Good News - Bad News
Behavioral finance is a relatively new field
that attempts to study financial markets on the basis of the
psychology of the participants. It is a bizarre world in which
nothing is as it appears. A business where good news can be
dangerous and bad news is not necessarily bad.
The older and more widely accepted Modern
Portfolio Theory teaches that assessing the risk involved in any
common stock investment is a function of the volatility of the stock
involved. In other words, if the price of a stock moves big in one
direction or the other on a regular basis, it carries a higher
average risk as an investment.
Charlie Munger on the other hand regularly
refers to this method of risk assessment as "twaddle." This is
hardly an academic debate, because nothing is more important to the
investor than being able to properly understand the risk involved in
any kind of potential investment. There is, after all, risk in all
investments. Even the supposedly safe stuff like bonds and CDs face
interest rate risk and periods where your return is eaten by
inflation. A good investment is one that minimizes the risk the
investor faces, and that pays you well for taking the risk. All
investments decisions should start by measuring risk.
If we are using "Beta" (Volatility) to estimate
the risk of an investment, and if it is, as Charlie says, "twaddle"
then our chances of making a good investment are slim. Charlie would
say that value is a better gauge of risk. An overvalued stock
carries more risk than an undervalued one. This is a rather simple
concept or as Charlie would say a concept "that is perfectly obvious
but very little understood."
Were established wisdom says that markets are
efficient and all price movements represent rational indications of
value, behavioral finance will throw in with Benjamin Graham and
accept the premise that markets are bipolar. So risk is dependent to
a large extent on current investor psychosis. Strong bullish
sentiment driven by good news makes a market more dangerous.
At this point, the process of valuing risk
becomes counter intuitive. The more the price of a stock goes up,
the more risk it carries. Many investors will watch as good news
drives the price up, and buy once a comfort level has been reached.
But while good news may make the investor more comfortable, the
truth is good news is bad because if the price is going up, so is
the risk level. Assuming the balance sheet is strong and you like
the business, then bad news is good, because as it lowers the price
of the stock and helps to reduce the risk that comes with a
purchase.
Another factor in determining risk is the level
of speculative short positions in the stock. Again this factor has
nothing to do with the volatility of the stock, and is counter
intuitive. Having a lot of speculators with short positions in the
stock would, on the surface, seem bearish, but the large short
positions are a sign that the stock is oversold. This in turn is an
indication that Mr. Market is currently suffering from depression
and that his normal optimism is currently in remission. Once the
onslaught of bad news has slackened, the large short position will
help to fuel a rally in the stock.