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Behavioural Finance and Stock Trends

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I find behavioural finance very interesting as it relates to personal investing.

Behavioural finance looks at human emotion and psychology to try and explain investment decisions and financial trends.

It is an area I will explore more later this year.

For today, a few quick thoughts triggered by an article I read on the weekend. 

You can learn the basics of behavioural finance in a series of Investopedia articles [4]. They are well worth your time.

When I discussed the Efficient Market Hypothesis [5] last week, I stated that I believed most developed markets to be semi-strong or even higher. That means that all publicly available information is instantaneously reflected in the asset price.

However, there are aspects of behavioural finance that pop the odd hole in that belief. One favourite is the January Effect [6]. Less pronounced now, it has occurred with some regularity over previous years. There are many other examples of recurring phenomena that also make one question the existence of semi-strong markets to some degree.

That said, I am still a believer. But a cautious one.

Over the weekend, I was reading Three Trends to Look for Before Jumping Back into Stocks [7]. The article reminded me a little of technical analysis and a little of behavioural finance.

The three trends are: Chicago Board Options Exchange Market Volatility Index (VIX); insider trading activity; corporate buybacks.

The Volatility Index

The VIX attempts to quantify the implied volatility of Standard & Poor’s (S&P) 500 index options. It is known as the “fear gauge” (emotion, psychological = behavioural).

In general terms, VIX values above 30 indicate high volatility (and fear) is anticipated. VIX values below 20 indicate complacency in the markets. At current levels of about 43 there seems to be a high amount of fear and the potential for significant changes in asset values.

As this involves historical trend analysis, it can also be considered a form of technical analysis. Especially if one trades simply based on the current VIX value versus historic averages.

Insider Trading

Insider trading is another interesting area for investors to monitor.

No, not insider trading in the illegal sense. Rather, the actions of corporate insiders – as defined by securities legislation – is studied to see if the individuals who know the company best are bullish or bearish on future results. In theory, if the President of a company is buying shares in the firm then he presumably believes the company is undervalued. If he is buying, then you should too.

One study found that insider trading can indicate outperformance [8] of the general market.

There may be something to this. However, there are many other possible reasons for the results. For example, when company management acquires shares of their own firms, other investors see this and wish to invest as well. This increases demand for shares and drives prices upwards.

One also must be cautious about insider trading. It is not always about company outlook.

The President may need to sell shares to finance his daughter’s wedding, not because he thinks the company’s prospects are poor. Or perhaps the President cannot sell shares due to public perception and its impact on company share price. Or there may be a blackout period in place where insiders cannot trade shares no matter how much they want. There are many reasons other than future corporate results that can explain why an insider buys or sells shares.

Corporate Buybacks

Corporations should use their assets to increase shareholder value.

That means investing capital in new products, technology, processes, debt repayment, etc., so as to enhance profitability. If there are no opportunities to invest capital, companies may pay out cash as dividends. The idea is that the shareholder can achieve a better return on the capital than the company can.

The company may also engage in share buybacks [9]. This serves two purposes.

One, it sends a signal that the company believes its shares are undervalued. By repurchasing shares today, a company may believe that they are buying at a discount value and will be worth more tomorrow.

Investors following this approach will also buy these undervalued companies.

Two, by reducing the number of shares outstanding, it increases earnings per share (EPS) and other per share financial data. These increases may trigger share price increases for those that buy based on certain per share valuations.

For example, a company with 1 million shares and net earnings of $1 million has an EPS of $1.00. If companies in the same industry trade, on average, at 10 times earnings (the price/earnings ratio), then the company will trade at about $10.00 per share.

But the company decides to repurchase 200,000 shares. Assuming earnings stay constant (a questionable proposition given the large cash outlay), suddenly the EPS is $1.25. If the company continues to trade at 10 times earnings, it share price will rise to $12.50 from $10.00. Not bad.

Of course, companies that can find no better way to invest their money than by repurchasing shares may not have great long-run potential. After all, the purpose of a company is to grow and increase profitability, not to make its financial ratios look good. So maybe these companies are not that great a deal all the time.

Investing based on insider trading activities and corporate buybacks is a form of behavioural finance. Individuals acquire and divest investments based not on actual business results. Instead, investors merely watch what the company does and invests based on those actions.

Money may be made by following these strategies. But they are not foolproof. And given the sheer number of investors employing these two tactics, one has to move very quickly to buy or sell. If you are late to the party, any opportunity for profit will evaporate as prices rapidly adjust to the information.

If you wish to follow the above trends, use them as indicators as to whether you should buy or sell. One of many variables you assess. But never substitute the VIX, insider activity, or share buybacks for proper quantitative analysis and research.