The psychology of investing – Cover story
Asset prices are all about fundamentals. This is a clear truism of investment. Leading business schools teach this as a core and unquestioned principle, with those learned types filing out of said business schools to scurry off into the City to imple- ment all their wise knowledge at asset manager firms. But what if it this is a house built on sand? What if there is something else that contributes to asset pricing and market outcomes, which has little to do with fundamentals, but instead is all in the heads of investors? That is to say, it is the mind that shapes investment. Howard Marks, author of Mastering of the Market Cycle, takes a psychological approach to investing. His contention is that the market is highly psychological, and market swings are usually created by behaviour rather than fundamental analysis. “The most important thing they do not teach you in business school is psychology,” he says. Highlighting why this is important, he gives a potted history of investment: “If you go back and look at a graph of the [US] economy in the past 50 years, it has an upward trend and modest divergence from the trend.”
A volatile mind Marks says that if you analyse company results over the same period, they go up and they go down, but more sharply. “If the economy is up 2%, profits go up 10%. If the economy is up 20%, profits go up 30%. And if the economy is down 2%, then for a typical company profits will be down 15%, and so forth. “So the graph of profits is much more volatile than the graph of the economy,” he adds. “And then if you look at a graph of the stock market it is up and down. Why? What is the differ- ence? The difference is psychology.” And when it comes to investment, the picture becomes compli- cated due to this psychological factor. “People rarely do what they are supposed to do,” he says. “Often they react in the extreme to events that develop. And that extreme reaction causes extreme volatility. Sometimes they do not overact at all, and sometimes they do not react as they should.” Marks’ view, a bit like his political namesake, appears quite rev- olutionary. His observations suggest a need for investors to understand markets from a psychological perspective. He goes further, citing physicist Richard Feynman. “Physics would be much harder if electrons had feelings.” Marks adds that people have feelings and people rarely do what they are supposed to do. “They often react in the extreme to the events that develop and those extreme reactions cause this extreme volatility.”
Taking a short cut
Therefore, the human dimension is, inevitably, always shaping the face of investment.
Issue 115 | July–August 2022 | portfolio institutional | 19
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