In a recent experiment, 8,500 students were asked to pick a number between one and 10, and the results were revealing. You would naturally expect to see a fairly even spread of numbers chosen, particularly given that there were such a large number of people in the experiment. But that wasn’t the case. Almost 30 per cent of the students picked the same number: seven. I won’t dwell on the 47 people who picked zero.
It seems that human number generation is not so random after all. My colleague Duncan Lamont imagines the thought process: Q "Pick a random number from one to 10." A "Hmmm… one and 10 are too obvious. Five stands out in the middle. Halfway between five and 10 is hidden in the mix. It won’t be the same number others picked… seven."
Interesting, but irrelevant for investing, you might think. In fact, this is an easy way to demonstrate how human behaviour is an important factor, even when dealing with seemingly simple, unbiased choices – and how statistical models don’t necessarily translate into the real world.
For investors in equity markets, this is a salient reminder. Analysts spend many man hours poring over company accounts, forecasting sales and costs, applying discounted cash-flow models to arrive at a target value for that share of a company. In itself, this process is open to an overlay of human opinion, and that perhaps distorts the data. Human analysis introduces cognitive biases such as confirmation bias (looking for evidence that supports your view) and extrapolation (believing that things will continue as they are).
In theory that is the price that the share should trade at in the market. But it rarely does, because markets are in the real world and prices are determined by humans. Human behaviour in investing is often characterised by fear and greed cycles, whereby optimism translates into euphoria at the top of the cycle and fear translates into panic at the bottom.
Understanding this behavioural element can unlock opportunities and reduce anxiety in volatile periods. Overlaying investment returns with investor emotions, we find that the best time to buy is when others are panicking, and that the best time to sell is when others are euphoric.
And this is why, when investing for charities, it is important to spend a lot of time analysing investment opportunities alongside the prevailing market sentiment. A long-term charity investor can watch the ebbs and flows of investor sentiment. They can buy when others are fearful and take profits when others are greedy.
As Warren Buffet once said: "The stock market is a device for transferring money from the impatient to the patient." And they can afford to be patient.
This article first appeared in Third Sector magazine