The Psychology of Money - An Investment Manager\'s Guide to Beating the Market

ing about in fits and starts as frenzied investors exaggerate the

significance of tiny bits of information. In such a state, the slightest

earnings disappointment may cause violent swings in a company’s

stock price, regardless of long-term prospects.

Vaga calls his work an example of theory catching up with

practice. One of our master investors, Marty Zweig, has established

a good performance record in the face of overwhelming “evidence”

from academicians that his technical analysis doesn’t work. The

coherent market hypothesis recognizes this fact and is broad enough

to include the possibility of success from either fundamental or

technical analysis, depending on the state of the market (i.e.,

groupthink or rational). In this sense, it also helps to resolve the

investing paradox of whether one should double up on stocks that

have fallen dramatically (“if you liked it at $40, you’ll love it at

$20!”) or sell them (“cheap stocks get cheaper... wait until it’s

formed a bottom”). The resolution involves a correct reading of

investor sentiment: If investor behavior is still characterized by

groupthink, then yes, you should sell; if the sentiment reading

indicates a rational state, however, then it’s safe to double up.

The point here is not that it’s always easy to determine what

the sentiment reading is, but rather that either view can be appro-

priate, depending on investor psychology. This broader framework

may help to defuse the usual catfights that ensue when “buy-cheap”

fundamentalists square off with “sell-rule” technicians.

The coherent market hypothesis, with its elegant mathematics

and quantitative foundation, stops short of a detailed explanation

of the psychology underlying investor behavior. Vaga refers to the

“Theory of Social Imitation” as the theoretical underpinning of

investor groupthink. This theory examines similar behavior in

nature (such as fish moving in schools or birds flying in formation)

and draws comparisons between these events and societal phenom-

ena such as fashion fads.

Interestingly, the readings recommended by my physicist cousin

suggested an explanation of crowd behavior slightly different from

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