Monday, November 7, 2011

21st Century Market Participants

If one were to have asked me when I started my investment career back in 1984 who was selling the shares of stock I was buying, a concept I don’t remember thinking about, I would have probably said other investors. The markets then were likely dominated by long-term buy and hold individual investors and corporate pension plans. A successful investor in that era could focus on economics and business analysis in combination with an understanding of stock price valuation models.

While Black Monday on October 19th, 1987, when the Dow Jones Industrial Average declined 508 points (22.6%) in a single day, made it clear that computer programs impacted stock market trading, the dominate factor through the end of the 1990’s was still the human being. Interestingly, the tech and telecomm bubble at the end of the last century highlighted that the human mind is a dual processing unit. While often logical and rational when focusing on longer-term issues, in a split second the emotional side driven by fear and greed can take over.

As such, a deep recognition of how human rational economic thought interacts with emotions would be a useful tool for an investor to have in order to fully appreciate stock price movements. This area of study is known as behavioral economics, and over the last couple of years, I have digested a number of books on the topic. I have used the information to better comprehend market action, to anticipate and empathize with my client’s feelings and most importantly to get a grip on my own decision making process.

2008 started a period of increased government intervention in the markets as a very large buyer of assets in the fixed income markets. However, the intention was to increase stock and real estate prices as well. In fact, the U.S. government ended up being a substantial equity investor in a number of this country’s financial institutions. In the words of Cullen Roche, “Know your government intervention. While all this government intervention might not be doing much for capitalism, the failure to understand it is surely detrimental to your portfolio’s well-being.”

After listening to the audio book The Quants by Scott Patterson, and not adding enough to share holdings prior to the recent three week 18% advance in the Standard and Poor's 500 stock index, I realized I needed to investigate the perspective of the computer programs that now dominate daily trading volume. As it turns out, these programs are the creation of academic math wiz computer geniuses that appear to have an affinity for poker. And in a nutshell, the programs are based on ultra-fast stock market pattern recognition, odds calculation and securities trading. This might seem like a risk free, high return way to invest, however there have been numerous spectacular failures of such portfolios in recent years.

Anticipating investment market behavior requires being aware of the various market participants, including rational investors, emotional humans, day traders, corporate institutions, government entities and pattern recognition computer programs, and how they interact in real time. As investment markets evolve, New West Investment Management, Inc. will continue to advance its research process to include the new information developed, with the traditional economic, business, finance and asset price modeling noted in the first paragraph, to increase investment performance for clients.

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