The Madness Of The Crowd

July 22, 2019

Alex Christodoulakis

Written by
Alex Christodoulakis - Co-founder & CEO @ Daedalus.

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A trader works on the floor of the New York Stock Exchange (NYSE) on October 15, 2014 in New York City. (Source - WBUR)


Personal and professional investing has been around for hundreds of years and a lot has been said about the market bubbles that eventually led to undesirable circumstances for the general public. Despite the extensive discussions about this subject and some clear observable patterns that are present in almost every single market bubble, investors around the world tend to blindly repeat irrational behaviors, overreact or underreacting to positive or negative news and developments, again and again, leading to new and “unique” bubbles and subsequent crashes. The very same subject of investors overreacting to market developments have been the subject of many behavioral finance studies as well, and some of the findings are remarkable. This article takes a look at what leads to overreactions by investors and the adverse outcomes associated with such overreactions and is the first of a series of articles that will describe the most significant financial market bubbles that have developed until today.

What is considered an overreaction?

An overreaction is an emotional response to new information about an asset, which could either be positive or negative. Release of new information regarding a security certainly requires a reaction – but not an overreaction. Investor rational and accurate reactions that reflect the true nature of the newly released information form the backdrop for Efficient Market Hypothesis, which in simple terms states that at any point in time market prices reflect all available public information (semi-strong form of EMH). However, it is not a secret that Efficient Market Hypothesis is an over-simplification and markets prices often deviate from their technical and fundamental public information. Overreactions lead the security in question to deeply undervalued or overvalued territory, depending on their magnitude.

On the other hand, these market deviation and irrational overreactions are exactly what many analysts and fund managers are looking for when considering an investment in a security: mispriced securities, either over-valued or under-valued, in order to gain an advantage, which is generally translated as a higher expected return, relative to the risk of investing in the security.

Why do investors overreact?

In-depth research has been conducted by many renowned economists, in an attempt to identify the reasons behind investors’ overreactions. In a study conducted by David Dreman and Eric Lufkin in 2000, it was concluded that the basis of investor overreactions is purely psychological. From a psychological perspective, investors are either driven by fear or greed and these are the main forces that drive irrational market movements. Understandably, investors who are driven by fear tend to pull down market prices more than they should, whereas investors driven by greed tend to push market prices higher.

In his Nobel-winning behavioral economics studies, Daniel Kahneman revealed a tendency by investors to overreact to new developments when investors are driven by the fear of loss. In his book, Thinking Fast and Slow, Daniel Kahneman discusses these concepts in detail. The loss aversion tendency is believed to have triggered many sell-offs throughout history as panic selling takes the center stage when investors are basing their investment decisions on fear of further losses.

In short, investors tend to hold on losing investment decisions, without stopping losses early, more than public information would suggest, just in the fear of realizing the hit. At the opposite side, investors tend to maintain winning positions, without taking early gains along the way.

Historical evidence of overreactions

Financial market history is rich in overreactions, be it in equity markets, bond markets or other financial and non-financial instruments. The first step is to identify the so-called ‘triggers’ that lead to market overreactions. Market overreactions could be triggered by a plethora of reasons and below are some of the reasons that stand out:

  1. Earnings surprises/misses
  2. Geopolitical tensions
  3. Trade tensions
  4. Political instability
  5. New product releases by companies
  6. Interest rate decisions

Overreactions and value investing

Value investors in any asset class have repeatedly over time emphasized the importance of leveraging market overreactions by the general investing public. Renowned value investors including Warren Buffett have seized opportunities to invest in stocks of companies that were unduly beaten by investors overreacting to negative developments.

Value Investing

(Source – See it Market)

A classic example is how the legendary investor, Warren Buffett, seized the opportunity to invest in banking and financial sector stocks during the aftermath of the financial crisis. Many investors were quick to dump banking stocks as the financials sector was in the middle of the crisis and many economists and media outlets blamed renowned financials sector companies for triggering the financial crisis.

However, investors certainly overreacted to these negative developments, or better-put underestimated the state’s reaction to protect and ensure the stability of the financial system, which paved the way for prudent value investors to pick banking stocks at bargain prices, especially after the dust cleared. Over the last decade, banking stocks have provided stellar returns, proving investors wrong, in the long-term, when they continued to dump banking stocks. In hindsight, investor overreactions always create investment opportunities, especially for value investors who are on the lookout for market anomalies.

Financials sector stocks have gained 192% since the financial crisis

Stock Price Increase

(Source – Fidelity)

Overreactions during a crisis

When there’s a crisis that affects the day to day life of investors, it’s easy to make investment decisions that are far from being rational. From a behavioral finance perspective, such overreactions trigger as fear overtakes the investment decision-making process of investors. Often, stock markets plummet during financial crises as a result of investor overreactions. However, historically, markets have been quick to recover from such overreactions and resume the normal course of events. This was evident during the catastrophic event of 9/11.

Dow Industrials

(Source – Marketwatch)

From a behavioral finance perspective, it has been proven that financial crises prompt investors to overreact which eventually leads to significant undervaluation of securities. This, in return, creates investment opportunities for prudent investors. As mentioned above, the horizon of each of the market irrationalities differs according to the underlying economic causes.

Elon Musk’s controversial tweet

A recent example is the taking Tesla private Saga that was triggered by the controversial tweet by Elon Musk.

Tesla Tweet

(Source – Twitter)

The day following this tweet, Tesla share price shot up by more than 15%. However, a prudent trader who realized that it would be near impossible for Elon Musk and Co to take Tesla private at a steep price of $420 per share would have entered a short trade at around the day’s high of close to $380. Such a short seller would have realized a return of more than 28% within a month.

Tesla Stock Price

(Source – Yahoo Finance)

The overreaction by many investors to Elon Musk’s tweet proved to be unnecessary and short traders were able to realize a healthy return on the back of this investor overreaction. On the other hand, any investor who purchased Tesla at sky-high prices would still be struggling to make ends meet, after more than a year from the incident.

How to resist to overreactions

As investors, it is crucial to develop and adhere to investment strategies that help minimize overreactions to new developments regarding a security. In the long-term, overreacting could prove to be a very costly mistake.

Keep perspective

Keeping perspective is the best strategy to overcome overreactions to new developments. When an investor keeps perspective and invests according to a previously defined plan, there are little chances of being carried away by new developments. The key is to define an investment strategy and a plan and stick to that plan, possibly with the help of an experienced financial advisor.

Avoiding emotional decision making

A common mistake that leads to market overreactions is basing the investment decision-making process on emotions rather than available information.

Avoid Investing Emotionally

(Source – Scripbox)

It’s important to draw a line between facts and emotions, which should help investors avoid overreactions. Whenever there’s a new development regarding a security, it pays to conduct thorough research to determine the impact of such new developments on the security in the long-term, before jumping to any conclusions. This way, investors would be in a better position to avoid overreactions and invest in markets rationally.

Seeking professional advice

Do-it-yourself investors are prone to make more errors when there is panic selling involved. As such, a viable strategy to avoid market overreactions is to selectively put sophisticated professionals to whom investors should allocate their capital to manage. Even though investors’ preferences all very different from one another, sophisticated investment funds nowadays deploy technologically and systematically advanced techniques to not only avoid participating in such market abnormalities but also be able to seize every opportunity that irrational deviations appear. Superior risk management techniques allow investment experts to isolate exposure to statistical arbitrage opportunities while hedging any other potential risk movements. For such professionals, having a high-end view of the dynamics driving financial markets at any point in time promotes rational investment decision making.

This way, investors can create diversified portfolios that take advantage of the irrationality of the crowd to earn high returns, with low risks.

Conclusion

Investor overreactions is an inherent characteristic of financial markets and such overreactions have led to many catastrophic market events in the past. Behavioral finance studies reveal that investor overreactions occur as investors are driven by either fear or greed in their investment decision-making processes. However, the world is far from finding a solution to such overreactions by investors. Prudent investors have taken such overreactions as an opportunity to invest in beaten-down stocks or to dispose of their investments at much higher prices than they initially thought would be possible.

The key for investors is to practice rule-based investing to avoid overreacting to new developments that could be proven undesirable for the long-term performance of their investment portfolios. In any case, wisely allocating investment capital to professionals, who can take advantage of the market’s irrational deviations, may be the best move for ordinary investors.

In the following articles, we will dive into some of the financial market bubbles that have had a huge impact all around the world.


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Alex Christodoulakis

Written by
Alex Christodoulakis - Co-founder & CEO @ Daedalus.