Tuesday, March 29, 2011
Monday, March 21, 2011
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Wednesday, March 16, 2011
That morning TV viewers could see video coverage of a 30 foot wave washing over coastal villages in Japan, to such an extent that entire towns were lifted and crushed by the wall of water.
Given that Japan is the third largest economy in the world, you might think that U.S. traders and investors would rush to sell shares, buy puts, hedge, and reposition.
Nope, by the close of trading on Friday, the DJIA was up 60 points.
It wasn't until Monday, and again today, that investors realized the full extent of the risks that had emerged. "What took them so long," is a fair question to ask. In this post I explain the psychological stages which drive financial markets after catastrophic events such as natural disasters and terrorist attacks.
Stage 1: Underreaction. In this stage people don't realize the scope of the disaster. They believe the stock rally will go on as is, and they believe the government assessment of the situation.
Psychological Driver: Cognitive Dissonance. We have trouble processing new information that is out of our comfort zone. We need time to reconcile it with our established habits and beliefs.
Stage 2: Reaction. We realize that all is not good, and we take action. The Nikkei drops 14% in one day. The S&P 500 sheds its 2011 gains. This is occurring early this week. Fund managers sell the stocks of companies that are likely to be hit, and buy shares of those likely to benefit.
Psychological Driver: Rational reappraisal. We incorporate the new facts, and revalue securities accordingly.
Stage 3: Overreaction. This is where is gets interesting. Uncertainty and fear color our assessment of the facts, and we believe we get more information from the market price action (plummeting) than from a rational appraisal of wind currents. Stocks sell off, Potassium Iodide (KI) sells out off store shelves in California. People sell their stocks just because others are doing so and prices are dropping, they don't want to be the last ones holding the bag. This is the "risk-off" trade, where indiscriminate risk selling occurs. This is occurring today.
Psychological Driver: Fear, uncertainty, and loss of a trusted authority. Radiation cannot be seen, is widely feared, and may spread beyond Japan. Perhaps most worrisome to investors, there is no longer a trusted authority who knows the truth - the Japanese goverment appears to either not understand the situation or to be trying to prevent panic by hiding the true impact of events. All of these factors lead to overreaction - usually occurring about 4-5 days after a crisis, and culminate in panic, when real investment bargains are to be found.
If you're waiting to buy Japanese construction and insurance stocks, consider stepping in.
And most importantly, our sincere condolences to all whose family, friends, or lives have been affected by this terrible crisis.
Richard L. Peterson M.D.
Thursday, March 10, 2011
Like gravity, it's the law: All markets must be difficult to trade. Most investors, traders and money managers do not match market returns. Trading and investing is one of the most difficult proving grounds an individual can test themselves. And it makes perfect sense.
Imagine that markets were easy to trade. They never tested our emotional maturity or triggered any one of sixty emotional biases, myths, mind traps and false beliefs that MarketPsych has identified. When the market made a pattern shift, we could all see it coming. We were able to find a statistical edge and create a trading system that worked reliably through all market conditions. As we made money, we increased the size of our trades and we were able to make even more money. Even though we were making more and more money, our ego remained humble, avoiding the destruction of hubris and pride.
If markets were easy to trade, what would happen?
If it were that easy for us, it would be that easy for most other traders. More and more people would be trading for a living. They would all be making more and more money. Soon everyone in the whole world would be wealthy beyond their wildest dreams.
Of course this is silly and we know it cannot happen. So what drives this unrealistic belief? It is attached to our most important dreams.
We chase this dream with new systems. We shift the asset classes we trade. We change gurus. We change indicators. We subscribe to a new newsletter. And still, the illusive dream of consistent profits eludes us.
This is the way is has to be. Because, if we take it to the extreme as we just did, the markets would not work. In fact, the markets are designed to make trading as difficult as possible.
Here is why the markets must challenge us
Depending on the market you trade, there are thousands or millions of participants. The market you trade is connected economically like a complex web to thousands of other markets and market players. There are speculators, investors, day traders, arbitragers, investment banks, hedge funds, mutual funds, brokerage firms, and international interests all jockeying for position, each with their own behavioral constraints, myths and judgments.
This is not to mention the pressure of global economic fundamentals, cost of capital, availability of capital, risk temperament, interest rates, currency fluctuations etc. that all have an influence on people's decisions in the market you are trading. Add to that incredible computerized sophistication that the big boys have to find and eliminate any obvious market anomaly in milliseconds.
Everyone is trying to take money out of the markets. There is no one whose goal it is to contribute their capital to you the trader, money manager or investor. Whew!
All trading systems work. All trading systems fail
It is difficult to find a trading system that DOES NOT work in some market some where some time. It is also difficult to find a system that DOES make consistent returns in all market conditions.
Here is the really good news
Investors and traders have the luxury of picking and choosing their trades. They don't have to trade all of the time. This is their edge. They can wait until the market patterns are working for them.
It is in the evolution and transition of trading patterns that a lot of money can be made. Because trading patterns are driven by humans who trade repeatedly with the same behavioral responses (this doesn't change!) the destruction and emergence of new patterns create profit opportunities.
It's like one of those Zen puzzles: any belief you are attached to, the market will destroy. As a trader, it is your ability to see new trading patterns emerge that has the most profit potential. To do this, the mind needs to see the markets as they are without the prejudicial filters we all carry around. If our ego is attached to a trading system and its success, the ability to see new patterns emerging is difficult.
Pattern Sniffer Mind Muscletm
- Define several market patterns that cover the range of normal market behavior for your asset class
- Create several scenarios for a "Black Swan." (That is an event that feels unlikely and the results could be catastrophic)
- Note what indicators would be likely to precede a shift for each pattern or swan.
- Once a day, pick a pattern/swan on a rotating basis and look for its leading indicators.
By envisioning these new shifts every day, we build our "Pattern Sniffer Mind Muscletm." We build our ability to see changes in the market. Every day, exercise that new Mind Muscletm
Training & Development
Friday, March 04, 2011
(The character Pogo by Walt Kelly)
In preparing for a session on ethics at an upcoming certification program for private wealth advisors, I reviewed the results from a recent Edelman survey (Trust Barometer). The results reflect answers to questions posed to affluent adults across the globe. I note that
In answer to the question, How much do you trust business to do what is right?, from 2010 to 2011, the US dropped 8 percentage points. I found particularly disturbing the following comparisons:
- Germany and France had increases of 12 percentage points for the year and were higher in 2011 in their trust of business than people in the US.
- Brazil, India, Italy, and China had strongly positive scores. Japan and Germany relatively neutral.
- The scale in the US is within 5 percentage points of the score in Russia.
People in China and Brazil strongly trust their government to do what is right with scores of 88% and 85% respectively. Government score in the US is a meager 40% and virtually the same as that in Russia at 39%.
In a broad measure of trust in business, government, NGOs, and media, between 2008 and 2011 the US relative ranking dropped from 4th place to 10th.
Our industry (financial advisors) seems, unfortunately, to be part of the problem. In an article last year in the CFA Magazine (The Challenge of Ethical Leadership), Jim Ware describes nine sample ethical violations to audiences from his talks. Virtually all of the attendees agree that the actions are properly classified as ethical violations yet an astounding two-thirds of the attendees openly agree that these violations occur routinely within their firms.
Relationships require trust, which seems to be in shorter supply than ever. To the degree that each of us assumes personal responsibility for taking action to improve our personal integrity and hold our professional colleagues to a high standard in this regard, I believe we can ultimately make a difference.
My suggestion is to
- Take a Personal Moral Competence Survey. See Moral Intelligence by Doug Lennick and Fred Kiel for questions and suggestions.
- Talk about it. Research by Dan Ariely on cheating suggests that periodic reminders of expressions of moral codes, or values makes it less likely that people will play loose with the rules. Review the professional codes that guide your practice and host periodic discussions of ethical case studies that present difficult choices for ethical behavior.
- Solicit client feedback aimed at enhancing your ethical awareness. Simply asking for feedback and remaining open to hearing about where and how to improve tends to strengthen trust.
How long since you took time to reflect on your values? I bet your clients will note and appreciate the subtle strengthening of your character over time when you do.
Tuesday, March 01, 2011
MarketPsych data is on the leading edge of this powerful movement with the tools offered through http://www.marketpsychdata.com/
Richard L Peterson M.D.