A Few Great Investing Books of 2005 - 2007

The last two years have been great for readers of financial literature. I've been thinking about doing a list of my personal favorites for a while. Today I completed Alan Greenspan's epic "The Age of Turbulence," which is a genuine classic. It tops my list:

1. "The Age of Turbulence" - Alan Greenspan. The best and classiest memoir I've ever read. It cements Greenspan in the Pantheon of last century's great leaders, and establishes a lofty benchmark to which future memoirists will aspire. I know many people feel frustrated by his hedges and equivocations when giving testimony in front of Congress, and frankly I wish he had asserted his opinions more strongly while leading the Fed. In any case, he is a survivor, and he lays out his meticulously reasoned economic judgment and political analysis over the past 40+ years.

2. "More Than You Know" - Michael Mauboussin. An innovative multidiciplinary approach to understanding financial markets. It is fantastic, and a revised version was just released. Mauboussin ecclecticism is sorely needed in financial theory, and Mauboussin delivers exquisitely formulated multi-dimensional analyses. The analogies he brings from other areas of research are truly eye-opening when applied to explaining paradoxes in the financial markets.

3. "Inside the House of Money" - Steven Drobny. An excellent collection of revealing interviews with top global macro money managers, conducted in 2005. It intelligently delves into the thought processes and psychologies of these high achievers, which sets it apart from more anecdotal collections.

4. "The Little Book That Beats the Market" - Joel Greenblatt. The best book I've read on the fundamentals of successful long term stock-picking. It covers the basics of business and stock valuation in an entertaining and engaging fashion.

5. "Fortune's Formula" - William Poundstone. Entertaining and very useful summary of the foundations of quantitative analysis. It describes the evolution and utility of the Kelly criterion, arithmetic vs geometric means in portfolio design, and the impact of return volatility in a fun-to-read and narrative style.

I'm often asked which books are ideal for getting acquainted with behavioral finance and investment psychology. I'll answer that question in another post.

Happy Holidays!

Richard

For Smooth Sailing, Winch up Your Financial Anchors

What's your anchor? If you don't know, it could be costing you.

There were some fascinating (but expected) results during a training program Frank and I ran for financial professionals this week. We asked one-half of attendees whether the Dow Index was likely to close above or below 18,500 in 12 months. The other half we asked whether the Dow would close above or below 10,250 in 12 months. After this first question, we asked each group to estimate where they thought the Dow would actually close in 12 months.

This is a classic experiment in which the irrelevant number mentioned in the first question profoundly affects the predictions made in the next one. It's called "anchoring" because people anchor their expectations to a recently seen, but irrelevant, number. In this case we had a positive anchor (18,500) and a negative one (10,250).

Amazingly, the average prediction for the high-anchor group was 15,644.
With the low anchor it was 13,792

The low-anchor group predicted a Dow gain of 2% over the next 12 months, while the high-anchor group predicted a 16% return. That's a 14% difference in range!

We get a spread about this wide whenever we do this experiment, and virtually every audience is shocked to see the size of the difference.

Anchoring affects analysts (who anchor on the most recent earnings estimates of other analysts), portfolio managers (who anchor on analysts' expectations), and individual investors (who anchor on IPO and recent or 52-week high and low prices).

Many investors anchored on an expectation of a 0.50% Fed rate cut this week. Ooops.

When expectations are anchored, then they can easily be disappointed, leading to emotional reactions that further impair judgment. It's a slippery slope.

Always good to be sure where you're standing (and what your anchor is).

Just some thoughts for improving self-understanding.

Happy Investing!
Richard

THE EROI (Emotional Return on Investing)

Has this ever happened to you?

Recently I sold half of a position (large drug company) that I had held for 5 years. Did I have a good reason? Not especially. I figured that as a solid company it was wort owning - I just didn't need THAT much of it.

But - as is always the case with Whack-A-Mole Syndrome (TM) - it immediately started to move up. In fact, it almost seemed that the stock had become aware that I had sold it and used that information as the catalyst to move up 3 percent over the next two days.

Then something weird happened; I found myself rooting against it.

As a rational, self-interested being I was struck by this reaction. After all, since I still owned the stock, every move higher was making me money. But every move up was also a stinging rebuke of my in retrospect completely arbitrary decision to dump half my shares. This resulting conclusion was inescapable; I literally found myself wanting to lose money.

Why would an investor ever want to do that??

It's simple. We invest for an emotional return that more important even then the financial return. In fact, money is never the goal of investing. It is the means to the end, a currency that buys us emotional states (e.g., feeling safe, feeling proud, feeling free).

Unfortunately, sometimes our emotional goals and financial goals are imcompatible.

Being aware of our secret reasons for investing The E.R.O.I (Emotional Return on Investing) is what helps us overcome our psychology and navigate through the emotional mindfield of equities investing.

Are there any times you felt yourself actually wanting to lose money? Feel free to post a response.

In the meantime, happy investing.

Oh! And check out Dr. Peterson's cool book for more great insights into how to become a better investor.

FREE Financial Psychology Tests

All of our online financial psychology tests are now free! This offering should last for at least one year.

As part of our constant efforts to understand how beliefs, values, personality traits, and even cognitive processing skills (see the Trader's Brain Scan!) drive financial decisions, we've been gathering research data from thousands of users of our online tests.

Our tests are grouped according to interest and affiliation:
Tests For Everyone
Tests For Wealth Management
Tests For Investors
Tests For Traders

We are planning on publishing some of our initial results with collaborators at Stanford University's psychology department in the next few years (we'll write a white-paper once the results are ready). We've learned a lot about how the mind impacts financial success, and we'll be sharing those findings via our academic affiliations over the next few years.

Best wishes,
Richard

Rising Fear, China, and Applied Behavioral Finance

The MarketPsych Fear Index is rising (it was already fairly high before today's selloff). Apparently there was a considerable amount of nervousness before the market opened today, and that nervousness escalated into outright fear by day's end. Maybe a front-page (C1) WSJ article about buying on dips sowed doubt in investors today. "When Crash Means Buy" - brings out the Chicken Little in me.

BUYING ON DIPS

There was no useful info in the WSJ article (such as when to buy on dips and when not to), except that it sowed doubt about what has seemed a surefire strategy. Essentially, since buying on the dips has worked so well for so long (definitely since 1987, excepting the 2 1/2 years for tech stocks after 2000), many investors have become used to increasing their position sizes every time there is a downturn in shares. The article is a little ominous, and certainly hit the market at an already nervous time.

SIVs are the newest "What the...?" to come to the attention of the market. And uncertainty is almost always a negative, especially when the cause is interminably murky and needs $100 billion bailout packages organized by the largest global banks. Once the damage of SIVs comes to light, then the market can rally again, but for now it doesn't look good that another hidden risk has emerged to damage the financial sector.

CHINA A-SHARES

If you've been a regular visitor to our website since it opened - which is doubtful :), then you've known that I've always been bullish on China, and even set up an Investing in China webpage in 2004 to facilitate research. As I mentioned last month, the market is topping now (though may have a little more juice until February, after which it's best to steer clear). Appears that Hong Kong H-shares are doing spectacularly as an arbitrage play. Also via the WSJ (fine journal, that).

As long as Hong Kong remains in anticipation of local Chinese monetary inflows (and as long as it hasn't started arriving), then that market (especially H-shares) will have upside pressure. Ironically, Chinese investors are having tremendous difficulty opening accounts in the one city where outflows to the Hong Kong markets will be permitted (Tianjin Binhai New Area), and the pilot program was ultimately postponed, so no Chinese cash has made it to Hong Kong legally yet. But that is the genius of the Chinese authorities. By announcing the impending program, the premium of A-shares over H-shares has started to dissipate. And if history is any guide (as when the Chinese gov't announced in late Feb 2001 that the B-share markets would open to local investors in June 2001), then the actual financial inflows from China will probably mark a medium-term top in both markets.

WHAT'S THE USE OF BEHAVIORAL FINANCE?

What's the use of behavioral finance? That's the motivating philosophy behind a wonderful organization in Los Angeles -- the Behavioral Finance Working group of the CFA society. Here's their discussion group online.

I was fortunate to give a talk to the group yesterday. I met some great people and got lots of new ideas about how to apply behavioral finance to several areas:
1. Defeating you own investing biases.
2. Helping advisory clients to understand and avoid making biased decisions.
3. Finding opportunities in the markets.
More about those in upcoming posts...

Happy Investing,
Richard

Neuroeconomics 2007 -- Happenings at the SFN Annual Conference

As if Boston wasn't brainy enough with 51 colleges and universities (see this list), the annual neuroeconomics conference was held there this past weekend. Excellent new neuroscience research gave the audience's grey matter some delightful brain candy to chew on all weekend. I'll just list a few of the fascinating findings below. There are many more that I will not mention for space reasons.

In an effort to break the conference's three days of presented research down into a bullet-point-speckled summary, I'll organize the studies in the three following categories:
1) How people, on average, make personal financial decisions. Such experiments manipulated conditions of risk, reward, punishment, and ambiguity or uncertainty in order to see what types of brain activity correlate with (or even better, predict), not-mathematically-rational financial decisions.
2) How people make social financial decisions. These are often simulated using strategic games played with others (or computers dressed as others) and are relevant to morality in general. Such decisions affect other people (and usually oneself) financially.
3) How people are different from one another in their financial decisions, especially in regards to the brain activity that leads to their different choices under similar conditions.

Under personal financial decisions, Peter Bossaerts excellent (and intricate) study of traders in a simulated market was one of the most fascinating. He found that excellent trading (in this case, based on "tape reading") did not appear correlated with mathematical ability. Rather, it required a unique ability to understand the minds and intentions of others (variously called "theory of mind" or empathy). His study is far too complicated to explain in more detail here.

Researchers at NYU demonstrated the behavioral (and some neural) consequences of loss aversion in an investment-type task. Interestingly, the NYU researchers asked subjects to view all their upcoming "investments" in terms of a portfolio to see if it reduced their loss aversion (it did, but not entirely). They also found that an individual's level of loss aversion correlated with a greater SCR response (arousal) to losses versus gains.

Researchers from the Soochow and National Yang-Ming Universities of Taiwan, in the Soochow Gambling Task, have continued to demonstrate that people prefer small high frequency gains punctuated by occasional large losses (negative overall expected value) to small losses that are occasionally punctuated by a large gain (positive ooverall expected value), even after they are told the odds and probabilities. See my book for more detail about this remarkable result.

Brian Knutson's group at Stanford found that priming subjects with a sexy photograph increased NAcc activation (in the reward system) and increased their willingess to take risky financial gambles, even though finance has nothing to do with seeing a sexy photo (I presume).

In a study at NYU using one of Paul Glimcher's tasks, adolescents were found to be more "ambiguity seeking" than adults, but more "risk-averse" than adults when they knew the odds of the gamble. Per the researchers, perhaps their drive to learn and explore overcomes an aversion to known risks that they might not be skilled enough to handle yet.

In the second category of studies, Paul Zak's group at Claremont Graduate University found that touch (a massage of Player 2) more than tripled the amount that Player 2s (in the Trust Game) gave back to Player 1s. And the amount of $$ returned was correlated with blood oxytocin levels (especially baseline level). Recall that in the Trust Game, Player 2 isn't obligated to give anything back to Player 1, so this is a pretty profound finding. The Trust Game is described in my book in some detail.

In the third caegory, studies on how people make decisions differently, it is clear that there are observable patterns of brain activation, circuitry, underlying personality styles, and patterns of behavior such as:
1) Intuitive versus reasoning problem-solving,
2) Those who succumb to regret aversion (avoiding organizing their finances, for example) versus those who plan for the future,
3) Impusive versus more deliberate decision makers,
4) Maximizing versus satisficing decision makers, and
5) Machiavellian (primarily self-interested) versus more cooperative decision makers.
The first four results (preliminary) were found by Scott Huettel at Duke University's Center for Neuroecnomic Studies.

Other researchers found that the ability to self-reduce one's level of fear (and one's physiological fear-resonse) was correlated with the thickness of a part of the brain (VMPFC) that inhibits the amygdala and appears to generate soothing thoughts. Also, thickness of the insular cortex correlated with an increased sensitivity to aversive (bad) outcomes.

One interesting mention was of prior studies indicating that one's score on a "Private Body Consciousness Scale" (one's degree of somatic preoccupation) correlates with an increased susceptibility to the placebo effect. Now if one supposes that marketing is in some way activating placebo-effect-type brain circuits (people feeling good about themselves for a product purchase or consuming a branded product, for example), then it might be true that brain activity predicting the placebo effect will also predict whether one believes that higher prices denote higher quality (and better taste). According to Hilke Plassmann at Caltech, they do. That is, people who scored highly on body consciousness, when they drank a wine they was priced higher (but identical) to a lower-priced wine, thought it tasted better (and this finding was correlated with specific neural activation).

Other researchers found that individuals' "risk-aversion" to financial gambles appears to have a broad brain ciruit which governs it and indicates a specific personality type.

I hope this laundry list of findings is interesting and useful for all who could not attend!

Cheers,
Richard

Visualizing Market Fear

How can you cope with market fear? Many investors consider this a crucial question. Yet it often isn't until periods of fear and sharp market downturns that investors think, "now I know I shouldn't sell everything, but it really hurts!" It's at these times that the excellent investors and traders stand out. They can muster the courage to buy in such markets, even as the financial news and media pundits are screaming, "The sky is falling!"


The MarketPsych Fear Index was displayed on the Wall Street Journal's C1 Money and Investing page a couple weeks ago (Tuesday, September 11, 2007) See article here. See left for the unsmoothed Index used in the article.

The MarketPsych Fear Index helps investors visualize the fear they are feeling that is affecting their judgment. Studies show that we're all affected by market fear, and it takes a lot of courage and experience to step back and see the fear and identify the opportunities that it creates. The first step is understanding that fear is contagious. The second step is identifying where it is and how strong it is. That's what our Index allows.

Now for a brief bit of self-congratulation. During his three CNBC appearances in August, Dr. Murtha rightly re-assured long-term investors that August was a good time to hold stocks, think long term, and consider buying where opportunities could be found. One of my blog posts called the bottom of the sell-off and predicted the rally to come.

Given the intensity of the recent fear, we're on track to continue a bullish Autumn for US equities. Malaysia (MAY) also looking good with deep discount to earnings (PE of 2) and declining dollar protection.

Interesting action (potentially near-term topping) in China. Tremendous profits made in Chinese shares so far the last couple years. Average PE is around 60 now (notwithstanding some accounting shenanigans, such as not counting state-owned shares towards market caps). More on China in another post.

Richard

Great Traders Start Young

... and usually by buying call options on Twinkies.

A brief break from our usual erudite posts because this article on Lunch Room Trading at the Onion is just too funny.

Market Fear: The Poison and The Antidote

If behavioral finance teaches us one thing, it is that Fear trumps Greed. In fact, it's not even close. Fear is like the Harlem Globetrotters playing the Washington Generals. Sure, ostensibly it's a real contest, but despite the ups and downs along the way, we always know who's going to win in the end. The outcome is predetermined, inexorable.

(Authors Note: I used to use the Yankees and the Red Sox for this analogy. But then David Ortiz hit that home run off Mariano Rivera in 2004 and rendered my metaphor obsolete. A pox on your house, Red Sox Nation!!!)

Fear drives the market. Why? Because losing hurts more than winning feels good. Because the future is uncertain, and the default emotion in cases of uncertainty is fear. Because you're not paranoid, the Market really is out to get you, and fear is the greatest weapon in the Market's arsenal.

How do we fight our fear? With "reason"? Well, some people do. And by "some people" I am chiefly referring to Vulcans - the supremely rational beings from the eponymous planet who are not afflicted by such human weaknesses as emotion. (Then again, Vulcans mate only once every seven years, so you can see why emotions could be a big drawback.)

No. For most of us on Planet Earth, we are forced to fight the battle on an emotional level. Reason definitely helps, but only so far as it helps us reacquire our emotional equilbrium.

Fear is a poison. But there is an antidote - Control. Not actual control (which is irrelevant) but the belief that that you have control. Fear beats Greed. Perception beats Reality - at least where our emotions are concerned.

We have seen this play out recently on marketwide level with the recent actions of the Fed Charmain, Ben Bernanke. The market flagged due to fear. (It always does due to fear.) But the fires of fear were stoked in large part because one of the main sources of investors' (sense of) control is the Federal Reserve Board.

After months of hearing "Inflation remains our primary concern", investors began to wonder if the esteemed Dr. Bernanke really "got it". The Market was saying; "Does he understand our concerns? Does he even care?"

Investors were riding shotgun with the Fed Chairman on a dangerous road. They were concerned there may be a cliff up ahead, but they were even more concerned that the Fed Chairman was asleep behind the wheel.

The first shot of control was injected back in July when Chairman Bernanke acknowledged that the mortgage crisis (and credit crunch) were on his radar screen. (Whew! He's not sleeping after all.) The second shot of control came when he lowered the discount rate. (He's awake and he's willing to hit the brakes.)

People called his decision to lower the discount rate a "largely symbolic move". Exactly. Symbols are important, especially when the symbolic gesture tells people, "Relax. I'm on it".

The Market has been calling (or is it whining?) for an interest rate cut. And I, for one, think that would be splendid. But investors got something even more important. They got back their sense of control.

It's like the immortal words of Mick Jagger:

"You can't always get what you want, but if you try sometimes, you might find you get what you need."

Bernanke's awake. It'll do for now.

Rally Happened, Now What?

The stock market rally I predicted on August 17th came to pass. How did I know it would happen?

First, let's recap the action. The US market is up 2.5% or so (the biggest one week gain in 4 months) since the prediction, the Hang Seng was up 12% last week, and the Kospi (Korea) and Bovespa (Brazil) were both up 9%.

So how was it clear to me that the market would rally for a week? Well, there was a definite sense of panic on the prior Thursday. Jim Cramer's doom-filled rant on Erin Burnett's CNBC show is one obvious example. Watch Cramer lose it here on youtube.

When the panic was over, there was a end-of-day rally -- the first positive sign. Then there was relief when the Fed dropped the discount rate 1/2% -- indicating that the Fed would bail out the markets if need be. That relief gradually spread and encouraged panicked traders to buy back in, prompting shorts to cover, and a rally ensued. Psychologically, if traders are not at peak fear (risk aversion), they are less risk averse (leading to greater buy pressure). Even when they are afraid (but no longer panicking), then the market will rally. It's all about levels of risk aversion relative to their recent extremes.

If another negative event had happened (some small ones did), the market wouldn't have fallen as much because the short-term players were already scared out. It would take a major event to convince the long-term money to sell.

On an individual basis, I know many traders and fund managers had difficulty staying long on that Thursday (August 16th). Most portfolio managers knew it was a good time to buy (as every asset manager has learned, it's a great time to "buy when there's blood on the streets"). But without long experience and tremendous courage, it is extremely challening to emotionally hold the line during such periods. My book Inside the Investor's Brain: The Power of Mind Over Money (Wiley Trading) has some tips for practitioners during market panics.

Happy Investing,
Richard

Rally Ahoy and Dr. Murtha on CNBC (again)!!

Setting up for a short-term (week or more) market rally. Yesterday's mid-day panic flushed out the weak hands, and today is time to buy for short-term profits over the next week as the sellers scramble to get back in (at higher prices, oops!). Fear levels have peaked and are now coming down in "relief." (Note: we don't endorse short-term trading).

Dr. Murtha on CNBC three times August 9th, 16th, and 17th, 2007. (subscription required).

Richard

MONEY-MONET!

I was on CNBC on Thursday, which I enjoyed immensely. (Clip here). They wanted a "shrink" to provide commentary of the current market psychology. We know people are jittery these days. How could they not be? But we also know that panic costs people money big time. So how do you get back to the proper perspective?

Well, start by checking out the picture above. What does it look like to you? If your answer is "not much", than you have something in common with the vast number of investors viewing the market's behavior the past couple of weeks.

The photo above is a painting by Claude Monet. Monet was the founder of a new style of painting, French Impressionism. The style is marked by, among other things, "open composition" and "visible brushstrokes". What that translates into (apparently) is "make a bunch of dots and the dots become a picture."

Here's the thing to remember: A portfolio is like a Monet. If you get too close to a Monet, all you see is a bunch of dots (a phenomenon comically illustrated in the movie Ferris Bueller's Day Off when he goes to the art museum). The same is true with our portfolios. When we get too close, we see nothing but a bunch of dots. It's data devoid of context. The picture makes no sense, and when it comes to our investments, that's scary.

The key to appreciating a Monet or a portfolio is viewing it from the right distance.

(Waterlillies)

This means resisting the constant pull to look at our investments from a weekly... daily... (minutely?) framework. If you look at a chart of the past month, it will provide a frighteningly volatile picture of big ups and bigger downs that may induce a feeling of motion sickness. If you look at a chart of the past 20 years, it is much more likely to produce what Glenn Frey would call a "peaceful, easy feeling". Volatility is not the same thing as risk, if you have the right time horizon. Perspective is everything.

I'm speaking of course not only about the distance of time, but of emotional distance as well. When we get "too close" emotionally to our portfolios the result is the same. This is one reason why working with a financial advisor (or failing that, an investing confidante) can be so valuable. Sometimes we need someone to tell us, "Take a step back".

Like Sisyfus rolling his stone up the hill in Hades or me organizing my desk, it is a neverending battle because, as humans, we are constantly, unconsciously and inexorably and being drawn into a short-term focus. (It's happening right now. Seriously. It is.) That's the side effect of paying attention to our world and we can't help it. But if we can make ourselves aware of it, and that gives us a fighting chance.

How do you keep yourself aware?: Reminders. Whatever works best for you. One option would be to get yourself a Monet print to hang in your office. They're cheap, they're easy to find, and they make a nice reminder of how we can't appreciate our portfolios if we don't have the proper distance.

Plus people at work will think you're "classy". Which is nice.

One Risk and One Opportunity

In my weekend readings - trying to figure out what is going on in the markets - I came across two interesting comments in Barron's. One is a frightening, and lingering risk, and one is a stunning and immediate opportunity.

The risk is this: If the credit crunch continues, the Fed will be compelled to lower the discount rate to return liquidity to the system. A rate cut will hurt the dollar, and foreign capital may flee if the dollar begins to fall. As a result, credit could tighten even as the Fed eases.

The opportunity is this: many long-short quant hedge funds buy value (i.e. low P/E, low price/cash flow, etc...) stocks and short high priced stocks. As these funds have been hit by paradoxical market action in early August, and because many of these funds use leverage, they have been bailing out of value stocks with a vengeance. I've been affected by the deepening of value myself, as a value portfolio I have been holding since January 2007 was up 35% in early July, but is now up only 15% (losing 10% alone in the past week). The stocks that value-seeking hedge funds are bailing out of have actually become very cheap -- presenting great opportunities for value investors (and I have a feeling that many will become even cheaper). Later I'll post some of these bargain stocks' names, when the coast is clear. I don't think this is a good time to buy.

Richard

CNBC INTERVIEW and Waiting 'till the Fat Lady Sings

NEWS FLASH: Marketpsych Managing Director Frank Murtha on CNBC today!!! See the video here.

Market fear is spreading, and that's a good thing.

This afternoon a stranger sitting next to me on the subway asked me how the market was doing today (someone who didn't know I work in finance). When anonymous strangers stop staring straight ahead, and start nervously inquiring after the health of the stock market, then it's about time to search for bargains. I figured that experience was the opposite of knowing it's time to sell when you shoeshine boy (or cab driver, or doorman) is offering you stock tips.

As predicted in my last blog post - shameless self-congratulation :) - the market would drop, bounce, and then drop again on greater fear. Below is this morning's market fear chart. Notice how investor pain has risen well above March's pain levels (this is a 7 month chart).

The sell-off will continue, in fits and starts, until the full depth of the (1) subprime mortgage defaults and (more importantly) (2) Credit (and thus liquidity) squeeze on borrowers is comprehended. As long as there is uncertainty, the markets will not rest, and the relief rallies will be only brief and tentative.

If the extent of overextended borrowers (and subsequent defaults) turns out to be as bad as the Chicken Little's are claiming (unlikely), then the market may not rally until congressional legislation is passed and it's ramifications are fully understood (not a good thing in the short-term). Such legislation would be intended to prevent further profligate borrowing by debt-weary consumers. And better credit monitoring and preparation for liquidity crunches (higher reserves) by financial institutions. As long as interest rates remain low, the expansion should continue with only minor economic consequences. It's just a waiting game now -- to see what the fallout will be, and then it will be time to buy.

Ah, but that's idle speculation of a nervous mind. We have had a pattern of profitable buying on dips recently (past 4+ years), and it's possible that many have become seduced by the ease with which they made money -- letting their guards down. That could end badly, or it could keep on. In any case, it will be safe to buy dips when the cards have all fallen and the hands are turned. We need capitulation, panic, and consequences. Then the liabilities of the losers will be known, and the mess can be cleaned up.

Happy Investing,
Richard

Psychology 101: Investor Panic! ... Time to Buy?

The U.S. stock markets have dropped 4% this week, and investors' fear levels are near the yearly highs set in March. Investor psychology is a funny thing -- but it's predictable -- and understanding it can make you a lot of money.

We've been mentioning in our blog posts over the past 2 months that as the stock market has gone higher, investors have grown more and more nervous. They have felt inclined to sell to "cut their winners short" just to lock in their gains so far. A brief market sell-off is exactly what drives investors to feel afraid when they've already made so much money.

Let me offer myself as an example. Every 6 months I create a 10 stock portfolio using a basic Yahoo! stock screener and a little due diligence (calling company CFOs, reading SEC filings, etc...). Takes me about 8 hours to complete the whole process, and the average return has easily been over 20% annually. Here are some of the older portfolios (which I stopped posting after 2005 due to time constraints). This January's portfolio is already up 25%. Which is obviously better than anticipated.

Frankly, that 25% 8-month return scares me. My account is 25% larger in only 8-months. Wow, it feels good. However, like almost everyone else, I want to take that money off the table so I don't lose it. I'm susceptible to cutting winners short. Why don't I? Because I know that my nervousness is not a trading plan, it's a road to underperformance.

Using our Marketpsych sentiment analysis tools, we've been watching the pain level rise over the past week. See this Marketwatch article (which mentions our Investor Pain Index) for a few details. The chart below was generated using our real-time proprietary sentiment software and it is plotted against the QQQQ (Nasdaq 100 ETF):
This chart shows the relative amount of pain measured among investors.

As you can probably see in the chart, the last time pain was so high was a great time to invest. So consider using stomach-churning pain as a Buy indicator. You don't need to "catch the falling knife," but you may want to enter buy stops slightly above the market, because any "relief rally' will be fast and furious.

Personally, I think the pain will probably spike again (and the market will sell-off), in a second wave, before a real buying opportunity presents itself (August and Spetember are yet to come). Consider investing some idle cash during an August sell-off, although also consider somewhere safer than the US dollar (e.g. Singapore or Malaysia) when those markets get hit.

Best wishes,
Richard

The Fiddler's Green: Curse of the Adjustaholic

It was Blaise Pascal, the brilliant French mathematician, physicist and philosopher who said:

"All of men's miseries derive from a single source; his inability to sit peacefully in his room."

Pascal was not referring specifically to investing -- but he certainly was including it. We love to tinker, adjust and monkey with. At least I do.

My name is Frank, and I am an adjustaholic.

My affliction began early in my youth. I would fiddle incessantly with the old rabbit ear antennae on the "television set" in a futile effort to achieve picture perfect clarity on a 1974 Magnavox. I would indulge in impulsive, hare-brained schemes such as throwing the football in an effort to knock the frisbee out of the tree. And then throwing the tennis racket at the football.

By 5 o'clock the tree on my lawn looked like Dick's Sporting Goods.

Sure. I could have waited patiently for my dad to come home and retrieve the offending object. Could have for 2 minutes that is, before the restlessness set in.

I'm older now. I have an HD TV and I don't play much frisbee anymore. But I am still a fiddler.

It raises to mind a behavioral finance question: What is to become of the Fiddler's Green? I'm not referring to the traditional Irish song (which is great by the way), but to the financial portfolio of the modern adjustaholic. If you are an adjustaholic like I am, there are some days you have an urge to fiddle. Somedays you just wake up, get a cup of coffee... and you just really feel like buying a stock.

Any stock.

I'm gonna do it. I'm gonna buy... geez, I dunno... something in the IBD top 10! Like SYNL! And why not? It's # 1 on their list for crying out loud! What exactly does SYNL do? They print $$$ for their investors, THAT'S what they do! It's up to 45. Have you seen the chart! It's a rocket ship! Besides, I'll just cut my losses at 8% if it drops. (And I really will this time too.) But it won't drop! That's the beauty of it! You may say I'm joining a game of Musical Chairs at the Greater Fools Social Club, but they're playing the live version of Freebird - and they haven't even gotten to the guitar solo yet!

Do I really need to tell you what happened next? Suffice it to say I capped my losses at 8% this time. (Okay, 10%). And the fiddler loses some more green.

I recently had a conversation with my colleague, Dr. Peterson. I stated that we cannot change human nature, but that we could plan around it.

Dr. Peterson pointed out that the same human nature that bedevils our investing process is equally apparent in our planning processes.

He has an undeniable and somewhat depressing point.

Well, I still believe we CAN plan around human nature, but it is not easy. It requires honesty with ourselves and self-awareness. It requires having, at the ready, a behavioral alternative that is less self-destructive than placing a buy order. Sometimes it may require help. One of the best things a busybody investor can do is to have a partner - a financial advisor, a friend - someone they can call in his/her moments of weakness.

I'm serious. Alcoholics Anonymous, Gamblers Anonymous, Smokers Anonymous -- one of the most effective methods of stopping a destructive behavior is to reach out to another person when your will is faltering. It helps.

Pascal was right. I cannot sit peacefully in my room, the one with the computer in it... and the access to my brokerage account.

Next time I feel the urge to buy SYNL, maybe I'll call Rich. Or maybe I won't bother to sit in my room at all, and I'll go for a long, long walk instead.

IT'S HERE: Inside the Investor's Brain

After a year-long writing odyssey, it's with great excitement that I announce the release of my new book, Inside the Investor's Brain. You can purchase the book here: Inside the Investor's Brain: The Power of Mind Over Money (Wiley Trading).

The ability to manage your mind in the markets is necessary for long-term trading and investment success. This book teaches the science of achieving high investment returns through an understanding of the power of mind. Endorsements are here. I won't repeat the publishers's long blurb (here: Inside the Investor's Brain: The Power of Mind Over Money (Wiley Trading)), but below is the table of contents:

Introduction.

PART ONE. FOUNDATIONS: THE INTERSECTION OF MIND AND MONEY.
Chapter 1. Markets on the Mind: The challenge of finding an edge.
Chapter 2. Brain Basics: The building blocks.
Chapter 3. Origins of Mind: Expectations, beliefs, and meaning.
Chapter 4. Neurochemistry: This is your brain on drugs.

PART TWO. FEELINGS AND FINANCES.
Chapter 5. Intuition: The power of listening to your gut.
Chapter 6. Money Emotions: Clouding judgment.
Chapter 7. Joy, Hope, and Greed: Hooked on a feeling.
Chapter 8. Overconfidence and Hubris: Too much of a good thing.
Chapter 9. Anxiety, Fear, and Nervousness: How not to panic.
Chapter 10. Stress and burn-out: Short term pleasure, long term pain.
Chapter 11. Love of Risk: Are you trading or gambling?
Chapter 12. Personality Factors: What are great investors like?

PART THREE. THINKING ABOUT MONEY.
Chapter 13. Making Decisions: The effects of probability, ambiguity, and trust.
Chapter 14. Framing Your Options: Seeing the world in black and white.
Chapter 15. Loss Aversion: Cutting losers short and letting winners run.
Chapter 16. Time Discounting: Why we eat dessert first.
Chapter 17. Herding: Keeping up with the Jones’.
Chapter 18. Charting and data mining: Reading tea leaves.
Chapter 19. Attention and Memory: What’s in a name?
Chapter 20. Age, Sex, and Culture: Risk-taking around the world.

PART FOUR. IN PRACTICE.
Chapter 21. Emotion Management: A balancing act.
Chapter 22. Change Techniques: Going deep.
Chapter 23. Behavioral Finance Investing: Playing the players.

Notes.
Glossary.
Index.

It is my sincere hope that Inside the Investor's Brain will help you achieve investment (and life) success beyond your wildest expectations.

Richard

Sell in May and Go Away

The 2% drop in the S&P500 last week brings to mind the old Wall Street aphorism - "Sell in May and Go Away." The assumption behind the saying is a solid one -- the summer action in the markets is generally unproductive for investors. Recent academic studies lend credence to this saying.

A small study I did for the 14 years from 1994 through 2004 yielded the following monthly average returns for the 10 largest Northern Hemisphere stock markets:

When you look out further in history, as the authors (Ben Jacobsen and Sven Bouman) of an excellent 2001 study have done, the data supports the "Sell in May and Go Away" pattern: "Surprisingly, we find this inherited wisdom to be true in 36 of the 37 developed and emerging markets studied in our sample. The 'Sell in May' effect tends to be particularly strong in European countries and is robust over time. Sample evidence, for instance, shows that in the UK the effect has been noticeable since 1694." The study shows that, on average, a buy-and-hold investor would do approximately as well as a "Sell-in-May-and-Go-Away" investor (holding stocks from November 1st to April 31st).

Other researchers have theorized that this effect is biological in origin. In the paper "Winter Blues: A SAD Stock Market Cycle" the authors find that the seasonal effect is more pronounced at higher latitude stock markets (such as Stockholm) where sunlight waxing and waning is more pronounced, and it is inverted in Southern hemisphere stock markets (such as Sydney) where seasons are reversed. In fact, a Stockholm to Sydney portfolio rotation (to match the late Fall to early Spring cycle) earned over 20% annually. Investing in each market (Stockholm or Sydney) alone throughout the year earned about 13%. The authors point out that "Seasonal Affective Disorder", a type of depression that is most pronounced in the late summer and early fall, has a similar cycle as the stock market.

In a more recent 2005 study, the seasonal effect was found to be pronounced worldwide in IPOs and earnings revisions, as if investors' expectations become overly optimistic during the Fall and Winter and then come back to reality in the Summer. This hypothesis of optimism fits with the biological hypothesis, as increased optimism is a hallmark of increased seasonal serotonin and dopamine levels in the brain.

All of these studies indicate that the old aphorism may really be true. Summer is an excellent time for reflection and research, and it will only rarely be a peroid of high returns.

Richard

Know When to Fold 'Em: What Makes an Investor Great

I love poker, particularly Texas Hold 'Em. If you're unfamiliar with the game, just turn on the TV. The chances are, it's on right now - on 37 different channels.

The game provides a great diversion, especially when you make a night out of it with friends, but more than that, it provides valuable self-insights into one's investing behavior -- if you're inclined to look.

Poker, like investing, is a game of decisions made with incomplete and unfolding information. Being good at it requires the same set of skills - patience, discipline, guts, and the ability to filter out our own emotions.

There's an expression in poker; great players lay down great hands. In fact, the ability to accept a loss and get away from a great hand is probably the most important (and difficult) skill to learn. Here's a typical example.

Let's say you've been losing all night when you find yourself dealt a pair of Queens as your starting hand. "Yes! I'm getting paid on this one!", you say to yourself. So you bet. Two people call your bet.

Then the flop comes, revealing a 5, a 7 and a King. You don't like seeing that King, because anyone holding a King in their starting hand has you dead to rights now. But you decide to get aggressive, you bet again. This time one of the bettors folds his hand. The other calls your bet.

Next comes the turn, revealing an Ace. Uh-oh, now you're really in trouble. If the other player is holding either an Ace or a King... you lose. But your opponent bet with that King on the board so you figure that while they may have a King, there's no reason to believe they're holding an Ace. You decide to bluff. You bet again, this time with even more money. They player calls your bet again. Now most of your money is in the pot.

The river comes, it's a harmless 2. You're committed to winning this hand, you decide to put some pressure on the opponent, so you bet half of your remaining money. This time, the opponent, doesn't call. He raises you, forcing you all in. Every bone in your body is telling you, not to call. Even a novice player recognizes he or she is almost certainly holding a losing hand. But you've put so much money into the pot already (financial investment) and you still have a sliver of hope you can win and get your money back (emotional investment). You think, "What choice do I have?" You call.

You show your Queens, and the other player reveals a pair of Kings AND a pair of Aces. Damn. Their starting hand was Ace-King. They had you on the flop and on the turn. Game over.

In behavioral finance parlance this is called the Sunk Cost Fallacy - the refusal to get out of a losing position, because you've already written the money off -- resulting in losing even more money.

Those Queens were one of the best starting hands in the game (the third best actually). But it soon became apparent based on the subsequent cards and betting behavior that it was no longer the winning hand. Information changes, but our emotions sometimes don't get the memo. You know in your head to cut your losses. It's your gut that won't let go. We tell ourselves, in poker and in stock market investing "There's a chance it could come back and, what the heck, it's down so much, there's no sense in getting out now anyway."

The ability to take a small loss to avoid a big one is the hallmark of smart poker player. It's also the sign of a great investor.

So how do you do it? How do you overcome the natural temptation to "dig your way out of a hole".

You have to reframe the situation and retrain your mind. In other words, you have to learn to love to take losses. One way I do this is by using the expression above; "Great poker players lay down great hands" is what I use to do that. I tell myself, "Sure, I lost a little money. But I demonstrated the quality necessary to be a long-term winner." In other words, I pat myself on the back.

Think of it this way; all financial investing is an attempt to meet an emotional need. If you can let the emotional gain trump the financial loss, you've found the secret to acquiring those tough-to-form habits.

Does it always work? Well, no. In the spirit of honesty, I can tell you that sometimes I get frustrated and make a dumb call anyway. I suspect we all do. But the next time your impulsive stock purchase drifts down 10%, remember those two Queens. It may just help you fold that hand, and pick up an even bigger winner on your next hand. It is, afterall, a sign of greatness.

The News is....Do the Opposite of What the News Says

I was pleasantly surprised to see the US markets up substantially today -- "the biggest one day gain of 2007" the media report.

To what do we owe this great day? Well, if you follow the daily financial media reports, then you'll see a few reasons put forward for the price jump -- declining bond yields, increasing retail sales, and diminishing concerns about inflation.

But that's today. Yesterday, per the financial media, investors were frightened when the 10-year bond yield symbolically breached 5%. According to the AP Business Wire today: "Rising bond yields amid inflation concerns had been pummeling stocks since last week."

Too often, the media is unhelpful for investors. Explaining events after the fact means little for future prices. In fact, future prices tend to do the opposite of what the news implies.

When the media is negative is actually the best time to buy. The chart to the left demonstrates how negativity in the media, this time around 9/11 and the war in Afghanistan, was inversely correlated with market returns. I quantified negativity by counting negative words (fear-related) in the Nightly Business Report online transcripts. A simple regression analysis found a significant inverse correlation between the prevalence of negative words in a transcript and the market's performance over the next week. No offense Paul Kangas and Susie Gharib, but your broadcast is useless for the average investor.

By the way, the above chart appears in my upcoming book, "Inside the Investor's Brain" (available from Wiley on July 9th).

When amateur investors hear the media experts predict a slowing economy after a sharp drop in the market, they get scared. When scared, they are more likely to sell. The financial news is better avoided by sensitive investors - those who might get scared at exactly the wrong times.

The media has numerous rationalizations, on a day-to-day basis, for the market's volatility. Beware. Paying attention to this information can be detrimental to your wealth.

Richard

Like the Kids Say... OMG,TMI!

There's and old expression; "A little bit of knowledge is a dangerous thing".

I'd like to add a corollary; "and so is a lot".

I was curious to see what the Market would do on Monday (June 4, 2007), because of the two events that occured on the weekend: 1) The Shanghai Composite dropped 8.3% and, 2) A terrorist plot to blow up JFK airport (and much of Queens) was nipped in the bud.

Truth be told, I was hoping for a nice big drop so I could go bargain hunting. But it was not to be. Perhaps because enough people shared my reactions; 1) The Shanghai Composite is a small and not terribly significant market that is nearly 70% comprised of small Chinese citizen investors - it shouldn't matter that much to us; 2) Oh, terrorists are hatching plans to blow up New York? Really? Tell me something I don't know.

And The Market shrugged. (Damnit)

So it didn't create the buying opportunity, I'd hope for. What it did do was call to mind our strange and paradoxical relationship with financial information; that we want more of it... and that getting it usually hurts our financial decisions.

Knowing too much hurts a lot of our decisions. In his book, Blink, Malcolm Gladwell details how Cook County Hospital simplified their ER triage. Their model eliminated all but four pieces of data to determine whether to admit a patient for a heart attack (electrocardiographic evidence, presence of unstable angina, fluid in the lungs, and a cutoff point for systolic blood pressure). Any additional data - even data that look relevant such as weight, age, etc. -- and the decisions got worse. To borrow an expression from teen-speak, it's "TMI" (Too Much Information.)

No one has understood or exploited the human mind's unhealthy relationship with TMI better than the Gambling Industry.

Ever been a horse track? The helpful track owners provide information on lap times, finishes in previous races, breeding, performance in mud, or rain, on grass, on dirt, the record of the jockeys... they give you literally 100s of different variables to factor into your decision. Does it help? No! It's TMI. Many data points are simply red herrings. But the relationships between the variables are too complex, and the sample sizes usually too small, to make any meaningful conclusions anyway.

The gambling industry knows that most gambling information is specious; it looks important, but is useless for prediction. Sometimes they even know that we know. At a roulette table, the board above the wheel posts the last 20 or so numbers that came up. Nothing could be more irrelevant, and only the most naive player doesn't understand this. But people actually pay attention to what happened before! They love it! "Oh, look. It hasn't hit # 23 in a while!", or "It's been black 4 times in a row now!" Seeking TMI isn't just a human inclination, it's fun!

So what of investing? With Blackberries, Real Time Market Quotes... Jim Cramer, we have more information than we know what to do with. And it's available any time. How do we sift through the haystack of data to find the needles or relevancy?

It starts with an understanding that much of the information we encounter is like that on the roulette board - interesting, but irrelevant. It also means recognizing that, even with quality information, you can have too much of a good thing. Lastly, we can recognize that information that is Frequent, Emotional Evocative in content, and Recent are most likely to be overly influencial in The Market's short term decision-making. (I would say that the terrorist plot meets the last two criteria and the Shanghai drop meets all three). It's a great way to spot short term buying and selling opportunities.

Simplify. Avoid TMI.

A Bull in the China Shop: The Fundamentals of the Worldwide Share Rally

We're in the midst of the biggest bull market in history. Virtually every asset class has been yielding double-digit percentage gains annually. Here in the United States, the boom is less obvious. In Asia, it is unmistakable and profound. Since this is a blog post, not a book on economic history, I'll try to keep my commentary on this world-changing transformation brief. In particular, we'll go back to the subject of China, which I think will be the defining story of the next century.

Pundits cite numerous reasons for the boom, the foremost of which is a liquidity glut. One explanation for the "easy money" says that as Asian and Middle Eastern nations receive US dollar payments for their trade with the United States, and they have enormous trade surpluses ($1 trillion in China's reserves so far), they are inclined to re-invest that money in dollar-denominated assets to avoid driving up the value of their own currencies. This buying pressure on T-bonds and T-bills leads to decreased interest rates and easier credit for business expansion worldwide.

The general idea is that lower interest rates make borrowing cheap. And who wouldn't borrow at 6% in order to invest in a business with a cashflow over 16%? That's a low-risk return of over 10% annually. Now multiply it times 4 using leverage (40% return), and you have a high-risk hedge fund or private equity fund at your finger-tips.

China alone is growing 10% per year. Many of its businesses are growing earnings 20-30% annually for the past 5 years, as evidenced in the China Stock Directory. Yet the Yuan is pretty stable versus the US dollar, so currency risk is low. Private equity funds can make a killing by arbitraging this type of interest rates to earnings differential. Makes sense that the Chinese government is a pre-IPO investor in Blackstone -- Blackstone gets preferred access to fast-growing Chinese companies, and China gets the know-how to set up a domestic private equity industry.

So there is a fundamental logic to the boom - that's my point anyway. But since this is an investor psychology blog, how can we know when bubbles form on top of booms? In particular, is China in a bubble? Some say that a PE of 42 for China Communications Bank is high, especially when HSBC has a PE of 13. Does a high PE alone mark the top of a bubble? Greenspan used the high PE = bubble logic when he insinuated the US market was irrationally exuberant in December 1996. His timing was way off, but it does have a historical logic.

In my studies of sentiment, tops are usually marked by high optimism. But so are the rallies on the way to the top. If you shorted every period of 2 standard deviations above average optimism over the last 20 years, you'd have zero returns. No matter how pessimistic you are, you have to admit that shorting optimism does not work without other objective criteria to go by.

In April, 5 million new stock brokerage accounts were opened in China. That is 2/3 more than were opened in all of 2006 (per the Economist magazine). That sounds like an investor frenzy. But guess what - they shoud be excited. China has been booming for 20 years, and the tipping point has finally been reached where domestic Chinese investors can chase hot stocks. It's healthy that people are getting involved. Does that mean they will emerge unscathed? No.

When will the psychology of the Chinese bubble become a problem? As I mentioned in a previous blog post, probably not until next year. So far the share prices have been rallying less than two years. While PE's are high in big name stocks, there are still some bargains in China(granted, many with murky accounting).

Even after last year's rally in the US (modest as it was), my stock screens found more cheap small-cap stocks this December than at any time in the past 3 years. And they are up 30+% since then. A rally does not prove a bubble, but it is necessary to one.

So the Asian economic boom is finally being followed by a real stock market boom (China and Vietnam in particular). This is good news, as it means their financial systems are globalizing. The selloff of May 2006 indicated that while some investors were skittish about the huge recent gains, the general trend remains extremely positive. This year is no different from 2006 in terms of economic growth in Asia, except that investors are finally catching on and assets are at or exceeding their fair values worldwide. Yet, they can certainly go further. There will be scary selloffs along the way (probably very steep), but they will be clearing the air for the next rally. Those are my thoughts at the moment. They may change at any time, as flexibility is the paramount virtue in the markets.

Next post we'll look at some recent neurofinance studies.

Richard

The Bugs Bunny/Road Runner Investing Hour!

Most of us remember growing up watching cartoons on Saturday morning.

I probably watched too much. It quite literally affected my ability to make sense of the world.

One of my favorites was The Bugs Bunny/Roadrunner Hour that featured the antics of a homicidal supra-genius named Wile E. Coyote who was obsessed with doing harm to a vocab-challenged Road Runner - the Moby Dick to his canine Ahab.

Of course, the coyote never succeeded. He got crushed, flattened and blown up every week. But he did teach us a fascinating lesson of cartoon physics that we can apply to markets -- particularly soaring ones.

In every episode, Wile E. Coyote would invariably pursue his elusive quarry off of a cliff. At this point, it became clear to the audience that the coyote was headed for a serious fall. And the more excitable among us were prone to yell things like, "Look out!" at the TV. The coyote; however, was blissfully unaware of his circumstances. In fact, breaking multiple laws of physics, Wile E. Coyote continued to churn his feet, levitating in the same spot, indefinitely free from all harm... until he did one thing; until he looked down.

Upon looking down, the impossibility (even absurdity) of his current status became clear. The coyote would gulp, usually produce a hastily assembled placard featuring the phrase, "Bye bye!" - and fall like an anvil into the void below.

Welcome to the world of investing bubbles. Welcome to Wile E. Coyote Sydrome (TM).

We've seen it before, throughout the late 90s when people were paying 200 P/Es for stocks based on metrics such as "eyeballs" ("eyeballs" is the new "earnings"!). The admonishments of the exasperated spectators (Julian Robertson & Dr. Robert Shiller come to mind), like those of countless children on Saturday morning, were there if you cared to listen -"Look out! You're going to fall!"

The Shanghai Composite has been running off the cliff for quite some time now. (I'm not saying you can't make money there. It's hitting new highs everyday, but if a market up over 200% in 2 years isn't a bubble... what is?) And the warnings coming from land are getting louder. But the coyote never listens. And he doesn't appear to hear Mandarin any better than English. He is far too engrossed in his pursuit to pay any mind anyway. But he'll look down at some point.

In the same way that the tragic coyote defies the laws of physics, investors defy the laws of economics, running on air as the market soars... 5%... 10%... 15%... I can't wait til next week!

But then the warning cries from the cliff break through to the investor's consciousness. And one looks down. (Sell). Then another. (Sell). Then another (Sell) and -- whoosh!-- (SELL! SELL! SELL!) -- the Panic, with its sickening plunge, is on.

And you don't need a sign that says, "Bye bye!" to know it.

Wile E. Coyote Syndrome (TM) at its finest.

So how do you approach this situation? Your wisdom (and high school physics) tells you to run back to land. But it's such a rush dancing off the ledge, and that's where the money is.

For one thing, do not underestimate human greed. Do not overestimate its reciprocal fear either. (Physics also teaches us that every action has an equal and opposite reaction, after all). Be prepared for both. Have cash available to pick the pieces off the ground. Anticipate the sectors to which people will flee. Run around on air for awhile, but take some profits too. Most of all, prepare yourself emotionally for the plunge, because its coming. And no one know when.

The great thing about ol' Wile E. is that when he gets smushed, flattened, and blown up, he bounces back good as new in the next clip.

Investors aren't so lucky. Raise your hand if you bought Intel at 90! (You can't see my hand, it's up.) In fact, many portfolios never bounce back.

So enjoy it while you can. Be prepared for the plunge. And you may want to consider shorting "ACME Gadgets Co." (Their rocket boosters have serious design flaws.)

"Cutting Winners Short": Of French Fries, Billionaires, and the Chinese B-shares

J. R. Simplot is an American eighth-grade dropout and a self-made multi-billionaire. He made his fortune through saavy investments in potato farming and french fry production. Currently he owns the largest ranch in the United States, the ZX Ranch in southern Oregon. His ranch is larger than the state of Delaware. Despite his tremendous wealth, Simplot is a modest man. He describes his accumulation of wealth to interviewer Eric Schlosser in the book Fast Food Nation:

"Hell, fellow, I'm just an old farmer got some luck," Simplot said, when I asked about the keys to his success. "The only thing I did smart, and just remember this—ninety-nine percent of people would have sold out when they got their first twenty-five or thirty million. I didn't sell out. I just hung on.”

Simplot's key to success was holding on to his winning investments. For most people, when their investments are doing well, they become afraid of giving back their gains. As a result, they do what Wall Streeters call "cutting winners short." Academics call this "the disposition effect."

I recently opened an account statement for one of my brokerage accounts, and I was shocked by the sudden increase in value since the beginning of this year. My first thought? "I've got to sell these stocks to be sure I keep the money." I was first elated by the large gain and then terrified of losing it. My fear inclined me towards selling out.

With world stock markets hitting all-time highs every week, there is a considerable amount of nervousness among long-term investors about the sustainability of the rallies. In China, investors who have been in the market since mid-2005 have 3-4 fold gains. Last week many Chinese B-share stocks were limit up (+10%) each day for 4 days in a row. That kind of gain is terrifying because 1) it makes no fundamental sense and 2) I might lose my enormous paper profits if the market turns down. With Goldman-Sachs analysts on CNBC calling the Chinese market an "overvalued bubble," I have more reason to fear a decline. Yet, as Simplot noted above, truly long-term investors can make an even greater fortune by riding their winners higher, not by selling out too soon.

Whether the Chinese markets will continue their rally is debatable. For psychological reasons, I think the Chinese markets will top in Spring 2008, a few months before the Beijing Olympics. What is most interesting to me now is the tremendous pressure that many long-term investors feel to take profits. Truth be told - if a downturn hits over the next few months, many probably will sell out. There's nothing like short-term declines to prompt long-term investors to "cut winners short."

This photo was taken in 2004 at a Shanghai brokerage (before a muscled bouncer showed me the door). We have had a marketpsych page devoted to Chinese stocks since 2004 here.

Richard

What's Your Ben & Jerry's Investing Moment?

The market has been setting a new record everyday now it seems. The Dow Jones Industrial Average closed on Friday at 13,264.62, a new all time high. And the broader Standard & Poor 500 Index also closed at 1505.62, also a new all time high.

I had a conversation with a friend the other day who is an active investor, and I mentioned that I'm 20% cash. He was surprised.

"You don't need to be 20% in cash!", he explained. "You're not going to need that money for 30 years. You should be more aggressive!"

And he's totally right.

Sort of.

I could certainly stand to me more fully invested. After all, we're talking about a long term investing horizon. And as one who drank the Kool-Aid long ago on the long term safety of equities, I should be able to do so with confidence.

But here's the problem.

One's investing strategy does not exist in a vacuum. It is dependent upon one's Investing Personality. Modern Portfolio Theory does a great job of determining what asset allocation strategy will maximize your returns. But if that investing strategy is not consistent with one's risk preferences, emotional resilience - even attention span, it will succeed in theory, but fail in practice.

Think of it this way: Investing plans are a lot like eating plans. If you want to lose weight, there are any number of diets that will do the job. Barnes and Noble bookshelves are full of them. But what makes a diet right for you, is not whether it "would work" (heck, they pretty much all work). What makes the diet right for you is that it is the plan that you can stick to.

And like proper eating, we're not talking about a short-term, "look good for a wedding" type of situation with our investments. We're talking about following a lifetime plan of prudence and self-discipline. So any long term investment plan doesn't have a built in mechanism for those Ben & Jerry's moments is ultimately doomed to fail. That's why the right plan for me is a sub-optimal investing strategy.

They say that truth lies in paradox. Well here's one for you; I can't be aggressive without a more conservative asset allocation.

When I explained that (emotionally) I needed a decent chunk in cash, my friend assumed it was because I needed to know that at least a part of my portfolio was "risk free". Actually, that doesn't quite hit it.

It's not that the money is "risk free" (i.e., I can't lose it). In fact, the cash position for me gets mentally classified as a loss; I feel like I'm losing money by not having it participate in the rally. No. The reason I need that money in cash is entirely different.

I don't mind risk. In fact, I like being aggressive. But in order to be aggressive (e.g., take some more speculative positions), I need a sense of control. I need to know that if the market gets whacked, I have cash ready to take advantage of it. That way I can cognitively reframe a "bad day" (lost money) into a "good day" (got some bargains). If I couldn't do that, the bad days would overwhelm my portfolio and knock me off course.

For me, losing money only becomes emotionally intolerable when I'm unable to take action, when I can't reclaim some sense of control.

That's my wings/pizza/cheesecake moment. That's when I screw up my plan.

What's your weakness? What are the temptations that push you off your plan? We invite you to check out some of Marketpsych.com's investor self-assessment tools to determine where you (or your client's) potential vulnerabilities may lie.

In the meantime, eat healthy and enjoy the bull market.

Investor Fear and Liquidity

“The key to making money in stocks is not to get scared out of them.”
~Peter Lynch

The market volatility the last few weeks has led to media speculation about possible causes: China's late February market plunge, the precarious financial straights of subprime mortgage lenders, and the biggest baddest reason of all .... Recession. In a different market climate, such events would have had little impact. But the market price action is now driven by emotional investors. By understanding how investors' fear generally plays out during such times, one can act proactively (rather than reacting) to such emotional markets.

Markets worldwide have been booming. In fact, on February 21st during a trip to India last month, I met the head of Asian investments for one of the largest New York-based hedge funds. He confided to me that "nothing in the world is cheap right now." And that was true for every broad asset class. In fact, the conclusion of our conversation was, "Only volatility is cheap." And that's a frightening position to be in. Within 2 days of our conversation the Bombay Sensex index began its latest correction, to be followed shortly by the Chinese and worldwide sell-off.

Many pundits have identified the "global liquidity glut" as the force behind stock market and commodity booms worldwide. But what is liquidity, really? Liquidity represents confidence -- the sense that one can borrow and make a greater return on their investments than the risk-free rate of return. And what is confidence but the lack of fear?

Today's sell-off is an opportunity. Many people who recently acquired risky assets are heading for the exits. But like last May, soon there will be a great time to load up on emerging market bargains.

Hundreds of billions of dollars have been committed to private equity, venture capital, and stock market investments in emerging markets. These outlays will be made over several years and will support emerging markets generally.

However, as with every opportunity, it's usually when it feels the hardest to buy, that the best price is available.

Richard

Thoughts For A Down Day from Peter Lynch

I guess a lot people suffer from acrophobia in China. The day after reaching an all time high, their market sold off nearly 9%. What is the exchange rate to US Markets? 9% in China = 3% in the U.S.

Now the 3% drop that we've seen in the Dow and S&P is hardly a disaster. Most of the people I've talked to consider it more "bloodletting" than "bloodbath" and have expressed some relief that the long anticipated correction may well be upon us. Of course, it may well not be. Time will tell. But I believe the wisdom of Peter Lynch is especially appropriate for today. Lynch once said,

"Far more money has been lost by investors preparing for corrections than has been lost in the corrections themselves."

Indeed, the Chicago Board Options Exchange Volatility Index <.VIX>, or VIX, shot up more than 37 percent today, the largest move since Sept. 17, 2001. In other words, the market received an injection of pure, unadulterated FEAR today.

So what does this mean? Well let's remember Mr. Lynch's counsel and take a look at the VIX.

Check out this chart:
http://finance.yahoo.com/charts#chart1:symbol=^vix;range=1y;indicator=volume;charttype=line;crosshair=on;logscale=on;source=undefined

Note the date at the top of this remarkable spike in fear -- June 13th, 2006

Now look at this chart:

http://finance.yahoo.com/charts#chart2:symbol=^dji;range=1y;indicator=volume;charttype=line;crosshair=on;logscale=on;source=undefined

Note the date on the market low for 2006... that's right. It's June 13th, 2006.

Why? Something I call Whack-A-Mole Syndrome (TM) . That is, the dangerous, but natural tendency for investors to become overly reactive to the stock market (i.e., selling low, buying high).

Personally, I love days like this. I hope the market drops another 3% before it closes. And I will be watching the VIX carefully. In my book fear = opportunity.

I'll close with another Peter Lynch quotation:

"The secret to making money in stocks is not to get scared out of them."

Good luck to all.

Market Psych in Money Mag

A brief bit of self-promotion. You can catch Market Psychology Consulting in the February 2007 issue of Money in Jean Chatzky's monthly column, "Money Talk". In her most recent column, titled Keep Cool in a Hot Market, she features some of Dr. Murtha's insights into avoiding retirement pitfalls -- of which there are many. (Note: Ambiguous modifying clause refers both to many pitfalls and many insights).

Thanks to Ms. Chatzky and Money for the mention.


Frank

Props to Behavioral Finance from Chairman Bernanke

I made a point of tuning in to watch the testimony of Fed Chairman, Ben Bernanke to the Senate Budget Committee on January 18. Why? Because I love watching senators who pretend to have a working knowledge of macro-economics attempt to ask "tough" questions of a man who clearly knows 500 times more about the subject. It reminds me of the conversations with my mechanic when I used to bring my old car in:

Me: So, what did you find out?

Mechanic: Looks like the needle valves in the carburetor got gummed up and its making a lean oxygen ratio in the float chamber. We'll have to change the plugs and patch the intake manifold. It'll take a couple days.

Me: Ah. I was afraid it might be the old Carbonator acting up.

Mechanic: Carburetor.

Me: Yeah, the Carburetor. That's.. uh, that's what I said.

To me it's the best part of the proceedings. But I experienced an unexpected delight when Mr. Bernanke single out the field of behavioral finance as being one of the most promising ways to address the long-term savings crisis.

He was asked what positive changes could be made in policy to help people's savings rates. He said that the most exciting options are coming from the psychological side of investing research. He referred specifically to the new "opt out" approach being taken by companies regarding their 401-K plans.

Tax free savings plans are a great idea, but they have always been optional. It used to be that employees were asked, "Do you want to take money out of your pay check to and put in the 401-K savings plan." A lower paycheck!?! Too many people said no.

But when the option was reframed to, "You're currently in our 401-K savings plan, would you like to opt out?" Again, most people said no.

The reason? Doing something requires an effort. Doing nothing does not. Physicists call this inertia. Behavioral Finance Consultants (such as Dr. Peterson and myself) call it The Status Quo Bias. The fact is, without a compelling reason we'd rather not generate the emotional energy necessary to make a change. The effect is so strong that most people who inherit a position will most likely make no change even when they admit that they never would have chosen that position for themselves!

Something as simple as applying the Status Quo Bias for savings plans does wonders for increasing the savings rates of employees. It was nice to see Chairman Bernanke credit the behavioral finance committee for its simple, yet revolutionary contribution.

Frank

Excited about a Good Deal

(or "Why value investors really are passionate people")

In a fascinating new neurofinance publication in the neuroscience journal Neuron ("Neural Predictors of Purchases", Professor Brian Knutson (Stanford) and economist colleagues at Carnegie Mellon (George Loewenstein) and MIT (Drazen Prelec) set out to discover the brain areas that drive purchases of consumer items. This is one of the pioneering studies in neuroeconomics.

In the experiments, Knutson showed experimental subjects a series of routine consumer products (such as a box of Godiva chocolates) and the prices at which they could buy those items from the researchers. The prices of the items had been discounted approximately 70% from their retail prices. The discount was necessary because subjects had been unwilling to buy the items near the full retail price.

Knutson found that activity in three brain regions predicted purchasing decisions. Activity in the Nucleuas Accumbens (NAcc) was associated with a preference for a product (a desire to possess it), and predicted that the participant would buy the item. The participants’ medial prefrontal cortex (MPFC) was activated when prices were very cheap, and its activation also predicted that the subjects would buy. Decreased activity in the brain’s pain center, the insula, occurred during this experiment, and this decreased activity also predicted buying. In conclusion, it appears there are three neural predictors of buying consumer items – desire for the product (Nacc), a cheap price for the product (MPFC), and low price (decreased anterior insula - fear and pain - activation).

There are several speculative applications of these findings to investment practitioners. The joy value investors feel when they find bargain-priced stocks may be due to MPFC activation. Value investors such as Warren Buffett, David Dreman, and Bill Miller may be driven by such reward-based motivations.

Stock investors who look for an exciting or desirable story may be buying stocks based on NAcc activation. Investors who see little risk in an investment are driven to buy by the absence of a perceived “downside” (decreased anterior insula activation). All of these brain functions are helpful for investors to identify excellent opportunities in the markets, and for the most part they appear adaptice and biologically-based.

By integrating these findings with what we already know about consumer behavior, neuroeconomists are developing a more coherent picture of what drives different types of financial decisions.

Richard