Reasoning with Investment Confusion

March 24, 2011 at 6:53 pm Leave a comment

Some things never change, and in the world of investing many of the same principles instituted a century ago are just as important today. So while we are dealing with wars, military conflicts, civil unrest, and natural disasters, today’s process of filtering and discounting all these events into stock prices is very similar to the process that George Selden describes in his 1912 book, “Psychology of the Stock Market.”

Snub the Public

Investing in stocks is nowhere close to a risk-free endeavor, and 2008-2009 was a harsh reminder of that fact. Since a large part of the stock market is based on emotions and public opinion, stock prices can swing wildly. Public opinion may explain why the market is peaking or troughing, but Selden highlights the importance of the silent millionaires (today’s billionaires and institutional investors), and that the true measurement of the stock market is dollars (not opinions of the masses):

“Public opinion in a speculative market is measured in dollars, not in population. One man controlling one million dollars has double the weight of five hundred men with one thousand dollars each. Dollars are the horsepower of the markets–the mere number of men does not signify.”

When the overwhelming consensus of participants is bullish, by definition, the small inexperienced investors and speculators are supplied stock from someone else – the silent, wealthy millionaires.

The newspaper headlines that we get bombarded with on a daily basis are a mirror reflection of the general public’s attitudes and when the euphoria or despondency reaches extreme levels, these points in time have been shown to correlate with market tops and bottoms (see Back to the Future Magazine Covers).

In the short-run, professional traders understand this dynamic and will often take a contrarian approach to news flow. Or as Seldon explains:

“A market which repeatedly refuses to respond to good news after a considerable advance is likelely to be ‘full of stocks.’ Likewise a market which will not go down on bad news is usually ‘bare of stock.’”

This contrarian dynamic in the market makes it virtually impossible for the average investor to trade the market based on the news flow of headlines and commentator. Before the advent of the internet, 98 years ago, Selden prophetically noted that the increasing difficulty of responding to sentiment and tracking market information:

“Public opinion is becoming more volatile and changeable by the year, owing to the quicker spread of information and the rapid multiplication of the reading public.”

Following what the so-called pundits are saying is fruitless, or as Gary Helms says, “If anybody really knew, they wouldn’t tell you.”

Selden’s Sage Advice

If trading was difficult in 1912, it must be more challenging today. Selden’s advice is fairly straightforward:

“Stick to common sense. Maintain a balanced, receptive mind and avoid abstruse deductions…After a prolonged advance, do not call inverted reasoning to your aid in order to prove that prices are going still higher; likewise after a big break do not let your bearish deductions become too complicated.”

The brain is a complex organ, but we humans are limited in the amount and difficulty of information we can assimilate.

“When it comes to so complicated a matter as the price of stocks, our haziness increases in proportion to the difficulty of the subject and our ignorance of it.”

The mental somersault that investors continually manage is due to the practice of “discounting.” Discounting is a process that adjusts today’s price based on future expected news.  Handicapping sports “spreads” involves a very similar methodology as discounting stock prices (read What Happens in Vegas). But not all events can be discounted, for instance the recent earthquake and tsunami in Japan. When certain factors are over-discounted or under-discounted, these are the situations to profit from on a purchase or shorting basis.

The Dow Jones Industrial Average traded below a value of 100 versus more than 12,000 today, but over that period some things never change, like the emotional and mental aspects of investing. George Selden makes this point clear in his century old writings – it’s better to focus on the future rather than fall prey to the game of mental somersault we call the stock market.

Wade W. Slome, CFA, CFP® 

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

Entry filed under: Behavioral Finance, Education, Themes - Trends, Trading. Tags: , , , , , , , , , .

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