Mark Tinker: Investors forced to act irrationally

Expert View

You need to be as much a psychoanalyst as a market analyst to deal with the past few months on the stock exchanges. As Keynes once said: "Investment is the successful anticipation of other people's anticipation." At the moment, understanding the "rational irrationality" of investors' behaviour is the key to any dis- cussion of what happens next.

Many investors and analysts now include behavioural finance as a key part of their investment process. For example, a few years ago some psychologists conducted an experiment. When a group of people were asked if they preferred a gain of $300 (£190)or the 80 per cent chance of $400 but a 20 per cent chance of nothing, they almost universally ignored probability theory and opted for the guarantee of $300. However, when offered an apparently identical but reverse option – between a guaranteed loss of £300 and an 80 per cent chance of losing $400 but a 20 per cent chance of losing nothing – almost all opted to take the risk.

Some of the recent problems on equity markets stem from the interplay with this "natural" behaviour and the benchmark constraints placed on institutional investors. In the UK, institutions are by far the largest owner of equities. Reflecting their enthusiasm, the capitalisation of the UK equity market was, until a couple of years ago, greater than that of all of the rest of the big European markets combined.

A key driver of the "cult of equity" was a tax break called ACT, ultimately abolished by Gordon Brown. Under this, institutions preferred to receive their returns in the form of dividends, which attracted a credit, rather than through interest on a corporate bond, which didn't. This meant the theoretical process whereby mature industries issued bonds to retire equity risk capital (and thus free up that capital to take on new risk) did not occur. In this sense the UK FT All-Share index became a blend of equities and quasi- corporate bonds, and meant that long-term funds had a very high weighting in equities.

However, the institutional investor was being rational in holding a high proportion of "equities" on the basis that it was really holding a blend of equity and corporate bonds

This tendency to "buy and hold" the equity market was fine until the arrival of the "new economy". Mixing these venture capital type assets in the equity pot increased the returns, but also the risks. Theoretically this was fine, but the law of unintended consequen- ces came into play due to a benchmarking system that in effect forced investors to target those higher returns, and to take those higher risks, whether they wanted to or not.

The peak of the market coincided with changes to the FTSE 100 in March 2000, when out went quasi-corporate bonds such as Scottish & Newcastle and in came "venture capital" such as Baltimore. Rational investors were compelled to swap the old economy for the new and act in a way that outsiders might consider irrational. They have now reversed the process, appearing to sell at the bottom and buy at the top. Again the benchmark system is forcing them to appear "irrational".

So what of recent weeks? Having been forced to target returns, part of the sell-off has reflected investors now being forced to target risk. Those who had portfolios protected at a certain level were left exposed and with little option under the rule-based system other than to sell. The lower it went, the more they had to sell. Rational irrationality.

But there are signs of hope. The momentum of forced selling seems to have abated and the value investor is gingerly emerging to pick up various stocks on high yields and low p/es. Those not forced to be irrational might be rational to follow their lead.

Mark Tinker is global head of debt and equity strategy at Commerzbank Securities.