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Which decides investors’ reactions to financial market questions more: economics or emotion?

Which decides investors’ reactions to financial market questions more: economics or emotion? © iStock

In uncertain times, having a reliable investment discipline to rely on can be very comforting to investors. We are firm believers, however, that over time there are characteristics that are consistent with bull markets and bear market conditions.

The discipline we ourselves follow can be summed up in three basic rules: Don’t fight the Fed. Don’t fight the Tape. And, beware of the crowd. The first two are pretty well established rules among investors and are easy to monitor and measure. It is only in recent years that the notion of investor sentiment and the study of behavioral finance have become more widely accepted.

The idea behind our “investor sentiment” indicator is to objectively measure optimism or pessimism among players in a market. The theory is that at extremes, these measures of sentiment provide good contrary signals. The saying, “Beware of the crowd” warns us to be on guard when too many players are on the same side of a position.

Simply put, when almost everybody is bullish, where will the new money come from to drive values higher? At the same time, the market is at risk of an outsized reaction to any negative change in macro or micro fundamental factors. We look at a number of separate factors to measure investor sentiment, including regularly conducted surveys of individual or institutional investors, and market-based measures like put/call ratios.

These factors, combined with our work on measuring market momentum and economic liquidity, can be helpful for measuring risk and opportunity in markets.

Assuming that investors’ reactions to financial market questions will be based on economics alone can lead to costly conclusions.

In addition to measuring the sentiment of the investing public, understanding a few concepts of behavioral finance can be important in portfolio positioning. Over our many years of dealing with markets and investors of all types, we have found that there are certain reactions that are more indicative of human nature than economics.

This study of behavioral finance has grown significantly over the past several years. It has been said that it is what you think you know about markets that does more harm than what you do not know. Just when players believe they have the obvious answers, the markets have a way of changing the questions.

Assuming that investors’ reactions to financial market questions will be based on economics alone rather than emotion can lead to faulty conclusions that can be costly. One famous experiment, repeated multiple times with similar results, is the following: A person is presented with the proposition of betting on a single coin flip that will yield a reward of $200 if he or she calls the result correctly. A penalty of $100 will be imposed if the guess is incorrect.

The expected value of this proposition is a +$50, so we should assume that the bet is one everyone will accept. The actual result, however, is that the majority of participants reject this proposition, proving the idea that emotion and loss aversion are more powerful than economics. There are other experiments, too, which reveal the impact of such human emotion over economic analysis, proving time and again what economists miss in evaluating markets.

We know from history that over almost every long-term period, stocks outperform bonds and that therefore long-term investors should invest solely in equities in order to get the maximum economic effect. The problem is that the human element interjects itself into the decision, and loss aversion takes hold despite what we know about market history.

Understanding emotion and its impact, then, is important in structuring portfolios that will allow investors to stay true to a discipline and not get caught up in that emotion at the most inopportune time. Beware the crowd!

Tony Maddalena is a wealth advisor with the Wealth Management division of Morgan Stanley in Purchase, NY. The views expressed herein are those of the author and may not necessarily reflect the views of Morgan Stanley Smith Barney LLC, member, SIPC, Morgan Stanley financial advisors engage Worth to feature this article. Maddalena may transact business only in states where he is registered or excluded or exempted from registration, Transacting business, follow-up and individualized responses involving either effecting or attempting to effect transactions in securities, or the rendering of personalized investment advice for compensation, will not be made to persons in states where Maddalena is not registered or excluded or exempt from registration. The strategies and/or investments referenced may not be suitable for all investors. CRC1650715 01/17.

This article was originally published in the February–April 2017 issue of Worth.

Investing and the Economy

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