Almost every student of the market would love to get his hands on the perfect indicator. For the preceding reasons, it is extremely unlikely that this creation ever has been or ever will be developed. The perfect indicator would have to anticipate changes in economic conditions, markets, and institutions. Moreover, word of this prognosticating marvel would gradually leak out, and in brief order it would be widely followed. In 1976 and 1977, stock market participants discounted the rise in rates during the 1978-1980 period, and they would just as easily anticipate the perfect indicator. In the end, market tops would occur when the indicator gave a buy signal and market bottoms would happen on sell signals. Later, the anticipators would anticipate the anticipators. The perfect indicator would be a joke.
In his book Money and Investment Profits, Hamilton Bolton, the founder of the Bank Credit Analyst, a monthly newsletter, commented, "It is perhaps ironic that to be of value an indicator must be far from ideal, subject to considerable controversy, and subject also to considerable vagaries in timing. The perfect indicator would be useless; the imperfect one may be of investment value" (p. 201). Until his untimely death in the late 1960s, he probably worked on more indicators in his investment career than any other person. Thus, a creative genius such as Bolton, who was a master at developing indicators and at forecasting markets, came to the conclusion that imperfection was an achievable and profitable goal, whereas perfection was an impossible objective and would be unprofitable anyway.
Many traders and investors spend their entire investment lives looking for the Holy Grail without realizing it. For example, a person may first get involved in the market through an appealing advertisement that promises investment success based on a particular approach or a wonderful track record. After a while, reality sets in and the investor sees that the approach has little or no merit. It is then discarded, and a new one is adopted. This process can continue ad infinitum.
This book, for example, may have been purchased as part of a search for the Holy Grail of investment. What often happens is that people become so engrossed in their search for quick profits that they rarely stand back and review their situation from a wider perspective. If they did, they would understand that these various approaches and systems in effect represent small psychological circles.
Each circle begins with the adoption of the new approach, indicator, expert, or system. Enthusiasm and confidence probably result in some initial profits as the user conveniently overlooks many of the new game's drawbacks. Gradually, losses begin to mount. This crumbling state of affairs eventually leads to dejection and the final jettisoning of the system, accompanied by firm resolutions "never to enter the market again." The passage of time is a great healer, and sooner or later another cycle in the search for the Holy Grail gets underway.
After a while, the thoughtful person will question this selfperpetuating cycle. One major plus is that the chastened investor has gained some experience along with the realization that investing and trading represent more an art than a precise science. Once market participants understand that the Holy Grail does not exist, they will have learned a valuable lesson. To paraphrase Bolton, the goal of imperfection in the investment world is likely to lead to greater profits than the pursuit of perfection.
2
How to Be Objective
There are no certainties in this investment world, and where there are no certainties, you should begin by understanding yourself.
-James L. Fraser
As soon as money is committed to a financial asset, so too is emotion. Any biases that were present before the money was placed on the table are greatly increased once the investment has actually been made. If none were present before, they certainly will appear now. However hard we may try, certain prejudices are bound to creep in. A successful investor realizes this and knows that he must try to maintain psychological balance through self-control.
Even if perfect objectivity is an unrealistic goal, we must still take steps to increase our impartiality as much as possible. Both internal and external forces can upset mental balance. By "internal," I am referring to the psychological makeup of an individual. Obtaining objectivity then becomes a matter of assessing mental vulnerabilities and determining how best to overcome them; this process is the subject of Chapter 2. External forces, which emanate from elements such as colleagues, the media, and events going on around us, will be covered in Chapter 3.
An investor or trader faces a constant bombardment of emotional stimuli. News, gossip, and sharp changes in prices can set the nerves quivering like the filament in an incandescent lamp unless properly controlled. These outside influences cause the emotions to shift between the two extremes of fear and greed. Once you lose your mental balance, even for an instant, your will and reasoning will be swept away, and you will find yourself acting as the vast majority of market participants acton impulse.
To counteract this tendency, you must be as objective as possible. Remember: Prices in financial markets are determined by the attitude of investors to the emerging economic and financial environment rather than by the environment itself. This means that price fluctuations will be determined by the hopes, fears, and expectations of the crowd as they attempt to downplay future events and their biases toward them. Your job is to try as much as possible to ignore those around you and form an independent opinion while making a genuine attempt to overcome your own prejudices.
The markets themselves are driven by crowd emotions. Nothing you can do will change that; it is a fact that you have to accept. Despite this, becoming a successful investor demands that you overcome your mental deficiencies and rise above the crowd. As a natural result, you will find yourself outside the consensus.
Learning to Act on Well-Founded Beliefs, Not Prejudices
The character and psychological makeup of each individual is unique. This means that some of us come to the marketplace with more biases than others. In this respect, it is important to note that many of our prejudices are shaped and influenced by our experiences. Someone who has suffered a great deal from financial insecurity through bankruptcy or a recent job loss, for example, is much less likely to take risks when investing. A given piece of bad news will send this person scurrying to his broker to sell. On the other hand, another investor may have had the opposite, pleasant experience of receiving a raise or an unexpected inheritance. Such an individual would come to the marketplace with a completely different outlook and would be much more likely to weather any storms. By the same token, this more fortunate person would be more likely to approach the markets with an overconfident swagger. Since such an attitude results in muddled thinking and careless decision making, this individual also would come to the marketplace with a disadvantage.
So we see that neither person is objective, because his actions are based on his experiences rather than on his beliefs. In the preceding example, both investors acted on impulse, not logical thought. The confident investor made the right decision, but he was lucky. If the price had dropped, the fearful investor would have come out in a relatively better position than his self-assured counterpart. Thus, for any of us, achieving objectivity involves different challenges based on our own characteristics-whether they be bullish, bearish, daring, or cautious-and shaped by our unique experiences.
This discussion will set out the major pitfalls that prevent us from reaching objectivity and establish some broad principles for avoiding these hazards. You are the only person who can appraise your experiences and the type of biases that you may bring to the marketplace. Only you can measure the nature and degree of your own preconceived ideas. Once you have assessed them, you will be in a far stronger position to take the appropriate action to offset them.
A doctor examines a patient for symptoms and prescribes the appropriate remedy. Treating a bad case of the "subjectives" is no different. Pain is the symptom of a headache; a string of losses is the symptom of poor investment and trading decisions. The treatment is to reexamine the events and decisions th
at led up to those losses using some of the concepts discussed in this chapter, and then to follow up by using the remedies suggested later in this book.
Mastering Fear and Greed
Figure 2-1 shows that the target of objectivity or mental balance lies approximately in the middle between the two destructive mental forces of fear and greed. Fear is a complex emotion taking many forms such as worry, fright, alarm, and panic. When fear is given free rein, it typically combines with other negative emotions such as hatred, hostility, anger, and revenge, thereby attaining even greater destructive power.
Aspects of Fear
In the final analysis, fear among investors shows itself in two forms: fear of losing and fear of missing out. In his book How I Helped More Than 10,000 Investors to Profit in Stocks, George Schaefer, the great Dow theorist, describes several aspects of fear and the varying effects they have on the psyche of investors:
A Threat to National Security Triggers Fear. Any threat of war, declared or rumored, dampens stock prices. The outbreak of war is usually treated as an excuse for a rally, hence the expression: "Buy on the sound of cannon, sell on the sound of trumpets." This maxim is derived from the fact that the outbreak of war can usually be anticipated. Consequently, the possibility is quickly discounted by the stock market, and, therefore, the market, with a sigh of relief, begins to rally when hostilities begin. As it becomes more and more obvious that victory is assured, the event is factored into the price structure and is fully discounted by the time victory is finally achieved. "The sound of trumpets" becomes, therefore, a signal to sell. Only if the war goes badly are prices pushed lower as more fear grips investors.
Figure 2-1 Fear-Greed Balance. Source: Pring Market Review.
All People Fear Losing Money. This form of fear affects rich and poor alike. The more you have the more you can lose, and therefore the greater the potential for fear in any given individual.
Worrisome News Stimulates Fear. Any news that threatens our economic well-being will bring on fear. The more serious the situation, the more pronounced is the potential for a selling panic.
A Fearful Mass Psychology Is Contagious. Fear breeds more fear. The more people around us who are selling in response to bad news, the more believable the story becomes, and the more realistic the situation appears. As a result, it becomes very difficult to distance ourselves from the beliefs and fears of the crowd, so we also are motivated to sell. By contrast, if the same breaking news story received less prominence, we would not be drawn into this mass psychological trap and would be less likely to make the wrong decision.
Fear of a Never-Ending Bear Market Is a Persistent Myth. Once a sizable downtrend has gotten underway, the dread that it will never end becomes deeply entrenched in the minds of investors. Almost all equity bull markets are preceded by declining interest rates and an easy-money policy that sow the seeds for the next recovery. This trend would be obvious to any rational person who is able to think independently. However, the sight of sharply declining prices in the face of such an improving background reinforces the fear that "this time it will be different" and that the decline will never end.
Individuals Retain All Their Past Fears. Once you have had a bad experience in the market, you will always fear a similar recurrence, whether consciously or subconsciously, or both. If you have made an investment that resulted in devastating losses, you will be much more nervous the next time you venture into the market. As a result, your judgment will be adversely affected by even the slightest, often imagined, hint of trouble. That intimation will encourage you to sell so that you can avoid the psychological pain of losing yet again.
This phenomenon also affects the investment community as a whole. Prior to 1929, the collective psyche lived in dread of another "Black Friday." In 1869, a group of speculators tried to corner the gold market. When the gold price plummeted, they were forced to liquidate. This resulted in margin calls, the effect of which also spilled over into the stock market causing a terrible crash. Even though few of today's investors experienced the "Black Thursday" crash of 1929, this event still casts a shadow over the minds of most investors. As a consequence, even the mere hint of such a recurrence is enough to send investors scurrying.
The Fear of Losing Out. This was not one of Schaefer's classifications of fear, but it is a very powerful one, nonetheless. This phenomenon often occurs after a sharp price rise. Portfolio managers are often measured on a relative basis either against the market itself or against a universe of their peers. If they are underin- vested as a sharp rally begins, the perception of missing out on a price move and of subsequent underperformance is so great that the fear of missing the boat forces them to get in.
This form of fear can also affect individuals. Often, an investor will judge, quite correctly, that a major bull market in a specific financial asset is about to get underway. Then when the big move develops, he does not participate for some reason. It might be because he was waiting for lower prices, or more likely because he had already got in but had then been psyched out due to some unexpected bad news. Regardless of the reason, such "sold out bulls" suddenly feel left out and feel compelled to get back into the market. Ironically, this usually occurs somewhere close to the top. Consequently, the strong belief in the bull market case coupled with the contagion of seeing prices explode results in the feeling of being left out.
I have found personally that this fear of missing the boat is frequently coupled with anger, which may be triggered by a minor mishap that compounds my frustration. These mistakes typically take the form of an unfortunate execution, a bad fill, a lost order, and so on. Inevitably, I have found this burst of emotion to be associated with a major, often dramatic turning point in the market. This experience tells me two things. First, I have obviously lost my sense of objectivity as the need to participate at all costs overrides every other emotion. My decision is therefore likely to be wrong. Second, the very nature of the situation-a lengthy period of rising prices culminating in total frustrationsymbolizes an overextended market. It is reasonable to expect that others are also affected by the same sense of frustration, which implies that all the buying potential has already been realized.
When you find yourself in this kind of situation it is almost always wise to stand aside. A client once said to me, "There is always another train." By this, he meant that even if you do miss the current opportunity, however wonderful it may appear, patience and discipline will always reward you with another. If you ever find yourself in this predicament, overcome the fear of missing out and look for the next "train."
Fear, in effect, causes us to act in a vacuum. It is such an overpowering emotion that we forget about the alternatives, temporarily losing the perception that we do have other choices.
Fear of losing can also take other forms. For instance, occasionally we play mental games by refusing to acknowledge the existence of ominous developments. This could take the form of concentrating on the good news, because we want the market to rally, and downplaying the bad news, although the latter may be more significant. Needless to say, this kind of denial can lead to some devastating losses.
Alternately, an investor may get into the market in the belief that prices are headed significantly higher, say by 30%, over the course of the next year. After a couple of weeks, the stock may have already advanced 15%. It then undergoes a minor correction that has absolutely no relevance so far as the long-term potential is concerned. Nevertheless, the investor's fear of losing comes to the surface as he mentally relives experiences of previous setbacks. The reasoning may be, "Why don't I get out now? The short-term correction that is likely to take place may well push the price below my entry point and I will be forced to take another loss. Far better if I liquidate and get back in when it goes lower." He has diverted his focus from what the market can give him to what it can take away. Getting out would be quite in order if his assessment of conditions had changed, but if the appraisal is based purely on a change in perceptions unaccompanied
by an alteration in the external environment, liquidation would not make sense. One way of solving this dilemma would be to take profits on part of the position. This would relieve some of the pressure but would also leave him free to participate in the next stage of the rally.
A more permanent and viable solution is first to recognize that you have a problem in this area. Next, establish a plan that sets realistic goals ahead of time and also permits the taking of partial profits under certain predetermined conditions. This approach would stand a far greater chance of being successful than knee-jerk trading or investment decisions caused by character weakness. If this type of planning went into every trading or investment decision it would eventually become a habit. The fear of losing would then be replaced by a far more healthy fear of not following the plan.
Greed
Greed is at the other extreme of our emotional makeup. It results from the combination of overconfidence and a desire to achieve profitable results in the shortest amount of time. In this age of leveraged markets, be they futures or options, the temptation to go for the quick home run is very strong. The problem is that this quick-grab approach is bound to lead to greater stress and subjectivity.
Let's consider the case of a trader, Rex, who decides that gold is in the early stages of a dynamic rally. He concludes from his fundamental and technical research that the bull market is more or less the proverbial "sure thing." There are a number of ways in which to participate. One would be to invest in the metal or in gold shares by paying for either in full. An alternative and far more tempting possibility would be to take a significant portion of available capital and speculate in the futures or options markets. In this way, his capital will be highly leveraged, and if he is right, the gains will be many times those of a simple cash investment.
Investment Psychology Explained Page 3
