Investment Strategies and Human Behavior

About Response is probably the most popularly known effect of human behavior
on market prices. All things being equal, a rational market the fundamentals of a company must determine the market and establish a clear relationship between the two. However, research - as well as a casual glance at CNN stock-ticker on any given day - shows that this relationship does not necessarily happen as expected.

Investors often overreact, often wild, thus pushing prices up too high or pushing
too low against its base. Not only is the market, therefore, are not entirely
rational in reality, but the effect can not be attributed to a financial or business-based
factor. The most likely reason for the anomaly appears to be the way investors perceive
and respond to, earnings surprises or news, or even actions of other investors. This
overreaction happens on the stock market and gives rise to a number of investments
strategies.

Contrarian strategies 

The overreaction effect is very pronounced 'out of favor' to compare (contrarian
shares) against the current 'favorites', or what are also known as value and glamor
stocks. 'Out of favor' stocks are not stocks that poor quality stocks are simply those who
are not attractive for the market, for which reason it might be. The interesting
is that over time, the stocks 'out of favor' to outperform the better overall
Favorites. Then, when the 'out of favor' stocks become the 'favorites' due to increased
buy the effect is reversed, and the process is repeated in a cyclical manner, while only a
small changes could be made to the fundamentals of the file. "This happens," says David
Dremen, which examined the effect of a portfolio of stocks over a period of ten years,
"Because these stocks will tend to pass the time than to return as investor expectations change.
Premiums paid for high growth stocks are overpriced, while out-of-favor "stocks
begin represent greater potential benefits. The effect is reminiscent of regression to the
mean, a statistical effect which measurement will tend to their average, and is
actually nothing new. Scientists have known for a few hundred years that this kind of effect
often occurs when human behavior is involved. What is new is that the effect has been
to act within a particular domain of stocks.

Whether a stock is a 'out of favor' or 'problem area' stock is indicated by their ratios.
According to James O'Shaughnessy, whose extensive and well-researched findings were
published in What Works on Wall Street, these include: price to book value (P / BV)
price to cash flow (P / CF), and earnings ratio (P / E). Stocks with the lowest ratios
to rise, especially in the most potential good news surprises, and therefore the
ones, of this opposing perspective, that has to be searched for, provided that they
essentially good stocks.

Momentum Strategies 

Contrarian investing seems that making money in the stock market to give than
and above the small but consistent returns of well-known companies like Microsoft or
IBM, requires just buying 'out of favor' or value stocks. However, this is not the case.
Indeed, if one were to buy one rising it to its logical conclusion
- That stocks were on their way to becoming glamor - and profitable opportunities would
be missed. In addition, value stocks take an average of five years to show a valuable
back. Clearly this is often unacceptable and research confirms, in fact, that momentum
pushes many files to new heights regularly, and money can be made on these files
significantly faster than five years. This does not mean you just buy all shares
are away from their rational price rises as a result of market or behavioral influences. Such
and unsystematic approach would likely result in a loss. Although, as Robert Vishny
points out, "You do not make money on the best stocks in the market, money per se but on the
inventories think everyone is going to be. for the best ' The rider of course you
still need to share that good or potentially good buy, even though they may not
the best. Since this is true, and you can locate these files, there are two
momentum strategies that can be employed.

The first strategy refers to combinations of the files, and makes use of so-called
the major stock effect. Research on the portfolio return of Andrew Lo and Craig
Mackinlay, using a mix of small and large capitalization on the New York
Stock Exchange, showed that there is a correlation between one week and the next,
where about ten percent of the price change in the coming weeks yield could be predicted from
This weeks. Although the effect only works for portfolios, not individual stocks,
and only in the short term - ie, daily and weekly returns - there seems to be a
observable lead / lag pattern. Which means, large stocks lead small stocks, hence the
name. For example, Microsoft is going up dramatically and there a few days later
price jump in other computer software manufacturers.

Consequently, buying second line stocks - mid caps and small caps - in a sector
believed ready for a re-rating to be sometime in the near future, and then sit on the
investments patient, can work very well. Although money can be made here purely from
momentum effects, my preference is for a portfolio that is financially sound and less
likely to be afflicted when it moves around. volatility by In other words, you are pitting
your wits against the market sentiment, the investor perception alone has decided this
stocks are out of fashion, not against fundamental financial and economic determinants
realities.

The second strategy involves intriguing findings Professor Joseph Lakonishok programs
show that a high momentum stocks - as measured by their previous six months earnings -
outperform low momentum stocks by 8 percent to 9 percent in the following year. Hence
buy high-momentum stocks can also be a suitable method for increasing his portfolio
return. Again, though, the rider is that you still need to stocks that are good or buy
potentially good.

Joseph Lakonishok and his colleagues, finance professors Andre Shleifer and Robert
Vishny, not only come with interesting scientific ideas. They run LSV Asset Management,
where they are in practice much of their research discoveries. In general, they tend
avoid choosing expensive growth stocks that have been given the dynamics tag. Instead,
they use momentum signals - such as increased sensitivity and volatility
earnings reports or news announcements - to value stocks that are just beginning to reveal
the upward phase of their recovery. This is no easy method of portfolio formation,
timing and stock selection are crucial, but like the professors, you will find it much
easier if you have a specialized computer!

Surprise Profit Strategies 

As far as momentum stocks, the trick in forming a wallet is in the use of
accurate measures indicating the stock starts rising phase. This can be somewhat
harder than it first appears, even with a specialized computer program. Nevertheless
Besides watching the stock of the past six months, profits, earnings surprises can also be used
as the decisive factor for stock selection.

One way to gain surprise, represented by the work of Victor Bernard and
Jacob Thomas at Columbia University, is by measuring the surprise against analyst
expectations. If the surprise is not only positive, but exceeds the expectations of analysts
there is a greater chance that a potential winning candidate for your
portfolio. However, it must be remembered that it is not always clear what
a useful positive earnings surprise, especially when it is considered that the profit
can be maintained or repeated in the future. One swallow does not make a summer! Has
The company actually changed at all?

Earnings surprises may also be affected in the market by the analyst
evaluations and this evolution overreaction in the extreme, which again provides a
useful strategy. For example, Intel showed a greatly exaggerated 20 percent in three days
when the stronger second quarter had reported. profits in 1995 This all came to 4
percent below the expectations of analysts, who had, behaviorally speaking, the impetus for
the drop. A change-around was inevitable but as profits continued to grow. By the
spring of 1997, Intel's stock had nearly tripled. Anyone knowledgeable about the
now, instead of after the investment crowd, would have made money in this
situation.

A similar striking example is Hewlett Packard, and it also serves to emphasize
how extreme reaction of investors to press releases can be. Exploiting this overreaction
leads to a profitable investment. In September 1992 the company
announced that profits would be below expectations of analysts. By the next day, the price
had plummeted 18 percent. This reaction was completely irrational and disproportionate. In
real terms for an expected decline in profit in the course of the following year a few
million dollars of the company's market valuation had plummeted in twenty-four hours with 3.5
billion dollars. Needless to say - if you have followed the scope of this article so far -
it will not come as a shock to know that the price was fully recovered within three months
and then some.

With a thorough understanding of these types of behavioral pricing anomalies, based born
by his success, and considers that a good investor may not be constant
trade, Warren Buffet put it well when he said: "Just look at the market to see if
Everyone has done something foolish that day when you can benefit. "

Merger Strategies 

Another way to make use of over-reaction that causes pricing anomalies is to exploit
certain types of merger situations. For example, in 1907 made a covenant between
Royal Dutch Petroleum and Shell Transport. These two companies have agreed to merge their
interests on a 60 to 40 percent basis, but remain independent incorporated in the Netherlands and
in England. As it was in the early 1990's, RDP acted primarily in the U.S. as a
component of the S & P500 and Shell was trading mainly in the UK as part
the FTSE100 (Financial Times Stock Exchange index Hundred).

Even taking into account the passage of years, a rational market dictates that the two
parts of the company to trade in the same or similar ratio of 60-40. Still, recent
research has shown that this is not the case, share prices of the corporation did
not reflect this relationship. On the contrary, after adjusting for taxes, transaction costs, and
exchange differences, the actual price ratio between RDP and Shell had departed
the expected ratio by about 35 percent.

Human behavior is back to work for the effect, because apart from the trade in
potentially most profitable part of the company's stock, can also be used with a
arbitrage approach. The strategy is long term perhaps, but for mutual funds or hedge
funds can be an ideal method of investment.

Apparent High Risk Strategies 

A seemingly high risk strategy involves dealing in investments that are considered
need a very wide berth because they will lead to heavy losses. The reason for this
strategy is that misinformation, lack of knowledge about the investment, or market
pressures, are influencing the investors think in a certain way and making them overreact.
Successful implementation of the strategy is to overcome these factors and rational
examining the proposed investment.

Junk bonds are an example here. These are high yield bonds with low credit ratings by
agencies, ie with a rated BB or lower. The general perception of this, intensified by
the media attention surrounding Mike Milken and Drexel Burnham in the late eighties,
that they are very poor and therefore extremely risky. But is that perception justified
or is it another case of investors overreact to the information they hear instead of
making their own considered assessment? The fact is these bonds are still around, so
someone is buying them - in fact worth $ 178.45 billion was spent during the five
years ending in 1996 (source: Securities Data Co.). Indeed, these individuals may well have
make their decisions based on various reports and studies that demonstrate the
performance of these tires under the appropriate conditions. In particular, the low-grade
bonds on average yield 50 percent more than quality and that defaults were not
considerably larger (looking at the data from 1900 to 1945 the Hickman report), the
default rate, according to TR Atkinson, was actually 0.01 percent from 1945 -1965, and
perhaps the most convincing that even when the default rate increased to between 0.015 percent
and 0.019 percent by 1981, at a yield premium of 4 percent of the risk was very acceptable.
What this has meant that it was the possibility of a gain was more than twenty times more likely than
the potential loss on the stand. But in the affected mentality of most investors
there was no chance of a sure gain. Faced with the possibility of what they believed
there were greater elsewhere in the market, and as prospect theory
Daniel Kahneman and Amos Twerski predicts, investors aloof from this possibility in
the benefit of what they believed were safer stocks, such as the upcoming Microsoft glamorous
and Yahoo! The irony is that many investors would later get burnt out on these files as their
ratings shot through the roof and then see-sawed.

Junk bonds are not for everyone, and certainly not for the beginner, they take a high
level of knowledge they trade successfully, they must be in a diversified portfolio,
and they must be of good quality, which many have not yet. But what this strategy
seen that there are many investments that further research be safer than
first appears. Human behavior, overreaction, concerns the importance of foreign
information, such as the media hype and expert advice, stopping investors from giving junk
bonds or similar apparent investments with a high risk of a careful consideration on their own merit.

A new wave of strategies 

While over-reaction can be utilized with a variety of strategies, as we have seen, up to now
overreaction is difficult to measure as a causative factor in determining price itself
anomalies. Knowing this would give us a very effective strategy. However, the scientific
jury is still out on what exactly overreaction. We know what effect it has, but
what actually is it? For example, it is a market-based or based individual investor
effect, or both? Can we know before we see the effects of the factors that promote
are in evidence? Attempts to with the help of a measure have produced mixed results, such as ABN AMRO
found with their behavioral finance fund has lost about 27 percent since inception.
Much work needs to be done before we fully understand how human behavior functions in the
context of the stock market.

There is little doubt that a knowledge of human behavior can improve
money-making opportunities when investing. Behavioral finance specialists, however, have only
just begun to scratch the surface of new strategies with a systematic approach
the understanding of the processes and the application of the findings. Much more useful
strategies are likely to occur in the coming years. The area itself is only about
fifteen years old, a newcomer in the financial arena, and one that is only now beginning
in order to show its value.