Rick Ferri has an interesting blog piece that was brought to my attention through Abnormal Returns. (Maybe I can stir up a little controversy for a blog you should be reading every day.) In it, Mr. Ferri suggests that investor sentiment surveys don’t work because they are equal-weighted. He contends that only the opinion of large investors matters and says to follow the money.
He says explicitly, in the case of bonds, that large investors were right and predicted falling interest rates—and he implies that large investors are typically right, and that by following the money you can be right as well. (In a recent well-publicized case, in fact, the largest private bond investor in the world, Bill Gross of PIMCO, exited all of his Treasury positions and called for higher rates. He got that call wrong.)
Rick Ferri has many interesting and valuable ideas, but I think he is off base on this one. Lot of studies of institutional big-money investors show they get things wrong just as often as retail investors. If Mr. Ferri were correct in his assertion, studies would show that institutions typically outperform and individuals typically underperform. That’s not what the data show at all. Institutions aren’t that different from retail investors.
Investor sentiment surveys work very well–it’s just that they work in a contrary fashion. The reason they work in a contrary fashion, I believe, is a psychological phenomenon known as cognitive dissonance. We’ve written about this before.
Cognitive dissonance leads to the desire to reconcile your actions and beliefs. The naive view is that we all have certain firmly-held core beliefs and we endeavor to act appropriately, so that our beliefs and actions are aligned. Lots of psychological research shows otherwise. In fact, we make decisions (act) and then construct our beliefs so as to rationalize those decisions!
Think about how this might operate in the financial markets. First we buy (sell), and then we report ourselves in the survey as bullish (bearish). We’re just trying to reconcile our beliefs with our actions. “Of course I’m bullish–I’m long” is the train of thought. How uncomfortable would a CNBC interview get if the investor was known to be short, but had a wildly bullish market outlook? Cognitive dissonance predicts that people will talk their book. I think that’s a pretty good description with what happens with all of us.
Contrary interpretation works with investor sentiment at the extremes. At one extreme, there are no bulls to be found. Why? Because they’ve already sold and are now reporting themselves as bearish. When the last investor sells, the selling pressure is gone and there is only one direction for the market to go—up. Colby and Meyer’s book The Encyclopedia of Technical Market Indicators has statistics on the Investors Intelligence sentiment survey that are quite remarkable.
In short, individuals do not have an insurmountable gap relative to investment committees at big-money firms. Intelligent decision-making may be rare in both places, but thoughtful and disciplined investors have an opportunity to perform well if they make good choices. It is not the size of the investor, but rather their mindset, that makes the difference.
