Don't follow your heart in the market

Following the market is one of the worst ways to make investment decisions, experts say.

Tue, Oct 12, 2010
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Know what drives the market

IT'S A well-known fact that investors love "hot" stocks.

They're always interested in learning about the latest market sentiments, which companies other investors are putting their money on, and chasing stocks that are on the upswing.

But following the market is one of the worst ways to make investment decisions, experts say. Investors miss prime buying opportunities and lose out on good returns, especially if they focus only on the short term.

"Value in the long run is determined by (company) fundamentals, while short-term gyrations reflect market participants' psychological weaknesses, such as herding," Georgetown University accounting and finance professor Prem Jain wrote in his latest book, Buffett Beyond Value: Why Warren Buffett Looks To Growth And Management When Investing.

"Knowledge is the best antidote to making wrong decisions," he said.

Such knowledge applies on a variety of fronts: understanding market psychology, examining the intrinsic value of a stock, and identifying your own buying and selling patterns.

Prof Jain may have highlighted the importance of fundamentals, but he and other experts would add that fundamentals alone do not drive stock prices - investors' emotions also play a role.

Stock prices often move in wild swings, particularly in the short run, because they are driven to a large extent by emotions and human behaviour.

Fear, greed, attachment, overconfidence, denial and optimism drive the market, often without much basis. Most investors also don't have the self-discipline to overcome these emotions.

Market trends leading to booms and busts do not last forever and will eventually reverse. As historical data shows, there are few warning signs for investors to take heed of before the market moves in the opposite direction.

Investors thus need to learn how to spot when emotions and human behaviour are driving stock prices.

They need to look beyond what others are buying and think of a winning strategy instead.

Commit to a strategy

As investors may well point out, it's easy to talk about behaving rationally, but it's immensely difficult to walk the talk

Essentially, investors need to prepare and pre-commit, argued Mr James Montier, author of The Little Book Of Behavioural Investing: How Not To Be Your Own Worst Enemy.

He pointed out that investors can and do control the process by which they invest: They simply need to remove the drivers of forced decisions from their portfolios.

To do that, they need to do their research in a cold, rational state. They must seek out the intrinsic value of a stock, and then pre-commit to following their own analysis and prepared steps of action.

Firstly, an investor might want to evaluate the fundamentals on a combination of fronts, such as the price-to-earnings ratio of the stock, its track record, how conservatively the company is financed, and what makes the stock likely to be worth more in the future.

Mr Montier also pointed out in his book that it's useful to have a "wish list" of companies you believe to be well-run and have sustainable potential, but are priced too high.

Standing orders can be placed with brokers to buy these stocks if, for some reason, the market brings their prices down to bargain levels.

Still, it might be also a good idea to follow Mr Buffett's core investment principle of investing only within your circle of competence, buying stocks of companies whose businesses you truly understand.

Understand your own investment behaviour

Another notable point highlighted by experts is that investors should focus more on the process of investing, rather than on just the outcome, as there are no magical short cuts to being a good investor.

Investors need to understand their own investment habits, particularly where their weaknesses lie.

And this is best done by putting it all down on paper, said Prof Jain.

He encouraged investors to write down the various investment decisions they made, what types of stocks they bought, pinpoint the reasons behind the decision, and separate all the months the market went up from the months it went down.

This would enable an investor to establish if he is a net buyer or net seller during the various months, and whether he may have a herd mentality.

"Systematic thinking will help you determine what you know or do not know, and help to overcome your psychological biases," said Prof Jain.

"Ultimately, everyone has to make judgment calls, but following a systematic approach will help you know when you are making a judgment call."

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If you're interested in learning more about the fundamentals of good investment, turn to Prem C. Jain and Jamies Montier's books, both available at major bookstores here at $49.17 and $35.26, respectively.