Strange as it may sound, but markets are a lot about psychology. Human behaviour is repetitive in nature, moving from complacency, to greed, to fear, to panic and back. It takes on a kind of form when it reflects on markets as mass psychology: Socionomics or Behavioural Finance, as it is called is an emerging area. This branch of economics helps forecast asset prices and interpret mass-market behaviour. Bernerd Baruch, the famous Wall Street financial leader, said, "What actually registers in the stock market fluctuations are not events themselves but the human reactions to these events."
To elucidate this further we have Daniel Kahneman''s Nobel Prize wining ?"Prospect Theory'', which says it''s easier to own something and develop possessiveness for that object than be indifferent. In other words it''s tougher to "Sell" and easier to "Buy". This seemingly simple theory can junk 200 years of economic thought, as it proves that market and corporate profits are not about maximising economic utility but about mass psychology. And hence it''s not the events that decide how high or low the BET-C, BET -FI, OIL, Gold prices, or Dow Jones will go, but sentiment. I belong to this other school of thought and my area of work is to forecast asset prices using sentiment and return a profit trading on local and international markets.
Let me try to elucidate this case further. After the Romanian Market left behind the huge success of 2004 returning 92% for the year, a majority of Romanian investors were gung-ho about the BET touching the skyline. A 35% return in January 05 boosted the sentiment further, as markets seemed unflappable. It was this extreme optimism, which suggested a contrarian strategy, i.e. to sell when everybody was buying, and vice versa. A contrarian is someone who understands that markets peak in extreme optimism and bottom when things are extremely murky. He understands that it is tougher to sell and easy to buy.
A small survey of fund managers in and around the country could have highlighted that a majority of the fund managers entered into the market near the January 05 tops and were holding very little cash to buy when markets formed an intermediate bottom around April. Though professionals are known to do a better job than non-professionals in most exchanged traded markets, playing contrarian needs a firm grip on market psychology.
Despite the fact that Romanian markets are relatively cheaper and more attractive than their pan-European, Western European and American counterparts, our strategy is clearly not to get trapped in long bouts of stagnant or sideways low return periods hoping that those real losses return a profit soon. It is this active approach to portfolio management, which convinces us that selling like buying is an important necessity to protect investments and avoid loss.
This was the reason derivatives markets (Futures and Options) were launched somewhere back in the 17th century to give the investor a financial instrument to hedge his risks and avoid financial losses. This reality is dawning on Romania''s Futures and Options markets today, especially with the EU integration perspective and market liquidity anticipated to increase by the day. A rough calculation can show that the seemingly non-descript derivatives (SIBIU) market with less than a million euros in daily trade can grow about 25 times from current levels along with a 3-fold increase in market capitalisation on the BSE. Well, these figures can be statistically defended on a global average basis.
Coming back to the active portfolio management approach and protecting the portfolio from a financial loss... Futures and Options markets give the investor an ability to sell against a spot (BSE) market by using instruments like Futures (SIBIU). Every growing economy and growing stock market has a risk premium attached to it and hence the profitable opportunity to hedge and manage that risk. The Romanian SIBIU Futures market is a boon despite its problems with illiquidity and lack of corporate action adjustments.
Apart from the attractiveness of the top traded Futures on SIF2, SIF5, SNP, TLV and RRC for speculation and hedging, there are riskless return opportunities involving cash - futures and futures - futures arbitrage too. And bear in mind SIBIU is the only market where you can sell for about 3 months, hedging yourself completely from market vagaries and declines that erode the market wealth.
In conclusion, portfolio investing is an art, which is not passive in nature. One needs to understand market sentiment extremes, have a grip on market psychology and use appropriate hedging mechanisms in uncertain times. It''s only then that one could have had the courage to sell in February 05 and buy now when markets are reeling under low volumes and disinterest. As the first lesson of market psychology says, "Buy in gloom and sell in boom".
* Mukul is an MBA and a practicing Chartist with more than 7 years of capital market experience around the world. He specialises in exchange traded derivatives and risk management.
He currently works as a consultant for SSIF Broker SA Cluj-Napoca.
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