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People love a good story. But beyond their entertainment value, stories play an important role in how we interpret the world. Psychologists have shown that we are more likely to accept and remember facts if they are presented as part of a story. Indeed the influence of the story is so powerful that we will often discount contradictory evidence if it does not fit into our current narrative. Most likely this tendency is a result of the way brains process information and attempt to make sense of a complicated world. Few people can accept that things just happen: we want a reason that explains our observations.
The share market contains thousands of companies, or stories, and otherwise sensible investors can often find themselves so spellbound by the story that more influential facts are often ignored. This is especially true in relation to start-up companies that have no proven track record and essentially attract investors through the story they tell. They may have a high level of debt, no cash flow and virtually no assets, but if their story is compelling enough investors will trip over each other in the rush to buy shares.
The classic example of this is with the ‘dot com’ bubble. Regardless of their underlying financials, companies that were involved in the IT industry were in high demand and at the height of the bubble were trading at levels well in excess of what earnings or assets would justify. People believed that the internet would revolutionise business and the story was so compelling that investors were prepared to pay anything to be a part of the action. (In fact, companies that had nothing to do with the IT industry were adding ‘.com’ to their names just to capitalise on all the hype!)
As ridiculous as this seems in hindsight, the fact is that this kind of thing happens all the time, albeit to a lesser degree. Since the “tech wreck” we have seen other stories dominate traders’ attentions. Expectations for an Australian nuclear industry saw uranium stocks come into favour, coal seam gas promises a cleaner and cost effective energy source, while the rapid growth of developing nations has raised demand expectations for commodities such as iron ore. The list goes on and on.
There is nothing wrong with believing in a story; indeed many companies offer very reasonable and compelling narratives. The trouble is that share markets are highly efficient, and expectations (positive or negative) are usually factored into share prices very quickly. So if a company has already experienced a rapid and significant rise in share price, chances are you may have missed the boat. For the price to continue upwards, one of two things must happen. Either the fundamental financial picture improves and hence justifies expectations, or the story continues to gain currency and expectations rise further still.
John Maynard Keynes, the famous economist and investor, described this as building “castles in the air”. This essentially means that when it comes to investing it doesn’t really matter what the ‘true’ worth of a company is, but rather the skill lies in working out what companies have the best story and will attract the attention of buyers. A company may well be trading way above its ‘fair value’, but as long as you can find a buyer prepared to pay more for the investment than you did, you will be able to make a profit. This relies however on anticipating investor demand ahead of the rest of the market: it doesn’t tend to work very well if the share price has already significantly appreciated.
The point is that it is dangerous to chase the winners. Sure they may have an attractive story, but if the market has already priced in the optimism it is likely that you will be late to the party and will have missed out on the best gains. Worse still, if expectations aren’t fulfilled the market will again account for this and send the share price lower – usually very quickly.
For example, an investor who continually chased the best performing sector would have underperformed the market by around 17% between 2001 and 2008, as is shown below.
Figure 1. Chasing the winner. At the start of each year the investor transfers all their capital to last year’s best performing sector. Average market performance represented by the ASX 200.
click to enlarge
The moral to the story? Don’t rush into an investment purely on the basis that it has performed very well in the recent past. Sure, there may be a good reason for the rise, but chances are the market has already accounted for this. Investors who arrive late are essentially gambling that the story will continue to raise expectations or be justified by the fundamentals. The risk of course is that if neither of these things occur, the share price will come crashing back down. The key thing to remember in these situations is that there is greater downside potential. In other words, the benefit of being right is often outweighed by the cost of being wrong.
Don’t let the lure of the story outweigh more rational and objective considerations, no matter how attractive it may seem. Otherwise it will most likely be a story with an unhappy ending.
Make the markets work for you
Andrew Page
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