Irrational fear, exuberance, are investors' enemies

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An interesting write up by Vasu Menon, for everyone's reading pleasure! Smile

Business Times - 26 Jun 2010

WEALTH INSIGHTS
Irrational fear, exuberance, are investors' enemies


Many lose the courage to sit through a major market correction, resulting in mass selling, which drives prices down and increases losses.

Vasu Menon
Vice-President
Wealth Management
Singapore, OCBC Bank

In a December 5, 1996 speech, former US Federal Reserve chairman Alan Greenspan used the phrase 'irrational exuberance' to warn against unduly escalating asset prices. Hours later, stock markets throughout the world reacted to Mr Greenspan's speech with the Japanese and Hong Kong bourses falling 3 per cent and markets in the United Kingdom, Germany and the United States falling by between 2 and 4 per cent.

The antonym of irrational exuberance is irrational fear, another aspect of irrationality, and sometimes speculative investor behaviour which can result in undue losses.

For example, many nervous and panicky investors bailed out on their investments last year when markets were close to the bottom in the first quarter. As a result, they suffered losses and missed the subsequent strong market recovery which resulted in gains of more than 100 per cent in some instances.

Similarly, many investors who were sitting on cash completely missed the boat, failing to buy when valuations were extremely low and attractive. Even the savviest investor lost courage in the overwhelming pessimism that permeated markets, passing over incredible opportunities.

The point is that in the face of mass market fear, many lose the courage to sit through a major market correction, resulting in mass selling, which drives prices down and increases losses. Many let their emotions drive investment decisions, abandoning long-held investment strategies and research methodologies, thus passing up on investments that they would have seized instantly at any other point in time.

Parallel this to the current Eurozone debt crisis that is roiling world markets. As problems in the Eurozone weigh on investor sentiment and risk appetite, there will be more volatility and possibly weakness in the markets.

However, this is unlikely to be the start of a bear market if investors keep the big picture in mind. Fundamentals and valuations are at reasonable levels, and with the earnings-recovery story in the US and Asia gaining momentum, investors who are sitting on cash and who can stomach the short-term volatility, can look to buck the trend and buy gradually over the coming months.

There are many cases of irrational fear on a personal level as well. Financial analysts have long puzzled over the number of intelligent individuals who are fearful of money matters.

Some of these individuals adopt a head-in-the-sand approach when it comes to money matters, seeking safety and security, and refusing to take risk by investing. The truth is, inflation may often rob your money of its purchasing power. Thus, it is necessary to take calculated risks in order to grow your money.

Some individuals have been burnt by the market previously, and have developed a phobia-like aversion to investing. Oftentimes, they wrongly blame external factors for their monetary losses.

In these cases, the individuals have to calmly assess the reasons for their past losses. It could be that they took on too much risk, being greedy and over investing, thus ending up speculators instead of investors. They could also have blindly followed the flavour of the month espoused by publications and advertisements, or followed hot tips from friends.

Overcoming fear

If any of these apply, then investors can overcome their fear by recognizing that they made a mistake and committing to learn from it. The crux here is that there are no financial shortcuts to success. Conversely, success is very much inversely related to the amount of fundamental research one does as well as having an investment plan with clear objectives and targets and sticking to them.

For completeness, we look at the other side of the coin which is irrational exuberance. Exactly like the Tulip mania, bubbles form because of herd behaviour and the snowball effect. As investors put more and more money into the market, the prices rise sharply. However, if there are little underlying fundamentals to support the price gains, then the bubble can burst just as quickly as it was formed.

A good example of this is the technology bubble in the late 1990s. Internet companies which were loss-making would appreciate exponentially upon listing, simply because they had a dot com extension to their names. At the height of the bubble, even profitable companies were trading at astronomical valuations and when the bubble burst in early 2000, investors who had ignored fundamentals and valuations were severely hurt by the sharp sell-off. Many are still licking their wounds till today.

Another example of irrational exuberance that strikes closer to home is in China where many retail investors chase after 'star value stocks' that their favourite celebrities invest in.

In China's notoriously speculative stock market, irrational decisions can be made based on such 'star value' rather than true value.

Recently, the famous National Basketball Association (NBA) basketball star Yao Ming, who hails from China, was believed to have sparked a share buying frenzy when he announced in March this year that he had invested 375,000 yuan (S$76,800) in Beijing UniStrong, a company making global positioning systems and which was about to list a month later. On the day of listing, the value of the stock jumped some 160 times to over 60 million yuan as investors clamoured for the stock.

Yao Ming's story is one of many in China where celebrities have sparked a phenomenon called ming xing gu (star stocks). Even an actor who plays a financial guru on television has a following of fans that track his every stock pick. The actor, Yu Entai, for example, has made more from announcing his positions in the market and watching them rally as fans rush in, compared to the money he has earned from his acting profession.

Investors should remember that irrational exuberance and fear are their enemies which can inflect severe wounds. Warren Buffet expressed this succinctly in a note to the shareholders of Berkshire Hathaway, warning that 'if they (investors) insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful'.

OCBC shall not be responsible for any loss or damage whatsoever arising directly or indirectly howsoever as a result of any person acting on any information provided herein.
My Value Investing Blog: http://sgmusicwhiz.blogspot.com/
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