Monday, April 3, 2017

Three reasons for market euphoria

What causes people to spend way too much on stocks? It’s an interesting question, especially given the recent euphoria over the IPO of Snap. Most investors today think that the fun will continue. They firmly believe as New Zealand Herald, Mike Taylor writes that “they are in a new paradigm.” Taylor gives three reasons for this mindset:

Anchoring: This is a trait where an investor will "anchor" to a price that is important to them, but may have no relevance at all to the market they are investing in. For example, being focused on doubling your money, and only selling an asset if or when the price reaches this point.

Loss aversion: Recognising a loss is uncomfortable for most people and investors will try to avoid it where possible. That means that if an asset is below the price the investor paid for it, they are prepared to wait in the hope they will get back to break-even. This can prove disastrous if the asset is in terminal decline. At best, it means your capital is stuck in a poorly performing asset when it could be reallocated elsewhere.

Herd behaviour: From a young age, we learn to succumb to peer pressure as the path of least resistance. When it comes to investing, we take comfort if everyone else is doing the same thing. For example, if everyone is buying over-priced internet shares, even if your rational brain tells you this is madness, you justify your decision because, "all my friends are doing it and they are making money, so it must be OK".

Surely, Buffett understands how to avoid the three behaviors Taylor lists. As one of the richest men in the world, he doesn’t get sucked into the euphoria of the markets. He only profits from them. How?

The important caveat from Buffett is that his determination that stocks look cheap based on the current environment of low interest rates. "If interest rates were seven or eight percent, these (stock) prices would look exceptionally high," he said. And of course, by all appearances, interest rates will continue to rise.
Why financial education is a must-have to survive

Unfortunately, the average investor doesn’t understand the fundamentals of the markets, let alone how interest rates impact the value of stocks. They just buy because the market is going up…and everyone else is doing it.

And this brings up an interesting question. What’s the antidote to anchoring, loss aversion, and herd behavior? 

The answer is found in financial education.

By understanding how money and markets work, you are better equipped to see the trends happening…and profit from them. Buffett has built his fortune doing just that. And so have I.