How to invest in a cleaver way?

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Markets are a wonderful mechanism. They can bring together buyers and sellers to mutual benefit, create prices for goods and services, and act as a clearinghouse for innumerable objectives. Looking at stock markets where prices of company assets are determined every minute of almost every day, one sometimes wonders what forces could possibly be at work. A company can report nicely higher earnings only to see its stock get pounded down. Stocks can be bid up to such extremes that it would take decades of earnings to justify such a price. Investors often forget that despite the dominance of computer-driven trading in stock markets, it is humans that lie behind the decision criteria that drive markets. And humans can be very emotional. As a result, markets can behave rationally, or irrationally.

Examining the stock market’s rally from the March 2009 lows demonstrates this emotional underpinning. Stocks went from fears that all major banks would be nationalized and a global depression was at hand to determining that none of that would actually happen; then turning to wondering if the economy would be stronger or weaker than projected. This frantic mood swing occurred in just a few short months and despite the pervasive information fountain that the internet provides (were investors lacking enough information in March 2009 to know if a global depression was occurring?). Finance and markets are, after all, built on trust and confidence, both emotional responses. Because of this emotional foundation to decision-making, the analytical framework that academia seeks to provide to describe “fair” asset prices – e.g. that stock prices are the present value of future cash flows – fails to truly explain what is going on and how investors are assessing risk and return.

Looking at the various types of investors shows the task undertaken by markets in clearing the myriad of disparate investment philosophies every day to set stock prices. Here are just a few examples of typical investor styles and types:

Day Traders: these investors are looking to profit from intraday stock price movements. They do not want to hold any stock over night, so each day offers a brand new portfolio. Because of their short timeframe, Day Traders are driven almost entirely by technical analysis as fundamental inputs offer little value. That said, a fundamental event such as an earnings announcement can be a catalyst for action in their world. It is important to note that Day Traders just need movement in any stock; they are not dependent on the market overall to do anything in particular.

Buy and Hold investors: these traditional investors typically look to analysis of a company’s balance sheet and income statement to determine asset value (and therefore a stock price) that is undervalued. By purchasing stocks that are perceived to be undervalued the buy and hold investor hopes that, one day, the market will come around to their view and similarly recognize that their stock deserves a higher price. This recognition by the market can be ongoing as a company grows its sales and/or earnings, thereby justifying an ever-higher stock value. As the vast majority of stocks follow the market’s predominant direction, higher or lower, Buy and Hold investors usually need the market to be moving higher in order to have their assumptions pan out and investment profits to be gained. But they also tend to be the investors that buy when the market is at its worst as the perceived values are most compelling.

Momentum investors: this group contains our trend-following brethren as they seek some sort of trend to drive their investment thesis. They can justify their purchase from a fundamental perspective, a la an Investors Business Daily (IBD) type framework, or just use a purely technical view of the market to determine which assets are moving. Some Momentum investors can find their momentum either going higher or lower, and therefore are long/short investors. They can seek multi-year or daily/weekly trends. Day Traders are also Momentum investors, of a sort, with a very short trend following horizon.

Contrarian investors: this rather selective group has the unique ability (and emotional fortitude) to jump when others are too afraid, sell when everyone says to buy, and generally seek to profit from the irrational behavior of their fellow investors. Many Buy and Hold investors would consider themselves to be Contrarians. And most investment professionals espouse such fortitude. Listen to any interview with a mutual fund manager and you will hear them talking about about buying when others were selling, having overweighted a sector when it was out of favor, etc. Unfortunately, these anecdotal heroics don’t seem to deliver performance (read our recent weekly on dismal mutual fund performance for the data). Of course, Contrarians need the market to change its tune and recognize the brilliance of their position in order for them to see profits. And a Contrarian, when right, can hit a home run as noted hedge fund manager John Paulson did when he bet that the residential mortgage market would implode.

Thematic investors: a variety of niche investors who rally around a common theme. Look no further than the “gold bugs” to find such a group. They come together around the campfire of the demise of fiat currencies, the failure of governments to control inflation, and other such disaster scenarios to prop up their notion of gold as the “only true storehouse of value”. These events happen often enough to keep the theme alive. They do so because humans and their emotions are at the heart of government and market decisions. Certainly, there are investors whose unceasing optimism similarly drives their investment thesis (for example, most stockbrokers?).

All of these investors can be and, at times, are successful. Each day, they place their money behind their favored investment philosophy and strategy looking for the market to validate their decision. Some investors need that validation far quicker than others in order to stick with their position. But it is this interplay between varying investor timeframes, objectives, emotions, and risk tolerances that leads to day-to-day stock market behavior. Having defined a few major types of investors, we will look in a coming weekly update at how they work together to push the market one way or the other.

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