(MENAFN - ValueWalk) You've no doubt recognised that is a dominating factor when it comes to a company's share price and the market in general. Key to this, of course, is both our own and the collective participants' confidence in that market and our desire that stocks will always go up in price.
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Image source: Investment Master Class
Unfortunately you don't have to scratch too deeply into history to see the effect on individual stocks, sectors and the market when that confidence is shaken. At those times, stock prices plummet and we are surrounded by uncertainty. And as naturally as you expect the sun to rise in the east each day, panic follows closely on its heels.
People prefer certainty. Certainty comes when is playing ball, the market indices are invariably gaining in value, and our share portfolios are producing great returns. The longer this happens, the greater our certainty will be that it will continue. People feel comfortable, assured, confident in their beliefs that things are going according to plan. It is in these times that people also often delude themselves into thinking they are . "Look at my returns! They speak for themselves!"
Reality often bites hard, however, when Mr Market decides, for whatever reason to playing ball. In these situations, those same people have their confidence shaken; uncertainty reigns and many will find it hard to see a way out of the mess. It is quite often that in their desperation they will look to others to see what they are doing, and end up invariably following the . Unfortunately, most of that same group of people are panicking themselves. It only takes one stone to start an avalanche, and the sad fact of the matter is that the crowd doesn't necessarily know any better.
'In general, when we are unsure of ourselves, when the situation is unclear or ambiguous, when uncertainty reigns, we are most likely to look to and accept the actions of others as correct' Robert Cialdini
'Psychologists have demonstrated that the vaguer and more complex a situation, the more we rely on other people, both for clarification and as touchstones for our own views. This helps us reduce our uncertainty toward our own beliefs' David Dreman
'When people are free to do as they please they usually imitate each other. We are social animals, influenced by what we see other people doing and believing. We believe others know more than we do. .. We avoid what others avoid. We imitate without thinking. Especially when many or similar people do it, when we are uncertain, in an unfamiliar environment, in a crowd, lack knowledge, or if we suffer from stress or low self-esteem' Peter Bevelin
"Man is extremely uncomfortable with uncertainty. To deal with his discomfort, man tends to create a false sense of security by substituting certainty for uncertainty. It becomes the herd instinct" Bennett Goodspeed
It is in to follow others and we often do it unconsciously. Have you ever walked past someone, or even a group of people on the street, who are all looking up at something and stopped to look for yourself? Sometimes we don't even stop to think before we imitate others.
'First, we seem to assume that if a lot of people are doing the same thing, they must know something we don't. Especially when we are uncertain, we are willing to place an enormous amount of trust in the collective knowledge of the crowd. Second, quite frequently the crowd is mistaken because they are not acting on the basis of any superior information but are reacting, themselves, to the principle of social proof' Robert Cialdini
It is also human nature to place more weight on stories and anecdotes than statistical data. People's inferences and behaviour are much more influenced by vivid, concrete information, than by pallid and abstract propositions of substantially greater probative and evidential value.
In the book 'Human Inference: Strategies and Shortcomings of Social Judgement', Richard Nesbitt and Lee Ross define vivid information as information that is likely to attract and hold our attention to the extent it is (a) emotionally interesting, (b) concrete and image-provoking, and (c) proximate in a sensory, temporal or spatial way - characteristics that should be familiar to every investor!
The authors note the emotional interest of an event is influenced by the degree to which it affects the participants' needs, desires, motives and values. They conclude that "the most disconcerting implications of the principle that information is weighed in proportion to its vividness is that certain types of highly probative information will have little effect on inferences merely because they are pallid. Aggregated, statistical, data-summary information is often particularly probative, but it is also likely to lack concreteness and emotional interest."
Is it any wonder people panic when they read headlines predicting a market crash, they see and hear of other people losing money and selling or they read of a company's recent problems - all without considering the probability that the information has value or the company's problems will be resolved.
'In a crisis, carefully analyse the reasons put forward to support lower stock prices – more often than not they will disintegrate under scrutiny' David Dreman
When people panic, the shares often becomes the 'news'. Other investors assume those selling know more than they do and decide to sell. A self-reinforcing cycle begins where selling begets more selling.
More often than not however, when everyone is aware of a risk, it is already reflected in the market or stock price.
"As a general observation, markets tend to over-discount the uncertainty related to identified risks. Conversely, markets tend to under-discount risks that have not yet been expressly identified" Jamie Mai
Having a solid of what you own is a strong countervailing force against the crowd. In a market correction, investors who have no clue as to why they own stocks [outside of 'because they have/and will continue to go up'] or what the of the stocks they own are, use price as their guide in decision making. They have no anchor upon which to assess the correct price for a stock. These investors sell in a non-discriminatory manner with no reference to value.
With the increasing popularity of ETF's and Index Funds it's likely even more investors in the future will be basing their decisions on the movement of 'market prices' as opposed to company fundamentals. If you've bought a biotech ETF for example, and have no idea of its composition or the underlying value of the constituent portfolio, how can you possibly know what the right price is to buy, hold or sell? It's no wonder, the CDO market went 'no bid' at the height of