Pull in the Reins on Your Market Steed

Physician's Money Digest, February28 2005, Volume 12, Issue 4

Financial theory has long statedthat stock markets instantaneouslyabsorb information as it becomesavailable, resulting in random price fluctuations.This type of thinking has causedmany investors to lose faith and turn topassive investments such as index funds,Spiders, and other exchange traded funds.Still, it is possible to make money usinglogical stock picking strategies if you keepsome market fundamentals in mind.

Investment Behavior

Market Volatility

Market volatility can be daunting,especially in light of the tech bubble,Wall Street scandals, and incessantgeopolitical concerns. Nevertheless, ifyou understand the causes, you can usethe information to your benefit. RobertShiller's book ($35; TheMIT Press; 1992) supports the explanationthat stock market volatility is causedby investor reactions due to psychologicalor sociological beliefs and that thisbehavior exerts a greater influence onthe market than good economic sense.Shiller also notes that substantial pricechanges are often the cause of a collectivemind shift by the investing public.

Academics have concluded that investorsare characteristically overly optimisticon earnings, slow to acceptchanges in the corporate horse race, andemotionally invested in their selections.These characteristics result in a herdmentality in terms of money flow intoor out of specific stocks or sectors.Therefore, it would seem that marketscan be characterized as behaving in asomewhat predictable, if not emotional,manner and that the market in generalachieves its ebb and flow based oninvestor psychology.

Investors need look no further thanthe "January effect" to find documentationof a predictable, inefficient, herdmentality that takes place during thefirst 2 weeks of the year and oftenresults in stock markets reaping the vastmajority of annual gains.

Tried-and-True Approach

During the glory days of the stockmarket bubble, heady investment behaviorwas rewarded because almost allstocks were rising in price; however, intoday's marketplace investors are justas likely to suffer significant financiallosses. Therefore, it would seem thatfreely available information is not necessarilyinstantaneously incorporatedinto stock market prices and that it ispossible to generate profits based onfundamental information, contrary towhat the efficient market theory wouldhave you believe.

In 1998, popular attitudes on investmenttheory began to change as newresearch showed that the probability ofrealizing excess returns was increasedby using systematic patterns for stockpicking. One documented study showedthat in addition to achieving betterresults through systematic patterns, thetheory of market inefficiency was furthersupported when company-specificinformation resulted in delayed pricereactions, allowing investors to profitfrom the news. The most comprehensivestudy of investment models, however,resulted in an important contributionto applied investments and determinedthat a disciplined approach toinvesting using models leads to out-performanceby significant margins on arisk-adjusted basis.

So while investor psychology can havean emotional effect on any given stockon any given day, in general, fundamentalinvestment strategies that are basedon sound investment models are yourkey to investment success.

is the president and

founder of Red Mountain

Research Company, an Internet-based

firm. She has been a money

manager for large and small firms

in the United States and abroad for

20 years. Ms. Helm created Red Mountain to offer

frank equity management advice to the public. She

welcomes questions or comments at contact@redmountainresearch.com, or for more information

visit www.redmountainresearch.com.

Colleen Helm