Nothing arouses as much passion in the investment community as stocks. The passion is doubled if the commentator is not as gung-ho about stocks; I must add, at current levels it is pretty much everywhere—as Yours Truly is.
To be accurate, I felt that investors were overly pessimistic in March. So, it was not difficult to recommend to clients to buy equities. By the third week of April, the Standard and Poor’s (S&P) 500 had gone up by 30% and the Morgan Stanley stock index for Asia excluding Japan was up by about 32% in dollar terms. So, it was easy to ask clients to trim their exposure a bit. Of course, since then, the S&P 500 has gone up by another 10%-plus. But the bulk of the action has been in emerging markets. The same Morgan Stanley index for Asian stocks (excluding Japan) has gone up by 20%-plus since then. I reiterated my cautious stance in May. In hindsight, I was too early to sound the note of caution on equities. Never mind that we also recommended emerging market bonds, still keeping that call open, and that they are doing rip-roaringly well, etc.
In this milieu, if one writes something regularly highlighting how the stock markets are losing touch with reality and decrying the tendency on the part of stock market investors to selectively absorb news, then one receives pushback: “Hey, you are shrill. It is sour grapes for you. You missed part of the rally. So, now you are defending yourself. In fact, you are now boxing yourself in. What will you do if the index breaches a particular level?”
Up to a point, it is a plausible reaction. After all, when one takes issue with market pricing, is it ex-post-rationalization or does one genuinely wish to warn investors not to get ensnared at certain price levels?
Also, look at the question carefully: “What will you do if the index breaches a certain level?” The question is rhetorical, and the answer is self-evident. You should buy more. The more prices go up, the more you buy! This is the inherently destabilizing logic of stock markets. Many experienced and erudite commentators have commented on this destructive reflexivity in the stock market.
Another colleague asks helpfully if there is someone else in the organization to challenge my views. In other words, he is hoping that the institution is hedged against my ignorant investment advice.
It is interesting that it is usually those who wish to see the good times roll on who react like this. I just wonder what their reaction would be if they were negative and I were to sound consistently positive—would they pushback or abandon their negativity and jump into the market? I strongly suspect that the latter reaction would be more likely.
In other words, being positive and wrong is tolerated more easily and for longer than being negative and “wrong” (for anything more than a week). For such critics, I would recommend repeat doses of “The Power of Negative Thinking” by Atul Gawande, published in The New York Times on 1 May 2007.
That said, these reactions are, at some level, unsurprising. Investors’ threshold for pain is far lower nowadays. They think they have had enough of it in 2008, and they deserve a break: “Who is this guy to tell me that I should be geared for more pain and that it is more reasonable to expect it than gains?” Perhaps, it is a more general phenomenon than one that explains investment behaviour alone.
Second, stock markets satisfy our innate thrill for gambling and speculating. It is an adrenalin rush. It does not need much analysis. The same does not apply for all other investments. Bonds are mathematical and earnings are fixed. For stocks, the sky is the limit for imagining earnings growth. With imagination as the constraint and luck as the tool, investing is gambling, and gambling is exciting.
Third, in a remarkable case of circularity, many investors are pointing to each other having a cache of money ready to be invested in the stock market and, therefore, electing to buy. In other words, one is investing not because of expected cash flows but because one is expecting the next fool to snap it up. All that we should do is buy before him so that we can dump it on him. This is called the greater fool theory of investing.
If only they’d pause for a moment, they’d know that merely having money to invest comes second. The first question to ask when investing is the prospect of returns. At higher prices, the prospects of returns recede. So, the correct behavioural response would be to hold back from investing. Instead, money chases other money and that seems both the necessary and sufficient condition for stocks to go higher.
Professor of behavioural economics Dan Ariely hopes we will understand our cognitive limitations the same way we understand our physical limitations. I am sceptical.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at firstname.lastname@example.org