Santa Clara University

SCU Today
Going With the Flow Can Backfire

Staff Reporter

May 1, 2005


Grab a company's stock chart and place down a ruler so it forms a line between where the shares traded three months ago and where they trade today. Assume that wherever the line is headed is where the stock is headed. If it's going up, buy. It may not seem like a very clever way to invest, but many investors follow such strategies nonetheless.


Some do so explicitly -- "the trend is your friend" and "don't fight the tape" are old sayings on Wall Street. But what's really surprising is how people invest in this manner unconsciously. The stock market's shaky footing -- the Dow Jones Industrial Average is down 5.5% so far this year despite a slight 0.3% gain last week -- is being blamed on signs that the economy has softened.


Reports on consumer confidence, orders for manufactured goods and gross domestic product came in weaker than expected. But the tendency to unconsciously follow patterns may also be part of the stock market's current woes. When the stocks have been going down, it's easy for investors to read the economic numbers in the worst light, and send stocks lower still.


Market Psychology An example of how stock movements can color views turned up in a survey of professional investors Merrill Lynch conducted in April, which showed that respondents, on balance, felt that stocks were somewhat overvalued. This was in contrast to the March survey, when they felt that stocks were inexpensive. Between the March and April surveys the Dow had dropped several hundred points. The investors had come to the odd-seeming conclusion that, by falling, stocks had become somehow more expensive.


"People extrapolate from whatever happened recently," says Meir Statman, a finance professor at Santa Clara University who specializes in investor behavior. "Stocks have gone down, therefore they will continue to go down. Therefore they are overvalued." Much of this comes down to simple psychology. Humans have an ingrained tendency to find patterns and then assume those patterns will recur. This is generally a good thing because it allows us to figure out how to act when we're faced with new, complex situations. But it can sometimes lead us astray.


Dartmouth professors George Wolford and Michael Gazzaniga and University of California, Santa Barbara professor Michael Miller have designed experiments where participants are asked to guess which of two lights will flash next. The way it's rigged, one of the lights flashes, in a random fashion, 80% of the time while the other flashes 20% of the time.


But rather than figure out that it's much better to consistently pick the one light over the other, people try to find a sequence in the flashes -- and so end up guessing correctly less than 70% of the time. Rats, in similarly constructed experiments, do a better job. The difference in the stock market is that the participants are also the people who are making the lights flash. If some investors see a stock going up and then buy it, it goes up some more. And if that brings in even more buyers, up it goes again.


Moreover, frequently this price momentum, as it is called, makes fundamental sense -- at least to begin with. Say that a particular company's business begins to improve. At first only a handful of investors may figure out that this is happening, or, as is often the case with a company that has recently undergone hard times, only a handful will figure out that the improvement is long lasting.


As more and more investors figure out what's going on, and buy, the company's share price goes higher. But this process of discovery can devolve into something else and people begin to confuse what's going on with the company's stock with the company itself. These perceptions also infect the analyst community and the news media.


A favorite example among some market observers is Time magazine making Amazon CEO Jeff Bezos its Man of the Year in December 1999. Amazon and other dot-com shares began a deep swoon shortly thereafter. The Amazon experience is representative of the allure and pitfalls of momentum investing. When it works -- and it often does -- it works very well. But when it doesn't work, the penalties are often swift and severe.


Now may be a good time for investors to consider whether they have unwittingly let themselves get caught up in momentum investing, because the market may be entering a period when the strategy goes sour. ING Investment Management senior quantitative analyst Paul Bukowski has found that buying stocks based on past price gains has worked best when the overall market has been moving higher and trading volatility has been low.


That's been the general tone in recent years, and one of the reasons momentum has worked. But Mr. Bukowski warns that the markets' recent struggles, plus a rise in volatility, may mean momentum's days are numbered. Choppy trading and market losses are bad for momentum stocks, perhaps, says Mr. Bukowski, because they make people less cocksure in their investing prowess. Here's one strategy that investors can use to check themselves against loving a stock they hold simply because it has been good to them in the past: Imagine if they would buy it now if they didn't already own it.


In doing this they realize that the reasons they bought the stock in the first place are no longer compelling. By the same token, it's important to avoid getting sucked in by the hype surrounding a hot stock, says Michelle Clayman, chief investment officer at New York money manager New Amsterdam Partners. Behavioral Trend "There's a behavioral trend for people to jump on the stock and try to figure out what's going on later," she says.


"But you should figure out what's going on first." This is because it's often easier to invent a reason for having bought a stock than to have a good reason to buy it in the first place. It's also the case that our tendency to look for trends and patterns may lead us to trade and change strategies too often when what we should really do is sit down with a good financial adviser and determine how much money we should be putting where. It's a lot like the light experiment, Mr. Statman believes. "People move from stocks to bonds trying to figure out the system," he says. "And in the end, they end up being stupider than rats."

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