Investor Behavior

Marshall Jaffe, in a recent article for ThinkAdvisor, made an outstanding observation:

In a world where almost nothing can be predicted with any accuracy, investor behavior is one of the rare exceptions. You can take it to the bank that investors will continue to be driven by impatience, social conformity, conventional wisdom, fear, greed and a confusion of volatility with risk. By standing apart and being driven solely by the facts, the value investor can take advantage of the opportunities caused by those behaviors—and be in the optimal position to create and preserve wealth.

His article was focused on value investing, but I think it is equally applicable to relative strength investing.  In fact, maybe even more so, as value investors often differ about what they consider a good value, while relative strength is just a mathematical calculation with little room for interpretation.

Mr. Jaffe’s main point—that investors are driven by all sorts of irrational and incorrect cognitive forces—is quite valid.  Dozens of studies point it out and there is a shocking lack of studies (i.e., none!) that show the average investor to be a patient, independent thinker devoid of fear and greed.

What’s the best way to take advantage of this observation about investor behavior?  I think salvation may lie in using a systematic investment process.  If you start with an investment methodology likely to outperform over time, like relative strength or value, and construct a rules-based systematic process to follow for entry and exit, you’ve got a decent chance to avoid some of the cognitive errors that will assail everyone else.

Of course, you will construct your rules during a period of calm and contemplation—but that’s never when rules are difficult to apply!  The real test is sticking to your rules during the periods of fear and greed that occur routinely in financial markets.  Devising the rules may be relatively simple, but following them in trying circumstances never is!  As with most things, the harder it is to do, the bigger the potential payoff usually is.

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