Investment
Psychology
Explained
Investment
Psychology
Explained
Classic Strategies to
Beat the Markets
Martin J. Pring
To my son Jason.
Acknowledgments
This book represents a distillation of the knowledge contained in the sources listed in the bibliography so the wisdom and experience of these authors should be acknowledged at the outset.
Many others have helped me both directly and indirectly with the preparation of the material that follows. Robert Meier introduced me to a number of sources from his extensive library on the subject and was directly responsible for the inclusion of the chapters on Brokers and Money Managers; any omissions or mistakes that may have crept in are entirely my own responsibility. My editor at John Wiley, Karl Weber, also deserves mention for his very helpful suggestions concerning the structure and outline of the book.
Special thanks goes to John Conroy for his help in translating the book into readable English, to my son Jason for his helpful suggestions on several of the chapters, and to Sheila Silvernail for her usual excellent job of preparing the manuscript and charts.
Finally, I would like to thank my partners in the Pring Turner Capital Group, Joe Turner and Bruce Fraser, for their constant encouragement and constructive suggestions.
Preface
Over the last hundred years, countless books have been written on the psychological aspects of markets and market participants. My objective in writing this one, therefore, is not to break new ground. Most of what you will read has been said before, but in different places, spread over a long expanse of time. My reason for writing a book of this nature is to bring together in one volume a distillation of the soundest wisdom and most basic common sense on the subject of market psychology, offering the market wisdom of the ages in a complete, easy-to-read, and clearly organized format. Anyone wishing to pursue the subject further is encouraged to refer to the bibliography at the end of the book.
As you read the book, it will become apparent that the road to success is not an easy one. Financial well-being has to be earned in incremental steps and built on a solid psychological base.
MARTIN J. PRING
Contents
Introduction 1
PART I KNOWING YOURSELF 7
1. There Is No Holy Grail 9
2. How to Be Objective 24
3. Independent Thinking 47
4. Pride Goes Before a Loss 67
5. Patience Is a Profitable Virtue 79
6. Staying the Course 89
PART II THE WALL STREET HERD 107
7. A New Look at Contrary Opinion 109
8. When to Go Contrary 134
9. How to Profit from Newsbreaks 154
10. Dealing with Brokers and Money Managers the Smart Way 167
PART III STAYING ONE STEP AHEAD 181
11. What Makes a Great Trader or Investor? 183
12. Nineteen Trading Rules for Greater Profits 205
13. Making a Plan and Sticking to It 224
14. Classic Trading Rules 244
Bibliography 267
Index 271
Investment
Psychology
Explained
Introduction
For most of us, the task of beating the market is not difficult, it is the job of beating ourselves that proves to be overwhelming. In this sense, "beating ourselves" means mastering our emotions and attempting to think independently, as well as not being swayed by those around us. Decisions based on our natural instincts invariably turn out to be the wrong course of action. All of us are comfortable buying stocks when prices are high and rising and selling when they are declining, but we need to develop an attitude that encourages us to do the opposite.
Success based on an emotional response to market conditions is the result of chance, and chance does not help us attain consistent results. Objectivity is not easy to achieve because all humans are subject to the vagaries of fear, greed, pride of opinion, and all the other excitable states that prevent rational judgment. We can read books on various approaches to the market until our eyes are red and we can attend seminars given by experts, gurus, or anyone else who might promise us instant gratification, but all the market knowledge in the world will be useless without the ability to put this knowledge into action by mastering our emotions. We spend too much time trying to beat the market and too little time trying to overcome our frailties.
One reason you're reading this book is that you recognize this imbalance, but even a complete mastery of the material in these pages will not guarantee success. For that, you will need experience in the marketplace, especially the experience of losing.
The principal difference between considering an investment or trading approach and actually entering the market is the commitment of money. When that occurs, objectivity falls by the wayside, emotion takes over, and losses mount. Adversity is to be welcomed because it teaches us much more than success. The world's best traders and investors know that to be successful they must also be humble. Markets have their own ways of seeking out human weaknesses. Such crises typically occur just at the crucial moment when we are unprepared, and they eventually cause us financial and emotional pain. If you are not prepared to admit mistakes and take remedial action quickly, you will certainly compound your losses. The process does not end even when you feel you have learned to be objective, patient, humble, and disciplined, for you can still fall into the trap of complacency. It is therefore vitally important to review both your progress and your mistakes on a continuous basis because no two market situations are ever the same.
Some of the brightest minds in the country are devoted to making profits in the markets, yet many newcomers to the financial scene naively believe that with minimal knowledge and experience, they too can make a quick killing. Markets are a zero-sum game: For every item bought, one is sold. If newcomers as a group expect to profit, it follows that they must battle successfully against these same people with decades of experience. We would not expect to be appointed as a university professor after one year of undergraduate work, to be a star football player straight out of high school, or to run a major corporation after six months of employment. Therefore, is it reasonable to expect success in the investment game without thorough study and training? The reason many of us are unrealistic is that we have been brainwashed into thinking that trading and investing are easy and do not require much thought or attention. We hear through the media that others have made quick and easy gains and conclude incorrectly that we can participate with little preparation and forethought. Nothing could be further from the truth.
Many legendary investment role models have likened trading and investing in the markets to other forms of business endeavor. As such, it should be treated as an enterprise that is slowly and steadily built up through hard work and careful planning and not as a rapid road to easy riches.
People make investment decisions involving thousands of dollars on a whim or on a simple comment from a friend, associate, or broker. Yet, when choosing an item for the house, where far less money is at stake, the same people may reach a decision only after great deliberation and consideration. This fact, as much as any, suggests that market prices are determined more by emotion than reasoned judgment. You can help an emotionally disturbed person only if you yourself are relatively stable, and dealing with an emotionally driven market is no different. If you react to news in the same way as everyone else, you are doomed to fall into the same traps, but if you can rise above the crowd, suppressing your own emotional instincts by following a carefully laid out investment
plan, you are much more likely to succeed. In that respect, this book can point you in the right direction. Your own performance, however, will depend on the degree of commitment you bring to applying the principles you find here.
At this point, clarification of some important matters seems appropriate. Throughout the book, I have referred to traders and investors with the male pronoun. This is not in any way intended to disparage the valuable and expanding contribution of women to the investment community but merely to avoid "he or she" constructions and other clumsy references.
In the following chapters, the terms "market" or "markets" refer to any market in which the price is determined by freely motivated buyers and sellers. Most of the time, my comments refer to individual stocks and the stock market itself. However, the principles apply equally, regardless of whether the product or specific market is bonds, commodities, or stocks.
All markets essentially reflect the attitude and expectations of market participants in response to the emerging financial and economic environment. People tend to be universally greedy when they think the price will rise, whether they are buying gold, cotton, deutsche marks, stocks, or bonds. Conversely, their mood can easily swing to fear or panic if they are sufficiently persuaded that prices will decline. Human nature is the same in all markets the world over.
I will also be referring to traders and investors and, to some extent, speculators. Traders focus their attention on intraday and intraweek market activity. Their time horizon is rarely longer than a couple of weeks. They tend to work on margin in the futures and options markets, so their equity is highly leveraged. As a result, they must be highly disciplined and quick to recognize a mistake, or they will soon be wiped out financially. The vast majority of traders use technical analysis as a basis for making decisions.
Speculators have a longer time horizon that can stretch up to six months. In his classic book, The ABC of Stock Speculation, Samuel Nelson defined speculation as "a venture based on calculation." This definition could just as easily apply to traders. He distinguished between speculation and gambling by concluding that gambling is a venture that is not based on calculation.
While traders and speculators are solely interested in capital gain, the investor also considers current and future income streams when making a decision. The time horizon of investors is much longer, usually spanning at least two years, often much longer. As a rule, investors do not use margin trading and take fewer risks than traders or speculators.
Even though the risks that each type of participant is willing to take, as well as the relevant time horizons, are different, the principles of market psychology are essentially the same. All market participants must be ready to take a contrary position when the crowd moves the market to an extreme. Similarly, each participant must strive to keep a clear and impartial mind, limiting emotional responses to an absolute minimum.
The techniques practiced by traders and speculators are as different from investors' techniques as a sprinter's training is different from that of a marathon runner. Both need to be disciplined and fit, but each has a different goal demanding a different regimen. There are many different approaches to the business of trading and investing. Two basic approaches, fundamental and technical, have their own branches and schools of thought. Fundamental analysis is concerned with the goods in which the market deals: profit-and-loss statements, balance sheets, prospects for a specific stock commodity or currency, for example. This type of analysis determines what the market outlook is likely to be in relation to current values. If a stock is cheap, for example, and the outlook is favorable, then it should be bought (and vice versa).
Technical analysis, on the other hand, is concerned with the price action of a specific market or stock. Technicians assume that the price reflects all the knowledge of all participants, both actual and potential, and that prices move in trends. Their objective is to try to spot these trend reversals at an early stage and to profit from that trend until the reversal becomes reality.
It makes no difference what approach a trader or investor takes or, for that matter, what method of analysis he chooses. The most important tool required by anyone approaching the markets is a methodology on which to base rational judgments.
No methodology is perfect, but it is necessary first, to satisfy yourself that it works, and second, to feel totally comfortable using it. It's no good adopting a chartist approach, for instance, if you hate the sight of graphs. And a final thought on methodology: Even when you possess a good one, you still need to master your emotions. Without the ability to do this, you are doomed.
Trading, speculating, or investing in the markets, then, is not a science, but an art that is carefully learned, nurtured, and practiced over a long period of time.
Part I of this book is concerned with personal psychology; learning to master and control our natural, but financially destructive, emotional tendencies. It discusses why decision making based on sentiment leads to ruin, and it makes constructive suggestions for overcoming this problem.
An understanding of the psychology of markets would not be complete without a discussion of crowd psychology and contrary opinion; Part II provides this perspective. Most of us know that when an idea becomes too popular, everyone has latched onto it and is positioned accordingly in the market. We know that we should go against the crowd and take the opposite stance, but we also know that this is far easier said than done. We will examine why this is so, and we will learn when contrary opinion can be profitable and how to recognize when to "go contrary."
Part III examines the attributes of successful traders and investors, the super money-makers-what sets them apart from the rest of us and what rules they follow. This Part also incorporates many of the points made earlier to help you set up a plan and follow it successfully. To solidify and emphasize the key rules and principles followed by leading speculators and traders in the past hundred years or so, I have compiled those guidelines followed by eminent individuals. While each set of rules is unique, you will see that a common thread runs through all of them. This theme may be summarized as follows: Adopt a methodology, master your emotions, think independently, establish and follow a plan, and continually review your progress.
This recurring pattern did not occur by chance but emerged because these individuals discovered that it works. I hope that it can work for you as well. All that is needed is your commitment to carry it out.
Part I
KNOWING
YOURSELF
1
There Is No
Holy Grail
Nothing is more frequently overlooked than the obvious.
-Thomas Temple Hoyne
You probably bought this book hoping that it would provide some easy answers in your quest to get rich quickly in the financial markets. If you did, you will be disappointed. There is no such Holy Grail. On the other hand, this book can certainly point you in the right direction if you are willing to recognize that hard work, common sense, patience, and discipline are valuable attributes to take with you on the road to smart investing.
There is no Holy Grail principally because market prices are determined by the attitude of investors and speculators to the changing economic and financial background. These attitudes tend to be consistent but occasionally are irrational, thereby defying even the most logical of analyses from time to time. Garfield Drew, the noted market commentator and technician, wrote in the 1940s, "Stocks do not sell for what they are worth but for what people think they are worth." How else can we explain that any market, stock, commodity, or currency can fluctuate a great deal in terms of its underlying value from one day to the next? Market prices are essentially a reflection of the hopes, fears, and expectations of the various participants. History tells us that human nature is more or less constant, but it also tells us that each situation is unique.
Let us assume, for example, that three people own 100% of a particular security we will call ABC Company. Shareholder A is investing for the long
term and is not influenced by day-to-day news. Shareholder B has bought the stock because he thinks the company's prospects are quite promising over the next six months. Shareholder C has purchased the stock because it is temporarily depressed due to some bad news. Shareholder C plans to hold it for only a couple of weeks at most. He is a trader and can change his mind at a moment's notice.
A given news event such as the resignation of the company's president or a better-than-anticipated profit report will affect each shareholder in a different way. Shareholder A is unlikely to be influenced by either good or bad news, because he is taking the long view. Shareholder B could go either way, but shareholder C is almost bound to react, since he has a very short-term time horizon.
From this example, we can see that while their needs are different, each player is likely to act in a fairly predictable way. Moreover, because the makeup of the company's holdings will change over time, perhaps the short-term trader will sell to another person with a long-term outlook. Conversely, the long-term shareholder may decide to take a bigger stake in the company, since he can buy at depressed prices. Although human nature is reasonably constant, its effect on the market price will fluctuate because people of different personality types will own different proportions of the company at various times. Even though the personalities of the players may remain about the same, the external pressures they undergo will almost certainly vary. Thus, the long-term investor may be forced to sell part of his position because of an unforeseen financial problem. The news event is therefore of sufficient importance to tip his decision-making process at the margin. Since the actual makeup of the market changes over time, it follows that the psychological responses to any given set of events also will be diverse. Because of this, it is very difficult to see how anyone could create a system or develop a philosophy or approach that would call every market turning point in a perfect manner. This is not to say that you can't develop an approach that consistently delivers more profits than losses. It means merely that there is no perfect system or Holy Grail. We shall learn that forecasting market trends is an art and not a science. As such, it cannot be reduced to a convenient formula.
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