Measuring Investor Appetite for Risk

Gauging investor sentiment is a useful exercise for any investor when forecasting the market direction. Measuring sentiment can be loosely defined as a way to try to gain insight into investors’ attitudes towards the financial markets.

Measuring Investor Appetite for Risk

Pacifica Partners’ Financial Post Weekly Column – January 29th 2010

This and other articles also available online at: Financial Post & Investment Waves Blog

Gauging investor sentiment is a useful exercise for any investor when forecasting the market direction. Measuring sentiment can be loosely defined as a way to try to gain insight into investors’ attitudes towards the financial markets.

Like many things, this is often easier said than done – but nonetheless, it is an endeavor that can be very useful. It is useful because extremes in sentiment are often found at key turning points in the market. For example, the American Association of Individual Investors (AAII) conducts a survey of its members to determine the percentage of its membership who are bullish, bearish, and neutral on the stock market for the next six months.

From the chart below, we can see that the survey can reach extremes at key turning points. For example, shortly before the stock market crash of 1987, there was a very strong bullish (green) stance taken by the respondents to this survey. The same can be said right at the height of the tech stock bubble or just before the financial crisis started to ravage the stock markets.

Negative or bearish sentiment fed by fear is usually found in abundance at market bottoms – shortly before markets tend to rally. Last March, just as the market was bottoming, we saw the highest level of bearishness since the survey first began in 1987. Today, we are seeing relatively low percentage of respondents to this survey saying they are bearish (fearful or negative on the markets). Yet, we are seeing the markets start the new year in a manner that many might find surprising given all of the imrpoving corporate earnings reports and gradually improving economic news.

The likely reason the markets are starting 2010 on a less than solid footing is that much of the good news we are hearing from corporations is already priced into stock prices. Investors looking at the sentiment data over the last few weeks are likely not surprised at the way markets are reacting to the “good news”. It was all baked into the cake – so to speak. But for investors who prefer to buy only when there is an abundance of enthusiasm or good news, so far 2010 is not going the way they would have thought.

S&P 500 and Investor Sentiment

(Click on chart to enlarge)

Other ways to gauge sentiment range from looking at the behavior of mutual fund investors. Over time, different studies have looked at whether capital is flowing into or out of equity mutual funds. The common pattern is that at or near market highs, mutual fund sales tend to be dominated by equity fund sales and during the period that markets are undergoing a bottoming process, redemptions and inflows into bond and money market funds are usually significantly higher.

As is always the case, no one indicator or set of indicators can be accepted as the sole pillar of good decision making. But investors should look at measures of sentiment, valuation levels and technical factors to build a well balanced approach to gauging market direction.

The “buy and hold” and “invest for the long term” messages are all well and good. But as we have seen for much of the past decade, charging into the markets with capital in hand is a recipe for disaster. Several months ago, Morningstar conducted a study measuring how the average mutual fund investor fared against what each category of mutual fund actually performed. The conclusion: over the last five years, in each mutual fund category, the average investor underperformed the category average. Why was this so? The most likely reason is that investors attempt to “time the markets”, or chase the latest hot mutual fund or sector. Essentially, buying high and selling low.

Time and again, one of the most costly errors for investors is to get aggressive and start thinking about being long term investors well after the market has gone on an extended run only to then panic and sell out when markets decline for an extended period of time. For the prepared investor, market declines should be welcome events – allowing one to capitalize on the inevitable opportunities that other people’s panic creates.

When Sir John Templeton, widely regarded as one of the greatest investors of all time, was asked what made him avoid the hype and eventual crash of technology stocks from 2000 to 2002, he replied: “When people are desperately trying to sell, help them and buy. When people are enthusiastically trying to buy, help them and sell”. In other words, Sir John was saying watch what the crowd is doing and then to consider doing the opposite. For most investors, this is a hard thing to do. But when it comes to investing, it pays to be aware of where extremes in investor behavior are resulting in rationality being replaced with fear or greed. After all, extremes in fear and greed are just reflections of market sentiment.

Pacifica Partners Capital Management

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Legal Disclaimer

This report is for information purposes only and is neither a solicitation for the purchase of securities nor an offer of securities. The information contained in this report has been compiled from sources we believe to be reliable, however, we make no guarantee, representation or warranty, expressed or implied, as to such information’s accuracy or completeness. All opinions and estimates contained in this report, whether or not our own, are based on assumptions we believe to be reasonable as of the date of the report and are subject to change without notice. Past performance is not indicative of future performance. Please note that, as at the date of this report, our firm may hold positions in some of the companies mentioned.

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