Long queues at petrol stations are not a sign of panic buying, but of the exact opposite. It’s quite rational to fill up your tank if you fear that others’ buying will cause a shortage. Sure, the total result of all these individually rational choices is a mess, but the essence of social science is that aggregate outcomes are not simply individual actions writ large.
What’s this got to do with investing? Plenty. Just as rational motorists anticipate the behaviour of others, so rational investors must do the same. We should ask not just “is this a good company?” or “what is the economic outlook?” but also: “what will others come to believe about this company or the economy?” We must ask: if I think this is such a good asset, why is somebody happy to sell it to me? And: mightn’t others have already realised its attractions and bid up its price?
Investing is not like rock-climbing where you test yourself against the environment. It’s a race against other people – some of whom says Meir Statman at Santa Clara University are wearing running shoes while you are in heavy boots.
What we investors must do, then, is know when it is us wearing the heavy boots and when it is those on the other side of our trades who are doing so. We must read other investors’ minds, intentions and moods. Brice Corgnet, Mark DeSantis and David Porter have shown that this is just what successful traders can do.
Failing to do this can be an expensive mistake. Take Aston Martin, or the lender Amigo, or retailer TheWorks. Shares in these companies have all fallen 80 per cent or more since they were floated in 2018. These are albeit extreme examples of a general fact – that newly floated shares do badly on average. A study of over 2,000 new flotations by Alan Gregory at the University of Exeter found that they underperform comparable shares by an average 10.8 per cent in the two years after flotation. Much the same is true in the US, as the University of Florida’s Jay Ritter has documented.
Investors pay too much for newly-floated shares because they don’t realise that they are in a game against sellers. The owners of these companies are not bringing them to the market because they generously want to offer us a share in a great company. They do so because they want to get out at the best time. Because they know the company better than others, they often do so. They are wearing running shoes and buyers heavy boots.
For another example, imagine two identical assets. The government then announces that one will be exempt from tax. Obviously, the price of the privileged asset will rise – to a level from which subsequent expected returns after tax will be equal. If you are the later buyer, there is therefore no point buying an asset for its tax breaks: these are in the price. By all means consider venture capital trusts because they give us exposure to good growth companies. But don’t buy them for the tax break.
Another example of failing to think strategically is when we try to spot future takeover targets. Sure, these will see big rises if we are right. But the problem is that other people are trying to do the same thing and have therefore raised the prices of anything that might be such a target. This means that if a bid doesn’t materialise prices will slip back. Looking for takeover targets is not therefore the free hit you might think.
All these are examples of investors forgetting that it is they who are wearing heavy boots while others are in running shoes.
Luckily, though, there are some cases where it is us who have the advantage.
We know that, on average, small speculative stocks are usually over priced because investors pay too much for the small chance of big pay-offs. We know also the flipside of this, that dull defensives tend to be underpriced and so outperform. We can therefore exploit others’ ignorance by holding defensives and avoiding most Aim shares.
You might object that people should have wised up to this by now. Not necessarily. In this context, fund managers are wearing the heavy boots. The one who holds lots of defensives will underperform if the market rises sharply. He’ll therefore lose clients, a bonus and perhaps his job. This causes him to avoid defensives, which keeps them cheap for the rest of us.
We have another advantage. We know there’s momentum in share prices, perhaps because investors underreact to good or bad news. Again, some investors don’t exploit this knowledge because they are wearing heavy boots. Momentum stocks sometimes underperform falling markets. And they are often growth companies that can get into all types of trouble because expansion plans can easily fail. Such risks cause some investors to avoid positive momentum stocks, meaning nice returns for the rest of us.
The efficient market hypothesis warns us not to be an active investor because any information we might have about a company is already in the price: it’s been put there by investors with faster feet than us.
This advice is a mixed blessing. Its defect is that it isn’t wholly true: two types of share, momentum and defensives, do beat the market.
But it also has a virtue. It warns us that other investors are clever people and it’s hard to beat them. It reminds us to ask: what do I know that the fellow on the other side of my trades do not? Often, the answer is: nothing.
