Mapping Investor Behavior...

posted Dec 2, 2013, 11:36 AM by Unknown user   [ updated Dec 2, 2013, 11:37 AM ]

Recognizing that investors and, in fact, society in general, have a propensity to act in a certain manner during particular periods of a cycle is indispensable information. Concerning the markets, if there is one thing known for certain, it’s that investors buy and sell based on the most primal of human emotions, fear and greed. To accept this notion is to recognize that both generational (long-term) and transitional (intermediate-term) psychological behaviors are a considerable influence on the driving force of these cycles and trends. In this paper we have collected data with assessments based on the behavioral finance disciplines.

Some behavioral analysts believe there are only four stages of investor psychology, while others designate as many as 12 to 14. We refer to this as Fusion Analysis. Fusion is a rule-based systematic method of deciphering a mass amount of data from multiple analysis disciplines. In this case, it is the combination of Fundamental, Technical, Behavioral and Quantitative Analysis. Our analysis is predicated upon our opinion that the larger ‘generational’ cycle (Secular) has only four, while the intermediate-term ‘transitional’ (Cyclical) encompass all 14.

The rationale behind the differentiation is the belief that generational memory is more ingrained and is therefore a more difficult stance to alter. The generational beliefs correlate to TAM’s perspective on ‘Straight-Line Thinking,’ whereas the transitional beliefs correlate to the ‘Herd Mentality.’ With generational psychology (5-10 years) focused on the primary conditions of optimism, euphoria, hope, and despair, the transitional cycle psychology (1-4 years) is much more defined and captures the general emotional state of investors through the four phases.
Generational (Secular) Cycle Psychology:

1) Optimism Bull

2) Euphoria Bull-Neutral (volatile idleness)

3) Hope Bear

4) Despair Bear-Neutral (volatile idleness)

Over the last few years, there has been some interesting, yet humorous, behavioral analysis done on what TAM’s 100-Year Market Theory (100-YMT) deems transitional (intermediate-term) investor psychology. The following is a compilation from multiple sources, plus some personal authoring liberties.

Transitional (Cyclical) Cycle Psychology:

1) Optimism

“Things look okay, I think I’ll invest”

2) Excitement

“I’ll get fully invested”

3) Thrill

“I should use margin and make more money”

{Shift to a shorter time frame}

4) Euphoria

“This is easy, I’m a genius”

5) Complacency

“I’d better pay closer attention and do more research”

6) Anxiety

“Everyone is in the same boat, so I’m okay”

7) Denial

“It’s okay, I’m a long-term investor”

{Shift to a longer timeframe}

8) Fear/Desperation

“I can’t sleep”

9) Anger & Bargaining

“Why Me?”

10) Capitulation

“I’m selling everything”

11) Despondency

“This is hopeless”

12) Depression

“Now what do I do?”

13) Hope & Reflection

“What’s going on – suckers rally?”

14) Relief & Acceptance

“It looks as if I was wrong about the market” (final psychological step)

Back to ….. Optimism

“Things look okay, I think I’ll invest”

Straight-Line Thinking (SLT) is a rather modest concept with immense repercussions. SLT is a persona – or better put, a mindset – which is extremely difficult to alter. It is a complete paradigm shift which alters one’s foundational thinking. SLT is created in one of two ways: A) ‘Memorial Permanence’ or B) ‘Shock and Awe.’

The first, memorial permanence, occurs when a specific scenario has been set for an extremely long time (10 plus years) and the conscious memory cannot recollect any other way than the way it has been. It is when an individual unconditionally and wholeheartedly believes in status quo; something that has become ingrained into one’s subconscious.

Common financial examples include such things as…

“Invest for the long haul.”

“You can’t time the market.”

“Buy and Hold; it’s the way it’s always been done.”

“It’ll work out, it always does.”

This is memorial permanence; not ever knowing any different and believing it to be so.

The second SLT is ‘shock and awe’ and is better explained through an example from the first Edition of the 100-YMT.

‘My Grandfather, Rocco, was born in 1911 and 94 when he passed in 2005, God bless him. At 18 the Great Depression hit. 18 in 1929 was a whole lot different than today: full-on family responsibility as a workingman and he was just that, a hard-working man. He was at the age where susceptibility of surroundings had the ability to shift paradigms, and not only generationally, but permanently.

When you are a few years from 20, staring at mile-long bread lines, hoping every day for a job, wondering if the bank(s) will open tomorrow, and for 3 plus years praying that the end of this debacle is around the corner, it changes something inside of you, way deep down in your soul.

After he passed, I was helping my grandmother clean out the freezer in the basement and voila, there it was. A green tin box with a small silver key latch was hidden in the back below the frozen leftover baklava. The box was full, to the point of nearly not being able to close, with thousands of all-mighty greenbacks. True Story. Did he miss opportunities because of his straight-line thinking? Yes. Did he care about the 1933 Banking Act FDR persuaded Congress to pass once he was elected? No. His mind was set! ‘You can’t trust the banks so you might as well keep it in the freezer.’

And there it was, as plain as day: SLT at its finest. For some, like the previous example, it will never change, for others it requires another event or a period of time where they will no longer remember what once was and begin to learn the new status quo. Conversely, the shorter-term psychology (transitional/herd) continues to go through its cycles regardless of the generational overtone. As time passes, dependent on the extreme nature of the generational period, it begins to shape, affect, and shift the longer-term paradigm.

When evaluating the smaller Transitional (cyclical) behavioral patterns, it’s important to remember behavioral finance is a broad-based analysis designed to ascertain massive waves of commonalities, not nuances. It is the masses, not the select few, which move mountains, hence the ‘herd’ analogy.

The easiest way to put a finger on ‘Herd Theory’ is the old adage of ‘success breeds success’ or ‘keeping up with the Joneses.’ The challenge is, the longer this monster’s tail (number of conformers), the less knowledge is being employed behind the decisions being made. “Somebody must know something I don’t. Let’s go with it anyhow.” Eventually there is a turning point in which the conformers begin continually to make bad and careless decisions until… until… until… there is no one left standing. The apex is widespread far-reaching hubris and irrational behavior, squashing the Efficient-Market Hypothesis theory of… “Financial markets are rational and efficient.”

Mass conformity, for the most part, reduces investors’ stress as there is comfort in the crowd. Oddly enough, this placates negative acceptability as losses soon become excuses based on collective belonging. “It’s okay because everyone is in the same boat.” Human nature is to do what ‘feels’ best or is ‘easily’ accomplished. Truth be told, the right decision is usually the hardest to make. This is precisely why the Pareto Principle – the 80/20 rule – differentiates the haves from the have-nots. Or better said, 80% of the returns come from 20% of the decisions.

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