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Alternative investment tools – break away from the herd

  • 18 October 2011

While our ‘comfort zone' is particularly appealing during economic crisis, disrupting the way we consider anything, including investing, can lead to dramatic change. Few market observers would deny the significance of emotions in investment decisions, and the notion of completely rational investors has gone out of the window with talk of double-dip recession and possible depression. But perhaps we can use our humanity in a more useful fashion by honing, say, our intuitive skills.

Fundamentally, understanding that markets are driven by stories, sentiments, and social interactions is perhaps a more worthwhile consideration that the algorithms used by ‘experts' to discover market momentum. So aside from using traditional analysis to determine stock shifts, what other tools are available?

 

Take a Random Walk

In his book, A Random Walk Down Wall Street, Burton Malkeil argues that "a blindfolded monkey throwing darts at a newspaper's financial pages could select a portfolio that would do just as well as one carefully selected by the experts".

When it was published several decades ago, A Random Walk was a polemic against the fashionable notion that investment was all about picking stocks or finding the right actively managed fund. Instead, Professor Malkiel put forward the then radical idea that stock markets are essentially unpredictable in anything but the longer term, and investors need to base their investment strategy around this insight.

This theory contradicts the work of chartists, who analyse past patterns of movement of prices to predict present and future prices.

A Mindful Money writer admits to employing this technique, asking his two children to stick a pin 25 times each into the Financial Times – the resulting portfolio of 50 stocks proved, after a year, to have performed as well as the top 10% of fund managers.

 

The Soros method of trading

The basics of the Billionaire financier George Soros's method of trading can be found in some of his books. The Alchemy of Finance (Wiley), for example, contains a detailed description of his trading methods.

One of Soros's pet theories is that financial markets do not tend towards equilibrium, as conventional theory would argue, but feed on their own misconceptions about events to produce exaggerated movements, which produce new misconceptions. This two-way feedback between perception and reality Soros describes as his theory of 'reflexivity'. It is, he claims, something that the shrewd investor can exploit by following the trend until it reaches the peak, and then, by identifying what Soros calls the 'inflexion point,' switching to the opposite tack.

 

Behavioural finance

The field of behavioural finance attempts to find systematic irrationalities in financial behaviour, proving theoretically as well as empirically that markets do not always get it right. Behavioural finance challenges the assumption of efficient markets, by demonstrating how emotions and cognitive misperceptions lead to herding behaviour and mispricing.

For instance, when it comes to buying things, or making investment decisions, many strange reasons can apply. Somebody might invest in a firm's stock because they have used the firm's products, and conclude that it represents a "good company". Somebody might buy a particular brand of washing powder, car or television because they think it will fulfil them in ways that it possibly cannot.

Gulnur Muradoglu, professor of finance at Cass Business School, and director of the Behavioural Finance Working Group, says: "Staying outside the herd is not easy, but if investors can become aware of their own behaviours and biases then it gives them an opportunity.

"So if they can realise they are following others rather than going on what they think is important; if they know that their decisions in a group changes; if they know they are over-confident, and if they ignore certain information sets, for example in favour of particular countries or firms. An awareness of these biases will give investors the opportunity to correct their behaviour."

 

Intuition as an investment guide

You know that classic "gut feeling"? Well, put it to the test when it comes to your investment portfolio. The digestive tract contains 100 million nerve cells - more than the spine. This part of the body sends an enormous number of signals to the brain, which may contain important messages, but which are sensed initially by the body rather than the mind, according to investopedia.

Intuition can also be useful with respect to market timing too, which tends to depend not only on measurable factors, but on a variety of issues that are difficult to quantify. We all know that it's usually sheer luck if anyone times the market accurately.  

Going back to George Soros' ability to trade markets, Stocks, Futures and Options magazine says: "According to Soros, his theory informs his decisions, and his body gives him the signals. The making of a self-reinforcing trend brings water to his mouth. The need for a portfolio shift makes his back hurt. His body "knows" he needs to take action, or to take careful note of a situation before his intellect can grasp it."

 

…But there is no one specific ‘tool' that will be a success, stresses Mindful Money's resident psychologist and "/wp/author/kim-stephenson/" target="_blank"> blogger Kim Stephenson, also author of Taming the Pound.

He says: "There isn't a magic pill – the "gurus", "experts" etc. who peddle sure fire ways to invest, or change your behaviour, are managing their money well by relying on the fact that human beings like simple answers and people will chase, and pay for, easy answers even when they know deep down there aren't any.  People are really complicated and compared to people, money is dead simple, but everybody still wants easy answers . So there isn't going to be an easy answer to what suits all people, in all circumstances and there aren't any ways to change behaviour that will work for everybody."

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