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Wednesday, June 25, 2014

RANDOM WALKER | Selling on bad news can never be good (or, how the mind plays tricks on you)

Since the start of April, the Philippine equities market has not seen much action, listlessly bouncing around the range bounded by 6,500 at the bottom and 6,900 at the top.

The same surface composure, however, cannot be said of the much-reduced number of investors and speculators remaining in the market. This depleted number of market players and their tendency to panic similar to how a crowd would respond to a zombie attack in a Grade B movie may both be attributed to market and investor psychology. More precisely, how otherwise rational people can be so taken up in the moment, when they set aside all they know and swap these for emotion-based decisions.

A recent case in point would be the government’s release on May 29 of a disappointing first-quarter economic growth of 5.7 percent, against forecasters’ consensus of 6.4 percent. Not a few so-called “market experts” subsequently predicted the end of the market as we know it, based on their belief that the GDP numbers directed the market’s trend. It does not. Moreover, given an information-efficient market, the term “market expert” can be an oxymoron.

Thus, on the day of the GDP release, the benchmark PSE index immediately responded by losing 1.6 percent and further lost an additional 0.4 percent the next day to 6,647. The index has since recovered above 6,800, and appears to be on its way to retest the year’s high of 6,908. Clearly, the market’s abrupt drop on the GDP news was a knee-jerk reaction that had no lasting effect on the overall trend.

Those who sold on the bad news must, justifiably, feel real dumb. The bedrock lesson is not only the fact that it is not good to sell on bad news. People have psychological biases that they may not be aware of but which determine their investing decisions that inevitably lead to losses or less than optimum returns. The financial literature labels these irrational tendencies as cognitive biases.

One of the most basic cognitive biases to which everyone in the market can be prone to would be loss aversion, coupled with the disposition effect. Loss aversion refers to people’s tendency to hate losses from the status quo, to the point that they would attach higher emotional content (fear and loathing) to losing, say, P10,000, than to the emotional thrill of winning the same amount of P10,000 (just meh). People with a high sense of loss aversion would be likely to sell in a panic during a market meltdown.

The disposition effect would tend to dig a deeper hole for people with high loss aversion. The effect refers to the inclination of people to sell a stock that has climbed for a short while with minimal gains while holding on for a long time to the stocks that are losing money. People tend to sell their winners and hold on forever to their losers. When a stock they purchased at P100 drops to P50 before recovering to P75, people would prefer not to take the loss at this point but would wait for the stock to go back to their purchase price. It may never do so. But still they wait, with the eternal patience of Penelope weaving her shroud.

Availability bias and the 'disappointing' GDP numbers

Most market commentators and analysts fell into the behavioral error called “availability bias.” When these experts are called to predict or forecast the probability of a certain event, they will do so on the basis of the most easily available similar event in the past. If an event happened in the recent past, this event is “available” to the experts’ perception. While this is not necessarily a cognitive error, the experts tend to inflate the probability of recent past events happening again in the future.

In this instance, the task was to predict how the market would react to the news of below-par GDP growth. The most available event would then be the global financial crisis, when the sudden slowdown in global growth in 2008 led to near-zero growth in the domestic economy and a 48 percent plunge in the PSE index. Obviously, from today’s perspective, this year is no way near the events of 2008.

A bad choice of a starting point, the most “available” event, would be compounded by the cognitive bias called "probability neglect." Being depressive realists, or reverse Pollyannas, market investors tend to focus on the bad news and worst-case scenarios, letting their emotions run amok to cloud their decision- making. Certainly, the market risked a drop towards the 6,500 floor, with a breakdown of this major support imminent, following the GDP news. The probability for this happening was real, but was it high?

Corporate earnings continue to be within expectations despite the GDP slowdown. Furthermore, economic growth is slowing, as expected, but not to the levels of 2008. The bias towards negativity had less probability, as it turns out.

The market’s emotional rollercoaster, separate from the actual trend in the market index, has likewise led to thinner crowds playing in the market. Just a year or so ago, it used to be that everyone and his long-lost twin played the market and had something to say about its prospects, mainly that the index is headed towards 7,000 and beyond.

Now, the investor multitudes have dispersed and this stock market column is left preaching to the choir. This too is a product of the disposition effect, which may be seen in the market’s trading volume trend. During the bull market, market trading expanded to exceed P10 billion a day, as players bought and sold stocks for short gains. Now, with the market having dropped from the highs, trading volume likewise dropped, indicating that players who got trapped in the market are likely still holding on to their losing positions.

(An MBA degree holder, the author used to be research head of BusinessWorld, and before that of Anscor Hagedorn Securities)

- Interaksyon

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