Psychology of the Auto Bailout (or lack thereof)

A few thoughts about the auto industry bailout failure:

As Congress is considering this decision, there is so much baggage from past consdierations (prior bailouts, anger about SUVs and "sabotaged" electric cars, union pay and benefits, etc...). The emotional baggage is getting in the way of rationality.

Psychological research shows that facts and numbers are needed to make the best decision in such a situation. Grandstanding over ideology is what happens when no one has come up with clear numerical projections. Numbers such as: 1) how many people will become unemployed and their families will draw federal and state benefits? 2) what are the consequences of bankrupcy reorganization to employees, suppliers, and others? 3) What are the realistic future strategies of the companies? 4) Who are the creditors who will be hurt by bankruptcy?

These are useful questions, but under stress and uncertainty the human mind will latch onto emotional images without such numbers, often making worse overall decisions as a result.

Richard

Oh, Ye of Little Faith

Faith.

What is it? What does it mean to investors?

If something is provable, certain... there is no need for it.

You don't need faith when you already know.

Faith is for the times when you really don't know.

It's the belief in something despite a lack of evidence.

The essence of faith is doubt.

We investors are getting our faith tested these days.

Faith in policies that we were assured will fix the problems. Faith in the people who make them. Faith in companies who say their balance sheets really are okay. Faith that investing in stocks is a good and safe choice for the long term.

Algonquin Round Table raconteur, Alexander Woollcott once said, "Everything I love is either illegal, immoral or fattening."

Exactly.

Cheating vs. Owning Up?

Looking the Other Way vs. Taking a Stand?

Broccoli vs. Red Velvet Cupcakes?

You want a short and reliable guide to making the "right" choice?

It's the one that's most difficult to choose.

So here we have a market that is tantalizingly cheap (historically speaking) and absolutely terrifying.

What choice do you make if you have a long term horizon?

I say unto thee, brothers and sisters: Those who have faith in this market will be rewarded somewhere down the road.

I believe that. In fact, I'm acting on it.

But to tell you the truth, I'm just going on faith.

Investors Are in the 4th Stage of Grief - Depression

It's been a depressing time to be an investor these past few weeks. In my opinion we're at the worst point in this crisis so far, yet surprisingly to me, the MarketPsych Fear Index has only begun to rise in the past 3 days.

I think investors have been in a state of despair, not fear. They have essentially become resigned to further losses. That's obviously not healthy for the markets. And on a technical level, it doesn't bode well for a price recovery. On a psychological level, I think the entire financial community is in the 4th stage of the Five Stages of Grief called "Depression." See midway through this blog post for a prior discussion of the five stages.

The image above was borrowed from Irvine Housing Blog, and even though it incorrectly orders the progression of the Five Stages, it gets the point across.

I've been to New York to train portfolio managers and financial advisors every month since the crisis began, and I'm finding a tragic progression in the psychology of the people I've spoken to, just like the stages of grief (above).

In late September, I still heard hope - "this is a bad year, but it might still recover." A few people were frazzled and had abandoned their long term strategies for cash, but the vast majority had stayed invested and were taking big losses. (In general, the hope for a recovery, and the attempts to time the bottom, are characteristic of a continuing price slide, not a bottom.)

By late October I encountered paralysis and shock. There was furious scribbling when I described stress management techniques, but otherwise the portfolio managers I spoke with were somewhat listless and exhausted.

Last week, I encountered profound sadness, hopelessness, and despair. Some people approached me with deep concerns about their abilities to keep their jobs and their clients.

Nothing will ever be the same on Wall Street, and I'm afraid the shakeout of the financial industry is just beginning.

By being real about where you are, and staying positive and proactive, you'll make it through this crisis OK. Remember to work on the things you can control, and let go of those you can't. And dust off your Plans B and C - hopefully you won't need it, but knowing it is there is psychologically settling.

Once you've come to terms with the sad realities we're in, then it's time to start positioning for the future. There are great opportunities that come out of every crisis, and there is usually plenty of time to spot them and take advantage, since so many others are paralyzed. For example, boat trailer sales are up, since many people can't afford marina slip fees for their boats anymore. And of course, Safe sales are up... There is always opportunity, but sometimes it requires a little more creativity to see it.

Best wishes,
Richard

Learn To Manage Financial Stress: A MarketPsych Guide

Are you glued to the financial news?
Ruminating and checking prices frequently?
Having difficulty sleeping? On edge, tense, or nervous?


These are all symptoms of stress, and they are common for anyone working in the finance these days. Unfortunately, stress can erode the ability to think clearly and perform consistently during the times we need those skills most. Fortunately there are several steps we can take to manage stress that will get us back on track to excellent performance.

Stress is the brain’s way of trying to protect us. It prepares us to handle unexpected surprises and potential threats. When we’re under stress, our adrenal glands release stress hormones such as adrenaline and cortisol. These hormones actually affect our brains, causing a short-term focus, increased pessimism, impaired concentration, reduced attention span, increased mental rigidity, decreased patience, and enhanced detail-focus. These traits can be problematic for investors since they predispose them to make impulsive trades and information processing mistakes. That’s why stress management techniques can help you “keep your head” in volatile and unpredictable markets. In order to reduce stress now and make a long term plan to prevent future stress, try the three stage process in the attached document.

Best wishes,
Richard

The Value of the Time Out

In the words of Dick Vitale... "Get a T.O., Baby!!"

The value of the time out to the investor and investors plural (i.e., "the market") is hard to exaggerate.

Whether it's FDR's famous "Bank Holidays," or suspended trading, or simply going for a long walk when you're tempted to make an impulsive trade, the "time out" is a major weapon in an investor's fear-fighting aresenal.

Why? Because fear FORCES us to think short term. It's simply the way our brains are wired. There is a sound biological/evolutionary reason behind this reaction.

When you're out gathering firewood for the cave and lock eyes with a large male Smilodon (read Sabretooth Tiger) who has just emerged from the glade, your brain simply CANNOT LET you indulge in thoughts like "what to wear to Zog's birthday party?" or "should I redo the cave paintings for the harvest season (antelopes are so "early pleistocene")?"

The Sabretooth has gone the way of the Dodo, but the evolutionary function remains. Intense fear still draws our focus on the here and now. As well it should.

This is where the time out can help. The ablility to take a break and regain our bearings (to "step out of the box" as Crash Davis would say) gives our amydalas a chance to stop firing. When that happens we can engage other parts of our brain. That's when we can pull up and out of the tailspin of panic. It's neurobiology. See Rich's critically acclained tome for more information.

This is, of course, the eternal struggle for investors: To pull out of the short-term focus and think big picture.

When we do calm our brains and revisit the situation, it doesn't mean our outlook becomes rosy. It just means we've given our brains the ability to reintroduce reason to our thinking processes - and perhaps a chance to spot the fantastic opportunities such crises produce.

A few days off may be just what the doctor ordered.

In the meantime, good luck out there, everyone.

Frank

The Psychological Prescription

This crisis is now fundamentally about psychology.

Trust is the oil in the engine of capitalism, without it, the engine seizes up.

Confidence is like the gasoline, without it the machine won't move.

Trust is gone: there is no longer trust between counterparties in the financial system. Furthemore, confidence is at a low. Investors have lost their confidence in the ability of shares to provide decent returns (since they haven't).

This is now a PSYCHOLOGICAL problem. That's what Frank and I do - manage psychology, so here is my prescription:

1. A show of financial force is needed. Confidence has been lost in the ability of any one institution or government to solve this crisis. Now, to restore order, EVERY major central bank in the world needs to stand shoulder-to-shoulder and say: "We won't let this system fail." What? I didn't hear you... "WE WON'T LET THIS SYSTEM FAIL!!!" That's what the business community in the world needs to hear. That's how confidence is restored. It has to be a HUGE intervention and very credible.
2. I've said for a while that if the bailout plan had passed the first time, it may not have needed to be spent. Sometimes just the idea of a price floor is enough. That requires action to demonstrate that there is a buyer of last resort who will establish that floor. Sadly, we've seen the weakness and pettiness of U.S. political leadership, which has terrified investors. And so the credit crunch continues.... Only coordinated action by governments with their hands on the money spigot can pour enough financial oil into the engine now.
3. We need to believe that a BIG entity or institution or consortium is in control, or plans to take control of sorting out the crisis. Otherwise the fear and credit contraction will continue.

That means that when the coordinated action happens, it can't be watered down, and it needs to include the sentiment EVERYTHING will be done to fix this. Less than urgent STRONG action is not enough. Everyday huge amounts of wealth and growth potential are being eroded. It doesn't have to be this bad, but it will if no one steps up to the plate.

Unfortunately, I'm concerned (as is the market), that no one with the power has the leadership drive or political will to get this done. There are huge political risks to this, and sometimes explaining the psychology of what you're doing is enough to undermine it. For that reason, the final solution will need to sound very mechanistic, but the fundamental effect will be psychological.

The implications of a huge coordinated bailout/buyout will be hard to swallow for many people, on philosophical grounds. They might say, "but how can you advocate what is essentially a worldwide regulator or central banking system?" To which I say, "would you prefer a worldwide depression?" This credit crunch and the current market panic is THAT serious. And it needs the appearance of such an entity, for restoration of global confidence.

We need a coordinated, BIG, credible, active, and absolutely forceful response that demonstrates who is in control (and it has to be a unity of governments and central banks with a strong leader). Maybe the IMF and Worldbank will come up with something at their annual meetings this weekend? Maybe...

Richard

DISCLOSURE: I'm net short equities.

Pressure Valve: Letting off Steam

Have you ever seen a steam pipe explode?

I did. I was in Boston driving down Boylston. I heard an explosion, checked the rear view mirror and what I saw looked amazingly close to the above photograph.

Market crises can create the investing equivalent of steam pipe explosions. Investors get caught between two competing pyschological forces that build up pressure:

On one hand, uncertainty causes indecision.

But on the other hand, when we are anxious, we naturally feel a need to do SOMETHING.

The result of these two psychological forces work against each other until -- Kaboom! -- the pressure becomes too much.

It's a vicious cycle and it goes something like this: Do nothing (and suffer), do nothing (suffer some more), continue to do nothing (suffer to the breaking point) then PANIC!!! (do something rash).

It's a wealth killer.

We need a way to let off steam, so that the pressure doesn't build to the point of explosion.

Now, let it be said that we don't give specific advice to investors here at MarketPsych.

Nonetheless, there are some tricks that people often employ to relieve the pressure.

One of the best pressure valves we have is to sell a small percentage of certain positions to free up some cash.

This works on a financial level, but more importantly it works on an emotional level.

Why does it work?

1) It fulfills a deep-seated psychological need to do something, to take back control of our lives.

2) It creates something safe. It lets us know that at least part of the money that was at risk, is now safe. We have less exposure to pain.

3) It gives us freedom. We now have money that we can put to work on our terms. Emotional forces can no longer compel us to sell what will we have already willingly sold.

4) It's a hedge against regret. We all have the same nausea-inducing fears of regret: E.g. "The moment I sell, the market will bottom out" or "It's going to keep going down, and I'm going to hate myself for riding it to the bottom." Selling a small percentage mitigates this crippling fear.

5) It allows us to reframe crises as opportunities. We know that market panics create opportunities. The problem for so many people is they simply don't have the cash available to take advantage of those opportunities. The ability to engage other parts of our brain is another fear-fighting tool that helps put investors back on a healthy investing track.

How much is enough? 1%? 5%?... 20%? Only you can decide. Sit down with your advisor and see where you stand.

If you would like more information on our trainings, please feel free to contact us.

In the meantime... good luck out there.

Frank

Keeping Your Cool in a Panicking Market

The market appears to be crashing (in an orderly way) as I write this.

On the NYSE, New Highs = 1, New Lows = 1000. The VIX is over 55. Our MarketPsych Fear index is the highest ever.

If you're an active investor, what should you do?

Here's an NPR Marketplace interview with me about this.

1. First take a deep breath.
2. If you can't think clearly: go exercise, change your pace, play with your dog.
2. Now orient to where prices currently are. Forget about where you bought a position, or how much it is down. Right now, prices are what they are. And the first source of mistakes is being unable to come to terms with where things are right now.
3. Now, if your holdings are still hurting you, then take some action. You can't think clealy until you stop the bleeding. That doesn't mean sell everything. That means consider selling a small portion of a very painful position to relieve the pressure.
4. But now come back and consider that this is a historic time to find bargains in the market.

For example, if you believe that financial catastrophe is coming (and you have logical reasons for believing this), then gold is usually a good bet. Recently gold mining stocks have fallen in tandem with other stocks (yet their profits will be greater in an inflationary environment).

If you believe deflation is coming, consider this statement: "During deflationary environments, equities have performed poorly; however, high-quality fixed income has performed well." This powerpoint is a primer on managing investments during deflationary and inflationary environments.

Keep in mind that the best investments going forward will often be in stocks that you probably haven't heard of. And corporate bonds may perform better than stocks.

A stock screen looking for companies with high cash levels (and little debt) is sure to find some great opportunities in both stocks and bonds.

Distressed debt and preferred stocks currently have high yields, and you are likely to be very happy about owning these going forward. Also consider convertible bonds. A bond screener (such as at Yahoo Finance), can help you locate these.

If you've ever considered buying Google shares, it's cheaper now than in the past 2 years: $371/share. And they have $12 billion in cash to use to buy cheap and washed out companies.

Remember:

Tune in to your internal sense of balance first. Stabilize your mind first, and only then begin the process of sorting through the rubble.

In general, you don't NEED to do anything. However, sometimes inertia can cost you if you're not well-positioned.

And keep in mind that it's always good to keep cash available for bargain shopping.

Richard

Disclosure: I own several gold mining stocks as a short-term trade (but I don't believe financial catastrophe is coming).

The Destructive Power of Revenge: Bailout Plan Fails

Studies show that people will pay to punish others who have violated "social norms." That makes some sense, since it ensures that we all have an incentive stick to the rules. But what is more unusual is that many people will pay their own hard-earned money to punish others even if they are unaffected by the rule-breaking. They simply want revenge.

This revenge urge is even stronger in men, than women.

In fact, studies show that the neurochemical dopamine is released in the brain (reward system) of people who take revenge on others. They actually get satisfaction from punishing rule-breakers. This can be addictive, and it certainly feels pleasurable to them.

So to me it makes some sense (biologically, not economically speaking) that a majority of House memebers voted down the bailout plan. They seem willing to endure some economic pain for themselves and their constituents in order to have the pleasure of punishing "greedy Wall Street bankers" (in the parlance I've heard used by some, such as Senator Richard Shelby, on CNBC).

The problem is, the pain our economy and reputation is going to endure is likely to cost much more than $1 trillion (how many trillions in stock and bond market equity have already been lost?).

Trust and confidence in financial institutions is the grease that keeps the capitalist engine moving. Unfortunately many in Congress are saying, "we don't see anything wrong." Well, sadly, they will. The engines of credit have largely dried up, and the longer they remain dry, the longer it will take our economy to right itself again.

Banks have lost trust in each other, investors are losing trust in the markets to provide a comfortable long term return, and now we are all losing faith in the ability of government to solve major problems (some people never had that trust in government, and unfortunately they'll see that government is necessary to the smooth functioning of the economy if we don't get a bailout package soon).

I moonlighted in prisons as a psychiatrist several years ago, and I'll never forget the inmates I met who seemed "hard-wired" to be enforcers of rules. These guys would punish someone for a perceived infraction, such as disrespect (even non-verbal disrespect such as standing in the wrong place), with violence -- violence that usually landed them in "the hole" and added about 90 days to their sentence. Some of them couldn't seem to stop punishing other inmates for breaking prison "norms," and so I would see them for a psychiatric evaluation. Some told me, with self-confident righteousness, about the "high" they got from punishing rule-breakers.

This is the dark side of "righteousness"-type thinking, which often fuels revenge. And I fear some of it may have leaked out from behind bars and into Congress. I hope not, but I'm beginning to wonder.

That's my 2 cents.
Richard

Managing Fear: A Primer for Investors

How do we manage our fear in these chaotic markets?

Below I'm reposting some questions from Asa Fitch, a reporter at www.thenational.ae in Abu Dhabi, followed by my responses.

The first assumption that is good to challenge is: "Is it good to buy on fear, or should we actually be selling on fear?"

>>> What's the prevailing thinking on this?

The truth is that most of the time it is a good decision to buy on fear. But sometimes, such as in the past year, it was bad to buy on fear (especially in financials, since they have dropped 90% since the overall fear level began to increase last year). Buying on fear in Japan for the past 18 years has also been bad.

This is why Warren Buffett has said: "We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful" And as Buffett knows, there is more to it than just the emotion.

In the short-term, it is almost always good to buy on fear. And if you are thinking of selling because you are afraid, wait several days before acting (the price will usually be better then).

As a trader, it is best to buy on decreasing fear. And if you know in advance what events are likely to decrease fear (such as the passage of the U.S. bailout), then it is good to buy on fear there.

So before learning to "stop" fear, we have to be sure that our fear is not justified. Sometimes we should be afraid! (E.g., the financial crisis last August was only the beginning).

>>> Are there psychological strategies investors can use to get past the overwhelming urge to move to cash?

Yes, there are several techniques they can use to manage fear:
1. Externalization -- see the fear around you so that you can distance yourself from your own fear. For example, look at how much fear others are experiencing by looking at the VIX (volatility index) or the MarketPsych Fear Index (www.marketpsych.com). Then recall the Warren Buffett quote above (in 2007 he was the world's richest person, so he clearly knows what he is talking about). This quote "reframes" fear.
2. Reframing -- remember that fear is a buying opportunity. Turn from a "fear frame" to a "opportunity frame." The traditional Chinese character for crisis is comprised of two traditional Chinese characters. The second (bottom) one is "opportunity," and the first (upper) is "danger." [Corrected by Kay McCharles - Thanks!]
3. Fear is an anticipatory emotion -- it is about the future, while panic is in the moment (right now). Someone might be afraid of jumping off a pier into the ocean, but they are still safe. When they are in the water, if they are sinking, then they aren't afraid anymore - they are panicking. So changing perspective to a long-term view can be very helpful. For example, deliberately think of how happy you are in your life/family/overall finances before panicking about one small position in the markets.
4. Fear biologically induces a short-term, minute-by-minute focus of attention. We need to break that and remember the big picture. Think of long term goals, remember the justification for your current trading strategy.
5. If you haven't backtested your investment or trading system over many historical periods and examples, then you should be afraid and should not continue to use it unless you test it during a period similar to the current one -- past crises.
6. Of course, most people are long-term investors, and for them the best antidote to fear is diversification across countries, currencies, and industries. You won't get rich quickly being diversified, but you will better manage risk and volatility.
7. Comparisons -- if you are a long term investor having trouble holding tight, look at how you are performing relative to the worst sectors and funds in the market. It could always be worse.
8. Relaxation techniques -- You can use deep breathing and meditation techniques to learn to let go of the stress inducing emotions.
9. Exercise -- this is perhaps the most important technique for reducing stress and clearing your mind. Be sure to elevate your heart rate and sweat for at least 20 minutes continuously. You are demonstrating to your body (and your mind) that you can control and work through physiological "stress" -- in this case "good stress" induced by exercise.
10. Diet -- eat more whole grains, fresh and steamed vegetables, and cut out refined sugars, fried foods, and creamy desserts. Also consider an Omega-3 supplement (best is filtered fish oil) to take every day.
11. Do one thing you enjoy every day.
12. Dramatically decrease your information consumption. Most people find that they are reading several newspapers and watching many newsfeeds and technical indicators during the market day. Cut down your information consumption to the most essential 3 sources or indicators. This will help clear your mind and reduce confusion.

>>>>> Should you put your foot back in the water slowly to avoid the inherent reluctance to get back in after a big loss?

Yes, but be careful not to invest in the same areas. Many people repeatedly get in and out of the same stocks as they go down. If you sold out of your positions, and want to get back into stocks, then be sure to buy something completely different. let go of the money you lost. If you "play revenge" with the market by trying to prove that you were initially correct, you will continue to lose money.

>>>>>> Should you keep some small portion of your portfolio in cash to satisfy this urge to get out?

Yes, everyone should have some cash in different currencies for investing during crises such as the current one. The cash takes some pressure off and allows us to realize that there are many opportunities in this market. Having cash and not borrowing on margin for investments keeps us from losing everything during times like
this.

I hope that helps!

Richard

Fear Index Highest in History

Our MarketPsych Fear Index is the highest in its 28 year history (the prior high was in March 2008). See our index page for the graphic.

As I've said in previous blog posts, it's important not to "catch the falling knife" in the markets. Don't buy the stocks that are plummeting until there is some news that addresses the underlying cause of the share price collapse.

Maybe that's why the markets continue to be so spooked. No one is addressing the root causes of the uncertainty. We've heard U.S. government officials say two things:
1. "We'll save you if you're too big to fail, otherwise too bad (example: Lehman)."
2. "We won't save anyone because that's socialism and uses taxpayers' money and these guys on Wall Street are soulless greedy louts anyway" (heard from presidential candidates and Senator Richard Shelby chairman of the U.S. House Banking Committee)

I think #1 doesn't go far enough. All these firms are interdependent, as we're again seeing with the collapse of Goldman and Morgan Stanley shares today.

I fundamentally disagree with #2. I'm a physician by training. When a patient is dying from a myocardial infarction (heart attack) it's not appropriate to teach them a lesson about eating well and exercising. If they survive, with your assistance, then yes you can lecture them after they've recovered, but while they're dying it's considered bad form.

In my opinion, we need to create a "Resolution Trust Corporation" type slush fund to absorb dodgy debt as we did with the S&L crisis. Yes, it will be extremely expensive. Perhaps we can have a special tax on financial companies to help pay for it. I suspect they would agree in order to stop the crisis.

As psychology experts, Frank and I know that the pain will continue as long as no one steps up to the plate and takes charge. Effective focused action is needed to root out the rot and identify the uncertainty. All the bad debt needs to come to light and be segregated from the good stuff.

In many cases the "bad" debt is in a descending positive feedback loop which reduces balance sheet values, which then causes further need for capital, then forced debt (CDS) sales, and again even lower market values due to more fire sales, etc.... If we waited a year or two, the CDS defaults wouldn't be as bad as anticipated. But with quarterly "mark to market" accounting rules, the companies holding this debt in the U.S. are in death spirals. And without real leadership, this has become the hurricane Katrina of the financial industry.

It's sad to see, because a little psychological saavy and leadership could have prevented this. Clear out the bad stuff, set it aside, and charge companies a lot (a dedicated tax) to manage it while markets stabilize.

But no one wanted to suffer the political consequences of being branded a "pinko." Too bad, because the rapid shock we're currently experiencing probably isn't the best for the country (or the world) in the long run. Psychological studies show that "ripping off the band-aid" causes more psychological distress and unhappiness than removing it slowly and gently. High finance has done an enormous service in globalizing and increasing the efficiency of our economy. Sad to see it left to waste in the name of ideology.

Richard

Financial Collapse?

Seems that principles may be trumping common sense today with the failed deals to back Lehman and AIG. It's not wise for the Fed and U.S. Treasury to give a lecture about moral hazard on Deck 5 as the Titanic is sinking.

Only one group has the credibility to prevent the collapse of significant U.S. banks(and later others in Europe) -- the Fed and U.S. Treasury. It appears that fear of indulging moral hazard (a principle) is prompting the Fed "to teach banks a lesson" today by allowing Lehman to collapse.

Lehman was the oldest bank on Wall Street. Lehman was relatively trusted and honest. Although it's true that Lehman has been circling the drain for a year -- see our prior blog post.

The core problem is that government economists assume people are rational. They assume that lessons will be learned and trust will be acquired by the most honest.

I'm from a psychiatry background. I don't think I've ever met a rational person. People respond to some rational direction for a while, but over time they are more likely to respond to incentives. The incentive structures on Wall Street (dictated by the Fed, Congress, and the SEC) are seriously deficient in this understanding of endemic irrationality and the limitless nature of uncontained greed.

The initial prevention was to impose adequate regulations (in advance) that would account for the lack of responsibility and short-term incentive structures on Wall Street. People are people (especially on Wall Street), and they will grab as many cookies from the cookie jar as possible if the lid is left open.

Lecturing Wall Streeters after they get diabetes is not helpful. Their diabetes has become contagious, and is infecting anyone within sneezing distance.

Locking the cookie jar, or limiting the outflows, is the only prevention. But it's not a solution now. We all have diabetes now, and we need our financial insulin (so to speak). But the private sector has run out of insulin.

The counterparty risk of Lehman's intertwined web of positions is unknown ($2 trillion in interrelated positions?). And that will spook the markets for weeks if not months as the carnage is sorted out (if it can be). Worse, the markets will continue to suffer as the disease spreads.

One thing I haven't seen in my (admittedly short) lifetime is fear that swelled into panic that caused a global financial collapse. I still haven't quite seen it, but we're getting close if no one (ahem, FED!!!) steps up to back the sagging real-estate linked assets of AIG and Lehman.

When ideology trumps practicality at the highest levels of policy making, we're all in trouble.

The Hong Kong government supported the Hang Seng in 1997 to prevent collapse, and it profited handsomely when offloading those shares (bought on the cheap) many years later. There are precedents for government support to excessively fearful markets, to restore confidence. With mortgage-related assets so cheap (and no willing buyers of size), and with the goverment inextricably bound to insure the performance of many banks anyway (through the FDIC), it makes little sense for the Fed and Treasury to dither.

Safe Investing!
Richard

The Wicked Garden Effect (TM)

I don't know if you've noticed, but it's been a bumpy ride for "The Market" so far this year.

And by bumpy, I mean horribly nauseating.

Many of us have individual holdings that have dropped 20%.

And many of us have holdings that have dropped a lot more than that.

Now, if you managed to hit the eject button early on and have resisted the urge to grasp at the knives falling all around us, I offer you my sincere congratulations. You've held fast to Warren Buffet's first rule of investing, "Don't lose money."

But if you're Un-Buffet-Like (and most of us are), you may be holding some positions that are way down. And if you need to clear up some cash, you may be put in the unenviable position of having to sell stocks when you'd prefer not to.

The question becomes; which stocks do you sell?

Here's a question: Imagine you've got two stocks in your portfolio. Stock A is up 25% from your buying price. Stock B is down (ugh) 25% from what you paid for it. Given just this information, which one would you be most inclined to sell?

What does your gut tell you to do in this situation?

Go ahead and think about it for a moment.

I'll wait.
...
...
...

Which one did you pick?

If I were a gambling man (and I am), I'm going to say you picked stock B. Most people do.

Now, Stock B may indeed be the best choice to sell. We have no way of knowing in this scenario.

But reflect on the reasons, the inner justifications for your decision above.

You may find yourself thinking things like.."It'll come back" or "Now is a bad time to sell" or "I can lock up a gain if I sell stock A" or "Why didn't Dirk Benedict get more work after he did The A Team... he was cool as hell on that show?")

Sorry. Got a little off track on that last one.

The desire to sell the winners in our portfolio, but hold the losers is a phenomenon that we at MarketPsych call "The Wicked Garden Effect."

We call it that because it's the investing equivalent of clipping all the flowers in a garden, and watering the weeds. And in my book, this is the worst mistake investors make. Over time you are left with a garden that is overrun by weeds, and the flowers have long been gone. The effect is devastating.

You may recognize this tendency in yourself or even recognize a couple of accounts that have become like Wicked Gardens.

Behavioral finance would cite the concept of Loss Aversion as the culprit. And they'd be right. But I view it as allowing our emotional needs (e.g., to feel good about ourselves, to not be a "loser") to override our financial needs (e.g., to invest in the best companies, to make money.)

Unfortunately, the price for feeling okay about ourselves often comes at the expense of our returns.

How do you defend against the Wicked Garden Effect?

1) Be aware of this powerful tendency.

2) Use solid objective criteria on which stocks to sell. (This is tough. It requires research and thinking... do it anyway.)

3) Identify the emotional need behind the sell decision and get some leverage on yourself. The fool isn't the one who made a mistake. The fool is the one who can't admit it.

For those who are interested, MarketPsych does (fun and interesting) investing workshops, trainings and presentations that explore this and other concepts.

Happy Investing.

Frank

Negative Expectations at Their Highest in History

Our MarketPsych index of negative stock market expectations is now the highest we've ever seen (we've got data back to 1984).

The Fed's actions and words -- explicitly committing to bail out mortgage lenders -- should have lowered market negativity. Instead we got a morning rally afterwards and then further selling.

What we saw last week was everyone jumping ship - a real crowd effect. The only information driving investors was downwards price action and rumors of further collapses. The more stocks dropped, the more they sold. A positive feedback loop was created.

In psychology, a positive feedback loop is created when people base their opinion of how bad a situation is on the actions of others. When everyone is doing this, we can usually call it the peak of a mania or the bottom of a panic.

The market stopped being comforted by the Fed, which is a bit scary. Fortunately, it was primarily the financials getting hit today. The Biotech index was actually up 4%. A rally is certainly near (though I was wrong last week).

Eventually, when the supply of sellers decreases, because they've run out of shares or capital to sell, positive feedback loops can't sustain their negative price momentum.

The danger is that acting on negative expectations can become a self-fulfilling prophecy. I wrote about this in my book, with the example of Brazil's near debt default in 2002.

Essentially, the more investors avoid new bond offerings, and the higher rates go (especially for junk bonds), the more squeezed are companies that need to raise capital. Eventually many will go bust because they can't afford the high interest rates (which are high because investors are afraid the companies will default). If the rates had been lower (because investors were more calm), then the debt would have been service-able and the company would have survived. The crowd's pessimism really can make things worse (just as its optimism was problematic in allowing such overconfident risk taking through 2007).

At this point, it's important to ask "can it get worse?" (yes), "will it get worse?" (probably), and "has this been priced in?" (in many sectors, yes, much too much).

In financials it's not clear to me if it has been priced in, hmmm.... A rally in financials won't happen until we know where the next bogeyman is. And right now, there are lots of terrible rumors, but no new sources of pain. I think investors are waiting to see how the current pain will spread, since it's clear that the economy is slowing and the real economic slowdown hasn't been reflected in the numbers yet. "Who's next to collapse?" is often heard.

There are some amazing bargains out there. A stock or bond screen will demonstrate great values. I don't trust the numbers on financials (never have), but in some traditional industries low debt stocks with PEs of 6 and trading under their book values are much more common. I won't get specific because the blog is about psychology, not stocks picks at the moment.

But watch out for stocks vulnerable to the self-fulfilling prophecy of higher interest rates for "risky" bonds. That's whay I mentioned to look for "low debt" stocks.

Solutions to the current crisis include better political and regulatory management of the psychology of risk-taking, which isn't likely anytime soon (as I mentioned in my last blog post). It will take some deep understanding of human behavior in the Fed and SEC (and maybe an in-house psychologist or two) before we get such enlightened policy. In the meantme, there will always be bubbles and panics to take advantage of.

Historic times we're in. Now let's make the best of it!

Richard

Expectations, the Stock Market, and The Prediction Addiction

Why is it so tempting to make stock market predictions?

Maybe it's an anxiety reliever -- predicting implies that there is a pattern, a cause, that can be found if only we look hard enough. Forecasting bolsters our sense of control.

At the same time, we all predict with similar neural "hardware." So maybe we all make predictions based on similar information, or at similar times? And if so, are we collectively usually wrong or right?

The answers to that question underlie our asset management service (MarketPsy Capital LLC).

The chart below displays negative expectations in the major business press (WSJ, Financial Times, Barrons, New York Times).



The chart shows Negative stock market expectations (the brown line) superimposed on a candlestick stock chart of the S&P 500 (SPY). As you can see in the chart, high negative expectations are not usually a good time to buy, until they fall.

Today negative expectations dropped when the Fed reported a willingness to lend to banks beyond September 2008.

However, creating a portfolio strategy out of the "buy on decreasing negativity" insight is not easy. For one thing, we can intellectualize and chart our pessimism, but we still believe it: "this time it's different, it really is THAT bad," we might tell ourselves.

And furthermore, somtimes negativity is justified, and the catastrophe really does happen.

Here is a chart of the same data series from a January blog post. Notice that we did get a stock market rally when the negativity decreased, but now it is higher than perviously.

The stock market is an anticipatory mechanism. It has priced in a lot of pain to come. The real question is, will the pain be worse than the market expects? If not, then it is likely to rally. And in general, people anticipate more pain than is actually experienced. They will even cause themselves greater pain in the present so they can stop anticipating future (smaller) pain. (This is called the cost of Dread). Many investors felt tempted to sell their stocks last week, just to save themselves the dread of further price declines.

This Fall we'll see if the credit crunch shows signs of abating. From what I hear and read (The Credit Crisis is Going to Get Worse), it will continue. And printing money (increasing liquidity) may not work as well in alleviating the squeeze this time.

That said -- and because I'm nervous about this market ;) -- I'd like to make a prediction. It's kind of a cheap sensationalist substitute for an educational blog post. Like the one that Frank just wrote. But here goes: I suspect we're due for another short-term rally. Expectations are vey pessimistic, and now they are becoming less so.

Those are my thoughts, but then, maybe I'm just seeing order in madness. On the contrary, given the statistical results of our research, I think we really have found predictive factors rooted in the collective psyche.

It was clever that Bernanke spoke about continuing debt relief today. Someday, I'm optimistic, the Fed will consciously direct fiscal, policy, and monetary factors to have a greater impact on the psychology of the economy's participants. This may help alleviate future bubbles and crashes.

But that may require a generational change, and I don't think we have enough evidence that it will not also do harm (though it can't be much worse than the enormous liquidity we've seen in the last decade). It's not easy to accurately model psychology or economic behavior, which keeps it out of the standard curriculum.

For now, we are seeing efforts to change fiscal policy that do have a positive effect on the psychology of consumers. Which is good. Someday those efforts will include specific language and will target more vulnerable psychological themes (housing insecurity, confidence to spend, fears of perpetual debt, etc...).

Richard

Fearless Forecasting: How Low Can You Go?

It's official. The DJIA dropped 20% from its highs last October.

In other words, the Bear is back.

Whenever we hit a nice round number (e.g., "Dow 10,000) or experience a round number move (e.g., "Down 20%) it leads to a big picture discussion of where the market has gone... and where it will go next.

That means "market predictions".

In an earlier post, I observed that employing a black-tailed marmoset to throw darts at a board would prove just as useful an exercise (and an infinitely more entertaining one.)

It may be useful in at this time to review two major causes of precisely why.

One major cause is something called the Gambler's Fallacy, a miscalculation that ironically tends to afflict more market savvy investors (pros) than casual investors (amateurs).

Quick Example: Say you're at Mohegan Sun (where I was last week) and you're observing the roulette table. The wheel turns up "red" results 7 times in a row. These results don't fit with our mental schema. We know that the odds of a ball coming up "red" vs "black" at a roulette table is roughly 50%/50% (47.368/47.368 to be more precise). Our brain says something to the effect of "Black is due"! And we feel the urge to bet (overbet?) on a black result next time. Of course, the odds of the wheel yielding a "black" result are the same as ever - roughly 50/50. But it feels like it should turn up black, and that feeling overrides our rationality.

This is the classic manifestation of the Gambler's Fallacy - the notion a series of independent events yield useful information about predicting future independent events.

Pretty elementary stuff, I grant you. So why should something so obvious effect even top Wall Street Strategists?

Because the same tendency reveals itself in Market Predictions.

Hersh Shefrin, in his landmark book, Beyond Greed and Fear, provides a relevant example. At the beginning of 1997, Barron's interviewed chief strategists from top Wall Street firms, requesting 12 month market predictions.

On June 20, the market had risen 19.7% for the year to 7796, well above every strategist had forecasted.

A chief strategist for Smith Barney said in response, "We've all been humbled".

When Barron's asked the strategists for revisions predictions in late June, the average prediction was for the DJIA to drop 10.3% by year end.

Point of fact, the DJIA close slightlty higher for the year at 7908.

So despite all we know about market tendencies to move higher, the experts predicted a steep, upstream move in the opposite direction.

Why did they do it then and why do they continue to do it?

The answer is the investing version of the Gambler's Fallacy, that template driven interpretation of regression to the mean. We know the Dow tends to go up on average 9% or so every year. And we have a strong desire to fit predictions into that template.

But there is nothing magical about a calendar year - it's just a handy way of charting time. And if stocks tend to go up 9% or so every 12 months, than regression to the mean demands we predict that stocks will go up 9% or so every 12 months - not that they will reverse themselves according to our schedule in order to provide yearly averages.

Now, I'm not throwing stones here. Believe me, I'm not. I'm wrong constantly. And certainly all the participants were wise and learned professionals whose opinions are worthy of respect. But that's part of what makes this so fascinating.

Even they (especially they?) are not immune from the same impulses that drive roulette players to overbet because they think "red" is overdue or because a single digit number hasn't popped up in a while.

And - I can't help myself, I'm gonna say it - the other factor is no, (gosh darnit) they were not humbled, despite declarations to the contrary.

Wrong? Yes. Embarrassed? Perhaps. But humbled? No way.

A crucial component to being humbled is admitting you are wrong.

By prediciting a 10% reversal, the experts adjusted their predictions to support their original predictions.

Trying to prove you were right all along is not humility. It is the opposite of humility.

So with a bear market here and the inevitable market predictions to come, what are some things for investors to keep in mind?

1) Stay ready.

2) Stay humble.

3) Recognize the mathematical illusions inherent in regression to the mean.

Happy Investing.

Frank

Crunch Time

Psychologically and fundamentally speaking, it's not looking good in the equity markets. So I've decided to write a macroeconomic analysis in this blog post today.

My thoughts: A liquidity squeeze is back. Stocks are selling off as firms sell equities to raise cash. The Fed is attacking the liquidity squeeze by increasing the money supply. The increasing money supply is accelerating inflation and the devaluation of the U.S. dollar (and other developed world currencies). The only safe haven for cash appears to be in raw materials. Real estate, a traditional hegde against inflation, won't protect against currency devaluation in the current climate. My reasoning follows.

DJIA was down 9.4% in June. Last Thursday 90% of the NYSE trading volume was on downticks.

Usually, these conditions are where a stock market bottom might occur, but these are not ordinary times.

It seemed to me that some institutions might be selling equities to raise cash reserves last week. That's a bit frightening because it implies that there could be a cascade effect. The more banks or funds need to sell equities to raise cash, or the more there are margin calls that must be met, the more stocks will drop.

In August 2007 and January 2008 the Fed put a floor under the markets by:
1) An emergency 75 basis point rate decrease - to increase liquidity for the financial syetem and fixed income markets. This was in response to the rapid deterioration and freezing of the CMO market in August.
2) Setting a floor price at which it would buy CMOs. This was in order to provide emergency liquidity to banks without enough marketable assets on their books (CMOs which could no longer be sold on the open market). This and the bail-out of Bear-Stearns (and facilitating its sale) saved the day this Spring.

But now things are bad again. What's the Fed (and all the other central banks) to do? Well, they have two options:

1) Let the credit crunch unfold. The crunch occurred because collateralized debt obligations (securitized) and other asset-backed securities can no longer be sold on the open market - there aren't enough (any) buyers. Fed non-action could lead to global bank failures and general catastrophe, so it's not really an option. However, there have been worrisome blaming noises coming out of the U.S. Congress - blaming the Fed for bailing out "rich" Wall Street bankers and overstepping their proper regulatory role. If Congress really understood how bad it was in January, and how the SEC was not even tuned in (per the WSJ), they wouldn't be so glib. Fortunately, the New York Fed has been quite vigilant.

2) The only other short-term option I can think of is to pump liquidity into the banking system. This will devalue the U.S. dollar.

Of course, every developed country is in a similar pickle to us. Most countries experienced massive credit borrowing, with scant collateral requirements, unjustified triple-A rated securities as collateral. Now that collateral is either impossible to value (for example, because there is no market for auction rate securities, certain real estate, CDOs, CMOs, and CDSs), or is devalued to the point where margin calls have been placed.

It appears that the Fed (and other central banks) have chosen option number 2. And that's one reason why we're seeing the developed world "devalued." It's true that the dollar's devaluation is primarily due to the massive trade deficit. Massive capital outflows, a rate of $500 billion annually, is occurring to petroleum producing countries. Our trade deficit is enormous (over $600 billion annually), and this puts downward pressure on the U.S. dollar (especially as Middle Eastern countries must de-peg their currencies from the U.S. dollar to slow their domestic inflation).

However, I think we're finally going to see money supply growth contributing significantly to inflation. Liquidity must be injected into the banking system in order to prop up banks and keep lending and the economy running smoothly.

Gold is a traditional hedge against inflation. But there will probably be a ceiling on the Gold price due to Central Bank selling of gold (especially over $1000/oz.). So we're seeing other commodities such as oil, food, metals, and commodified raw materials appreciate rapidly in price. They are the new hedge against inflation.

Real estate isn't going to hedge investors adequately against inflation, not when Europe, the U.S., and Japan are being devalued versus their developing-world peers.

The Fed and other central banks are doing what they must - providing liquidity to our system - so we don't have a banking collapse. This is accelerating the devaluation of our currencies. The only protection appears to be in commodities, and the companies that produce and sell commodities.

That's the way it seems to me currently. I wish I owned more raw materials!

Happy Investing!
Richard

Why It's So Hard to Let Go (Hint: It's all in your head)

Another brilliant new study from the SPAN lab at Stanford elegantly describes the neural predictors of the endowment effect. If you recall from some of our past blog posts, the Endowment effect describes the tendency for people to overvalue what they own, and value less what they don't.

A classic example of the Endowment Effect is playing out in the housing market. In a normal housing market, people value their own houses more than is justified by what the market will pay (often about 12% over the market price). During a market downturn, the normal homeowner tries to sell their house for an average of 33% over market value (per Hersh Shefrin on NPR, March 30, 2008).

So what could drive people to cling to what they own and demand a higher price for it? It turns out that we are hardwired for "scarcity," and we don't want to let go of something we already have.

It even appears that we fear losing something we think we are going to get, and we'll chase it with a higher price at an auction (such as Ebay). This is seen in an insightful study by James Heyman, Yesim Orhun, & Dan Ariely called : AUCTION FEVER: THE EFFECT OF OPPONENTS AND QUASI-ENDOWMENT ON PRODUCT VALUATIONS).

Brian Knutson, Elliott Wimmer, Scott Rick, Nick G. Hollon, Drazen Prelec, and George Loewenstein demonstrated in a study published by Neuron tomorrow, called Neural Antecedents of the Endowment Effect, that activation in the anterior insula (appearing in the top image), predicts the strength of the Endowment Effect.

Importantly, there are "individual differences" in the intensity of the Endowment Effect. That is, the activation in any one person's right anterior insula predicted how much value they assigned (and how much money they would demand from a bidder) for a consumer product. Each individual is different in this regard. And I imagine (though I have not seen it shown experimentally) our own propensity to the endowment effect changes over time depending on recent events in our lives.

Remember, the anterior insula often activates when someone is afraid of losing something, when they are in physical (and imagined) pain, and when they are experiencing disgust. So the idea of giving up a product is actually painful, and so we assign a higher value to it - to avoid the pain of loss.

Maybe that's another reason why it's so hard to let go of a sagging stock, especially one with a great story that is a former high-flyer. It's actually painful! More on this study and its implications later...

Happy Investing!

Richard

Et Tu Lehman? The Contagion of Fear

There are many events, and more importantly RUMORS of events, putting the market on edge.

There has been a surge in the MarketPsych Fear Index, in part due to Lehman's potential implosion, this time due to excessive and illiquid leveraged positions. With Lehman's request for $6 billion to fill in the hole dug by CMOs and excess borrowing, the market is back on the brink.

All this in the context of early summer. Recall from a prior blog post that there is truth in the saying "Sell in May and Go Away" - here is a great graph of the effect.

The specter of world oil and commodity price shock, inflation, flooding in U.S. agricultural regions and drought in Australia's, war with Iran, and general purpose catastrophe has reared it's head again. I don't mean to be glib. There is danger afoot. This isn't one of those merry "buy on the pullbacks" type of markets. Or is it?

There is indeed a developed world deleveraging happening. Will that spread to the developing world? It appears to be anticipated in recent stock market performance, but then, that may have been developed world money fleeing those markets, which is my opinion. And that doesn't mean the sky is falling.

The "sucker's rally" Frank and I predicted in March has come and gone. The DJIA passed 13,000 and then dropped back again. So here we are again, down 8% for the year.

So it's not looking good for anything except commodities and oil? No, that's not what I'm saying. I'm fairly interested in technology, pipe (yes, steel tubes for drilling), recycling, shipping, land, and many mining stocks. India and China aren't slowing their growth much, even though the US is, and they use lots of raw materials still. One land and oil trust that I've held for years, and plan to hold for many more is Texas Pacific Land (TPL), and also a pipe company, WEBC. Yes I own shares in these, and if you try to buy WEBC, you'll move the market, so please don't.

But wait, I need a legal DISCLAIMER here of some sort. Hmmmm..... (nervously scratching my head)... OK, so don't buy TPL or WEBC. I'm not recommending them. I'm just saying they're out there. I don't want to get sued because someone bought one now and sold it when it fell or went bankrupt and they lost money. Like I said, "DON'T BUY TPL OR WEBC!!!!!" Please don't, really.

I think I'm covered now. Whew!

And here's what's interesting: when investors are primed to be cautious because of one bad event, they often extrapolate that danger into other spheres (in my case, fear of litigation). When in fact they might want to find inflation-hedged stocks, which will continue to perform over time. But this is very difficult to do when you're afraid, because of neural "priming" in the anterior insula of the brain.

A fascinating study which we profiled here, by neurofinance geniuses Brian Knutson and Camelia Kuhnen, demonstrated that activation in the brain's anterior insula predicted excessive risk avoidance in an investing task.

Building on this finding, Greg Larkin, Brian Knutson, and collaborators found that anterior insula activation appears beneficial for learning which dangers to avoid. See their paper here. A light summary in Psychology Today is here. Interestingly, people who are more constitutionally "neurotic" (nervous) have more insula activation when faced with monetary losses. While being "neurotic" isn't usually seen as a personal positive (especially by neurotic people, who are already predisposed to worry that something isn't right anyway), it turns out that neurotic people (with their greater reactivity of the insula), are better at learning to avoid financial losses going forward. Insula activation did not affect learning to pursue or avoid financial gains. So I didn't do the study justice here, but hopefully more on its implications later.

While perma-bulls buy on the dips, more anxious investors may be rightly on the sidelines, waiting for these storms to pass. And their sitting out the volatility has now been proven right a few times over the past 12 months. Yet, then they might get stuck sitting and never acting. The market is always a balancing act.

In our in-house research, it's not the absolute level of market fear that predicts a market rally, but a retreat from a high level to a lower one. That's what you'll want to look for before buying. And for the past 12 months we've had historically high levels of fear.

What causes such retreats from peaks to lower levels? It's usually a resolution of some dangerous anticipated event. For example, the collapse of Bear Stearns and the Fed's willingness to step up and put a floor under the CMO market. That resolved a tremendous amount of uncertainty.

If Lehman can raise $6 billion, at a not horrible price, then I think another level of uncertainty will be resolved.

If the Iranian government stops declaring they plan to wipe Israel off the map (fat chance!), then there's another level resolved.

So it looks like the fear will continue for a while..., but we'll still hae some ups and downs that present good buying oppotunities in select sectors.

Happy Investing!

Richard

MarketPsych Says Let's Make A Deal!: What Would It Take To Buy You Off?

I'm going to assume that if you've visited our MarketPsych blog, that you are, in fact, an investor.

But what kind of an investor are you?

Do you invest for to get a financial return or to get an emotional return?

(Okay. That's a trick question. We invest our money for both reasons.)

But getting back to you for a momemt, what is your style? Which kind of return is most important to you?

Here's one way to get an insight; ask yourself this question:

Imagine that we at MarketPsych can magically guarantee you an average annual return on your investments, but in exchange you will forfeit your right to ever invest your own money again. In another words, for agreeing to keep your paws off your investments we will (again, magically) guarantee you ____ % per year.

Let's Make A Deal: How high does that percent need to be in order for you to agree to the bargain?

(MarketPsych Legal Counsel Disclaimer: The above is meant to be a playful exercise in the hypothetical. In no way is MarketPsych actually offering this deal. In fact, despite Richard's launching of MarketPsy Capital, which we are confident will be a big success, it is always irresponsible and unethical to guarantee market returns. Moreover, MarketPsych does not engage in wizardry, magic, alchemy or any other occult arts. Although Frank does own "lucky socks".)

Now, we know that the average return for "The Market" over time has been close to 10%. (Note: There is still some disagreement on this. How do you define "The Market" -Dow Jones Industrials? S&P 500? Russell 5000?)

But we know over time, major indexes have yield on average close to 10% For the sake of argument, let's call it 9%.

So if 9% is the average, what would it take to buy you off and have you completely delegate all investing to someone else (a financial advisor, for example).

Some investors will immediately say - "I'll agree to the bargain for 9% per year. After all, it's a reasonable return, a "fair" return."

Some investors will say - "Heck, I'll sign up 7%! If the return is guaranteed, I'll never need to worry again. It's worth a "below average" return for the peace of mind."

Some investors will say - "I need more. I like investing money. I enjoy it. And I think I can do better. I need 10%... 15%... 25%! to make it worth my while."

A rare minority will simply never go for it, at any price.

So ask yourself that question. No matter what your answer is; it will be revealing.

It calls to mind a true story of an avid poker player who also happened to be a day-trader. Let's call him, Mr. B.

Mr. B was losing at poker. He'd bluff too much. He'd play ill-advised hands. He'd refuse to fold. Fact is, he sucked.

He became sick of losing, so he hired a professional to teach him how to play winning poker. And lo and behold, it worked. After a few lessons, Mr. B began to see better results. He found himself making a little money, and slowly began to build a bank roll.

And after 2 months, Mr. B quit playing.

Why?

"Too boring," he said.

So was Mr. B playing the game for financial reasons (like he thought), or was he playing for something else, to satisfy emotional needs?

And what exactly were these emotional returns that he valued above financial returns?

Knowing the answer to the above question in red is a great first step to knowing where your investing values, strengths and vulnerabilities lie. All other things being equal, such knowledge makes you a better investor.

We also offer you another deal, to come to one of our Professional Seminars (there's nothing else like them out there - don't be fooled by imitations!) whether one designed for everyday investors, or for investing professionals.

Cheers.

Testosterone and Sexy Ladies

While this isn't yet a porn site (so long as the profit motive doesn't overcome our desire to educate investors), we should report on two independent studies that are showing a correlation between Testosterone, sexy photos and financial risk taking.

I'm not talking about "financial porn."

I know it sounds strange, but a hormone level (Testosterone) correlates with higher trading returns (see this study). Taking external testosterone won't boost returns, but having a higher baseline level in the morning, independent of other events, may increase the aggressiveness of risk-taking and lead to higher returns. However, while the effect was significant, the sample size was fairly small (17) and homogenous (intra-day traders).

Seeing an unrelated sexy photo increases financial risk taking (See Brian Knutson's study here), which is where the above image comes from. Knutson's study indicates that external, irrelevant photos that activate our old friend, the Nucleus Accumbens, appear to have a lingering and substantial impact on subsequent risk taking. This may explain why casinos put ther female staff in revealing clothes and car companies and others use lightly clad women to sell their completely unrelated products. The dopamine surge accompanying the sight of a sexy photo increases financial risk taking going forward. There are other stimuli that also cause dopamine release in the Nucleus Accumbens, and these can plausibly be assumed to increase financial risk taking as well. As I have mentioned in the past, the genius of Knutson's studies is that the researchers are able to PREDICT financial risk-taking behavior. This allows them to study behavioral modification techniques in future experiments. That cannot be said of virtually all other neurofinance studies, including the Testosterone study cited above. In fact, the authors' media comments about the Testosterone effect are highly speculative (can you give a trader testosterone or cortisol to alter their financial risk taking? - now that would be a predictive study), and Testosterone is likely working through the Dopamine circuits anyway.

Happy Investing!
Richard

Rally Ahoy? (again)

A short-term rally will probably happen this Spring. If so, it is a "sucker's rally."

Maybe it's a quirk of human psychology, but it seems like far too many investors buy at the high and sell at the low. It's such a common mistake that the inverse saying ("Buy high, Sell low") may be the most common in the Wall Street rule-book.

Many investors with cash may sit on the sidelines over the next few months as the stock market moves upwards. Near the high they will buy into the market, just when they can't take the pain of watching from the sidelines any longer.

We're coming off a Fear-bottom now (as Frank pointed out, the Bear-Stearns news was the straw that prompted a cleansing "capitulation"). It was "cleansing" because it knocked the weak money out of the stock market. Now strong money remains, and the race to Dow 13,000 is on again.

Why does this "Buy high and Sell low" misbehavior happen, and why is it so predictable? It seems to be one of the many mysteries of market psychology.

Richard

Nice Call, Master Yoda

Market: I'm not afraid!

Rich: You will be.... you. will. be.

Regarding your previous post, you may not have to be worried about the absence of fear for long.

The MarketPsych Fear Index has seen an uptick recently.

One reason I believe it has meandered of late is that a critical and catalyitc component was missing: The appearance of a nightmare scenario that the individual can; 1) experience viscerally, and 2) consider credible.

The Bear Stearns news today presented just such a scenario, and it sent a shockwave of fear through the markets.

We simply do not live in a world where "Modest CPI Numbers" can compete with "Wall Street Institution Imploding Overnight" in a market-moving contest.

If it sets off a "fear cascade" (think dominoes), we may just see Market Panic make it's first reappearance in years.

Getting my cash ready now...

I'm Afraid of the Absence of Fear

The MarketPsych Fear Index has been showing low Fear readings (see our Market Analysis page). This seems odd with stocks falling, the economy slowing, housing values falling, oil rising, and gold rising. Seems that inflation and low growth is coming -- a re-emergence of the old bogeyman: "Stagflation."

I double-checked this low reading by also looking at sentiment levels. Same result -- sentiment about the stock market is not so bad. I guess this makes sense considering the recent articles touting "Bargain stocks" and "Cheap shares."

The bad news, including falling stock prices, doesn't phase investors like it used to. It's like Learned Helplessness. Ironically, I'm worried by that lack of concern. It seems that investors are complacent about the bad news. As a long-time stock market investor, I've learned that we should take advantage of investor fear but avoid a complacent market.

Richard

Emotional Baggage: When it's so hard to let go...

Selling a losing stock shouldn't be hard. Yet many investors find that as bad news begins rolling in, they are in disbelief. The stock they loved has turned on them.

Take Starbucks (SBUX) for example. Last year the announcement that hot creamy drinks weren't selling as well as anticipated during the summer was a shocker to many star-struck (pardon) investors. I could hear the disbelief from investors in slow-motion withdrawal: "Starbucks can always keep growing and raising their drink prices, they just need to serve faster, colder drinks, fresher coffee, expand to Bhutan, etc..., can't they?" Yet, after Starbucks appeared on nearly every street corner, it should have seemed natural that growth had to begin slowing.

The Onion even noted in 1998 that Starbucks had begun opening Starbucks outlets in the bathrooms of existing Starbucks (see article here). To continue growing, Starbucks had to begin cannibalizing itself.

For most investors, the stages of coming to terms with a "Stock Gone South" are like those of someone dealing with other sad events in life. I cou;d even speculate that such stages might follow the logic of the Kubler-Ross model of the "Five Stages of Grief."

First, investors look for reasons why the bad news isn't really true or was maliciously fabricated by outsiders (DENIAL). If the bad news continues, then they feel ANGER (and maybe blame the management or "evil" short-sellers). Next they begin to negotiate (BARGAINING) with themselves, "I know this has been a great stock, but maybe I need to let her go for a while - I can always buy some shares again later." Unsentimental investors then sell, while the more sensitive types become indecisive - paralyzed with disappointment (DEPRESSION). If they make a habit of wallowing in self-pity, then they are likely to end up at the fifth stage of grief called ACCEPTANCE, whilst still owning the Stock as a hopeful "comeback kid" (though in reality it is likely to be sunburned pink (sheets) and panhandling for change somewhere near the equator).

At risk of jeers and taunts from those still in DENIAL, the same as is happening to SBUX might be happening to (drumroll please).... Google (GOOG)!!! Truth be told, GOOG actually looks relatively inexpensive under $450/share ... or am I too emotionally attached to see clearly? (Disclosure: I don't own GOOG shares...yet).

It might seem like an easy decision to cut GOOG loose and re-invest the money elsewhere. Unfortunately for investors there is an innate human tendency, called "the endowment effect," which unconsciously compels them to cling to familiar, fun, or long-held stocks. Associated with the endowment effect is a thought process that justifies continuing to hold a weak stock ("It's just a temporary setback;" "I'm a long-term holder;" "It's actually a good time to buy ... if only I wasn't already holding too many shares..."

We got some great evidence for the endowment effect at a training we ran for financial advisors last week. In our experiment we give out fancy "MarketPsych" pens to half the attendees (because we "forgot" to bring enough, oops!). We then decide to redistribute the pens using a market mechanism - for fairness sake. We ask those who received a pen to write down a price at which they would sell their pen (the ask), and those who did not receive a pen write down how much they would pay for one (the bid).

At our meeting last week there were NO transactions for pens among audience members, The average bid was $1.35 (which approximates the actual value of the pen). Remarkably, the average asking price was $8.80 (ranging from $3 to $15). The sample was small, and we usually see asking prices around $5, which is still remarkably high.

The high asking prices are a testament to the power of emotional attachment and its ability to cause overvaluing of those things we like (and those that are scarce). One way to increase the endowment effect, and widen the bid-ask spread, is to ask those who received a pen to describe the things they like about the pen, and to ask those without a pen to describe objective aspects of the pen. When we do that, the spread is even bigger.

So how can you fall out of love with SBUX, GOOG, or any other stock that is disappointing you? (And it usually is true that these stocks will continue underperforming going forward). Think of the objective aspects of the investment, not the ones you love to love. Don't think about how tasty frappuccinos are, think about the price to book value. Instead of remembering the pleasure you got the first time you Google'ed yourself, think of declining profit margins and ad revenues. It requires deliberate action, but it is definitely possible to toss aside your emotional baggage and learn to see stocks more rationally. It's just not very fun...

Happy Investing!
Richard

MarketPsy Capital

Our new spin-off asset management firm, MarketPsy Capital, was mentioned in a new Popular Science Magazine article. The fund will be using our ground-breaking linguistic analysis technology to identify and exploit psychological mis-pricings in stocks, currencies, and commodities. For more information, please contact Richard Peterson at [email protected].

Rogue Trader Psychology: What Makes Them Tick?

"You have to have men who are moral... and at the same time who are able to utilize their primordial instincts to kill without feeling... without passion... without judgment... without judgment. Because it's judgment that defeats us."
Dennis Hopper playing Kurtz, in "Apocalypse Now!"

"You show them you have in you something that is really profitable, and then there will be no limits to the recognition of your ability."
Kurtz, the original rogue trader, in "Heart of Darkness" by Joseph Conrad.


With the loss of $7.5 billion by Societe General trader Jerome Kerviel, speculations about the psychology of rogue traders is in the news. How could one person end up losing so much of someone else’s money?

The psychological factors cited to explain Kerviel’s misdeeds range from the redundant (“he wanted to be a great trader”), to the fatalistic (“some people can’t help themselves”), to the pop psychological (“he was born provincial and wanted to prove himself as one of the elites” – see the WSJ), to the ultra-modern (“his brain is wired differently”). See Frank’s excellent CNBC “Closing Bell” appearance on February 7, 2008 for more about the brain and hard-wired “risk-seeking errors.”

I don’t know Kerviel, and even if I did, I wouldn’t speculate about his psychology. (Frank didn’t speculate on CNBC either, instead he mentioned some common brain-related investing errors).

Don’t get me wrong, speculating can be useful if it helps to establish the “profile” of rogue traders. And there have been some decent attempts in this regard. Financial firms, and their HR departments, have a vested interest in preventing the losses of billions of dollars because the proverbial mail-boy had "a hunch." Thus they use every psychological screening tool available to find and weed-out potential rogue traders.

Besides the obvious disqualifications for a trading job (a stint in prison, repeated personal bankruptcies, frequent stays at a high-rollers suite in Las Vegas, a penchant for fast cars and loose women (or men) at work), it isn't possible to find a consistent profile of rogue traders. But that doesn't stop us from trying.

The problem with profiling is that there are so few rogue traders and the vast majority of traders don’t become rogues. As a result, we don’t have the statistical power to find any simple profile.

So what do we have to go on in finding and screening out rogue traders? Many factors are cited, but the sample size isn’t large enough to really prove any of these factors.

Here are a few of the common themes found (See the excellent source article):
1) Most have previously had some record of success.
2) They believe they are better than average traders.
3) They base their expectations on recent prior events.
4) They think they can make up the losses by taking more risk or working harder.
5) Isolation is common (living in a city outside their native country).

For the statistical example, suppose that Kerviel, Hunter (Brian Hunter of Amaranth Capital), and Iguchi (Toshihide Iguchi of Daiwa Bank) all owned toy poodles named “Fluffy.” Given that 1) they have accounted for a sizable proportion of all losses incurred by rogue traders, and 2) it is (fairly) rare for traders to own toy poodles named Fluffy, there is a strong correlation between toy poodle ownership and rogue trading. But as everyone knows, correlation does not equal causation.

MarketPsych Disclaimer: While we do not know the pet ownership habits of any rogue traders, I think it is safe to assume that pets do not cause rogue trading itself. However, we could be wrong. There are certain species of Koi that do, in fact, release neuroactive chemicals from their tear ducts which induce rapid and frenetic trading among genetically susceptible investors. The same may occur following exposure to toy poodle saliva. We simply can’t say.

A more interesting reason that it is so hard to profile rogue traders is the similarity of their trading styles to those of the greatest traders (huge losses notwithstanding). Many great traders have said that they made the bulk of their profits on a handful of trades or positions that went tremendously well.

For example, Warren Buffet is a famously low-turnover investor. What percentage of his current net worth can be attributed to his five best performing investments? Probably a lot.

Consider John Paulson, the trader with the single best trade in history [Trader Made Billions on Subprime] in which he made $3-4 billion for himself in 2007 by betting against subprime loans. In a telling recap of Paulson’s initial experiences betting against the bubble, the Wall Street Journal notes: “Housing remained strong, and the fund lost money. A concerned friend called asking Mr. Paulson if he was going to cut his losses. No, 'I’m adding’ to the bet, he responded, according to the investor. He told his wife, ‘It’s just a matter of waiting,’ and eased his stress with five-mile runs in Central Park.”

Peter Soros, a relative of George Soros, noted in the next paragraph: “Someone from more of a trading background would have blown the trade out and cut his losses.” But, “if anything, the losses made him more determined.”

Paulson made the largest return in history by sticking to his convictions, even when markets went against him.

It’s odd then, that “determination,” “adding to losing bets,” and “overconfidence” are also used to describe the follies of rogue traders. Rogue traders had concentrated positions that went against them…they added to the positions…and the markets went against them some more. Now they are in the history books (for unfortunate reasons).

In the excellent book, “When Genius Failed,” Roger Lowenstein notes that John Merriwether, founder of Long Term Capital Management, had successfully increased his investments in positions moving against him while at Solomon Brothers, even when management was terrified about the amount of risk the firm was taking. Of course, doubling down in losing positions eventually backfired on Merriwether, but only after he had launched the most lauded (and now vilified) hedge fund in history. And it should be noted that he is again a successful hedge fund manager.

So what is the lesson in this? Well, I would say:
1) Traders should be lauded not for the sizes of their gains, but the consistency and discipline of their returns.
However, the reality is that most people invest for returns, not consistency.

How about this lesson:
2) Don’t double-down on losses, cut them instead.

This is a trading classic. Yet there are many exceptions. Paulson didn’t cut losses, and he made the biggest trading profits in history. Buffett has said, “we prefer to hold our positions forever.” Buffett often can’t exit positions smoothly due to his size. Merriwether didn’t cut losses, and now he runs a successful hedge fund (granted, he did almost take down the global financial system, but that’s another story).

A quantitative risk-management system would be helpful in managing losses, but the markets are such that there are no optimal stop levels, except just below the entry price in some cases I’ve looked at.

Identifying rogue traders isn’t east, but perhaps the simplest technique is to identify those traders who have violated in-house risk management norms. There should be a no tolerance policy and immediate termination of employment. Without that kind of draconian enforcement, the rogues will never be caught, and will always be able to bend the rules just a little at a time, until the big one hits.

Buffett, Paulson, Soros, and (maybe) Merriwether have proven themselves as experts, and as such, they are working with investors who understand and trust that these guys can manage the risk dynamically. They don’t need hard-and-fast systems to enforce discipline.

But everyone else does...

Some additional reading:
“PROPHETS OF LOSS.” Andrew Cornell. 28/05/2004. Australian Financial Review. Page: 27
FEBRUARY 10, 1997 VOL. 149 NO. 6. INTERVIEW: "I DIDN'T SET OUT TO ROB A BANK". Time Magazine.
“Doubling The Risk Of Damnation.” Stephen Brown. January 21, 2004. Australian Financial Review.

Happy investing,
Richard

How To Scare the Pants off an Investor

Fear may drive the markets. But when it comes to scaring investors, most people are amateurs.

Take all these doom and gloomers you see on TV. I bet they think they're reeeeeeally scary. With their "GDP numbers" and their "recession forecasts".

"Well, Sue, it's pretty bad out there. In fact, we've upped the likelihood of recession from 45% to 52% by Q2." (Pause for reaction).

Is that supposed to scare me? To you, I say, "Ha, would-be fearmonger! You've got nothing! I've seen Barbra Streisand movies that are scarier than that!"

(Actually, I find all Barbra Streisand movies utterly terrifying... perhaps that's a bad example)

You know why their analysis isn't scary? Because it's not emotion... it's math. I mean, you're not even engaging the right part of the human brain! (Dr. Peterson's opus is the definitive source on that subject).

"Uh, wait. There's a 52% chance of recession... but only a 76% chance of that. And that's only if LIBOR drops under 4%... Hold on, let me get my calculator." I mean, honestly.

Math is only scary when you're in 5th grade and are asked to go up to the blackboard and do long division problems in front of the class (and you know Mrs. Schecter picked you because she caught you passing notes to your buddy, Rob earlier in the day).

You want to know how to really scare the pants off investor? You want to really know how to get the stampede started?

First off, ditch the math. The odds of experiencing a loss don't scare people; it's the amount of that loss that scares people. This is the first crucial step toward sewing fear. Ever seen that show, Deal or No Deal? (e.g., I know my odds, but I could lose a guaranteed $300,000). It illustrates the difference beautifully.

And it's not just the degree of loss. Even that's still numbers, and number is the language of math. It's how those numbers will impact the quality of the investors' lives that generates the fear.

Investors have to imagine what they will feel like when the loss changes their lives. That's what turns their stomachs.

Also, fear is personal. You want to scare investors? You gotta make it personal.

You pictured sending your beloved son to an Ivy League School. You pictured walking across the quad and soaking in the beauty of the gorgeous Georgian style buildings and 300 year old Elm trees. How proud you would feel. Nothing but the best for your son! But...

There's no way you can afford that now. Your vision and his dream have been crushed. Instead, imagine the sense of shame and longing when you pull up to that shabby dorm at the state school with it's ugly utilitarian architecture. The best companies barely even recruit there. He'll never get the opportunities there you envisioned for him.

(MARKETPSYCH LEGAL COUNSEL DISCLAIMER): State schools provide excellent educational experiences. The quality of education is often superior to that of private colleges. In fact, Marketpsych founders have attended public schools, proudly. Moreover, many state schools have lovely campuses. They are not necessarily ugly or utilitarian, with the exception of the State University of New York at Buffalo's Amherst Campus which was apparently outsourced to the Soviet Ministry of Architecture in 1971.)

Not scary enough yet? Fine. You know that 0ctogenarian who was behind the counter at that chain book store? Remember the twinge of pathos you felt? Well guess what? You're going to be that guy because you can never afford to retire. Every morning you will put on your uniform, get the bus to the mall and spend all day on your aching feet squinting at book prices because your eye sight "isn't what it used to be". At lunch you will get a half an hour to eat the bologna sandwich you made that morning. You will be doing this the rest of your life.

I think we're getting warmer.

Lastly, add some regret. (i.e., And not only did this awful thing happen... but it was all your fault!)

Of course, different investors imagine different worst case scenarios. But we all have them. Wheyn you create the connection from how their investing loss would lead to that terrifying reality, and the investor actually pictures themselves in that situation and feels what it would feel like... that's when you really.

Fifty-two percent chance of a recession?

Whatever, math-guy.

Talk to me when we get to the catfood.