Given the complexity of investment markets and investing, along with the massive amount of information available to investors, many people rely on logic based on ‘common sense’ or simple ‘rules of thumb’ in making investment decisions.
However, while some rules of thumb are reasonable, in many cases they are not and can result in investors missing opportunities or losing money. Let’s have a look at some of these and why they are unreliable.
This argument is wheeled out every time there is a recession. If it was correct then economies would never recover from a recession. Rather, they would spiral down into the sort of crises that Karl Marx predicted would ultimately lead to the demise of capitalism. Of course, this does not happen. Instead, the boost to household discretionary income from lower mortgage bills, tax cuts and stimulus payments eventually offsets the fear of unemployment for the bulk of people still employed. As a result, they eventually increase spending, which in turn stimulates the economy. In fact, it is normal for unemployment to continue rising during the initial phases of a recovery as businesses are slow to start employing again, fearing the recovery will not last. Since share markets normally lead economic recoveries, the peak in unemployment often comes a long time after shares have bottomed. In Australia, the average lag from a bottom in shares following a bear market to a peak in the unemployment rate has been 12 and a half months.
This argument is also rolled out during recessions. The problem with this myth is to ignore the fact that capacity utilisation is low in a recession simply because spending – including business investment – is weak. When demand increases, profits improve and this drives a pick-up in business investment which in turn drives up capacity utilisation. Therefore, while business investment in key countries right now is poor, providing there will be a pick up in demand – and several indicators are pointing to such later this year – then business investment will start to improve even though many factories are still idle.
Again this myth sounds like good common sense. However, senior business people are often overwhelmingly influenced by their own sales figures but have no particular lead on the future. In the late stages of the early 1980s and early 1990s recessions, anecdotal comments from Australian CEOs were generally bearish – just as recovery was about to take hold. Note this is not to say that CEO comments are of no value, but they should be seen as telling us where we are rather than where we are going.
A common mistake investors make at business cycle extremes is to assume that the business cycle won’t turn back the other way. After several years of good times it is common to hear talk of ‘a new era of prosperity’. Similarly, during bad times it is common to hear talk of ‘continued tough times’. But history tells us the business cycle is likely to remain alive and well.
This ‘safety in numbers’ concept has its origin in crowd psychology. Put simply, individual investors often feel safest investing in a particular asset when their neighbours and friends are doing so and the positive message is reinforced via media commentary. The only problem with this is that while it may work for a while it is usually doomed to failure. The reason is that if everyone is bullish and has bought into the asset there is no one left to buy in the face of any more good news, but plenty of people who can sell if some bad news comes along. The opposite applies when everyone is bearish and has sold – it only takes a bit of good news to turn the market up. As we saw in March this can be quite rapid as investors have to close out short positions in shares. The trick for smart investors is to be skeptical of crowds rather than drawing comfort from them.
This is another classic mistake that investors make which is again clearly rooted in investor psychology. Reflecting the difficulty in processing information, short memories and wishful thinking, recent poor returns are assumed to continue and vice versa for strong returns. The problem with this is that combined with the ‘safety in numbers’ myth it results in investors getting into an investment at the wrong time (when it is peaking) and getting out of it at the wrong time (when it is bottoming).
This is generally true over the long term and at various points in the economic cycle, but at cyclical extremes it is usually wrong and constitutes another big mistake investors make. The problem is that share markets are forward looking. When economic data is really strong the market has already factored it in. In fact, the share market may then start to fret about rising cost pressures and rising short-term interest rates. As an example, when global share markets peaked in around November 2007, global economic growth and profit indicators looked good.
Of course, the opposite occurs at market lows. For example, at the bottom of the last bear market in shares during March 2003, global economic indicators were very poor and the general fear was of a ‘double dip’ back into global recession. As it turned out, despite this ‘bad news’, stocks turned around with better economic and profit news only coming along later in the year to confirm the rally. A similar situation may be occurring right now with Gross Domestic Product figures worldwide confirming the worst global recession since the 1930s.
James was the editor and publisher of SmartCompany and LeadingCompany for five years. He is now the Australian Financial Review‘s companies & markets editor, and a former BRW editor.
