Technically Speaking: A Simple Method Of Risk Management

Yesterday, I addressed the issue of how market innovations and “crowding” into specific trades have been signs of market excesses in the past. To wit:

“That is the cycle of innovation in the financial marketplace. Despite the best of intentions, and advances in innovation, humans will always seek out the comfort of other humans in times of distress. The rising notoriety of Robo-advisors and the crowding of investors into ‘passive indexing’ are the current symbols of excess in the markets today. They will also be the ‘whipping boy’ of the next decline as ‘passive indexing’ is realized as a ‘foolish’ investment strategy.” 

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“I have been around long enough to see many things come and go in the financial world, and there is only one truth: ‘The more things change, the more they stay the same.'”

Just recently, Scott Nations via MarketWatch also made an interesting point with respect to the “psychological” influences that drive behaviors in the longer term:

“One problem investors face is the concept of the ‘anchor’ price, first described by Daniel Kahneman and Amos Tversky. Regardless of the value of a share of stock, we tend to believe that value must be close to the only bit of information many of us have — the current price. This anchoring effect makes it easier to justify paying a wildly inflated price for a company that is operating at a loss or for a market that is hugely overvalued by any objective measure.

Another common fallacy investors face is ‘herding,’ or the tendency to use the actions of others as a measure of sensible behavior. Fads, fashion, and stock-market bubbles are three examples of this mindset. When investors lose the sort of hard-nosed skepticism and difference of opinion that marks a healthy market, it becomes fashionable, and nearly unavoidable, for too many investors to buy too many stocks that have too little going for them.”

The psychology behind “market exuberance,” is an issue that has recurred with regularity in the financial markets and was always dismissed as “this time is different.” Unfortunately, for investors, it never was.

As Scott notes:

“If it were just psychological quirks that lead to runaway stock market rallies, the bubble might deflate itself slowly as the anchor price is gradually lowered and as financial fads and fashions change.

But the stock market isn’t a purely psychology exercise; too often the real world intrudes. Each modern stock-market crash has been precipitated by a catalyst that has little to do with finance and that catches us off guard. These catalysts push a system barely able to maintain equilibrium into chaos.”

Actually, it’s every time.

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Chee Hin Teh 4 years ago Member's comment