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    Investor psychology

    It is absolutely amazing how quickly investor sentiment can change, moving prices and values quite quickly in a short space of time. Just 6 months back at the beginning of March, the pervasive sentiment was a negative one – and for lots of very good reasons.

    Now just 6 months later mass global pessimism has quickly turned back to an optimistic view, taking prices back up.

    And then many investors wonder what causes asset prices to be so volatile!

    Investorpedia defines Market psychology as “The overall sentiment or feeling that the market is experiencing at any particular time. Greed, fear, expectations and circumstances are all factors that contribute to the group's overall investing mentality or sentiment.”

    Now we know that there is no such thing as “the market”, but it’s the composite of all participants that contribute to the pervasive mood.

    Mentor to Warren Buffett, Benjamin Graham humanised market sentiment by creating an imaginary investor, called Mr Market. His moods can fluctuate anywhere between incredible optimism and overwhelming depression. One day he will nominate a higher price to buy or sell, the next day he might increase it, lower it, or even appear uninterested in whether he buys or sells.

    It’s this sentiment that drives volatility and hence market inefficiency.

    As a fund manager pointed out this morning in a presentation, if markets were perfectly efficient, with all participants having exact future knowledge then there will be no opportunity for profit. Because a current price is the discounted value of all future cash flows, if these future cash flows were known perfectly, as was the one true discount rate, then a true price could be established, which would not fluctuate over time.

    The reality however is that markets move at varying speeds from optimism to pessimism and back again – not on a consistent or defined basis, but with a high degree of regularity that it is a truism that markets are mean reverting.

    Astute investors, whatever their methodology and processes used, will look to take advantage of this fluctuation from the mean. I.e. they will look out for deviations and take the other side of the trade.

    Deviation from the mean, or volatility can and only does occur when the mass of investors take an increasingly optimistic view or an increasingly pessimistic view of specific shares, bonds, market sectors or even geographic regions.

    As the local JSE touches 26000 and earnings have declined, so the value has declined dramatically from 6 months back. The historical price to earnings now across the market is at 15 times. 6 months back it was less than 9 times historical.

    While optimism is self fulfilling, as it escalates, so investors should rather look to reduce exposure.

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2009-09-17, 17:10:08, by ian Email , Leave a comment
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