Monday, September 29, 2008

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.

Wednesday, September 24, 2008

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 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 ( 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

I hope that helps!


Wednesday, September 17, 2008

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.


Sunday, September 14, 2008

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!

Thursday, September 11, 2008

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.