Murderous, money management

While huddled together with dozens of other commuters in a cramped subway station in Oslo, it came to me. The actions taken by my fellow commuters can explain how investors behave in a time of uncertainty (like the current situation). I was witnessing irrational behavior.

First, let me rewind. Social psychology is the study of how people and groups interact (thanks Wikipedia). Diffusion of responsibility (also called the Bystander effect) may occur in such a group, when the number of individuals reaches a critical size and when responsibility is not explicitly assigned. Such a case may explain how rational people may make irrational decisions.

In an intricate murder case in New York City, Kitty Genovese was stabbed to death in an alley in Queens. Although tragic, it's not the murder that's interesting, but the actions or lack thereof, of the witnesses. According to a newspaper article published a few weeks after the homicide, 38 witnesses saw what happened or heard the cries for help. No one reacted or called the police. The investigators did not confirm that there were in fact 38 witnesses, but the theory is interesting nonetheless: will people act irrationally due to a lacking sense of responsibility?

Well, the same Bystander effect or diffusion of responsibility can be found in a lot of places - including the equity markets. For instance, investors have a strong tendency to buy too late and sell too late. Because one's not convinced the market is going to continue to be a bull market. When finally everyone else has bought, the transaction is made. The fear of making the wrong investment supersedes any rational behavior about fundamental value, just like in the murder case (assign more value to what your neighbor is telling you than what your head is saying). The same fear leads one into selling too late, since one never wants to cash out a negative position, accompanied by some self-justification in the form of: "Don't worry Jane, it's only a paper loss."

Fund managers are no different (at timing the market that is). The best equity, fund manager in Norway over the past five years is Jarl Ulvin according to Citywire. His fund has returned 232.33% while the average fund manager has only returned 137.17%. However, his fund has been outperformed by the average fund manager for the past three years (see diagram below).


Pretty good selling point still though, right? Jarl Ulvin is the best fund manager in Norway. Well, hopefully not and I'll explain why. Looking at the graph below, the line for Mr. Ulvin resembles the line of the average fund manager's performance pretty neatly. The difference is the size of the volatility (consistently larger for Mr. Ulvin's fund), not the direction. This trongly suggests that Mr. Ulvin manages a fund that is a lot riskier than the average fund, not that he's better at stock picking. His fund profited from the bull market between 2005 and 2007, but he has been punished significantly more than the average fund manager the past few months. In fact, if you invested your money in June 2005 in Norway's best fund manager, you would emerge with less money than if you invested in the average fund. It seems like Mr. Ulvin's "top performance" is a case of adding risk to his portfolio.


Obviously, if most stocks are going down, then stock picking becomes even more important. However, it seems like Mr. Ulvin does not score well here either. Falling markets also provide fund managers with an excuse: "The markets are sour, all funds are losing" (did anyone say lacking sense of responsibility?). What sets fund managers apart is the amount of risk taken, not competencies. Fund managers, just like investors, go with the flow and the psychology of the general market and are unable to time the market any better than the average Joe. Thus, investors should do what equity managers can't: diversify into different assets.

So, what were the actions taken by my fellow commuters that led me to think of the social psychology phenomenon? While waiting for the train to come to a complete stop, commuters walked across the platform along the side of the train, in a 45 degree angle. This is irrational, because the probability of the door opening up right in front of where one's facing is equal to the probability of it opening up 5 meters down the platform (unless you're in Japan where the pavement is marked showing where the doors will open). People react to surroundings and to other commuters instead of sense (instinct versus rationale). Since the "pack" walked in the same direction, no one wanted to break that pattern. They probably felt a sense of urgency as well that the subway may speed up instead of stopping, while they're left on the platform (which again is irrational or at least highly unlikely). As a result, I ended up taking the same approach to the train as all the other commuters.

Next time, I'll walk in the complete opposite direction in pure spite.

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This blog is intended for the interest of the readers only and the blogger bears no liability as a result of investments undertaken from advice given in this blog. I have used citations that are accurate to the best of my knowledge, information that is correct and I apologize in advance for any spelling errors.