Herd and miss out feelings....

In Investing

Have you heard of the joke about an oil speculator who dies and reaches at the gates of heaven to meet St. Peters? “Heaven is already full of oil speculators. No place left for you,” declares St. Peters.

“I make my own place.” With these words, the oil speculator leans through the gates and yells, “Hey, boys! Oil discovered in Hell.” A stampede of men with picks and shovels duly streams out of Heaven and enter into Hell.

“I guess you do deserve a place in Heaven. Come on in,” an impressed St. Peters waves the speculator through.

“No thanks,” says the speculator. “I’m going to check out that Hell rumour. Maybe there is some truth in it after all.”

That kind of sums up the way Observer Effect plays out in stock market. A famous investor, let’s call him Mr. X, openly talks about his recent investments. Small investors (and sometimes even big ones too) get influenced by this and start buying the stock which results in a jump in stock price, precisely because of increased buying activity. This jump in price will seem to validate Mr. X’s hypothesis. And in short term you see a positive feedback loop reinforcing the stock price. This further reinforces Mr. X’s confidence in his investment and he starts considering buying even more.

It should be obvious to any serious value investor that a stock’s attractiveness rests on its purchase price and if a good business is available at expensive valuation, it ceases to be a good investment. So in this case, just because a good business became visible (to observers i.e., investment crowd) to many, the stock’s attractiveness changed.

In other words, markets can influence the events that they anticipate. George Soros’ theory of reflexivity too is based on Observer Effect. He writes –

When we act as outside observers we can make statements that do or do not correspond to the facts without altering the facts; when we act as participants, our actions alter the situation we seek to understand.