Investor Confidence

Much has been said about the crisis in investor confidence. Much has been said about the need to restore investor confidence. But how can investor confidence be restored? Indeed, what is investor confidence?

Two synonyms for the word confidence are trust and faith. It takes a lot of trust to invest in corporate securities. When you think about it, what investment do you actually hold? Most people hold a piece of paper with a mutual fund's name on it. This statement has a name and account number on it. It takes trust to believe that the piece of paper is actual wealth. How many investors have actually seen a stock certificate of a company they own? Unlike gold or real estate, when you invest in corporate securities, you hold only paper. It takes a great deal of faith in the system to convert your hard cash to financial statements from brokerages and mutual funds. Indeed, investor trust is the foundation on which the entire securities market is built.

Not only is trust a requirement for entering into the securities markets, it is also a force in decision-making for many investors. Consider two types of investors ”the assessing investor and the trusting investor. The assessing investor uses analytical tools to evaluate the value of an investment. He or she does not trust what the CEO of a firm says or what analysts recommend. The assessing investor makes decisions on what to buy, when to buy, and when to sell after exhaustively gathering and analyzing all relevant information.

On the other hand, the trusting investor makes decisions based on the level of trust that has been achieved. ^[4] Trust is built over time. To know the degree of trust deserved, the trusting investor looks to the past. If a person, company, or mutual fund behaved in a particular way in the past, the trusting investor assumes the behavior will continue in the future. Psychologists and behavioral finance experts call this a representativeness bias. The events of the past represent what to expect in the future. The trusting investor will buy and own securities when the past behavior meets his or her threshold for trustworthiness . This investor is induced to invest after a company has shown a history of good performance and the stock has provided good returns. Because trust is built over time, trusting investors tend to be momentum investors. That is, it takes good returns over time to build up the trust to induce investment. Trusting investors buy the securities that have increased in price over time.

Notice the difference in behavior between assessing investors and trusting investors. After a stock price has risen, the trusting investor is likely to buy. The assessing investor determines whether the stock has risen too much (and is thus overvalued) or still has some upside. When stock prices fall, the trusting investor begins to lose faith. If the price falls too far, he or she loses confidence and sells the security. The assessing investor again trades on the basis of whether or not the stock is undervalued or overvalued.

Are there any assessing investors? Probably. Many books discuss how to conduct security analysis. Tens of thousands of people are trying to become certified as a Chartered Financial Analyst (CFA) by taking the rigorous tests on securities analysis. This analysis is also taught in business schools everywhere.

Are there any trusting investors? While there are many investors who know about security analysis, there are probably many more who do not. These investors make decisions based on other factors. How many people buy the stock of a company when they really are not sure how that company makes money (take Enron, for example)? How many people actually know what stocks are owned in their mutual funds or in the funds in their 401(k) plan? Indeed, how do people pick mutual funds? The decision for many investors is usually based on past return. The mutual funds that ranked in the highest 20 percent in performance last year are receiving nearly all the new investment money this year. ^[5] Trusting investors put their money in the funds that have earned their trust by performing well in the past. They also take their money out of mutual funds that performed poorly.

Faith in securities markets also applies to asset classes. The great bull market of the 1990s brought millions of new investors into the stock market. The market earned their confidence by producing good returns. Most of these investors did not learn how to conduct security analysis before buying stocks. They still do not know how to conduct analysis ”they are trusting investors, not assessing investors. These investors lost confidence during the bear market of 2001 “2002 and the corporate scandals. Most trusting investors had had enough by the summer of 2002 and sold their stock. Looking for another investment class that they can have faith in, they noticed that bonds had earned a solid return while stocks experienced a bear market. Sure enough, record flows of investment money poured into bonds in the summer of 2002. This is more likely the money of trusting investors rather than that of assessing investors. Assessing investors are more likely to find that securities are undervalued after a market decline and overvalued after a price increase. Bond prices had risen and stock prices had fallen . As a result, assessing investors were more likely to buy stocks rather than bonds. Even investors just rebalancing their portfolio would be selling bonds (because they had increased to a larger portion of the portfolio) and buying stocks (which had decreased in portfolio allocation).

Trusting investors do not necessarily have to trust a company's CEO or a particular analyst. They may learn to trust the corporate system of incentives and monitors to continue behaving as it did in the past to continue producing the good returns. A history of favorable experiences strengthens trust.

A history of unfavorable experiences makes trusting investors distrustful. The large decline in the stock market and a series of corporate scandals have given trusting investors many reasons for losing confidence.