Irrational Behaving Markets

My favorite investment book is "A Random Walk Down Wall Street" by Burton G. Malkiel. This is a good book for any investor. At the end of Chapter 3, a little paragraph summarizes irrational behavior in the stock market or any other market such as interest rates or commodities.

An underlying assumption that investors make is that the markets are both rational and efficient acting in a predictable manner. While this is true most of the time, it is not true all of the time. "The market evantually corrects any irrationality-albeit in its own slow, inexorable fashion. Anomalies can crop up, markets can get irrationally optimistic and often they attract unwary investors. But eventually, true value is recognized by the market, and this is the main lesson investors must heed."

Yesterday's blog touched on this topic. Because of numerous factors any market can act irrationally for a period of time. People only know that it was irrationally high after a correction or irrationally low after a bounce. It is kind of like driving by looking in the rear view mirror. A savvy, disciplined, or just plain lucky investor can sometimes recognize irrational behavior and make money.

An investor that goes with the flow will buy toward the top and sell toward the bottom. Human nature wants to invest in a proven winner because it makes us feel good. Human nature wants to get rid of something that seems like a failure. This means that we tend to buy late and sell late. The more money we lose the greater amount of pain.

From painful experience, I can tell you some of the signs of irrational behavior:

• It seems that everyone is talking about it. It is on the news. Everyone seems to become obsessed about it.
• A statement is made by someone in the know, whomever that is, that the price is just going to keep on going as if the trend will continue forever. Reasons are given and on the surface it makes sense. After challenging a few assumptions, it becomes obvious that this is just repeating what someone else said without a justification.
• The investment has a track record of going up at a fairly steady rate for a substantial time period such as housing prices have been going up on average at about a 5% rate for the last 40 years.
• The rate changes by a significant amount each year for a while, like a few years.
• The price is much higher than any historical level such as a price of 100 times earnings versus 20 times earnings or $1,000 per ounce versus $300 per ounce.
• A herd mentality exists because somebody has recently made lots of money with this investment and the herd joins because they want to become a winner.
• The price has some fluctuations at the top but always seems to bounce back. The stock price goes up or down by 5 - 10% in a day. If it goes down 5% today, surely it will bounce back this amount tomorrow.
• An event happens, like a comment from an expert or the publication of a report and all of a sudden the thing that was going to keep the price climbing higher didn't.
• The price comes down over time, like a staircase, in a painful fashion.
• If you ever say surely it can't go any lower than this, you know that you are in trouble. This is a statement to justify hanging on to it. If you say this, SELL.

It is relatively easy to not get burned. If you own a stock, place a stop loss sell order at a price that you would be happy to get if something went wrong, so if this something happens you will still be happy. If you own some mutual funds and one gets rather excessive in proportion to the rest then sell some of it to get your portfolio back in balance.

Don't learn this lesson the hard way like I did. Profit from my mistake.