When Is a Small Investor Attracted to the Stock Market?
- Economists, particularly those in the influential American Chicago School, have long postulated a relationship between rational stock market valuations and investor behavior. Thanks to the wisdom of crowds, according to this model, cool-eyed investors independently spot irrational booms and quickly drive prices down to what future cash flows will justify. In fact, behavioral economists have blown holes in this conveniently rational theory.
- Several studies from 1990 to 2000 by influential behavioral economists have shown that investors often act in response to beliefs about future cash flows based upon recent market performance, which explains why retail investors step up their investments late in up cycles and divest late in down cycles. If past performance in a rising market predicted future behavior, the market would simply become an ever-expanding creator of wealth. As many U.S. investors who lost substantial percentages of their stock-market-based retirement accounts in 2008 can attest, past performance does not predict future performance.
- While a rising market does not predict future performance, recent studies have shown that rising investor optimism in a rising market has relatively consistent consequences that do have predictive value. They have shown that as a market boom progresses, newer, less-profitable companies with low capitalizations and companies in financial distress benefit from share increases that substantially exceed the share increases in more substantial, better capitalized companies. Putting this simply, in boom markets, dubious penny stocks will enjoy percentage rises that large-cap stocks do not. This further defines the behavior of retail investors, who will not only invest late in boom markets but will tend to drive up the prices of the weakest and most vulnerable stocks, which will then have the greatest losses as the market cycle turns to the downside.
- While advising retail investors to stay away from sentiment-based investing or even rational, fundamental-analysis-based investing, financial writers Felix Salmon and Jon Stokes in a December 2010 "Wired" magazine article point to exchange traded funds (ETFs) and particularly index funds as safer ways of investing in an age when computer-based trading has made market movements unpredictable and increasingly volatile. Other analysts are less pessimistic, but most agree that investing in the middle of boom cycles, which retail investors tend to do, will ensure bad outcomes.
