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Part 1

Investor Psychology 200

“A bull market shouldn’t be described as a percentage price movement. For me, it’s best described by what it feels like, the psychology behind it, and the behavior that psychology leads to.” -Howard Marks

Lions and tigers, bulls and bears, alpha and beta, oh my. Much of the market vocabulary and key investing concepts that regularly are thrown around can confuse the uninitiated and those who are “green” in the world of markets. As Mr. Marks points out above, while there is a technical definition of a bull and bear market (20% gains or declines in either respective direction), the psychological character of the market is perhaps a more important determinant than some arbitrary level of gains or losses. Bull markets are marked by optimism and the Fear of Missing Out (FOMO), leading to forced liquidation. Bear markets are characterized by pessimism and declining economic prospects. The market is in a bull market most of the time, and they tend to last longer and produce more returns to the upside than bear markets result in to the downside.

Investor Psychology 200
Source: First Trust

This forced liquidation, or essentially panicked selling, tends to bring asset prices irrationally low which then entices discerning investors to start purchasing again. As the prices improve, it can often signal to other investors that things aren’t as bad as the panic suggested. As prices rise, more and more investors begin to feel that recent history will continue repeating itself and so buy as asset valuations continue to appreciate, sometimes to levels unjustified by underlying cash flows.

As the expectation becomes ubiquitous that times are good, the risk of the whole process starting over again rises. Sometimes, an exogenous shock like COVID-19 can knock markets off their kilter, or sometimes investor ebullience naturally resolves itself when no more buyers are left. Then comes the forced liquidation that resets this delicate psychological dance. While analysis at the security level is critical, analysis of markers of where investor psychology is can be equally crucial in determining whether it’s time to buy or sell stocks.

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Buy low, sell high. Sounds easy, right? Only it is not. Investors behave in strange ways that often defy logic, and if you think markets are easy and can’t understand what all the fuss is about, you might be right on the verge of being humbled. The market routinely bests even the Wall Street Pros. You might hear about this year’s hot hedge fund or portfolio manager that is outperforming the market by however much percent. The odds are that they will be trailing the market level of return in the next year or two. A sizeable intellectual contingent of academic and financial thinkers believes that beating the market over time is impossible. The numbers somewhat vindicate them but don’t explain the cream of the crop of active managers who have outperformed the market successfully over time.

Investor Psychology 200
Source: Dr. Paul Rodrigue, Hoffstra University

Prolific investment theorist Benjamin Graham famously described the market as a voting machine in the shorter term while describing it as a weighing machine in the longer term. Since the S&P 500 was introduced in its modern form in 1957, it has returned an average of 10% a year. However, in only six of those years was, the annual return between 8% and 12%. This means there’s massive divergence in returns every year and that most of the time, the annual returns will most likely be far from the long-term average in either direction.

Buying low and selling high is deceptively straightforward advice, kind of like “just hit the ball straight at the hole and get there in as few strokes as possible” is definitely sound advice in the game of golf. Achieving such an outcome is infinitely more complex. As in golf, investing is simultaneously a game against opponents and yourself. Your score is kept in relation to the score of other golfers, but if you don’t master your temperament and discipline, you might end up hacking up the fairway and scoring double digits on a par three.

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Many things can lead to investors making poor decisions. However, before understanding how to score well, we must understand a few basic concepts that are crucial to understanding how people keep score in investing. We will then walk you through some critical ways investors score poorly compared to others. Mastering the concepts of investors’ psychology is an intellectual house of mirrors but learning how to spot the folly of the crowd, or whether you even want to compete with it at all, can significantly lower your stress and help you get better returns. Remember, while every time has unique catalysts and factors that drive markets, the perennial presence of irrational investor behavior is also always a factor at play as well.