Don’t let other investors’ stupidity lull you into a false sense of confidence

We all like to think that we're above average.

I'm willing to bet that you think you're smarter than the average investor.

And when you see what other investors do sometimes, it's no surprise.

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But I'm going to humbly suggest today that this might not be the best way to think about your peers in the market...

Wow! Some investors are really easy to fool aren't they?

A tweet from Joe Weisenthal, a writer for Bloomberg, caught my eye this morning. It was a chart of a tiny US biotech company formerly known as Bioptix that has recently changed its name to "Riot Blockchain".

The company a penny stock had decided to move away from the biotech sector, and instead focus on investing in cryptocurrencies and blockchain businesses. Its share price nearly doubled in the run-up to the announcement, and leaped by almost 20% on news of the name change.

That's quite a lot of easy money for simply "refocusing" your strategy and changing your name.

Yet believe it or not, this phenomenon is well documented in financial markets. Many, many studies have demonstrated that during mania phases, stocks with names that reflect the current "hot" trend do better than stocks that don't even if they're all in the same business.

During the dotcom bubble, stocks that added .com, or .net, or other internet-ty-sounding things to their names, saw their share prices rise sharply (and during the bust, companies that removed internet-ty sounding terms from their names also saw their share prices jump.)

Same thing has happened during various other manias. When investors are gripped with enthusiasm for Chinese stocks (such as between 2006 and 2007), companies with the word "China" in them have outperformed in the past. And if you go further back, you see similar effects during the "electronics" boom of the early 1960s.

Now if you're a real "efficient markets" aficionado (you know, the theory that markets are always right and investors are always rational) then you can tie yourself up in knots trying to justify this.

You could argue that the company now deserves its premium of 70% or so to yesterday's price because it has demonstrated to investors that it is going to work in a hot new field as opposed to the old unfashionable one.

I think it's hard to make that one stick though. I mean, what due diligence can you do on a biotech company that decides it wants to be a blockchain company? Or a gold miner that decides to become a marijuana plantation (another common occurrence a few years ago)?

Also, the research has shown that two companies can be operating in precisely the same sector, but the one that changes its name, or already has the relevant terminology in its title, is the one that makes the gains. So it's hard to argue that it's anything other than the name change that makes the difference in these cases.

You could also argue that these are often small stocks in dodgy markets and so they are riddled with inefficiencies in any case. (Although then all you are doing is noting that there are exceptions to the efficient markets hypothesis).

Or you can simply accept that a significant number of investors are lazy, and that they like lottery ticket stocks, because they want to get rich quick. And they also panic when they see other investors getting rich quick. And very few people have gotten rich quicker than the lucky few who bought and held their blockchain investments. Hence the enthusiasm for the name change.

It's not just laziness it's second-guessing

There's a lot of truth to that. And it might make you feel like a relatively clever investor. But if it was just lazy, stupid, greedy investors, it probably wouldn't matter. Because there's likely few enough of them that this sort of thing would have little effect on the market.

But it goes deeper than this.

John Maynard Keynes who was a great investor (eventually) along with all his other dabblings once compared the market to betting on the results of a beauty contest.

The first thing to remember in order to be successful is that you are not trying to pick the person you personally find most beautiful. You are trying to pick out the person that everyone else will think is most beautiful. So you're trying to figure out who the average person will bet on.

But then, you've also got to take into account then anyone halfway sensible will realise that, too. So no one else is choosing the person that they find most attractive either. Instead, they're trying to pick the person that they think everyone else in the market thinks that the average person would vote for.

You can go down that rabbit hole for ages. "I'm betting that he's betting that she's betting that he'll reckon that contestant number 2 is more attractive to the average investor in this market than contestant number 4, but then that one's got a weird smile, so maybe but is it just me that thinks that? gah"

But what it means in this context is that, while some people buy these stocks because they're lazy, a whole other set of people buy them because they believe that some investors are lazy and stupid, and they want to take advantage of that by anticipating the flow of money into these stocks, even though it's happening for entirely superficial reasons.

What you can learn from other investors' stupidity

So some investors are daft. And other investors think they are so clever that they can anticipate the daftness of daft investors. What can we take from this, if anything?

Firstly, it's a useful reminder that markets are not efficient. If markets are not efficient, that means it's not entirely a fool's errand to attempt to beat them.

Second, this is not in itself, a good way to try to beat markets. Betting on the short-term stupidity of your fellow investors tends to lead to hubris, and that generally leads to nemesis, which in this context, means losing all your money. The market might be inefficient, but that still doesn't mean you can predict the future, and when you get cocky, that's usually when it teaches you a hard lesson.

Keynes learned this the hard way, incidentally. He thought he was smarter than everyone else (and he almost certainly was), but he still couldn't consistently second-guess the market, It's why he gave up speculation in favour of value investing (which is basically second-guessing the market over the long run, a much more viable road to riches).

Third, and more controversially, this is one area where I do wonder about the impact that increased passive investing and exchange-traded funds (ETFs) in particular, have on the market. You've probably noticed a continuous stream of thematic ETFs being launched.

If we accept that there's a significant group of investors out there who really don't do much research before they pile into a sector, then you can argue that ETFs simply facilitate people's existing propensity to allocate capital mindlessly and based on little more than where they hope capital flows will rush to next.

I mean, how many people understand what half of the stocks in your average thematic ETF or tracker fund even do? If you're investing in cybersecurity or robotics or lithium, do you know what the top ten holdings are? Do you know, specifically, what those companies are doing, and what the investment case is for each one?

Or are you just taking a wild punt because you know that other people's capital is flowing into that sector and you want to get lifted up on the tide with all the other boats?

I'm not saying it's a mistake to invest in these sectors, or that ETFs are a bad thing. What I am saying though, is that we're all a good bit lazier than we like to admit. We're all a lot more average than we like to think.

And unless you can look at your portfolio and articulate clearly why each and every holding is in there, you're nowhere near being able to think of yourself as the "smart" money.