Human Nature and the Markets

Why is it hard to do the smart thing?

Have you ever heard someone say their strategy is to “buy low and sell high”? The wisdom of such a simple, logical statement needs no explanation. If you can execute this simple strategy, you will be a successful investor.

Then why does human nature make execution of this strategy so difficult? Most investors find it easiest to make new commitments when there is optimism in the air, and things are looking up. That’s also the time when prices are moving up, or have already moved from lower levels. Conversely, when prices are down and pessimism abounds, investors typically pull back into their shells and postpone new investments. This phenomenon strikes me as an illustration of the power of human nature. Most investors, when faced directly with these facts easily conclude that the best time to buy is when no one wants to buy, and they should be selling (or at least not making new commitments) when everyone is bullish. So why can’t they do this?

Be a contrarian

I think the reason is most people seek the approval of others, and taking action opposite to that of the heard exposes people to criticism or ridicule. There is also an element of self-doubt that creeps in. I’ve heard people say that they understand they should buy during the market troughs, but “this time is different”.

Contrarians are investors who devise a plan to force them to buy when prices are low and sell when prices are high. There are numerous ways to do this, but they all attempt to accomplish the same goal – to get investors to overcome human nature, and to buy low and sell high. Some stock market contrarians only buy stocks that went down last year, and sell the ones that went up last year. Conversely, many investors make the mistake of buying the ones that went up last year, not realizing that it is likely to be other stocks that will go up this year. This is an example of how human nature works against executing a strategy that most investors would accept in concept as a good one.

What to do now?

My best advice is that this is a good time to look for new commitments. Prices in our local market are down about 10% from the peak, and with a ballooning inventory of properties the choices are greater and the competition is less. It is truly a buyers’ market, so why wait for the seller’s market to return to make new commitments? This is not to suggest that the direction of the market is about to turn up immediately, but guessing that point with accuracy is impossible. What is true is better buys can be made today that could have been made 2 years ago, and they will be better than can be made some years into the future.

Market Report

The inventory of available homes has grown about 25% since the 1st quarter of this year, but the dramatic change has been the fall-off in the volume of houses sold. The result is that as of the end of the 3rd quarter the inventory represented a whopping 15 months of supply. That’s up from about 2 months supply during the hot market of a couple of years ago.

Before over reacting, it’s best to recognize that the September 2007 results were severely impacted by the unusual events in the mortgage market. In short, the uncertainty surrounding mortgage financing did what uncertainty typically does, which is it causes everyone involved to stop and wait to see what will transpire. As can be seen, this seizing up in the mortgage market contributed to sharply lower numbers of homes sold.

No doubt that needed adjustments have and will continue to effect the availability of mortgage financing, but it’s my view that the market has already begun to settle down and seek new and better ways to provide mortgage financing. I expect this emerging trend to continue, and the negative impact of the mortgage turmoil will decline as each month passes.

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