There have been some quite significant moves in asset prices in recent times. The dramatic increase in the price of gold over the past year has probably not escaped your attention, but it is not the rise in the yellow metal that is most interesting to me, rather the behavioural implications. How does extreme positive performance from any asset class or fund make us think and act, and why?
The behavioural drivers
Availability: The availability heuristic exerts a huge influence. This is the mental shortcut where we judge something not based on the weight of evidence, but by how prominent and frequent it is. When an asset class keeps hitting new highs, we conflate the volume of ‘evidence’ with its strength. There might be lots of articles, but if they are all saying the same thing, they are far from independent reasons for us to believe the performance will continue. In these situations, availability also leads us to understate risks – because we are not seeing the downside risks, we are likely to severely neglect them.
Stories: Humans understand the world through stories, and when an asset class is on an unprecedented run of good performance, plenty of stories will be told. We will treat these stories not just as explanations as to why something has occurred, but as a prediction of its persistence. We are inherently uncomfortable with things happening without a clear explanation, so to escape this dissonance we look for convincing explanations so that the world makes sense.
Extrapolation: The combination of high-profile performance and persuasive stories inevitably leads to extrapolation – the trenchant belief that what has been happening will persist into the future. The stronger and more sustained the high returns of an asset class, the more we struggle to see anything to stop it.
Fear of Missing Out: We are relative creatures. Our feelings about most things are framed by how it compares to something else (often other people). Two things happen in this regard when an asset is producing strong, high-profile performance. Those of us that don’t have exposure to the asset class will envy those that do, and those of us that do will wish they held more.
Feedback loops
This combination of behavioural factors creates powerful self-reinforcing feedback loops that can serve to further boost an asset’s performance. It works something like this:
Stage One: High returns from an asset class receive significant attention.
Stage Two: Stories are formed to explain the performance; these stories are prominent and convincing because performance is strong.
Stage Three: The combination of high returns and compelling justifications increases the belief that the trends will persist.
Stage Four: More investors are drawn into the asset class.
Stage Five: Returns are boosted by increasing investor appetite.
And so it goes on, until it doesn’t.
These feedback loops are driven by changes in investor behaviour and sentiment, and impact all asset classes over the short-run. For assets that generate cash flows, over time the phenomenon will be outweighed by the gravitational pull of valuations and fundamentals (at some point someone might say “maybe 100x earnings is a little too rich”). This doesn’t occur for ‘belief assets‘ that are not tethered to fundamentals (such as gold or crypto), which makes the range of potential outcomes incredibly wide.
Thresholds
Another fascinating aspect of what happens when the price of an asset rises substantially is at what point do different types of investors become involved (and when might they withdraw). This is clearly a complex topic, but the best model probably comes from Sociology and the work of Mark Granovetter. He explored the subject of crowd psychology and, in particular, how people in a group will have different thresholds for engaging in collective action.
For example, in a group of protestors, there might be some individuals who have an incredibly low threshold for engaging in disorder, whereas others have an incredibly high threshold. Those in the latter group won’t start throwing bricks until almost everybody else has. Granovetter’s argument is that the composition of a group and how behaviour cascades through it will be critical to how it acts.
In a financial market context, we have a huge group of potential investors all with different thresholds for participating in the ascent of an asset class. Day traders, momentum traders, macro hedge funds, all the way to long-term valuation-driven investors. The first group have a very low threshold for engagement, whereas the latter group might only invest when the pressure not to becomes too great (perhaps their job depends on it). The longer strong performance persists, the greater the chance that those high-threshold investors get drawn in.
This threshold model also matters for the reversal of extremely strong performance trends – the key question becoming the reverse: what is the threshold for investors to exit an asset class if returns start to deteriorate? This is what is typically meant when people talk of the dangers of speculative or ‘tourist’ money. Money with a low threshold for exit can create sharp and severe downside risks.
Although the overarching behavioural patterns of investors are similar, their motivations and strategies will be different, and that matters.
Extremely positive performance from an asset class can be caused by and encourage extreme behaviour. The more prominent the unusually high returns are, the more important it is to reflect on what might be driving our own decision making.
Joe Wiggins is Director of Research at UK wealth manager, St James’s Place and publisher of investment insights through a behavioural science lens at www.behaviouralinvestment.com. His book The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions.
This article was originally published on Joe’s website, Behavioural Investment, and is reproduced with permission.