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Investment Psychology
by David Stanowski
29 May 2007

Why do consumers buy more CD's when the price drops from $15 to $10, but investors buy more stock when the price jumps from $100 to $150 per share? Why do people, who are contemplating the purchase of a computer, become more motivated to buy when the price drops from $2,000 to $1,500, but renters suddenly feel a need to buy their first house, when prices jump from $100,000 to $150,000?

Consumers seem to have an instinctive sense of
established levels of value, and see price drops, below these levels, as buying opportunities. Investors have much more trouble establishing levels of value, and, unlike consumers, low prices make them nervous and uncomfortable, so they wait for higher prices as signals to buy.

Very successful investors have always been aware of this oddity, and have had the good sense to do just the opposite. In the years after WWII, some analysts began to study this phenomena quantitatively. These so-called Contrarians developed tools such as the divergence between price and value, historical price/earnings and price/dividend ratios, and sentiment measures in an attempt to quantify and graph this data.

Studies by Contrarians have confirmed that, as a group, investors do NOT seek out, nor want to buy at bargain prices! They only feel comfortable buying after prices rise! The higher and faster prices go up, the more they are drawn to, and chase after a market. In bubbles or manias, all previous measures of value are ignored as investors abandon any concern for price in the craze to acquire more!

After prices have diverged from value, far and long enough, eventually the positive mood becomes exhausted, and prices reverse some, or most of their previous rise, as they return to levels of established value. Ironically, even though many investors are vaguely aware of this historical reality, they seem unable or unwilling to acknowledge, and act on this fact, when they are in the thrall of a bull market or mania!

The fact that people act rationally when they buy consumer goods or services, but irrationally when they invest, is now a well-established, but perplexing fact. Recent studies have shown that going along with the crowd reduces the anxiety that is produced, by the primitive parts of the brain, when taking independent action. This is the reason why most people find it more comfortable to follow the herd.

These studies confirm the fact that most people use their higher brain functions to decide whether or not to buy things that they will use and consume; such as TVs, appliances and cars; but use their lower brain functions to make decisions about their investments!!

In the first situation, people receive more satisfaction, and comfort from buying at lower prices. However, when it comes to investments, buying at HIGHER prices reduces their anxiety, because, as prices rise, it convinces them that everyone else BELIEVES that they are doing the right thing! In this case, there is comfort in following the majority opinion.

Contrarian techniques are very helpful in determining when to buy, and when not to buy investments, but they are much more difficult to use to decide when to sell, because you never know just how far investors can push a market beyond levels of established value.

In 1929, the dividend yield on the DJIA fell to 3%, confirming that it had reached an historically high price. This point of extreme deviation from established levels of value lead to a 
90% drop in the market. In 1991, the dividend yield fell below 3%, and by 1999, reached a low of 1.5%, which lead to a bear market that took the NASDAQ down more than 70%. However, because the DJIA did not drop nearly as much as the NASDAQ, its dividend yield has remained BELOW 3% from 1999 to the present time! If the DJIA is still at a point of more extreme deviation from established levels of value than it was in 1929; is it a good time to buy, or a good time to sell? Once investors stop buying, just because other people are buying, what is likely to happen?

At the height of the 2002-2006 real estate bubble, investors waited in line to buy houses and condos, many sought to buy and flip houses in order to buy more expensive houses to flip again, and some bought several houses at the same time. All of these behaviors indicated that people were buying JUST BECAUSE prices were high, which put them in consensus with the herd. These are classic symptoms of things that happen at extreme deviations from established levels of value. Now that this bubble is deflating, prices should return to "normal" levels.

Contrarian techniques have been extremely difficult to use, successfully, since the late 1990's, because the massive amount of credit, that has been injected into the system, has allowed investors to keep buying, and to "
abandon any concern for price, in the craze to acquire more", longer than in any other period in history! Can this continue much longer?

What do your higher brain functions tell you?

"The individual has always had to struggle to keep from being overwhelmed by the tribe. If you try it, you will be lonely often, and sometimes frightened. But no price is too high to pay for the privilege of owning yourself."
Friedrich Nietzsche

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