Howard Marks: Psychology-Induced Errors In Investor Behavior

In his book – Mastering The Market Cycle, Howard Marks explains the phenomenon of capitulation in financial markets. In the early stages of a bull or bear market, most investors refrain from joining the trend, lacking the insight or courage to act early.

As the trend gains momentum, these investors continue to resist, maintaining discipline not to join late. However, eventually, many investors capitulate due to feelings of regret, envy, and fear of missing out, leading them to buy into a rising market or sell in a falling market at inopportune times.

This behavior exacerbates their initial mistake, resulting in significant losses. The last investors to capitulate often mark the market’s peak or bottom, triggering a reversal. This cycle highlights the detrimental impact of psychology-induced errors on investor behavior.

Here’s an excerpt from the book:

I’ve mentioned capitulation before. It’s a fascinating phenomenon, and there’s a dependable cycle to it, too.

In the first stage of either a bull or bear market, most investors refrain (by definition) from joining in on the thing that only a tiny minority does. This may be because they lack the special insight that underlies that action; the ability to act before the case has been proved, and others have flocked to it (after which it’s no longer unappreciated and unreflected in market prices); or the spine needed to take a different path than the herd and behave as a non-conforming contrarian.

Having missed the opportunity to be early, bold and right, investors may continue to resist as the movement takes hold and gathers steam. Once the fad has resulted in market movement, they still may not join in. With steely discipline, they refuse to buy into the market, asset class or industry group that has been lifted by bullish buyers, or to sell once selling by others has caused prices to fall below intrinsic value.

It’s not for them to join the trend late. But most investors do capitulate eventually.

They simply run out of the resolve needed to hold out. Once the asset has doubled or tripled in price on the way up—or halved on the way down—many people feel so stupid and wrong, and are so envious of those who’ve profited from the fad or sidestepped the decline, that they lose the will to resist further.

My favorite quote on this subject is from Charles Kindleberger: “There is nothing as disturbing to one’s well-being and judgment as to see a friend get rich” (Manias, Panics, and Crashes: A History of Financial Crises, 1989). Market participants are pained by the money that others have made and they’ve missed out on, and they’re afraid the trend (and the pain) will continue further.

They conclude that joining the herd will stop the pain, so they surrender. Eventually they buy the asset well into its rise or sell after it has fallen a great deal. In other words, after failing to do the right thing in stage one, they compound the error by taking that action in stage three, when it has become the wrong thing to do.

That’s capitulation.

It’s a highly destructive aspect of investor behavior during cycles, and a great example of psychology-induced error at its worst. Of course, when the last resister has given up and bought well into the rise—or sold well into the decline—there’s no one left to fall in line.

No more buyers means the end of the bull market, and vice versa. The last capitulator makes the top or bottom and sets the scene for a cyclical swing in the opposite direction. He is the “fool in the end.”

You can find a copy of the book here:

Howard Marks – Mastering The Market Cycle