Stock Trading Psychology

By Author: Anthony Green
Total Articles: 36
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Investors over-react to new information so buy when others are selling and vice versa; market participants are slow learners so there may still be an opportunity to trade after an announcement; investors change their mind frequently and irrationally; tendency for investors to be swayed by the crowd; tendency for investors to hold on to losers too long and sell winners too soon. Keynes compared playing the stock market to guessing the winner of a beauty contest the winner will be the one who best gauges who the judges will pick.

Value:

- A low PBV may be a measure of risk and justified if a low ROE is expected; a firm expected to earn an ROE less than the Cost of Equity should trade at a discount to Book Value. Therefore, look for low PBV, a high ROE and low default risk (Debt ratios). Tobin's Q provides an alternative to PBV � a low Tobin�s Q firm is more likely to be taken over.

- Low PE stocks may have high-risk earnings or low growth. You could modify earnings e.g.

a) P/Normalised Earnings

b) P/Adjusted Earnings or

c) P/Cash Earnings [=P/Cash Earnings + Depreciation ...
... + Amortisation].

Then check for Risk using Beta or Debt to Equity Ratio. Assess growth and eliminate declining Earnings or Earnings Growth lower than the sector.

� EBITDA multiples - EV/EBITDA = Market Value of Equity + Market Value of Debt � Cash & Marketable securities. If using this multiple, screen for low Investment Needs and high ROC.

� PSR - A low PSR is a useful measure for smaller firms. Look for low Risk, good Margins and low Debt (or EV/Sales).

� High Yield - Need to check Dividend Cover and Reinvestment needs.

� Overall, Value investing needs a long time horizon and reasonable diversification.

� Contrarian - Markets tend to over-react and stocks doing well/badly tend to reverse over time. For example, buy stocks that have gone down the most over the last 5 years. Need to hold for long periods.

� Vulture Investing = betting on a restructuring or a recovery. Avoid sectors in long-term decline; buy a poorly performing company in a positive sector; bad managers can be removed. Bad companies will often get worse before they get better. Companies take long periods to recover. Diversification is crucial with this strategy. Need to be of independent mind and not easily swayed. Some investors lack patience and bail out early. Need to be able to cope with short-term volatility. If the company divests assets the market usually responds positively to the news operating performance tends to improve after the divestitures. With a Spin-off the parent company�s share price tends to increase on the announcement. Debt is often the problem some believe no debt is best; Damodaran believes in an optimal debt ratio e.g. a firm with stable and large cash flows and a high tax rate can gain value from the use of debt. Evidence suggests changes in management are generally viewed as good news. Managers tend to be stubborn and resilient.