Bipolar Investing

It seems that virtually everybody agrees that during the last few weeks, the investment markets have been ruled more by emotions than logic.  But as we watch the markets rise and fall like giant ocean swells, it's fair to ask: how, exactly, does this happen?

A recent report by the Reuters news service, entitled "The Madness of Wall Street" (http://www.reuters.com/article/2011/08/19/us-markets-volatility-idUSTRE77I2SA20110819)  offers some insight.  It describes a "bipolar market" made up of traders and policymakers who are constantly trying to guess how daily events might affect other market participants, rather than buying based on what they perceive to be the actual value of the company shares.  Some are using high-frequency trading algorithms that react to headlines and overall market trading patterns, which exaggerate every trend on the upside and downside.  The article points to a study by the Tabb Group, a financial markets research firm, indicating that during the week of August 8, high-frequency trading firms and strategies accounted for 65% of the daily trading volume in the U.S.

The problem for the rest of us is that there is no good market forecast that will predict what might start these twitchy programs buying or selling.  Meanwhile, the media has become a virtual echo-chamber; instead of a mature discussion of the economic fundamentals, you hear breathless reports of what is happening now, which reinforces each current trend even further.

A number of economists in the article say that they expect this volatility to continue until the unlikely day that traders give up their algorithms designed to respond to headlines, and the news organizations decide to emphasize fact over frenzy.  They worry that this experience, so close to the market panic of 2008, could change investor behavior for the worse, either driving more individual investors into the herd to buy high and sell low in a panic, or to avoid the markets altogether and lose out on the higher returns that are generally associated with stock investing.  Either behavior would endanger their ability to fund their retirement.  It would also mean they would lose the chance to take advantage of stock bargains every time the twitchy programs decide to dump everything.

Because of this emotion, the stock market is the only part of our economy where people flock into the store to buy when prices are going up, and rush for the exits whenever prices go down.  Here's a prediction: a few years down the road, a lot of investors will look back at their participation in the herd mentality and wish they could have had the fortitude to buy when everybody else was selling.