Moods and Markets: A New Way to Invest in Good Times and in Bad
From watching CNBC or reading The Wall Street Journal, it would be easy to conclude that it is the economy or corporate earnings that move the market. On any given day you might hear that stocks rose on a better than expected employment figure, while on another day stocks’ fall is attributed to a drop in profitability at Research in Motion or some other company.
Something had to make the market go up or down, and there are plenty of confident pundits and journalists whose job it is every day to tell us just what that specific something was.
At the risk of alienating the entire financial media complex, that something had nothing to do with today’s corporate earnings or economic reports. Although they are interesting facts, what we typically attribute a market move to are much more likely to be effects rather than causes.
Instead of considering how a positive earnings report propels stock prices higher, investors would be far wiser to think about what causes an improvement in earnings and valuations in the first place. Similarly, rather than looking at how falling housing prices might be associated with falling equity markets on any given day, it would be better to consider why housing prices dropped at all.
I believe that markets are not moved by corporate or economic data or even by external events but by us; by how we feel—our mood—and, importantly, by how changes in our mood drive our preferences and in turn the specific decisions that we make every day.
Before diving into the decision-making linkages to changes in mood, I first want to define what I mean by mood, particularly our collective, or social, mood. To do that, I first want to start with mood at an individual level.
At the risk of over-simplicity, I think of our own individual mood as our underlying confidence. It is how sure we feel, often unknowingly, about ourselves and the world around us. But please appreciate that confidence is an entirely forward-looking measure. Although our level of confidence at any moment exists in the present, confidence is in fact all about the future and how certain or uncertain we are, not only about what we believe is ahead (the future itself), but whether our own immediate choice of actions—our decisions—are in fact going to be successful in that future or not.
I realize that that is quite a mouthful, but confidence is all about how we see ourselves faring ahead. And only we can determine how confident we are. Others can tell us that we have too much or too little self-confidence. The reality, however, is that only we ourselves know our own confidence level. While I can try to coach a less than confident person to be more confident, I can’t make him or her more confident. Confidence (or lack thereof) is ultimately determined and measured from within. Just try to convince someone you believe to be overconfident that they are overconfident and you will quickly see just how self-determined confidence really is!
Why I like “confidence” so much as a synonym for “mood” is because the word ties together what I think of as the two critical elements of mood: a measure of certainty (or lack thereof) and our own belief system—what we think or feel is right at a specific moment in time—both assessed in a forward-looking manner. And it is that forward-looking element that is vital to mood’s usefulness to an investor. While our mood can and will be shaped by events from the past, it is how we apply those events to our outlook (through our hypotheses/predictions/strategies) that is critical. And as you will see, this allows us at different times to both under-and overestimate risk without necessarily realizing it. It also enables us to react differently to what is arguably the same information at different moments in time. As experienced investors know, some days markets rise on good news and on other days they fall on good news. It all depends on our level of confidence.
I also like the word “confidence” as a synonym for “social mood” because confidence has the same forward-looking aspect as equity values. That is to say, we value a stock today not on what is happening today within a company, but what we believe will happen in the future. I come back to this point in Chapter 2, “Horizon Preference: How Mood Affects Our Decision Making,” but please consider here how naturally aligned stock values and our level of confidence are.