One of the best times to buy stocks is when everyone else is selling, and vice versa. When it all looks so good, that can be the best time to take profits. But is that what you actually do? Most investors only feel comfortable following the herd.

Delving into the world of investment psychology can open your eyes to the mistakes made by many of your fellow market participants. Understanding why individuals act in certain ways should prompt you to reassess your own decision-making process and hopefully become a better-quality investor.

Think about the last share you either bought or sold. What prompted that decision? Let us take a hypothetical situation where an investor buys shares in Whitbread (WTB). They have seen how the share price has been steadily rising over the past few years and reckon it could be a good long-term holding as there is always someone on the high street brandishing a cup of Whitbread?s Costa coffee.

Our investor may take comfort from the share price performance and brand strength. Yet a more savvy portfolio builder might argue that all the good news about Costa?s popularity is already priced into the shares and growth could be harder to achieve over the coming years.

Differing opinions are what make a market - there always has to be a seller for every buyer in order to execute a trade and here the two participants are in effect disagreeing over what is the correct valuation of a firm?s future cashflow. Always remember that - when you buy or sell, you are effectively saying the market is wrong. This is a bigger call than you think, given the number of active professional and retail investor out there, so it is not a decision to be taken lightly.

This is why every week Shares seeks to educate our readers about how to better understand issues such as valuation, corporate governance, accounting and strategy so you can research portfolio options more effectively and build a basket of holdings which best suits your goals, time horizon, appetite for risk and target returns. The other magic ingredient you need to grasp is market psychology. Our technical analyst Simon Griffin argues this is reflected in the charts and Shares? hard-bitten team of fundamentalists will use valuation as the best gauge of whether sentiment, and thus a stock, is overcooked or not. But judging what is ?in the price? is a skill in itself and this ?feel? for the market is often a result of experience more than anything else.

In a hole

Whitbread is arguably an easy business to understand. But what about mining stocks? Let us say our investor also puts money into an exploration company - they might have heard good things from a friend; the management might have created a buzz about the company through presentations or articles; or the share price is rising. But does the intrepid portfolio builder really understand what the miner does?

Beowulf Mining (BEM:AIM) is a great example of a stock that attracted lots of private investors a few years ago with the promise of greatness. Iron ore was all the rage and suddenly we had a small cap miner in a geopolitically-strong location (Sweden) and lots of talk by the chairman that Beowulf ?firmly believe(s) that we have discovered a world-class deposit? (23 Dec ?10). The shares went racing ahead but the company then displayed massive levels of management incompetence and the commodity price fell back. Worse still, the exploration results did not live up to the hype, although many investors would probably not have realised because they could not tell if drill results and resource statements were good or bad.

BEM - Comparison Line Chart (Actual Values)

You can see from the chart that investors piled into Beowulf shares during 2010 and 2011 but then the clever ones headed for the door at the first sign of bad news. But it was impossible for everyone to get out in time - just remember our previous point that there must be a buyer for every seller. Beowulf had lots of devoted investors who topped up their holdings during times of share price weakness and refused to believe the company would disappoint.

Beowulf is a perfect example of the market emotion cycle, where investors buy shares in a flurry of excitement, go through denial as the shares start falling and then sink into depression as the share price collapses and they are left holding stock worth a fraction of the price they paid.

Insurance claims specialist Quindell Portfolio (QPP:AIM) is a further good example. Everyone was happy to jump on board as Quindell?s shares rallied in 2012, rising more than three-fold as the market latched on to its buy-and-build strategy. Once the bulk of the company had been assembled, the market shifted its attention to the quality of earnings and the risks involved as well as the growth it was generating. It thus began to question what valuation was appropriate for the firm?s earnings and cashflow.

Contract wins subsequently failed to move the share price, which should have sent a warning sign to take profits - any experienced market player will tell you an asset that does not go up on good news is usually a ?sell? and one that does not fall on bad news is usually a ?buy? as everything is now ?in the price?, or discounted by a particularly lofty or lowly valuation.

QPP - Comparison Line Chart (Actual Values)

When Quindell used a complicated derivative instrument that essentially gave protection to participants in last December?s share placing, many investors started to question the transparency of the business. After all, the Aim-quoted play had not made clear the fund raising was linked to a complicated swap contract, which looked like a failure of corporate governance if nothing else.

Most people did not have a clue how the swap contract worked and neither could inexperienced investors work out why Quindell on 7 May it reported £202 million debtors, higher than its full-year turnover figure of £137.6 million. Capitulation ensued and the share price tanked as previously bullish holders took fright and rushed to the exit without necessarily trying to understand Quindell?s explanation.

Emotional rollercoaster

Investors go through lots of different emotions when putting their money into the stock market. The following graphic illustrates the different mindsets for an investor.

Feature graphic

The start of the up-cycle begins with ?hope? which leads into ?optimism?, then ?excitement?, particularly if corporate earnings show surprising gains. The cycle then moves into ?thrill? followed by ?euphoria?. This is now the point of maximum financial risk. This is probably the point at which investing once again becomes a mainstream topic of discussion. There is a good chance a taxi driver, bell boy or local shop keeper will offer you some stock tips during casual discussion. We would argue this is probably the point at which to lock in any profits, either on a specific stock, index or even an entire asset class.

At this stage in the emotion cycle, investors worry less about losing money and more about missing stock opportunities, so reckless decisions can be made at this stage. There is no thought to risk, no contemplation of the vital issue of valuation and the prospect of losses seems unimaginable.

A share price that has displayed a strong rally will need catalysts to keep rising otherwise it will start to correct downwards. We regularly write about catalysts in Shares, highlighting earnings upgrades from analysts and positive economic activity as two of the most powerful catalysts. Markets just love narrative. Yet in its absence, share rallies can quickly reverse.

The trigger for the correction could be disappointing economic data or a company?s earnings falling short of investors? irrationally optimistic expectations. It could simply be that someone, somewhere suddenly sees sense and realises that valuations have got totally out of hand. That puts investors through the emotional stages of ?anxiety?, ?denial?, ?fear?, ?desperation?, ?panic?, ?capitulation?, ?despondency? and ?depression? in that order.

The timeline (left) outlines some of the most famous stock market rises and falls, or bubbles and crashes, of all time. All feature this pattern and the gains end when the scales finally fall from someone?s eyes and they twig the valuation is wrong. Edward Chancellor?s book on the history of bubbles, Devil Take the Hindmost cites a pamphlet which noted how the 2,500 florins paid in 1637 for just one tulip bulb would have bought 50 tonnes of rye, 27 tonnes of wheat, three tonnes of cheese, two tonnes of butter, 12 sheep, eight pigs, four fat oxen, four kegs of beer, two vats of wine and a silver beaker. No effort was made to justify bulbs? valuation, only their price. Worse, the bulbs were still in the ground, so the Dutch were trading in futures, and they were doing so on margin, to again reveal how important the availability of easy credit when it comes to driving asset prices up to silly levels.

Punting bulbs may sound daft but it is no less dangerous than valuing a start-up company with no revenues at hundreds of millions of pounds, as happened in the US, UK, Europe and Asia during the technology bubble of 1995-2000.

The risk business

While each asset or stock may have its own individual issues to address, you can apply these emotions to the general state of the markets as a whole. ?The first price declines cause investors to rethink their analysis, conclusions, commitment to the market and risk tolerance,? writes legendary fixed-income money manager Howard Marks, chairman of Oaktree Capital Management (OAK:NYSE) in a note to clients in January. ?It becomes clear that appreciation will not go on ad infinitum. ?I?d buy at any price? is replaced by ?how can I know what the right price is??,? he says.

Marks says the next stage is the average investor realising ?things are getting worse? and selling replaces buying. This progresses to individuals who switch from worrying about missing an opportunity to worrying about losing. Financiers become more cautious about extending credit to investors; those using spread betting face the risk of having margin calls; and then the general market embraces a negative attitude.

?Eventually we hear some familiar refrains: ?I wouldn?t buy at any price?, ?There?s no negative case that can?t be exceeded on the downside?, and ?I don?t care if I ever make another penny in the market; I just don?t want to lose any more?,? says Marks who adds: ?The last believer loses faith in the market, selling accelerates, and prices reach their nadir. Everyone concludes that things can only get worse forever.?

He makes some excellent points but we have to single out the following lines as being the one you should always remember: ?The riskiest thing in the investment world is the belief that there?s no risk. On the other hand, a high level of risk consciousness tends to mitigate risk. I call this the perversity of risk.? He says becoming more and less risk averse at the right time is a great way to improve investment performance. ?Doing it at the wrong time - like most people do - can have a terrible effect on results.?

Pattern of thought

The illustrated emotions cycle can be summarised in just four words: ?hope?, ?greed?, ?fear? and ?regret?.

An investor is always hopeful their capital will increase in value. You would not make an investment if you thought it would lose money. But hope can also mean staying in a losing trade in the belief it will move back into the black. You need to have the right qualities to know when to cut your losses and exit a losing trade.

Greed is when you have made lots of profit and can now only focus on how much more you can make by staying in the trade. Never be afraid to bank some or all of your gains. Knowing when to exit can be very hard, particularly if you get emotionally attached to a company - something that affects many mining investors as they are often forced to wait years for value-generating progress to be made.

Fear tends to result in panic selling, usually near the bottom, as the desire to avoid losses overcomes the desire to make potential profits. Many investors are wary of volatility but the great ones welcome and embrace it as wild swings provide chances to sell well above the intrinsic value of a stock or buy well below it during bull and bear markets respectively.

Regret is either losing money or missing out on an opportunity. Investors should take this experience on board and simply learn from either scenario. You should never start piling into stocks simply because someone else is making money, as their approach may not be right for you. Worse, you could simply end up buying your neighbour or best mate?s position and let them get out for a profit just before the smash hits and then you really will feel sick.

Know Yourself

Being aware of emotions and identifying your own weaknesses can mean the difference between profit and loss for your investments.

Mark Fenton-O?Creevy, professor of organisational behaviour at the Open University, says one of the worst mistakes an investor can make is to suppress their emotions. He has carried out research at investment banks in London, monitoring more than 100 traders using sensors. ?We looked at their heart rate variability. The more experienced traders were able to manage their emotions,? he says. Fenton-O?Creevy discovered that traders found it more difficult to manage their emotions when the VIX - the measure of market volatility - was high.

vix

To advance the research, the professor then engaged with private investors, particularly those who transacted via the internet. ?Some said they shouldn?t have any emotions. One person (with one year?s experience trading) said they were a ?cold fish? with no emotions. Half an hour into the interview, he admitted he used to throw up as he was so scared of what was going on in the market.?

The professor says investors should establish and stick to a strategy. ?Write it down and never change it unless you then write down the reasons for doing this. It is about integrity and discipline. Be honest about your role in any trade and your strategy, including intended and realised outcome, and stick to your strategy.? He says this approach sets accountability for oneself in the future.

The Motley Fool published an interesting list last year entitled 50 Unfortunate Truths About Investing. One entry, in particular, caught our eye which was: ?The best investors in the world have more of an edge in psychology than in finance.? Whether you agree or not, we do believe that to be a better investor you need to identify and overcome your psychological weaknesses.

One of the key challenges is to be able to read the market and understand where the crowd is heading. Shares endeavours to provide this information every week in the magazine and in our daily web stories on www.sharesmagazine.co.uk. A good investor should understand that one of the most important decisions to make every time you are prepared to put money into the stock market is knowing what not to buy, rather than simply always searching for stocks to buy.

But does understanding where the crowd is going suggest following the herd? You could certainly argue that ?the trend is your friend? theoretically implies that momentum trading is the best strategy and therefore renders contrarian investing null and void. And it certainly implies that you should go with the herd, not against them. ?The market can remain irrational longer than you can remain solvent,? famously said economist and keen stock market punter John Maynard Keynes. Yet the best contrarian investor is ultimately one who takes a position before momentum runs out of steam and changes direction.

Timeline: Blowing bubbles

Nowhere does the concept of market psychology, and the twin emotional drivers of greed and fear, show themselves more clearly in so-called ?bubbles?, where investors simply lose the plot. As greed takes over, rampant speculation overwhelms the fundamental premise of patient wealth accumulation through investment. Buyers fall over themselves to pay seemingly any price for an asset simply because they think they can sell it to someone for more - a concept known as the ?greater fool theory.? At this point, vital issues such as valuation are simply tossed aside in the scramble to get involved, irrespective of the dangers.

The most famous example is the technology, media and telecoms bubble of 1995-2000. The internet and third-generation (3G) mobile telecommunications systems now deliver everything that was expected of them over a decade ago - and more - but at the time company valuations became wildly overheated as loss-making start-ups, or even firms with no revenues at all, were given multi-billion market caps. Even solid, cash-generative, well-positioned plays such as microprocessor architecture designer ARM (ARM) became overcooked. The Cambridge firm?s shares peaked at 969p in 2000 and then took 13 years to get back there.

This only serves to show how bubbles can turn even good companies into dreadful investments if you get your timing wrong and pay an excessive valuation. The tech boom and bust is just one example of a time when investors completely lost first their marbles and then their cash. (RM)

Investor checklist

> Investor psychology is a huge topic and one which we could debate much further. Hopefully this article has triggered some interest in examining the way in which you personally trade. Here are some bullet points to recap on the subject and provide actionable ideas:

> Before buying a share, write down the pros/cons and your expected return. Regularly revisit the risks and opportunities; particularly if you hit your profit target or the value of your investment falls below the invested capital.

> Always monitor the market. Write down the best and worst performing sectors each week and try to establish reasons behind these trends; understand sector rotation.

> Understand what moves a share price.

> Use stop losses to minimise portfolio hits.

> Never get emotionally attached to a stock.

> If you do not understand a business or the terminology that accompanies its trading updates or progress reports, do not invest in this stock.

> Always establish the risks facing a business and whether these are reflected in the share price.

> Do not assume that people on message boards have the correct answer. They rarely do.

Always remember there is a big difference between price and valuation. Sentiment drives the share price but ultimately fundamentals such as cashflow will dictate a stock?s fair value. You can make the most of erratic market psychology by buying below intrinsic value and selling above it.


HOW BUBBLES INFLATE.... AND POP

Hard to believe as it may be, asset price bubble episodes are not actually that rare. History is littered with such episodes, which always end in disaster, as summarised by economist John Kenneth Galbraith?s aphorism: ?The speculative episode always ends not with a whimper but with a bang?.

You can also learn how to spot a bubble by studying past examples, as they all tend to have a similar shape, even if they come from different decades, or even centuries, and relate to a variety of asset classes. The economist Charles P. Kindleberger?s seminal work Manias, Panics and Crashes outlines both the usual cycle represented by the formation and then collapse of a bubble, based on thorough study of the many examples offered over time.

The first step in the formation of a bubble is usually the appearance of a transformational opportunity, such as the chance to invest in trade flows with America, the railways, mines, real estate or a new technological development. The initial legitimate entrepreneurial profits then attract more capital, often made through the concurrent availability of cheap credit, which then facilitates further sound investment before matters get out hand and fraudsters appear to target the unwary.

Eventually someone, somewhere realises the price being paid for an asset in wrong - at the peak of the 1636-37 tulip bubble, bulbs were changing hands up to 20 times the average Dutch annual salary. The trouble is no-one can get out, credit disappears, frauds are discovered and panic sets in as prices collapse.

The trick is to have the nerve to get out for a healthy profit without getting greedy, knowing you will never call the top correctly but that the alternative could be getting caught in a sudden collapse from which there is no escape. When asked about his investing success, Nathan Mayer Rothschild, the first Baron Rothschild, said :?I made my fortune by selling too early?. Joseph P. Kennedy, father of ill-fated US president John F. Kennedy, took this to heart over 100 years later. He sold all the stocks he had in summer 1929, barely three months before the great Wall Street Crash, after a bellboy in a hotel started giving him stock tips. The patriarch decided if the bellboy was up to his neck in stock then it would be pretty difficult to find an incremental buyer, someone who was below the humble hotel employee in the economic foodchain.

It can be difficult to resist the lure of a rising market. As Kindleberger says, ?There is nothing so disturbing to one?s well-being and judgement as to see a friend get rich.? That is what sucks in the last buyers who inevitably become the biggest losers when the bubble pops. Some commentators believe central banks? quantitative easing (QE) policies are leading to bubbles in junk bonds, emerging market debt and even government bonds, let alone gold or equities, as share prices race ahead despite still dodgy economic fundamentals. Shares is far from convinced equities are a bubble as we have yet to see that parabolic surge. Yet we are on alert as record-low interest rates force cash to go looking for a home and thus one pretext of a bubble - cheap, hot money - is very much in evidence. (RM)


THE EXPERT?S VIEW

Dr. Emily Haisley applies insights from behavioural finance and economics to wealth management at Barclays Wealth. Her work involves understanding and counteracting common investment mistakes, as well as the impact of personality on financial decisions.

At March?s London Economics Symposium (see Feature, Shares 4 Apr), an event organised by a crack squad of economics, mathematics, management and psychology students from Royal Holloway, University of London and in particular the founders of the OMK Investment Club, Dr Emily Haisley spoke on the subject of investor psychology and the two schools of thought represented by two Nobel Prize winners.

On the one hand there is the economist Harry Markowitz, a specialist in long-term asset allocation, portfolio diversification and optimisation and a believer in efficient markets which require a rational approach, self-control and discipline if you are to succeed. On the other there is psychologist Daniel Kahneman whose work in the field of decision-making argues people fall victim to cognitive biases and that they thus never execute a portfolio plan even if they have to discipline to draw one up, as matters take a hand to defeat their self-control.

Haisley suggested the way information is framed tends to lead to inconsistent choices, such as a bias toward domestic equities, especially as aversion to a loss seems to be a stronger instinct than desire for a profit. She then cited an example of how this could be measured, noting Andrew Clare and Nick Motson?s 2010 paper Do UK retail investors buy at the top and sell at the bottom?. Their data suggested that over time there is a ?behaviour gap? in performance, caused by emotions. Between 1992 and 2009, Clare and Motson argue the average UK retail investor underperformed the returns of equity mutual funds, as measured by IMA benchmarks, by 1.2% a year. This might not sound much, but the aggregate impact is cumulative underperformance of 20%.

?You need to do the opposite to this cycle if you are to behave in a rational way, but it takes great emotional fortitude,? Haisley said. To try and help investors avoid riding the cycle of emotions described by the graphic shown on page 27 (Haisley referred to a version of her own) the Barclays expert described how she helped to draw up financial personality assessments, matching people?s attitude to risk with their decision style. Risk tolerance is matched with perceived market experiences, composure with an ability to delegate and level of market engagement with faith in financial skills. (RM)

This is an edited version of an article first published in May 2013 by Shares.

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Issue Date: 20 Dec 2013