The market is not purely data. That explains the craze movement we see for sometimes crazy reasons. In the real world, the formula for prices in capital markets is:
“Data + Assessment and Judgement of Current Data + Emotion = Market Movements”
What skews perceptions one way or the other is an environment impacted by fear, euphoria, or a focus on anxiety related to uncertainty.
That is what is happening right now; uncertainty is ruling the day across the globe and that is what’s driving market volatility.
Elections, the Middle East, you name it; there is always a new headline to shake investors.
One only needs to look at the fluctuation in Apple stock to see how sentiment can drive market returns. Look at HP this week; Meg Whitman is outlining a turnaround and the stock drops 15%. Likewise, with the 10 year Treasuryyield now at 1.5% and mortgage rates below 4% on a 30 year mortgage, it would seem as if a low-interest rate environment is in store for the market for years to come. The Federal Reserve is injecting adrenaline into a comatose economy.
In other words, all seems well temporarily and the markets have responded to this short-term adrenaline injection. Perception is trumping the data.
What is one to do as an investor when the markets are so momentum and emotion driven? And how does one quantify panic and euphoria as investment decisions are made?
The answer to these questions is to have an understanding of the main psychological drivers causing market movements and to decide what your real portfolio strategy is based on your beliefs. As portfolios are managed, understanding that short-term perceptions can influence portfolio values matters in today's uncertain world. Sentiment is driving markets. Everyone knows that headlines drive markets, and knowing the trading effect of these headlines is what separates one from success and failure in portfolio performance.
As irrational as it may seem, on occasion it is best to invest portfolios based on shorter action being taken to support markets despite the long-term consequences to economic growth. Carefully assess long-term economic and market trends; these patterns are important and form the foundation of investing for the long-term. But short-term environmental influences do matter. Emotion matters in the short term.
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At DWM we favor Modern Portfolio Theory to a certain degree. But it is important to recognize that this philosophy for investing only works if time horizons are very long. Because of this, we employ a strategy that is a modification of modern portfolio theory called Thematic Allocation Strategy (TAS); it is the foundation of how we invest assets.
Essentially, TAS combines modern portfolio theory with themes that we believe will play out over the short and long-term. By combining these perspectives, our tactical adjustments carry a 35% weight as we make investment judgments. 65% of our portfolio strategy relies on allocation strategy. We believe that one day this will be the preferred method ofinvesting as managers recognize that headlines and irrational emotion moves markets. Rational thinking is not the only important element that moves markets; fear and euphoria also play a part.
(Read More: August Factory Orders Show Mixed Picture for US Economy)
Investing, as much as we would like it to be an exact science, is an art as well. As an investor today, read and understand the data. But recognize that what matters is the perception of that data. We do not live in a vacuum. The markets will jump and dive based on perception; to ignore this reality will result in never-ending consternation. And will likely also result is returns that don't meet your hopes and expectations.
Micheal Yoshikami will be a guest on CNBC's "Closing Bell" today, October 4 at 4pm/et. Topics of discussion include Meg Whitman's comments, market strategies and a preview of the upcoming jobs reports.
Michael Yoshikami, Ph.D., CFP®, is CEO, Founder and Chairman of the DWM Investment Committee at Destination Wealth Management. Michael is a CNBC Contributor and appears regularly on the network. DWM is a San Francisco Bay Area-based independent money management firm that provides fee-based wealth management services to institutions and individuals around the world. Michael was named by Barron's as one of the Top 100 Independent Financial Advisors for 2009, 2010 and 2011.