Recently I wrote an article here on Seeking Alpha regarding the impact that a better understanding of behavioral economics could have on one's portfolio. As a result of that article, I received a series of private messages; all of which maintained a similar theme. Readers of the article wanted to know, in more specific and instructional terms, what steps they could take as individuals to improve the investment management techniques that they employ. Instinctively, I set out to reply to each of the messages as best I could. About halfway through the first response, it struck me that I was engaged in a fool's errand. I immediately began to rethink my approach of offering a timely and satisfactory response to each individual request.
The fact of the matter was, and remains to be, that from a behavioral finance perspective, addressing individual portfolios, one by one, would require a detailed and intricate understanding of each individual's personal methods, objectives, tendencies, and beliefs. It would require a thorough disclosure of their previous failures and successes in the markets, as well as a full behavioral analysis of what they have done in the past and why it needs to be corrected moving forward. Generally, these types of reports are done for institutional investors, and require an inordinate amount of time to prepare, put together, and present. Completing this task for a handful of individual investors, whom I know very little about, while utilizing only a web-based communication platform, would have been all but impossible.
Hence, I elected instead to write this article. My objective here is simple. I want to address the most common questions asked of investors with an interest in behavioral economics. Ideally, I will meet this objective in such in a way that the concepts presented are both easy to understand and put into action. It will be presented so that all investors, from novice to expert, are capable of following the subject matter.
A Brief Message to All Readers
This article will not be able to address every question or inquiry that every type of investor may have. Therefore, I intend to employ an approach that will serve to be relevant to the majority. To those of you on either extreme of the bell curve, who may not see their specific conundrum addressed herein, I can only hope that some areas addressed in this article serve you with some level of reassurance, satisfaction, or benefit.
Undoubtedly, we've all heard the expression "if you can't beat 'em, join 'em.''' Like many popular colloquialisms, this phrase can be successfully applied to a diverse array of circumstances. In this case, we're going to use it in reference to the ongoing challenge for investors to out-perform, out-pace, and out-think the market. Admittedly, this presents a daunting task of the highest degree. So our objective isn't as much to "beat 'em" but rather to "join 'em.'' We want to think like the markets act. We want to put into action numerous strategies that will allow us to be proactive instead of reactive. We want to be successful in foresight, as opposed to regretful in hindsight. Essentially, we want to better gauge what the markets will do, as opposed to being subject to the consequences of what they have already done.
With that being said, let's define, and offer solutions for, a few popular circumstances that every investor has, or is certain to come in contact with.
Man Versus Market
Each of the following three scenarios will be identified and addressed individually.
The Thrill of the Chase
Momentum is a dangerous, albeit essential, catalyst for investors. Investors can react to it, create it, or even crumble under it. It is a powerful, if not simple, instrument of the market.
In all likelihood, each one of you has encountered the "momentum monster" on various occasions. More often than not this momentum has caused you to react in one of three ways;
First, there is the "I knew it!" reaction. At some point, before the stock started its upward surge, you had said to yourself numerous times "I bet this thing is gonna fly" but failed to act based on either fear, lack of resources, or a miscalculation of the timeline.
Secondly, there is the "this must be the one I've been waiting for!" reaction. In this case, the hype, attention, and coverage of a stock prior to, during, and in the aftermath of the jump, have convinced you that this particular equity must be "the one." As a result, you leap in with both feet hard, fast, and lacking in your own satisfactory due diligence.
Lastly, there is the "this train's leaving the station!" reaction. Here, you ignore the perils of buying at a peak, or even a 52 week high. You are convinced that even if you're the last guy on the train, that the benefit is just in being on board. You want to be on this stock, in part, simply because so many other people are on it already. You think to yourself, "all these people can't be wrong."
No matter how you ended up there; you're there. You're following momentum, and this is what is called "the chase." You are now chasing profits without even having a full understanding of how it all started. Was the catalyst that initiated this run legitimate? Does it appear to be short term? Could it be long term? Did it arise from earnings, a press release, a recent SEC filing, or indicators on a chart? Does the catalyst, and its potential results, match up with your ambitions? In other words, are you a short investor looking at short-term catalysts for short-term gains? Are you a long investor seeking out promising indicating catalysts for tempered growth over time? In the moment, none of that really matters (although it always should), because you're now "chasing."
While sometimes chasing can serendipitously lead to profits, such events have proven to be the exception and not the rule. So if you're going to chase, the objective should be to chase intelligently.
For the purposes of this example, let's examine the recent activity of the micro-cap biotech stock Biozone Pharmaceuticals (OTCQB:BZNE). This example is not intended to be an indictment of, nor an endorsement of, the company itself. It is being used here because its 30 day activity simply offers an applicable example for the purposes of this article. Biozone has recently had multiple catalysts, increases in daily volume, and a running momentum. Take a moment to review the chart below;
As can be seen, I have labeled points A, B, C, D, and E. Point "A" is to be considered the first catalyst. It occurred on September 26. It was largely due in part to a popular Seeking Alpha contributor who wrote a quality article on the company in question. Over the next few days, volume soared, and the price ran from a PPS of .52 to a PPS of .79 (indicated by point "B" on the above chart). That run represented a growth of 66% in an extremely minimal timeframe.
However, all short-term catalysts tend to have short-term results. Once the momentum slowed down, the stock price began its inevitable return to equilibrium. The point here though is that what tends to happen in the marketplace, especially with micro-cap and small-cap equities, is that the post-catalyst price, when dealing with short-term catalysts, tends to return to a point below the pre-catalyst price during the correction process. Thus, please direct your attention to point "C" on the above chart.
In less than two weeks, from September 26th to October 7th, the PPS moved from .52, to .79, and then dropped as low as .45. Point "C" was proven to be lower than point "A."
Those two weeks could have easily represented ample time for an investor potentially interested in Biozone to conduct due diligence on the company. This decision could have been pivotal. For those who simply chased the momentum as a result of the short-term catalyst, they would have been buying at a price of between .52 (Point "A") at the time of the catalyst, and .79 (Point "B") at the short-term peak. As the inevitable decline began between September 30th and October 7th (Point "C"), the momentum chaser would have lost money, assuming they maintained their position into the first week of October.
In the event however, that an investor had seen the momentum as a reason to investigate, as opposed to invest, they could have taken advantage of the market's typical short-term catalyst behavior. Knowing that when dealing with short-term catalysts, the best time to buy is at the post-catalyst dip would have been advantageous for prospective investors. The investor could have potentially procured a position in the company at a PPS of .45 (Point "C"), as opposed potentially, to at its peak of .79 (Point "B"). That is a savings in price per share of nearly 50% simply for exercising patience over impulse, and understanding the typical behavior of the market.
As can be seen on the above chart, the pattern repeated itself again at points "D" and "E". The catalyst at point "D" was an 8-K filing posted on October 17th, which led to a spike in momentum starting at a PPS of .69 (directly below point "D") and carrying as high as .935. Then, as the market adjusted accordingly, the PPS fell once again to below the pre-catalyst price of .69, to .64 (point "E") on October 23rd. Sure enough, at point "E" the stock again regained momentum with yet another 8-K filing posted on October 24th. This is simply how the market behaves when dealing with short-term catalysts. Over time, and with enough of them, a stock price can climb incrementally, but on the way up it will inevitably pull back periodically along the way.
Simply by understanding the behavior of the market, as well as why the market behaves in such a way, an investor can better prepare their entry points into any equity. This can allow for the right amount of time to do meaningful research for oneself. If one is going to chase, be prepared for the best time to enter the race.
Ringing the Register
Greed plays a major role in the behaviors of both individual investors and the market. It creates an internal battle within the mind and emotional constructs of an investor on a near daily basis. It is by their own nature that an investor is someone who wants to make money; to improve their financial circumstances, and to add to their inherent net worth. By definition, an investor is involuntarily walking the line between ambition and greed in an unrelenting and repetitive pattern.
Greed isn't always bad. It's good to want more. It's healthy to want to improve. However, if allowed to get the best of you, greed can lead to far more losses than gains.
As Isaac Newton first said, "what goes up must come down." Apparently he was already preparing for tradable capital markets in the 17th century. The fact of the matter is that no stock, none, not a single one, always goes up. Behaviorally speaking, an upward trend in any activity subject to external exposure of any kind is incapable of a one direction trajectory. Since markets are absolutely affected by numerous stimuli, if a stock price goes up, then at some point, it must come down.
Now, some prices stay up longer than others, and some companies' revenues grow faster than others. There is no template for successfully predicting at what exact time in the future that any stock, or the market as a whole for that matter, will begin to decline at any particular rate. If there was, nobody would ever lose any money. This is why it is pivotal to "ring the register" prior to allowing greed to extend your position in an equity beyond a time where growth is sustainable.
In the last segment (The Thrill of the Chase), it was said that one must be prepared for the best time to assume their position in any equity. The reason for this is in order to be better prepared to inevitably take profits. As a popular phrase, ringing the register is a way of simply suggesting that if you are up substantially with any investment, then cashing in on at least a portion of your position secures part of your profits. This stands true regardless of whether you are invested in a micro-cap with a high beta or a mega-cap that behaves right in line with market. After all, the money you make in the market really only matters once it's in your pocket.
Let's assume that two people are chasing the same stock. One of them behaves rationally and thinks as the market behaves. They wait for the post catalyst pullback, do their due diligence, and they make their buy at that point. The other investor chases the momentum like a crazed dog pursuing a tempestuous cat, and they jump in the deep end of the pool without even getting their bathing suit on. As a result, they enter the same equity at a higher price.
Utilizing the same chart from above, let's assume that the first investor (the one behaving rationally) waits for the post catalyst drop on October 7th and purchases about 22,000 shares at a PPS of .45 (point "C") for $10,000 dollars. The second investor (the one jumping in the pool with his clothes on) is blindly chasing the momentum and buys immediately on the first Monday after the short-term catalyst. They would anxiously invest the same sum of $10,000 on September 30th as soon as the market opens, and would only get 12,600 shares because they are paying a price of .79 per share (point "B"). Both investors have their position, and they have paid the same amount of money to invest in the same company. The rational investor holds 22,000 shares and the irrational investor holds 12,600 shares.
Let's assume, strictly for the sake of this example, that the price of that stock moves to a PPS of 1.00 by year's end. The rational investor, because he exercised patience in the entry process, is more than content with having doubled his money. As a result, he chooses to "ring the register" and sell his shares. He calculated his entry point, and he recognizes that having doubled his money, he has done well above average. Regardless of whether someone is invested in a mega-cap or a micro-cap, if one doubles their money, that register needs to ring; even if they only cash in a portion of their position.
The irrational investor though didn't enter at the right point, and part of him is, at least subconsciously, harboring resentment for that fact. That resentment becomes pride, and pride grows into greed. He isn't satisfied with the 1.00 price on the stock despite the fact that there is nothing to be ashamed of with a 26% gain. He simply can't escape the haunting idea that if he had entered at a different point he would be holding profit at a factor times three. As a result, he is determined to double his money as well, and therefore he is holding out for a price target of 1.58 per share. He doesn't have any reasonable substance supporting his price target other than gluttony. In his mind, he wants to double up, and so he decides he isn't selling until that happens.
Let's now assume that the 1.00 price on the stock proves to be unsustainable, and drops back down to a PPS of .90. As we've covered, nothing maintains an upward trajectory constantly. Now the second investor is overly emotional about his money. He entered at the wrong price, refused to exit at a high price, and is now left frustrated, irritated, and indecisive. Should he sell at .90? Should he wait? Will the price go back up? Will it continue to go down? His ability to rationalize at this point is completely compromised because his behavior is being dictated strictly out of greed, insecurity, and resentment. He chased the momentum, and now he has no idea where it is going to go. He is, for all intents and purposes, just a leaf caught in the wind.
Where the stock goes from there, for the purpose of this article, is of no consequence. The point here has been made. An investor has to know when to ring the register, no matter what the circumstances. However, the confidence and willingness to do such is largely affected by their ability to enter a stock at the right and calculable point. You won't always enter low and exit high like the rational investor in this example, but you stand a better chance of doing so, and thus standing to make more money, in the event that you strive to think more like the market behaves.
Managing the Managers
This is the simplest idea to actively put into place. By "managing the managers" one is anticipating the behavior of portfolio managers operating in the market congruent with the calendar year.
Nearly everyone knows that the majority of portfolio managers take their profits on a quarterly basis. As a result, it becomes quite an easy task to anticipate the likelihood of high performance stocks losing some ground after a successful quarterly performance. This is especially relevant if the stock you own is peaking for the quarter, or even the 52 week average, as the end of the quarter approaches. For the sake of this example, let's consider the chart for Netflix (NFLX) as it approached the end of Q3 this year.
As can be seen, indicated by the "A" on the chart, Netflix was peaking around 313.00 per share on the 27th of September 2013. At the time, that value represented the all-time high for Netflix, with the end of the quarter imminent. Netflix, a popular stock held by a considerable number of portfolio managers, saw volume increase dramatically between September 27th and October 3rd. It is certainly reasonable to conclude that many portfolio managers, wanting in their own right for profits, were consolidating their positions at that point. In the following days in fact, announcement of market mogul Carl Icahn partially ringing his own register in Netflix was making headlines.
For the investor who understands market behavior, cashing in on end of quarter highs is a way to ensure profitability. In fairness, yes, Netflix stock did continue to climb after the fact, and some wide-eyed investors even speculate that it could be the next stock to reach the one thousand dollar price plateau. Regardless, selling at least part of a position in a popular portfolio stock towards the end of a quarter when reaching an all-time high, is a no-brainer move every time. Behaviorally speaking, to not sell a stock, at that time, in that kind of position, would qualify as complete and utter lunacy. Certainly, in the case of Netflix, the upward trend may continue, but that would be the exception and not the rule. After all, once again, nothing moves upward forever, and greed is one of the heaviest crosses to bear for investors.
To understand the behavior of the market is to understand the behavior of market managers and vice versa. By cashing in on at least a portion of your position in similar circumstances, time will prove that you made the right move 99.99% of the time. If you act before portfolio managers act, especially in positions lacking the strength of Netflix, you dramatically improve your chances of getting out at a more advantageous price point. You will find yourself successfully managing the managers.
Market behavior and human behavior are two sides of the same coin. Understanding the effects of short term catalysts on behavior, the consequences of greed, and the conduct of portfolio managers are three lessons that can have profound effects on your portfolio. These three considerations cannot meet all of your individual challenges, but if considered, they will invariably help your portfolio's performance. I used Biozone Pharmaceuticals and Netflix as examples intentionally because they represent the two opposite spectrums of the investment world; a prospective biotech and an established media powerhouse. In addition, the Biozone example represents a clear cut case of when to apply the theories detailed herein successfully. Whereas, in the case of Netflix, some of you will think to yourselves, "what is this author's point, the stock kept going up?" That is exactly my point.
Not everything in the marketplace can be predicted. Some decisions you make will work out, others will fail miserably. However, if behavioral finance theory is considered in your decision making process, then the odds of success are tipped further in your favor far more often than not. Maybe Netflix will get to $1000 per share. Maybe it will fall into the range of $270 per share. Nobody knows for sure. The very survival of the markets is dependent on most people getting it wrong. Capitalism requires that there be a winner for every loser and a buyer for every seller. It is a give and take relationship.
So, in the battle of "Man Versus Market", if you employ these practices, you may not win every time, but you will increase the frequency of your wins. Enter the stock at the right levels, don't succumb to greed or hindsight, and take profits at the right time. These are three of the ingredients in the recipe of long-term success.
Additional disclosure: The specific stocks included in this article were selected for reasons other than my personal evaluation of them. Their inclusion here should not be perceived as indictments or endorsements for them as investments. Their activity and statistics simply provided appropriate instruments for the purposes of this articles objectives.