A number of Nobel Prize winning theories start with the assumption that investors are rational. In the real world, many investment professionals discover through their daily interactions with investors that there are occasional bouts of irrationality. In discussing the markets with the public, it’s important to understand this since questions and firmly held beliefs could be rooted in that irrational behavior.
Rational investors most likely only exist in Modern Portfolio Theory. The argument makes sense intuitively. Investors will buy the portfolio that maximizes the potential returns while minimizing their personal preference for risk. But in the rule world, emotions like far and greed, infiltrate the decision making process.
Potential returns are generally defined by discounting the future cash flows of an investment back to its present value. In theory, some investments will be undervalued and these should be bought. Others will be overvalued and would be avoided, or sold short if the investor had sufficient risk tolerance to trade on the short side.
These ideas are based on the firm foundation theory, which was probably first well defined by John Burr Williams in his 1938 book, The Theory of Investment Value. Interestingly, the economist John Maynard Keynes had described the market in more speculative terms in his The General Theory of Employment, Interest and Money two years earlier.
Keynes argued that no one really knew what the future held for any company. It is entirely possible that a stock selling for $25 a share is fundamentally worth $45 a share based on sound assumptions related to future earnings and dividends. But, he noted, if an investor thought the market would value the stock at $15 in six months, no one should buy it at $25.
He famously simplified the stock market to a newspaper beauty contest. To win, contestants need to pick the six most beautiful pictures out of a group of 100, based on the results of a poll. In other words, the contestants need to pick the six pictures that most people will consider to be the most beautiful. Their own personal judgment isn’t as important as what they think other people will think.
In effect, this is what a market is. The value of something isn’t what one person is willing to pay, but instead it’s what the collective group of investors thinks others will pay. Buying means that the buyer thinks that someone else will place a higher value on the asset and their desire to pay more, so that they can in turn sell at an even higher price, will allow the original buyer to earn a profit.
Keynes’ model is sometimes called the greater fool theory of investing, and thinking about the internet bubble may help explain why. Someone would buy nobusinessplan.com because they intended to make 100% on their investment and sell it at the end of the day. If a shortage of fools developed, the market could crash, and that is exactly what happened.
For hundreds of years, the public has demonstrated that they will follow the crowd and invest when the timing may not be best. Keynes’ theory helps explain why sentiment measures can offer valuable insights to the markets.
Sentiment measures are one of the tools of technical analysis, a field that is itself based on three simple ideas:
1. Market action discounts everything.
2. Prices move in trends.
3. History repeats itself.
A more detailed look at a sentiment indicator will be featured next month.
Michael Carr, CMT, is a member of the Market Technicians Association, and editor of the MTA's newsletter, Technically Speaking. He has served as a director of the MTA Educational Foundation, promoting the value of technical analysis to the academic community. He is the author of two investment books, Smarter Investing in Any Economy: The Definitive Guide to Relative Strength Investing (W&A Publishing, 2008), and Conquering the Divide: How to Use Economic Indicators to Catch Stock Market Trends (W&A Publishing, 2011).
