- Understand emotions. Investors need to recognise that investment markets are not only driven by fundamentals, but also by the often-irrational and erratic behaviour of an unstable crowd of other investors. Also, not only are investment markets highly unstable, they can also be highly seductive. Be aware of past market booms and busts, so when they arise in the future you doe not overreact – piling into unstable bubbles near the top or selling everything during busts and locking in a loss at the bottom.
- Consider how you react. Recognise your emotional capabilities. Be aware of how you are influenced by lapses in your own logic and crowd influences. An investor should ask: “Am I highly affected by recent developments (positive or negative)? Am I too confident in my own expectations? Can I bear a paper loss?”
- The right strategy. Choose an investment strategy that can withstand inevitable crises while remaining consistent with your financial objectives and risk tolerance.
- Discipline. Essentially stick to your broad strategy even when surging share prices tempt you to consider a more aggressive approach, or plunging values might suck you into a highly defensive approach.
- A contrarian approach. Finally, if tempted to trade, do so on a contrarian basis. Buy when the crowd is bearish, sell when it is bullish. Extremes of bullishness often signal market tops, and extremes of bearishness often signal market bottoms. But contrarian investing is not foolproof – just because the crowd looks irrationally bullish or bearish does not mean it can’t get more so.