Investoid

In order to get into short term investing, you need to understand what human traits causes people to act irrationally. The field of behavioural finance is dedicated to this topic. In this straightforward introduction to the subject, Jay Ritter provides us with the common faults that human investors/traders make. While there are many failings highlighted, the ones that I find most influential are:

• Overconfidence: people tend to overestimate their abilities (for instance, ask them if they are better than the average driver), while underestimating what they are up against. This can lead to under-diversification as well as continuing to employ a losing strategy.
• Representativeness: people tend to underweight long term behaviour and averages in favour of near term trends. This is one of the main factors behind asset price bubbles, as people only see the upside and forget about the eventual reversion to the mean.
• Disposition effect: people are known to take profit too early and hang onto losing positions for far too long. This is because people think about paper gains/losses differently than realized gains/losses. As a result volume is typically higher during bull markets than bear markets. Ken Fischer calls this effect ‘mental liquidity’.

This paper indicates that most short-term deviations in asset value away from the theoretical ‘fair value’ are hard to capitalize on due to a lack of short-term mean reversion, while more systemic and/or long term deviations (eg. tech bull market, 1987 market crash) can be taken advantage of.

I don’t necessarily agree with this conclusion, since most stocks have a pretty wide 52 week range that does not coincide with material changes in their underlying value (eg. earnings, dividends, etc.). As Joel Greenblat observes, do most companies report 100% changes in earnings each year? If not, then why do their prices behave as such? Earnings and financial performance have only a partial influence on a stock price.

My theory behind such volatility is the continual change in assumptions as to what the stock price will be in the future. Other informational influences such as economic news, rumors, buyout activity, etc. all play a part in the daily variation of stock prices.

Knowing what basic human characteristics inhibit your success in the markets is quite important. I plan on keeping a list of all the potential pitfalls I could fall into close at hand and review them every week to ensure that I am managing my positions appropriately.