A friend of mine recently asked if I had read a book called Psychology of the Stock Market. Given the subject matter, I was quite surprised that I hadn’t come across it. Even more surprising is that it was first published over 100 years ago. So, how do George Charles Selden’s thoughts on investor and market behaviour from 1912 compare with today? Has much changed?

Let’s look at some highlights:

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“The market is always a contest between investors and speculators.”

Selden argues that there are two types of market participants. Investors – who are focused on the fundamental attributes of a security or asset, and speculators – who are concerned only with the direction of the price.

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“The speculator cares nothing about interest return…He would as soon buy at the top of a big rise as at any other time.”

The idea that large swathes of investors have no real concern about the underlying value of a security is similar to something I wrote about valuation and price in 2022. He just got there a little earlier than me.

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“However firm may be his bearish convictions, his nervous system eventually gives out under this continual pounding, and he covers everything…with a sigh of relief that his losses are no greater.”

Selden writes of a short seller who – despite retaining a stridently negative opinion – capitulates because of the pain of being the wrong side of a trade. Evoking not only loss aversion, but the emotional strain of being wrong.

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“It is hard for the average man to oppose what appears to be the general drift of public opinion. In the stock market it is perhaps harder than elsewhere.”

We are inescapably drawn towards the behaviour of the crowd. Taking and maintaining contrary views can be exacting and exhausting.  

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“the average man is an optimist regarding his own enterprises and a pessimist regarding those of others…he comes habitually to expect everyone else will be wrong, but is, as a rule, confident that his own analysis of the situation will prove correct.”

This description of overconfidence from Selden still resonates today. The odds and evidence are against everyone else successfully picking stocks, timing the market or making economic predictions – but, of course, I can do it.

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“If you are long or short the market you are not an unprejudiced judge, and you will be greatly tempted to put such an interpretation upon current events as will coincide with your preconceived opinion.”

Confirmation bias remains as strong now as it was back in 1912.

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“When the market looks weakest, when the news is at the worst, when bearish prognostications are most general, is the time to buy, as every school boy knows; but…it is almost impossible for him to get up the courage to plunge in and buy.”

Here Selden describes the difference between our behaviour in a hot and cold state. In our cool, calculating moments, it is easy to plan what we will do when markets are in turmoil; yet when that moment arrives our emotions will take hold with fear and anxiety overwhelming us. Selden was unknowingly advocating systematising future investment decision.

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“It is a sort of automatic assumption of the human mind that present conditions will continue”

Extrapolation remains one of the most damaging investor behaviours.

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“Some events cannot be discounted, even by the supposed omniscience of the great banking interests.”

Selden is writing of our inability to anticipate or price certain risks. Although we might think of this as similar to black swans, he goes on to mention earthquakes – so this is more about ‘known unknown’ tail risks, than events we have not even considered.  

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“Even the clearest mind and the most accurate information can result only in a balancing of probabilities, with the scale perhaps inclined to a greater or less degree in one direction or the other.”  

Selden alights on two vital topics for investors here. The need to think in probabilistic terms and the requirement to temper our confidence. Both are essential for dealing with such a complex system as financial markets. Humility is critical.

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“The professional trader…eventually comes to base all his operations for short turns in the market not on the facts but what he believes the facts will cause others to do.”

Selden pre-empts the Keynesian beauty contest here and describes the behaviour of many investors then and now. Decisions are not made based on new information, but how it is perceived other investors will respond to that new information.

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“Both the panic and the boom are eminently psychological phenomena.”

It is at the extremes of market behaviour that investor psychology is most apparent and difficult to resist.

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“The “long pull” investor buying outright for cash and holding for a liberal profit, need only consider this matter enough to guard against becoming confused by the vagaries of public sentiment or by his own inverted reasoning.”

By “long pull” Selden is referring to long-term, fundamentally driven investor. To benefit from the long-term benefits of stock market investing one must ignore the fickle and forceful shifts in investor opinion and resist our own behavioural foibles. Easier said than done!   
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“Another quality that makes for success in nearly every line of business is enthusiasm. For this you have absolutely no use in the stock market… Any emotion – enthusiasm, fear, anger, depression – will only cloud the intellect.”

It is difficult to overstate the extent to which our investment judgments are driven by how they make us feel. A good rule of thumb is – the stronger our emotion, the worse the decision.

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“Sometimes it may become necessary to close all commitments and remain out of the market for a few days”

Selden is writing from a trader’s perspective here, so most of us can turn his “days” into weeks, months and years. The less we check our portfolios and watch financial news, the better our outcomes are likely to be.

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Although Selden doesn’t use the same terms, it is impossible not to recognise the behaviours he describes. I am often asked whether an improved awareness of the pitfalls of investor psychology has improved behaviour. Unfortunately, I don’t think it has. Rather the ease of which we can trade, monitor our portfolios, and receive new information (noise) has made things worse. Selden’s words from 1912 are just as relevant today, if not more so. 

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You can get a copy of Psychology of the Stock Market here.

I am not sure if my book – The Intelligent Fund Investor – will still be around in 100 years, so in case it isn’t you can get a copy now – here (UK) or here (US).

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Before you stop reading, I promise this is not another SVB explainer. While (too) much ink has been spilled detailing the bank’s failure; it is often useful to take a step back from tumultuous market events and consider our own behaviour. What happens to us during such stressful periods and what does it tell us about how we deal with investment risk?

Our time horizons contract – The key danger for investors during periods of market stress is the contraction of our time horizons. Even if we have a long-term orientation, we quickly start to worry about the immediate future. All our carefully considered behavioural plans can be torn asunder, as we seek to remove the anxiety we are feeling right now.

We focus on one thing – It is not just that our time horizons contract, but our focus narrows. The attention of virtually all investors turns to one thing, typically at the expense of issues far more important to our long-term fortunes.

We feel like we must act – Never is the most damaging investor urge of ‘something is happening in markets; we must do something to our portfolio’ more powerful than during a concerning and unexpected market event. It feels like everything is changing, so our investments must also change. We never let our failure to predict what has just happened stop us predicting what will happen next.

We are all ‘after-the-fact’ experts – When a significant market event that nobody predicted occurs, hindsight bias runs amok. Many people have now cogently explained the risk inherent in the SVB model, not many did so before it failed. While everyone is busy discussing what transpired, it is worth reflecting on why nobody expected it.

Uncertainty hasn’t increased – During stressful periods in markets it is common to hear people comment that markets are now ‘more uncertain’. This makes no sense. Markets are always uncertain. If we felt more confident in the future before the surprising occurrence with SVB then it turns out that we were wrong. We simply don’t know what is going to happen tomorrow.    

Market / economic predictions are tough – I don’t recall reading many 2023 market forecasts which mentioned the failure of a major bank. The problem with complex, adaptive systems is that things change / events happen and that alters everything. Let’s stop making short-term market predictions.

The most meaningful risks are the things we don’t see coming – Both how we think about and model risk is conditioned by what we have seen and experienced. The most profound and material risks are the ones that we do not anticipate.

Risks are either understated or overstated – We are prone to treat risks in a binary fashion. Either completely ignoring them or hugely overstating them. We tend not to buy flood risk insurance until our house is under water.

We focus on risks that are available and salient – The risks that we focus on are those that are available (in recent memory) and salient (provoking emotion). This is why rising interest rates after a period of secular decline has been so problematic (see SVB, or LDI in the UK). It is easy to be complacent about risks that have not come to pass in a long time (perhaps in our living memory).

This risk is now available and salient – Now the type of risk encountered by SVB has become available and salient it will be at the forefront of our thinking and decision making – we will see it everywhere. Unfortunately, the next major risk event is likely to be something that is not.  

Exciting stories overwhelm risk awareness – A useful rule of thumb is that the more compelling an investment narrative – the more adulatory front pages and gushing stories – the greater the hidden risks. There are two reasons for this. First, good stories can leave us blind to detail. Second, when a captivating story is working or making money, it can feel too costly not to join the party.    

Unexpected market events are anxiety inducing and provoke some of our most damaging behaviours. It will be in most investors interest to focus less on the current issue and more on our response to it. Sensible investing principles – such as taking a long-term perspective, systematic rebalancing and being appropriately diversified – are designed to deal with situations like these. Let’s not forget them.  

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My first book has just been published! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

In 1907 English polymath Francis Galton published an account of a forecasting competition that had taken place at a country exhibition in Plymouth the year before. He described how 787 participants had attempted to win prizes by correctly guessing the weight of a slaughtered ox. After reviewing the entries, Galton observed that the median guess was within 1% of the actual weight.[i] This remains one of the foremost examples of the idea of the wisdom of crowds, whereby combining a diverse array of independent opinions can lead to robust forecasts, often superior to those made by any individual.

The notion of the wisdom of the crowd is often applied to equity markets, particularly those arguing that they are (at least close to) efficiently priced. Unfortunately, the conditions for the wisdom of crowds to function do not hold for public equities. In fact, the behaviour of the crowd – in a variety of ways – creates inefficiencies rather than removes them. The inevitable presence of inefficiencies, however, does not make markets easy to beat or mean that we should even try.

For the purposes of this piece, we can assume that efficiently priced means to reflect the best collective estimate of an asset / markets’ value based on all available information. It is easy to see why the wisdom of crowds is a compelling description of how equity markets operate. We have a vast array of distinct investors making independent judgements. Doesn’t that get us to a similar situation to Galton and the Ox? Not quite.

As investors know only too well, crowds are not always wise. There are several characteristics required before we can begin to value their wisdom. [ii] The three most relevant are:

– Diversity of opinion: There does not necessarily need to be different information but, at least, the same information interpreted differently.

– Independent judgement: Views must be reached without the influence of others.

– There must be a means of collecting diverse opinions: There needs to be some means of aggregating group perspectives.

While equity prices are certainly an excellent way of collating the individual judgements of a participating group; applying the wisdom of crowds to equities breaks down when it comes to independence and diversity of opinion.

Although it may seem that the sheer number of participants in equity markets guarantees that prices reflect a varied range of perspectives, there will be times – particularly during market crashes or bubbles – where investor focus becomes trained on a very narrow set of ideas. In addition to this, it is at such times where investor decisions are most likely to be influenced by the behaviour of others. Extreme events in markets will be generated and sustained by the shared stress, fear and excitement of the crowd.

This destructive crowd behaviour leads to what we can think of as acute or episodic inefficiency. Where the price of an asset or security can diverge wildly from any reasonable assessment of fair value because the crowd / market has lost its independence and diversity of opinion.
 
It is not simply these bouts of dramatic crowd behaviour that prevent the market being efficiently priced. There is something else. Galton’s ox and other similar examples (such as judging the number of sweets in a jar) work because everyone involved is trying to guess the same thing. To believe that equity markets are efficiently priced because of crowd behaviour assumes that all or most of the crowd are attempting to make decisions based on their estimate of the fair value of the underlying securities. But they are not.

There are a huge range of motivations as to why investors make purchase and sell decisions, which have little relation to any assessment of long-run fair value. Investors might be passively following a market cap index, they might be chasing price momentum, they might be attempting to assess which company has the best earnings revisions prospects over the next 12 months or simply predicting how other investors will react to the latest news. All are valid approaches, but none require the estimation of a security’s fair value.

We can think of this situation as akin to Galton’s ox scenario, but where each participant is guessing the weight of a different animal – one a pig, one a sheep, another a goat. There is no reason to believe the average of such estimates will get us close to the weight of an ox.

Contrary to the aforementioned acute inefficiency, this is a chronic inefficiency. Where we should not expect the views of the crowd to equate to fair value (at any given point in time) because different people are forecasting different things.  

How might these two types of inefficiencies interact? Markets are typically in a state of chronic inefficiency where prices fluctuate based on the behaviour of investors with differing objectives, but with some slight gravitational pull from fair value. This will be punctuated with occasional bouts of acute inefficiency where investors (the crowd) move in concert and focus on a particular issue or story.  

If crowd behaviour means that there are both chronic and acute inefficiencies with markets unlikely to approximate fair value, does that mean everyone should be an active investor? No. Markets being inefficient does not mean they are easy to beat.

Episodes of acute inefficiency create the greatest opportunities in terms of the level of divergence from fair value, which will often be extreme. Exploiting them is, however, no easy task. It will be incredibly difficult for us to escape the pull of the crowd or the specific issue that is the focus of their attention. Even if we do manage to separate ourselves, we have no means of predicting when the behaviour will abate. Avoiding the madness of crowds can be painful and costly.

Although taking advantage of chronic inefficiencies may not be as emotionally exacting as escaping the fervour of a crowd, it remains a herculean challenge. Not only do we have to have a means of identifying some reasonable range of fair value for a security or an asset; we have to wait for it to be realised. If investors in aggregate are not attempting to find this fair value (because they are investing for other reasons) there is no reason for it to reach it anytime soon. So we need analytical prowess and (a lot of) patience.

The idea of the wisdom of crowds tells us more about why markets are likely to be inefficient (at times extremely so) rather than efficient. It also provides insights as to why taking advantage of that inefficiency is quite so difficult.

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[i] A 2014 paper by Kenneth Wallis “Revisiting Francis Galton’s Forecasting Competition” found some discrepancies in the original work that actually served to strengthen Galton’s theory as the mean estimate of 1197lbs was found to have exactly matched the weight of the ox.

[ii] See James Surowiecki’s excellent  “The Wisdom of Crowds” for more detail on the conditions required for a ‘wise’ crowd.

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My first book has just been published! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

I am in a forecasting competition and asked to predict global iPhone sales. I can choose to make an estimate over one of two time periods – either the next three months or the next ten years. Which would I prefer? This is a simple decision – the next three months. There will be far less noise and uncertainty over the quarter then there will be over the decade. This aligns with Philip Tetlock’s work on super-forecasting, which suggests that predictions for the near-term are likely to be more accurate than those we make for the distant future. Does it therefore follow that investors are best placed to focus their attentions on the short-term? Almost certainly not. In fact, where we do have to make forecasts, it typically is in our interest to take a long-term view. Why is investing an exception?

Before exploring this idea further, it is worth starting with a caveat. Forecasting most things is difficult and we are notoriously bad at it. Predicting the behaviour of a complex adaptive system such as financial markets is particularly challenging. Our default setting should be to avoid it, where at all possible.

But as investors we must make certain types of projections, even if we don’t realise it. When we build a portfolio the decisions we make (how much to allocate to equities? How much to bonds?) are underpinned by expectations about the future. Not all forecasts are created equal however, even when they are about the same asset class.

Let’s take equities. In very simple terms if we want to take a view on the prospects for global equities then there are two things that matter: sentiment (how other investors ‘value’ them) and fundamentals (the earnings stream we receive through time). The importance of each element alters dramatically depending on the time horizon applied.

The shorter the time period the more sentiment dominates outcomes. This creates a prediction problem. It is close to impossible to hold confident views about what events will occur and how market participants (in aggregate) will react to them. The amount of noise and randomness is pronounced, and the range of potential outcomes vast.

As the horizon extends, however, the fundamental factors start to matter more. The compound impact of earnings begins to overwhelm the influence of fluctuating sentiment. If we are making a ten year forecast for an asset class, we are thinking about the accumulation of cash flows / earnings over that entire period, not just what they are by the end of it.

The influence of multiple years of earnings should mean that the range of outcomes narrows as our time horizon increases. In the graph below we can see the breadth of annualised returns for global equities since the late 1980s:

A one year horizon is the point of peak sentiment driven uncertainty, which then tapers materially as the period extends.

If we are investing in global equity markets today, we know the starting yield, the valuation and can set a prudent expectation for growth (long-run global GDP). It is reasonable to expect our returns to gravitate towards this over the long-run. There are clearly no guarantees here and there remain profound uncertainties. We should, however, have more confidence in these types of assumptions than in what might happen in equity markets over the next year.

Although it is more likely that we will enjoy success in making long-term asset class return forecasts, it is important to define success. We are not going to predict ten year returns accurately to 2 decimal places (or indeed 1); one of the few things we can be certain about is that such point forecasts will be wrong. This does not mean, however, that long run views are without value; there are many situations where they get the odds on our side.

Take the below three examples. These are all scenarios where I would prefer to make a ten year to a one year prediction:

• Setting a sensible range of expectations of where asset class returns will reside: I would expect the dispersion of returns to narrow as the time horizon moves past twelve months.
  
• Ranking asset classes by relative preference: I have no idea about how equities will fare compared to government bonds over the next year, give me ten years and I will be far more confident.
  
• Judging the likelihood of positive absolute performance: The odds of positive returns from most traditional asset classes improve as our time horizon extends.

The benefits of adopting a long-term approach when setting return expectations is reliant on being diversified. If we are heavily concentrated (for example owning a single stock) we should not expect the spread of potential outcomes to contract materially as our time horizons extend because of the ever-present spectre of idiosyncratic risk.

Whenever we make a forecast we should seek to understand what the most influential variables are and how unpredictable they are likely to be. For investors making decisions based on short-run asset class performance it is critical to be aware that outcomes will be incredibly noisy, driven by erratic sentiment and have a wide range of potential paths. Although imperfect, extending our time horizons can give us a little more confidence.

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My first book has just been published! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).