"Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular, and do well.”
Those are the words of one of the greatest investors of our generation, Warren Buffett.
The investment guru got me thinking: why is the stock market so different from every other market?
If you went into a supermarket and a tin of baked beans was half the price it was a month earlier, you are far more likely to buy it now than a month ago. This would apply even if the only reason it was half price was that the tin had a dent in it. After all, the beans would still taste the same.
The reverse happens in the stock market. If a stocks price falls 50 per cent because it’s taken a bit of a battering, you immediately think that something is wrong with it.
There is less chance of you buying it than when it was twice the price a month ago and looking all shiny.
Fundamentally, like our tin of beans, it’s still the same stock.
Since the late 1970s, a number of academics have put forward theories that have developed the idea that stock prices can be overly influenced by human behaviour as opposed to fundamentals.
This has led to the development of the theory of behavioural finance.
Ever since the Dutch Tulip Bubble in 1630, there have been numerous stock market bubbles and crashes – the most recent of which we can all too well remember: the global financial crisis of 2008.
These bubbles and subsequent crashes led the academics to observe that, despite the advances in technology and the availability of information, investors continue to make the same, or similar, mistakes.
Rather than being cold, rational decision-makers, investors are often driven by human behaviours and emotions.
The human brain has evolved over thousands of years to cope with the changing environment. However, there are moments when the brain is frightened or overstimulated, and the rational logic required to make investment decisions is overridden.
Quite often you are unaware that it has happened, but the brain subconsciously ignores what it perceives to be unnecessary inputs. Instead, it relies on a handful of inputs which it recognises or feels comfortable with.
This can lead to investors having overconfidence in their decision-making process, anchoring on preconceptions rather than evaluating the full picture before making a decision. And it can often lead to people following the herd through fear of missing out.
This is probably why the stock prices tend to go up the escalator but down the lift.
For those investors who are able to override their emotions and avoid being sucked in by hype from other market participants, there are opportunities.
Smart investors focus on the fundamentals of the companies that they are looking to invest in. It is also important for investors to be able to re-evaluate those fundamentals as the news flow surrounding them changes, without letting historic and possibly irrelevant information cloud the decision-making process.
Just like the baked beans, the underlying fundamentals of the company could be better than the discounted price suggests.
Put more simply, don’t be frightened of buying the battered tin of beans just because others are avoiding it.
After all, they are still the same beans, and will taste just as good.