Investors emotive cycle and the credit crisis

In high school, we were introduced to economics and the cycle of Growth, Maturity, Slowdown, Depression & Revival. For centuries most businesses and industries have treaded from peaks to troughs. An investor's job is to identify the current cycle state of those businesses at the stock market and take an informed decision to invest or divest based on the valuations.

But these patterns are not just applicable for businesses or sectors. Infact, individual human behavior isn't any different at all. There are 5 behaviors that best describe an investor's state in the muddled financial markets - Greed, Disbelief, Denial, Fear, Anger.

While the first four are very prominent phases during financial crises, 'anger' is one behavior that seems to have taken over investors. George Soros is angry with the Federal Reserves; the Feds are livid over the PEs and hedge funds who bought mortgage-backed securities; these institutions are hurling abuses at rating agencies who incorrectly rated those tranches; the rating agencies are furious at the lack of data provided by banks offering these assets; these banks are blaming mortgage consumers; and the consumers blaming these banks for over-leveraging them; the banks are crying because the Feds increased interest rates thereby lowering prices of housing ... the blame game never ends. Everyone is angry !

Anger occurs when one's trust is violated. But who is to be blamed for this? Look at it this way, you wouldn't lend money to the nice family that lives 3 houses down the road. But you are comfortable lending it to an unregulated institution called a hedge fund. You have placed your trust (and money) on a stranger.

As an article in the Economist puts it (here), the financial market mostly works on trust. Regulators have to trust financial institutions for they cannot predict the peril of a financial idea before the peril has happened. They have to let markets develop. Incidentally, the credit crisis have called for a much higher participation by regulators. As Josef Ackermann, CEO of Deutsche Bank aptly puts it, "I no longer believe in the market's self-healing power".

While risk is always there while investing, as value investors our approach should be to minimize the impact of these risks. Like Charlie Munger who says, "build a 30,000 ton bridge for a 10,000 ton truck". He and Warren Buffett have also held that they are nervous investing in businesses which they dont understand. The mortgage crisis was similar because the complicated structures made it difficult to understand the nature and quality of the asset .. even today banks ad the central banks are not sure of the extent of the damage .. some say it can be as high as USD 30 trillion.