In Times of Uncertainty, Stock Pros Can't Cope Says James Surowiecki

If you ever believed that anyone can really pick stocks accurately on a regular basis then I've got a bridge to sell you. But the New Yorker just published a new article by James Surowiecki that further blows that myth apart. Surowiecki for those who don't recognize the name is the author of the book Wisdom of the Crowds. It's a widely cited and best selling work about how the masses, working together can come up with decisions that are often better than the best experts. It's been widely cited and is especially influential in the Internet community, where mass-collaboration is becoming increasingly popular.

But I digress...

In his latest article, he researches why the markets have become so much more volatile since the credit crunch unfolded. To explain it, he cited two interesting fields of research.

The first reason why volatility has gotten so bad is herding.

"In conditions of uncertainty, humans, like other animals, herd together for protection. In unstable markets, this leads to trend-following: buy when others buy, sell when they sell. Many studies have found that mutual-fund managers herd, for a couple of important reasons. First, herding offers money managers the reassurance that their performance, whether good or bad, won’t diverge too much from the norm. It also gives them a chance to piggyback on the knowledge of their competitors."

That's why the portfolios of so many mutual funds look the same. These big time mutual fund managers simply copy the portoflios of their peers. And that's why the same fifty stocks are always discussed. Herding.

But that's not the worst of it. It turns out that most traders are actually more confident of their abilities than they should be:

"A 2005 study of traders and investment bankers at two large banks, for instance, found that they significantly overestimated their knowledge of finance and the accuracy of their predictions."

Whereas mere mortals in times of uncertainty button down the hatches and try to wait out the storm, these trading gods think they are above the storm and actually trade more heavily.

"Overconfidence matters, because it can encourage excess trading. A study of individual investors by the economists Markus Glaser and Martin Weber, for instance, found that investors who thought more highly of their ability also traded more. What’s worse, the effect seems to be magnified in times of uncertainty. The business-school professors Itzhak Ben-David and John Doukas, in a study based on twenty years of trading by institutional investors, found that when there’s a profusion of “ambiguous information” about stocks investors trade more frequently, not less. And they do so even though, on average, they end up losing on their trades."

So, there you have it. The research shows what we have always know, the Wall Street goons not only can't handle mortgages, mortgage-backed-securities, etc. but their fat heads actually make their bloated egos worse when it comes to performance.

I just thought you should know this the next time you talk to your stock broker and he advises you to trade-trade-trade.

This is no way counters my central axoim of investing, which is buy low sell high. It just means you don't need to trade while everything is falling through the floor. Wait for the damage to end and then come back into the market.