Investment Strategies and Human Behavior

Overreaction is probably the most popularly known effect of human behavior on market prices. All things an existence equal, in a rational market the fundamentals of a worktable should determine its market price, and there should be a empty relationship needle the two. However, research - as well as a aloof glance at CNN's stock-ticker on any given day - shows that this relationship doesn't necessarily happen as expected.

Investors regularly overreact, often wildly, so pushing prices up too high or pushing them down too low in opposition to their fundamentals. Not only is the market, therefore, not wholly rational in reality, but the effect cannot be ascribable to any financial or company-based factor. The most likely reason for the differentness appears to be the way investors perceive, and react to, earnings surprises or news items, or indeed other investors' actions. This overreaction occurs fronting the stockmarket and gives rise to several investment strategies.

Contrarian Strategies

The overreaction effect is highly pronounced when analogy 'out of favor' (contrarian stocks) in preparation for current 'favorites', or what are also known as value and glamour stocks. 'Out of favor' stocks are not stocks that are bad quality stocks, simply ones that are not lovely to the market, for whatever reason that might be. The interesting thing is, however, that over time the 'out of favor' stocks will, in general, outperform the 'favorites'. Then, when the 'out of favor' stocks wax the 'favorites' due to increased buying the effect is reversed and the process is repeated in a cyclical manner, while only minor changes may take place to the stock's fundamentals. 'This occurs,' says David Dremen, who researched the effect with a portfolio of stocks over a ten year period, 'because these stocks will tend to reverse over time as investor expectations change'. Premiums paid for high growth stocks reconvert too expensive while 'out-of-favor' stocks begin to represent greater potential gains. The effect is reminiscent of regression to the mean, a statistical effect where measurements will tend towards their average, and is in fact nothing new. Scientists have known for several hundred years that this kind of effect often occurs when human behavior is involved. What is new is that the effect has been found to occur within a particular domain of stocks.

Whether a stock is an 'out of favor' or 'favored' stock is indicated by their ratios. According to James O'Shaughnessy, whose extensive and well-researched findings were published in What Works on Wall Street, these include: price to book value (P/BV), price to cash flow (P/CF), and price to earnings (P/E). Stocks with the lowest ratios have the most potential to rise, particularly on good news surprises, and are therefore the ones, from this contrarian perspective, that should be sought after, providing they are essentially good stocks.

Momentum Strategies

Contrarian investing would seem to indicate that making money in the stockmarket, over and else the smaller but consistent returns from well-known companies like Microsoft or IBM, requires marketing only 'out of favor' or value stocks. However, this is not the case. Indeed, if one were to take this to its logical conclusion no one would buy rising stocks - that were on their way to delicate glamour stocks - and profitable opportunities would be missed. In addition, value stocks take an standard of five years to show a worthwhile return. intelligibly that is often unacceptable and research bears out, in fact, that momentum pushes many stocks towards new heights regularly, and money can be made on these stocks considerably faster than five years. This doesn't mean that you simply buy any stocks that are rising away from their rational price due to market or behavioral influences. Such an approach would be unsystematic and likely to result in a loss. Although, as Robert Vishny points out, 'You don't necessarily make money on the best stocks in the market but on the stocks everyone thinks are going to be the best'. The rider here, of course, is that you still need to buy stocks that are good or potentially good, even though they may not be the best. Inasmuch as this is true, and you can locate these stocks, there are two momentum strategies that can be implemented.

The first strategy applies to combinations of stocks, and makes use of what is known as the big stock effect. Research on portfolio returns by Andrew Lo and Craig Mackinlay, using a mixture of small and large stake companies on the New York Stock Exchange, showed there was a correlation needle one weeks return and the next, where close ten-percent of the price change over of next weeks return could be predicted from this weeks return. Though the effect only works for portfolios, not for individual stocks, and only in the short-term - that is, daily and weekly returns - there appears to be an observable lead/lag pattern. Which means, big stocks lead little stocks, hence the name. For example, Microsoft goes up dramatically and a few days later there’s a price jump in other computer software manufacturers.

Consequently, purchase second line stocks - mid caps and small caps - in a sector believed to be ready for a re-rating sometime in the near future, and then sitting on the investments patiently, can work very well. Though money can be made here purely from momentum effects, my preference is for a portfolio that’s financially sound and less likely to be buffeted at close quarters by volatility once it moves. In other words, you are pitting your wits for market sentiment, where investor perception solo has decided these stocks are unfashionable, not in contact with fundamental financial determinants and economic realities.

The second strategy relates to Professor Joseph Lakonishok's intriguing findings which show that high momentum stocks - as measured by their previous six months gains - outperform low momentum stocks by 8 percent to 9 percent during the following year. Hence, buying high momentum stocks can prove to be unique useful method for increasing portfolio returns. Again, though, the rider is that you still need to buy stocks that are good or potentially good.

Joseph Lakonishok and his colleagues, finance professors Andre Shleifer and Robert Vishny, don't just come up with interesting visionary ideas. They run LSV honour Management, where they put into practice many of their research discoveries. Generally, they tend to avoid expensive growth stocks that have been given the momentum tag. Instead, they use momentum signals - such as increased sensitivity and volatility to earnings reports or news announcements - to reveal value stocks that are just beginning the upward phase of their recovery. This is not an easy method of portfolio formation, timing and stock way of escape are crucial, but just like the professors, you'll find it a lot simpler if you have a specialized computer program!

Earnings Surprise Strategies

As far as momentum stocks are concerned, the trick in forming a portfolio is in using accurate measures indicating the stock is starting its rising phase. This can be somewhat harder than it first appears, even with a specialized computer program. Nevertheless, besides looking at the stock's past six months gains, earnings surprises may also be used as the deciding factor for stock selection.

One way of ranking the earnings surprise, suggested by the work of Victor Bernard and Jacob Thomas at Columbia University, is by measuring the surprise to analyst's expectations. If the surprise is not only positive but exceeds analyst's expectations there is a greater likelihood of it a potential winning bidder for your portfolio. However, it needs to be remembered that it isn't usually discernibly what constitutes a useful positive earnings surprise, especially when it is considered whether the earnings can be maintained or repeated in the future. One swallow doesn't make a summer! Has the muster revolutionary at all?

Earnings surprises can also be flamboyant negatively in the market by analyst's evaluations and this prompts overreaction in the extreme, which yet provides another useful strategy. For example, Intel dropped a hugely excessive 20 percent in three days when it had reported stronger second quarter earnings in 1995. These though came in at 4 percent under analyst's expectations, which was, behaviorally speaking, the impetus for the drop. A change-around was inevitable though as earnings continued to grow. By the spring of 1997 Intel's stock price had in effect tripled. Anyone knowledgeable most the company, rather than following the investment crowd, would have made money in this situation.

A similarly striking example concerns Hewlett Packard, and it also serves to emphasize just how extreme investors' reaction to news releases can be. Exploiting this overreaction once contra leads to a profitable investment strategy. In September 1992 the company announced that earnings would be next analyst's expectations. By the next day, the price had plummeted 18 percent. This reaction was totally irrational and disproportionate. In real terms for an expected reduction in earnings during the following year of a few million dollars the company's market valuation had plummeted in twenty-four hours by 3.5 billion dollars. Needless to say - if you've followed the thrust of this inform against so far - it won't come as a shock to know that within three months the price had fully recovered and then some.

With a profound insight into these types of behaviorally based pricing anomalies, born out by his success, and taking the view that a good investor doesn't need to be constantly trading, Warren smite put it well when he said, 'Only look at the market to see if anyone's done something foolish that day on which you can capitalize'.

Merger Strategies

Another way to make use of overreaction that institute pricing anomalies is to exploit certain types of merger situations. For example, in 1907 an bond of matrimony was made between Royal Dutch Petroleum and Shell Transport. These two companies acquiescent to merge their interests on a 60 to 40 percent right but remain independently incorporated in Holland and in England. As things stood in the early 1990's, RDP was trading primarily in the US as a constituent of the S&P500 and Shell was trading primarily in the UK as a constituent of the FTSE100 (Financial Times Stock Exchange One Hundred index).

Even permissive for the passing of the years, a rational market dictates that the two parts of the cartel should trade in the same, or similar, ratio of 60 to 40. Yet, recent research has highlighted that this was not the case; stock prices of the corporation did not reflect this ratio. On the contrary, according to humble for tax, transaction costs, and foreign exchange differences, the present price ratio RDP and Shell had deviated from the expected ratio by generally speaking 35 percent.

Human behavior is after all at work to warrant the effect, which, in a backwater from dealing in the most potentially profitable part of the company's stock, can also be exploited with an arbitraging approach. The strategy is long-term perhaps but for mutual funds or hedge funds it can be an ideal method of investment.

Apparent High Risk Strategies

An self-deluding high risk strategy involves dealing in investments that are considered as needing an extremely wide roads as they will lead to heavy losses. The rationale for this strategy is that misinformation, a lack of knowledge helter-skelter the investment, or market pressures, are influencing investors thinking in some way and leading them to overreact. Successful implementation of the strategy involves overcoming these factors and rationally examining the proposed investment.

Junk yoke are one example here. These are high yield restraint with low ratings by credit agencies, ie issues rated BB or lower. The general perception of these, strengthened by the media coverage surrounding Mike Milken and Drexel Burnham in the late Eighties, is that they are very bad and therefore exceptionally risky. But is that perception justified or is it otherwise case of investors overreacting to the information they hear rather than making their own considered assessment? The fact is these pillory are still near enough to so someone is marketing them - in ultimate truth $178.45 infinity worth was issued during the five years ending in 1996 (source: Securities Data Co.). Indeed these individuals may well have based their dealing decisions on a variety of reports and studies that demonstrate the high performance of these straitjacket under the imitate conditions. Notably that low grade bonds on wonted yield 50 percent more than high grade ones and that defaults were not substantially larger (the Hickman report looking at data from 1900 - 1945); that the default rate, harmonic to T. R. Atkinson, was undoubtedly 0.01 percent from 1945 -1965; and perhaps most convincingly that even when the default rate rose to needle 0.015 percent and 0.019 percent by 1981, on a yield premium of 4 percent the risk was highly acceptable. What this meant was that the possibility of a gain was over twenty times more likely than against the potential loss on the default. But in the bastard mindset of most investors there wasn't any what might be of a sure gain. Faced with the possibility of what they believed were greater gains elsewhere in the market, and as prospect theory developed by Daniel Kahneman and Amos Twerski predicts, investors steered unadulterated of this opportunity in favor of what they undoubted were safer stocks, such as the upcoming glamorous Microsoft and Yahoo! The irony is that many investors would later get scorched on these stocks as their ratings shot through the roof and then see-sawed.

Junk bond are not for everyone, and to be sure not for the novice; they take a high level of knowledge to trade them successfully, they need to be in a diversified portfolio, and they need to be good quality, which many still aren't. But what this strategy demonstrates is that there are many investments that on cemented scrutiny are safer than first appears. Human behavior, overreaction, overweights the importance of extraneous information such as media hype and expert opinion, stopping investors from giving junk bonds or similar perceivable high risk investments reflective consideration on their own merit.

A New Wave of Strategies

While overreaction can be exploited with a variety of strategies, as we've seen, so far overreaction is itself difficult to measure as a impulsive factor in determining price anomalies. Knowing this would give us a highly effective strategy. But, the scientific jury is still out on what exactly constitutes overreaction. We know what effect it has but what positively is it? For example, is it a market based or individual investor based effect, or both? Can we know previously we see its effects that the factors that promote it are in evidence? Attempts at using a measure have produced mixed results, as ABN AMRO have found with their behavioral finance fund which has lost upwards of 27 percent since inception. Much work needs to be done in advance of we fully understand how human behavior functions in the context of the stockmarket.

There is little doubt that a knowledge of human behavior can improve our money-making odds when investing. Behavioral finance specialists, though, have only just begun to scratch the surface of new strategies with a systematic corridor to understanding the processes involved and appropriate the findings. Many more useful strategies are likely to materialize in the next few years. The field itself is only about fifteen years old, a newcomer in the financial arena, and one that is only now beginning to show its worth.