Investment Psychology Explained

by Martin J Pring

  Sentimentality

  Everyone involved in markets sooner or later discovers an area for which they have a special liking. It may be a specific commodity, stock, or industry group. It could be the company you work for or an old inherited stock that has consistently grown and grown. So-called "gold bugs" feel that way about the price of gold, for example. There is certainly nothing wrong in developing a philosophy or expertise that empathizes with a particular asset class or individual entity provided you hold it for sound reasons. On the other hand, if you become married to a particular stock, for example, never questioning its justification in your portfolio, you are really holding it for sentimental and not rational reasons.

  Companies go through life cycles and cannot be expected to grow at a consistently high rate forever. Figure 2-2 shows the life cycle of a typical company. First comes the dynamic stage of innovation. This is followed by consolidation and maturity. Finally, as new innovations and techniques come to the fore, the process of decay begins. This final stage usually occurs long after the original founders have left the scene. The current management essentially is resting on the reputation of a company that was built up by the nucleus of the original farsighted managers. Unmotivated by the same ideals and goals of its founders, the firm has become fat and lazy. At the same time, new dynamic competition has appeared on the scene, and the business environment conspires against the company's maintenance of its number one position in the market.

  This process is not immutable; many corporations have successfully managed to rejuvenate and proceed to even greater heights. The point is that no one should ever be married to a particular company or market just because it has treated them well in the past. Here's a typical refrain: "I bought Consolidated at $10 years ago because of its prospects. It's now at $100 and owes me nothing." The reason you bought "Consolidated" stock in the first place is not a justification for owning it today. Anyone who makes such a statement or who feels that way is really taking the easy way out. Such a person is saying to himself, "I don't really want to take the time to look at alternatives. I don't want to have the worry of getting involved with something new." Being married to a particular area or stock avoids the important process of continuous objective analysis. If the situation is reviewed on a periodic basis and it still makes sense to own the stock that is fine, but conditions can and do change. What might have been a good situation for the past 10 years is not necessarily going to be a good one for the next 10.

  Figure 2-2 The Industrial Life Cycle. Source: Investment Information Services, Inc.

  Figure 2-3 IBM 1931-1991. Source: Perrett, Diversify, p. 77, (London: Longman, 1990).

  Figure 2-3 shows the long-term history of one of this century's premium growth stocks, IBM. In the 30 years prior to 1983, the price had risen from just over $1 to over $100, but something new happened in 1983. Prior to this date IBM had always been a bull-market leader, but the decade following 1983 saw the stock move sideways. Anyone "married" to IBM would not have lost much money, but they would have lost the opportunity to run with one of the strongest bull markets in history, since almost any other blue-chip company would have done much better than Big Blue.

  Projecting a Market Direction We'd Like to See, Instead of the Direction Indicated by the Facts

  A principal obstacle to maintaining an objective stance occurs when we inflexibly adopt a preconceived idea of where the market is headed. This is quite different from postulating several scenarios of what might happen in a given set of circumstances because that practice implies a more open and flexible state of mind. The greatest danger occurs when we become quite dogmatic about our interpretation of where things are headed. The result is that we are more likely to blot out of our minds any evidence that might conflict with these preconceived notions. It is only after the market has moved against our position and is dealing out some financial pain that we begin to question our original belief. Consequently, anyone who holds a strong inflexible view is coming to the market with a tremendous bias that is inconsistent with the desired state of objectivity.

  There is an old saying that the market abhors uncertainty. This adage makes sense, because the market is-as you now know-effectively the sum total of the attitudes, hopes, and fears of each participant. As individuals, we do not like uncertainty. The need to have a firm opinion of where prices are headed is therefore a mental trick that many of us use to eliminate this uncertainty. Removing this bias is difficult, because we are all influenced by events and news going on around us.

  Let's take an example of an economy coming out of a recession. The news is usually quite bad as unemployment, which is a lagging indicator of economic health, gets prominent play in the media. However, leading indicators of the economy such as money supply and the stock market do not have the same human interest aspects as mass layoffs and similar stories. You don't sell a lot of newspapers or increase your TV ratings if you tell people that overtime hours, which are a reliable leading indicator of the labor market, are rebounding sharply. As a result, we experience a continual bombardment of bad news at the very moment that the economy is emerging from hard times. This media hype is bound to have a detrimental effect on our judgment, causing us to come up with unrealistically pessimistic scenarios. We find ourselves deciding that stocks will decline, and we execute our investment plans accordingly. When the market rallies, it catches us completely by surprise. We deny the reality, since it does not fit in with our preconceived notions of the direction that it "should" be taking.

  One way of overcoming such biases is to study previous periods when the economy was emerging from recession and try to identify economic indicators that might have signaled such a development ahead of time (i.e., leading indicators). This exercise need not be that complicated. Some signs to look for would be a six-month or longer decline in interest rates, including a couple of cuts in the discount rate by the Federal Reserve, a four- to sixmonth pickup in housing starts, and an improvement in the average amount of overtime worked.

  This exercise can provide a foundation for a sound view of the economy's future course. If we rely on a consensus of a number of indicators such as the preceding ones, we will be alerted to any important change that may take place in the direction of the economy.

  Economic indicators move in trends lasting a year or more. If you base a long-term scenario on one month's data, the chances are that it will give you a misleading portrait of the economy, especially as this interpretation is most likely to be similar to that held by other market participants and the media. In effect, it will be highly believable to the unwary.

  An investment approach based on solid indicators that reacts in a cautious manner to highly publicized monthly readings of the market beats one that is based on a knee-jerk reaction to economic stories that the media have hyped or exaggerated way beyond the bounds of reality. Careful study of the economic indicators just cited and others that have a good forecasting track record help to establish a set of objective criteria that make it less likely an investor would try to make the market dance to his or her tune.

  I have presented but one instance of a simple framework that could serve as such an unbiased foundation. Any proven investment philosophy or carefully designed system would serve the same function. For example, stock pickers may base their investment decisions on a specific set of fundamental criteria that over a long period of time have proved to be profitable. Others might use a technical system based on price action. The essential factor is that all these approaches give the practitioner an objective basis for making investments or trading decisions.

  Summary

  A good starting point for self-examination is to review your own investment or trading record over the past few years. Even if you have made a profit, careful examination may reveal that the record owes a considerable debt to one particular investment whose success was due as much to chance as to any other positive factor.

  Even successful investing, then, leaves room for improvement, and this
can be achieved by anyone with determination. The improvement will not come overnight because it involves a change in habits, and this can occur only with constant repetition and reinforcement over a long period. Our habits are deeply ingrained emotional patterns that were established fairly early in our lives. Psychologists tell us that they are unlikely to change unless we make repeated and concentrated efforts to change them.

  All our emotions lie ready to give or receive impulses based on external criteria. The direction of these impulses, or the manner in which we react to a given stimulus, is determined by our previous experiences and biases. The very fact that you are reading this book indicates that you have the desire to improve your thinking.

  Independent

  Thinking

  A man must think for himself; must follow his own convictions. Self-trust is the foundation of successful effort.

  -Dickson G. Watts

  in the previous chapter, I established that one of the most important requirements for successful investing is the ability to achieve total objectivity. This is far easier said than done because however hard we try to achieve mental balance, biases from our experiences or outside influences are bound to color our judgment. Despite the difficulty, however, we must try to increase our impartiality as much as possible.

  Forces both internal and external can upset our mental equilibrium. To attain objectivity, we must assess the internal forcesour psychological vulnerabilities-and determine how best to overcome them. This process was covered in Chapter 2. External forces emanate from colleagues, the media, and events going on around us. These factors will be discussed in this chapter.

  For the most part, exogenous factors have an unhealthy effect on our emotions, distracting us from clear and independent thinking. As such, they represent a major obstacle to achieving our investment goals. It is difficult for people operating in a highly technological society to insulate themselves from all these destructive tendencies. The obvious solution would be to move to an isolated part of the world, turn off all communications, and never read a newspaper. In this way, we would never have our views distorted by events and outside opinions. Such a solution is, of course, totally impractical. Moreover, as we shall learn later, these negative outside influences in the form of groupthink or crowd behavior can actually be used in a positive way. Media hype, broker talk, tips, and idle gossip can themselves become invaluable analytical tools for making wise investment decisions when used as a basis for contrary investment thinking.

  Once we accept that random opinion creates a certain level of mental "noise," then achieving the goal of maximum objectivity requires us consciously to filter out as many of these unhealthy influences as possible. Jesse Livermore, acknowledged by many as one of history's greatest speculators, tried to insulate himself from external influences that might affect his ability to make money in the markets. In his book Jesse Livermore's Methods of Trading Stocks, author Richard D. Wyckoff describes the steps taken by Livermore to avoid such influences.

  For a long while he did not enjoy the advantages of silence and seclusion but many years since, he has made a practice of trading from his own private offices where he is not disturbed by the demoralizing hubbub of a customer's room. The morning journey from his town house . . . is made by automobile; he does not use the railroad trains or subways. Many wealthy and prominent financiers do so, but they have no special reason for avoiding contact with other people. [author's italics] Livermore has; he knows that if he mixes during the trip to his offices, the subject is bound to turn to the stock market, and he will be obliged to listen to a lot of tips and gossip which interfere with the formation of his own judgment. [author's italics] Playing a lone hand, he does his own thinking and does not wish to have his mental processes interfered with morning, noon or night. (p. 12)

  Wyckoff later describes Livermore's office setup. Essentially, it was very simple, consisting of a stock tape and quotations of some leading stocks and commodities. (This indicates that the interconnections among the various markets being popularized today were already known and practiced more than half a century ago.)

  Jesse Livermore spent his day closely watching the tape and seeing how the ticker responded to news stories. His interest in monitoring the news flashes was based not on emotion (i.e., buying on good news and selling on bad), but on careful reflection of how those news stories affected the market or a particular stock. Livermore was a great believer in the theory that the real news is not in the headlines but behind them. He believed that the only way to succeed in the market was through careful studying and understanding the economic conditions that underlay the financial and fundamental situation of specific companies. Livermore had a particular affinity for studying and interpreting the action on the tape. Other successful people have taken different approaches. In this respect, each of us must search out investment philosophies and decide which one suits us best. Some may choose value investing; others might specialize in growth stocks, asset allocation, or the execution of some simple but effective technical system. As long as it works reasonably well, the nature of the approach is unimportant. What is essential, though, is an ability to execute a chosen technique in a way that does not become sidetracked by unhealthy outside influences.

  Although he was not an extremist, Livermore did believe that a sound body helps to create a sound mind. This idea of clearheadedness growing out of good physical condition is reflected in the fact that he was almost always on his feet and standing erect during the trading day. This posture, he asserted, enabled him to breathe properly and ensured unimpeded circulation. Wyckoff also tells us that another Wall Street legend, James R. Keene practiced a similar standing routine.

  This brief look at Livermore's operations shows us that he was prepared to make important changes in his habits and lifestyle to accommodate his ambitions. He understood early on that it was important to learn as much as he could about the subject of investing. Livermore also knew that market prices are very much influenced by psychological factors, and so he undertook the formal study of psychology as well. When Wyckoff asked him to identify the two most important attributes of a successful investor, Livermore said patience and knowledge. He insisted that to do well, a market operator must in some way isolate himself to control the debilitating psychological effects of outside influences because they can easily divert the unwary from executing an otherwise perfectly conceived plan of action.

  Having established the importance of maintaining an objective stance, we can now turn our attention to some of the more common ways in which our judgment may be distorted. At the same time, we can consider some techniques to help us overcome these seductive influences. The influences that we will examine fall under these headings: The Price-News Drug Effect; Gossip, Opinion Experts, and Gurus; and what I shall call "The Greener Pastures Effect."

  The Price-News Drug Effect

  Years ago, the only way investors and traders could obtain continuous, up-to-the minute price quotes was to visit a broker's boardroom. These rooms featured a ticker tape set aside for the firm's customers. The boardrooms enabled them to obtain up-todate information on the performance of their favorite stocks. This was not, of course, an exercise in philanthropy by the sponsoring broker, because the firm knew quite well that exposure to tape action would stimulate trades, thereby lining the firm's pockets with commissions.

  Today, the situation is far different, since traders and investors have access to a tremendous selection of inexpensive online data, stock-quotation news, and charting services. It is now possible to get instant access to every trade and emerging news event in the comfort of your own home or office. Financial news channels featuring every conceivable analyst with his or her "expert" opinion on the latest developments also are available. The value of such instant and hardly thoughtful analysis is questionable. Moreover, the prognosticators typically appear free of charge, so they are motivated invariably by self-promotion and ego enhancement.

  In essence, any inves
tor or trader now has extremely easy access to prices, news, and analyses that tend to stimulate emotions and override the intellect. Last night, for example, you might have done some pretty thorough research on the bond market and concluded that interest rates were about to decline and bond prices would rally over the next few months. This morning you call your broker and purchase some bonds. Even though you have bought them for their long-term potential, you are so excited about their prospects that you can't avoid the temptation to check in with your broker, a financial channel, or an on-line quote service to see how they are doing. As it turns out, they are rallying. This makes you feel good, so later on in the day you check in again. This process has stimulated your emotions to the extent that you are already "booking" the paper profits on the way home from the office and wondering about buying some more tomorrow. The following morning you can't wait for the market to open because you are really anxious to buy more bonds.

  Even though the extra purchase goes against your game plan, you feel that this rally is "for real." You just have to get some more. As it turns out, other people have the same idea. Bond prices open higher. This just serves to increase your confidence, for you think, "I'm on the right track." During the day, prices continue to rally. You are fully informed of this because the frequency of calls to your broker has now increased substantially. Even though bond prices actually close lower on the day, you regard this to be of little significance, because your confidence level is very high.

  Let's analyze what happened. You have made a perfectly good investment based on sound judgment. However, frequent calls to your broker have heightened your emotional involvement. As a result, you have purchased far more bonds than you intended to originally and have greatly shortened your time horizon. Remember that the bonds were initially bought with a holding period of 3 to 4 months in mind. Now you are watching and being influenced by every twist and turn in the price, and so you find it difficult to see the forest for the trees.