Our MarketPsych index of negative stock market expectations is now the highest we've ever seen (we've got data back to 1984).

The Fed's actions and words -- explicitly committing to bail out mortgage lenders -- should have lowered market negativity. Instead we got a morning rally afterwards and then further selling.

What we saw last week was everyone jumping ship - a real crowd effect. The only information driving investors was downwards price action and rumors of further collapses. The more stocks dropped, the more they sold. A positive feedback loop was created.

In psychology, a positive feedback loop is created when people base their opinion of how bad a situation is on the actions of others. When everyone is doing this, we can usually call it the peak of a mania or the bottom of a panic.

The market stopped being comforted by the Fed, which is a bit scary. Fortunately, it was primarily the financials getting hit today. The Biotech index was actually up 4%. A rally is certainly near (though I was wrong last week).

Eventually, when the supply of sellers decreases, because they've run out of shares or capital to sell, positive feedback loops can't sustain their negative price momentum.

The danger is that acting on negative expectations can become a self-fulfilling prophecy. I wrote about this in my book, with the example of Brazil's near debt default in 2002.

Essentially, the more investors avoid new bond offerings, and the higher rates go (especially for junk bonds), the more squeezed are companies that need to raise capital. Eventually many will go bust because they can't afford the high interest rates (which are high because investors are afraid the companies will default). If the rates had been lower (because investors were more calm), then the debt would have been service-able and the company would have survived. The crowd's pessimism really can make things worse (just as its optimism was problematic in allowing such overconfident risk taking through 2007).

At this point, it's important to ask "can it get worse?" (yes), "will it get worse?" (probably), and "has this been priced in?" (in many sectors, yes, much too much).

In financials it's not clear to me if it has been priced in, hmmm.... A rally in financials won't happen until we know where the next bogeyman is. And right now, there are lots of terrible rumors, but no new sources of pain. I think investors are waiting to see how the current pain will spread, since it's clear that the economy is slowing and the real economic slowdown hasn't been reflected in the numbers yet. "Who's next to collapse?" is often heard.

There are some amazing bargains out there. A stock or bond screen will demonstrate great values. I don't trust the numbers on financials (never have), but in some traditional industries low debt stocks with PEs of 6 and trading under their book values are much more common. I won't get specific because the blog is about psychology, not stocks picks at the moment.

But watch out for stocks vulnerable to the self-fulfilling prophecy of higher interest rates for "risky" bonds. That's whay I mentioned to look for "low debt" stocks.

Solutions to the current crisis include better political and regulatory management of the psychology of risk-taking, which isn't likely anytime soon (as I mentioned in my last blog post). It will take some deep understanding of human behavior in the Fed and SEC (and maybe an in-house psychologist or two) before we get such enlightened policy. In the meantme, there will always be bubbles and panics to take advantage of.

Historic times we're in. Now let's make the best of it!

Richard

    Why is it so tempting to make stock market predictions?

Maybe it's an anxiety reliever -- predicting implies that there is a pattern, a cause, that can be found if only we look hard enough. Forecasting bolsters our sense of control.

At the same time, we all predict with similar neural "hardware." So maybe we all make predictions based on similar information, or at similar times? And if so, are we collectively usually wrong or right?

The answers to that question underlie our asset management service (MarketPsy Capital LLC).

The chart below displays negative expectations in the major business press (WSJ, Financial Times, Barrons, New York Times).



The chart shows Negative stock market expectations (the brown line) superimposed on a candlestick stock chart of the S&P 500 (SPY). As you can see in the chart, high negative expectations are not usually a good time to buy, until they fall.

Today negative expectations dropped when the Fed reported a willingness to lend to banks beyond September 2008.

However, creating a portfolio strategy out of the "buy on decreasing negativity" insight is not easy. For one thing, we can intellectualize and chart our pessimism, but we still believe it: "this time it's different, it really is THAT bad," we might tell ourselves.

And furthermore, somtimes negativity is justified, and the catastrophe really does happen.

Here is a chart of the same data series from a January blog post. Notice that we did get a stock market rally when the negativity decreased, but now it is higher than perviously.

The stock market is an anticipatory mechanism. It has priced in a lot of pain to come. The real question is, will the pain be worse than the market expects? If not, then it is likely to rally. And in general, people anticipate more pain than is actually experienced. They will even cause themselves greater pain in the present so they can stop anticipating future (smaller) pain. (This is called the cost of Dread). Many investors felt tempted to sell their stocks last week, just to save themselves the dread of further price declines.

This Fall we'll see if the credit crunch shows signs of abating. From what I hear and read (The Credit Crisis is Going to Get Worse), it will continue. And printing money (increasing liquidity) may not work as well in alleviating the squeeze this time.

That said -- and because I'm nervous about this market ;) -- I'd like to make a prediction. It's kind of a cheap sensationalist substitute for an educational blog post. Like the one that Frank just wrote. But here goes: I suspect we're due for another short-term rally. Expectations are vey pessimistic, and now they are becoming less so.

Those are my thoughts, but then, maybe I'm just seeing order in madness. On the contrary, given the statistical results of our research, I think we really have found predictive factors rooted in the collective psyche.

It was clever that Bernanke spoke about continuing debt relief today. Someday, I'm optimistic, the Fed will consciously direct fiscal, policy, and monetary factors to have a greater impact on the psychology of the economy's participants. This may help alleviate future bubbles and crashes.

But that may require a generational change, and I don't think we have enough evidence that it will not also do harm (though it can't be much worse than the enormous liquidity we've seen in the last decade). It's not easy to accurately model psychology or economic behavior, which keeps it out of the standard curriculum.

For now, we are seeing efforts to change fiscal policy that do have a positive effect on the psychology of consumers. Which is good. Someday those efforts will include specific language and will target more vulnerable psychological themes (housing insecurity, confidence to spend, fears of perpetual debt, etc...).

Richard

    
Psychologically and fundamentally speaking, it's not looking good in the equity markets. So I've decided to write a macroeconomic analysis in this blog post today.

My thoughts: A liquidity squeeze is back. Stocks are selling off as firms sell equities to raise cash. The Fed is attacking the liquidity squeeze by increasing the money supply. The increasing money supply is accelerating inflation and the devaluation of the U.S. dollar (and other developed world currencies). The only safe haven for cash appears to be in raw materials. Real estate, a traditional hegde against inflation, won't protect against currency devaluation in the current climate. My reasoning follows.

DJIA was down 9.4% in June. Last Thursday 90% of the NYSE trading volume was on downticks.

Usually, these conditions are where a stock market bottom might occur, but these are not ordinary times.

It seemed to me that some institutions might be selling equities to raise cash reserves last week. That's a bit frightening because it implies that there could be a cascade effect. The more banks or funds need to sell equities to raise cash, or the more there are margin calls that must be met, the more stocks will drop.

In August 2007 and January 2008 the Fed put a floor under the markets by:
1) An emergency 75 basis point rate decrease - to increase liquidity for the financial syetem and fixed income markets. This was in response to the rapid deterioration and freezing of the CMO market in August.
2) Setting a floor price at which it would buy CMOs. This was in order to provide emergency liquidity to banks without enough marketable assets on their books (CMOs which could no longer be sold on the open market). This and the bail-out of Bear-Stearns (and facilitating its sale) saved the day this Spring.

But now things are bad again. What's the Fed (and all the other central banks) to do? Well, they have two options:

1) Let the credit crunch unfold. The crunch occurred because collateralized debt obligations (securitized) and other asset-backed securities can no longer be sold on the open market - there aren't enough (any) buyers. Fed non-action could lead to global bank failures and general catastrophe, so it's not really an option. However, there have been worrisome blaming noises coming out of the U.S. Congress - blaming the Fed for bailing out "rich" Wall Street bankers and overstepping their proper regulatory role. If Congress really understood how bad it was in January, and how the SEC was not even tuned in (per the WSJ), they wouldn't be so glib. Fortunately, the New York Fed has been quite vigilant.

2) The only other short-term option I can think of is to pump liquidity into the banking system. This will devalue the U.S. dollar.

Of course, every developed country is in a similar pickle to us. Most countries experienced massive credit borrowing, with scant collateral requirements, unjustified triple-A rated securities as collateral. Now that collateral is either impossible to value (for example, because there is no market for auction rate securities, certain real estate, CDOs, CMOs, and CDSs), or is devalued to the point where margin calls have been placed.

It appears that the Fed (and other central banks) have chosen option number 2. And that's one reason why we're seeing the developed world "devalued." It's true that the dollar's devaluation is primarily due to the massive trade deficit. Massive capital outflows, a rate of $500 billion annually, is occurring to petroleum producing countries. Our trade deficit is enormous (over $600 billion annually), and this puts downward pressure on the U.S. dollar (especially as Middle Eastern countries must de-peg their currencies from the U.S. dollar to slow their domestic inflation).

However, I think we're finally going to see money supply growth contributing significantly to inflation. Liquidity must be injected into the banking system in order to prop up banks and keep lending and the economy running smoothly.

Gold is a traditional hedge against inflation. But there will probably be a ceiling on the Gold price due to Central Bank selling of gold (especially over $1000/oz.). So we're seeing other commodities such as oil, food, metals, and commodified raw materials appreciate rapidly in price. They are the new hedge against inflation.

Real estate isn't going to hedge investors adequately against inflation, not when Europe, the U.S., and Japan are being devalued versus their developing-world peers.

The Fed and other central banks are doing what they must - providing liquidity to our system - so we don't have a banking collapse. This is accelerating the devaluation of our currencies. The only protection appears to be in commodities, and the companies that produce and sell commodities.

That's the way it seems to me currently. I wish I owned more raw materials!

Happy Investing!
Richard

    
Another brilliant new study from the SPAN lab at Stanford elegantly describes the neural predictors of the endowment effect. If you recall from some of our past blog posts, the Endowment effect describes the tendency for people to overvalue what they own, and value less what they don't.

A classic example of the Endowment Effect is playing out in the housing market. In a normal housing market, people value their own houses more than is justified by what the market will pay (often about 12% over the market price). During a market downturn, the normal homeowner tries to sell their house for an average of 33% over market value (per Hersh Shefrin on NPR, March 30, 2008).

So what could drive people to cling to what they own and demand a higher price for it? It turns out that we are hardwired for "scarcity," and we don't want to let go of something we already have.

It even appears that we fear losing something we think we are going to get, and we'll chase it with a higher price at an auction (such as Ebay). This is seen in an insightful study by James Heyman, Yesim Orhun, & Dan Ariely called : AUCTION FEVER: THE EFFECT OF OPPONENTS AND QUASI-ENDOWMENT ON PRODUCT VALUATIONS).

Brian Knutson, Elliott Wimmer, Scott Rick, Nick G. Hollon, Drazen Prelec, and George Loewenstein demonstrated in a study published by Neuron tomorrow, called Neural Antecedents of the Endowment Effect, that activation in the anterior insula (appearing in the top image), predicts the strength of the Endowment Effect.

Importantly, there are "individual differences" in the intensity of the Endowment Effect. That is, the activation in any one person's right anterior insula predicted how much value they assigned (and how much money they would demand from a bidder) for a consumer product. Each individual is different in this regard. And I imagine (though I have not seen it shown experimentally) our own propensity to the endowment effect changes over time depending on recent events in our lives.

Remember, the anterior insula often activates when someone is afraid of losing something, when they are in physical (and imagined) pain, and when they are experiencing disgust. So the idea of giving up a product is actually painful, and so we assign a higher value to it - to avoid the pain of loss.

Maybe that's another reason why it's so hard to let go of a sagging stock, especially one with a great story that is a former high-flyer. It's actually painful! More on this study and its implications later...

Happy Investing!

Richard

    There are many events, and more importantly RUMORS of events, putting the market on edge.

There has been a surge in the MarketPsych Fear Index, in part due to Lehman's potential implosion, this time due to excessive and illiquid leveraged positions. With Lehman's request for $6 billion to fill in the hole dug by CMOs and excess borrowing, the market is back on the brink.

All this in the context of early summer. Recall from a prior blog post that there is truth in the saying "Sell in May and Go Away" - here is a great graph of the effect.

The specter of world oil and commodity price shock, inflation, flooding in U.S. agricultural regions and drought in Australia's, war with Iran, and general purpose catastrophe has reared it's head again. I don't mean to be glib. There is danger afoot. This isn't one of those merry "buy on the pullbacks" type of markets. Or is it?

There is indeed a developed world deleveraging happening. Will that spread to the developing world? It appears to be anticipated in recent stock market performance, but then, that may have been developed world money fleeing those markets, which is my opinion. And that doesn't mean the sky is falling.

The "sucker's rally" Frank and I predicted in March has come and gone. The DJIA passed 13,000 and then dropped back again. So here we are again, down 8% for the year.

So it's not looking good for anything except commodities and oil? No, that's not what I'm saying. I'm fairly interested in technology, pipe (yes, steel tubes for drilling), recycling, shipping, land, and many mining stocks. India and China aren't slowing their growth much, even though the US is, and they use lots of raw materials still. One land and oil trust that I've held for years, and plan to hold for many more is Texas Pacific Land (TPL), and also a pipe company, WEBC. Yes I own shares in these, and if you try to buy WEBC, you'll move the market, so please don't.

But wait, I need a legal DISCLAIMER here of some sort. Hmmmm..... (nervously scratching my head)... OK, so don't buy TPL or WEBC. I'm not recommending them. I'm just saying they're out there. I don't want to get sued because someone bought one now and sold it when it fell or went bankrupt and they lost money. Like I said, "DON'T BUY TPL OR WEBC!!!!!" Please don't, really.

I think I'm covered now. Whew!

And here's what's interesting: when investors are primed to be cautious because of one bad event, they often extrapolate that danger into other spheres (in my case, fear of litigation). When in fact they might want to find inflation-hedged stocks, which will continue to perform over time. But this is very difficult to do when you're afraid, because of neural "priming" in the anterior insula of the brain.

A fascinating study which we profiled here, by neurofinance geniuses Brian Knutson and Camelia Kuhnen, demonstrated that activation in the brain's anterior insula predicted excessive risk avoidance in an investing task.

Building on this finding, Greg Larkin, Brian Knutson, and collaborators found that anterior insula activation appears beneficial for learning which dangers to avoid. See their paper here. A light summary in Psychology Today is here. Interestingly, people who are more constitutionally "neurotic" (nervous) have more insula activation when faced with monetary losses. While being "neurotic" isn't usually seen as a personal positive (especially by neurotic people, who are already predisposed to worry that something isn't right anyway), it turns out that neurotic people (with their greater reactivity of the insula), are better at learning to avoid financial losses going forward. Insula activation did not affect learning to pursue or avoid financial gains. So I didn't do the study justice here, but hopefully more on its implications later.

While perma-bulls buy on the dips, more anxious investors may be rightly on the sidelines, waiting for these storms to pass. And their sitting out the volatility has now been proven right a few times over the past 12 months. Yet, then they might get stuck sitting and never acting. The market is always a balancing act.

In our in-house research, it's not the absolute level of market fear that predicts a market rally, but a retreat from a high level to a lower one. That's what you'll want to look for before buying. And for the past 12 months we've had historically high levels of fear.

What causes such retreats from peaks to lower levels? It's usually a resolution of some dangerous anticipated event. For example, the collapse of Bear Stearns and the Fed's willingness to step up and put a floor under the CMO market. That resolved a tremendous amount of uncertainty.

If Lehman can raise $6 billion, at a not horrible price, then I think another level of uncertainty will be resolved.

If the Iranian government stops declaring they plan to wipe Israel off the map (fat chance!), then there's another level resolved.

So it looks like the fear will continue for a while..., but we'll still hae some ups and downs that present good buying oppotunities in select sectors.

Happy Investing!

Richard

     I'm going to assume that if you've visited our MarketPsych blog, that you are, in fact, an investor.

    
While this isn't yet a porn site (so long as the profit motive doesn't overcome our desire to educate investors), we should report on two independent studies that are showing a correlation between Testosterone, sexy photos and financial risk taking.

I'm not talking about "financial porn."

I know it sounds strange, but a hormone level (Testosterone) correlates with higher trading returns (see this study). Taking external testosterone won't boost returns, but having a higher baseline level in the morning, independent of other events, may increase the aggressiveness of risk-taking and lead to higher returns. However, while the effect was significant, the sample size was fairly small (17) and homogenous (intra-day traders).

Seeing an unrelated sexy photo increases financial risk taking (See Brian Knutson's study here), which is where the above image comes from. Knutson's study indicates that external, irrelevant photos that activate our old friend, the Nucleus Accumbens, appear to have a lingering and substantial impact on subsequent risk taking. This may explain why casinos put ther female staff in revealing clothes and car companies and others use lightly clad women to sell their completely unrelated products. The dopamine surge accompanying the sight of a sexy photo increases financial risk taking going forward. There are other stimuli that also cause dopamine release in the Nucleus Accumbens, and these can plausibly be assumed to increase financial risk taking as well. As I have mentioned in the past, the genius of Knutson's studies is that the researchers are able to PREDICT financial risk-taking behavior. This allows them to study behavioral modification techniques in future experiments. That cannot be said of virtually all other neurofinance studies, including the Testosterone study cited above. In fact, the authors' media comments about the Testosterone effect are highly speculative (can you give a trader testosterone or cortisol to alter their financial risk taking? - now that would be a predictive study), and Testosterone is likely working through the Dopamine circuits anyway.

Happy Investing!
Richard

    A short-term rally will probably happen this Spring. If so, it is a "sucker's rally."

Maybe it's a quirk of human psychology, but it seems like far too many investors buy at the high and sell at the low. It's such a common mistake that the inverse saying ("Buy high, Sell low") may be the most common in the Wall Street rule-book.

Many investors with cash may sit on the sidelines over the next few months as the stock market moves upwards. Near the high they will buy into the market, just when they can't take the pain of watching from the sidelines any longer.

We're coming off a Fear-bottom now (as Frank pointed out, the Bear-Stearns news was the straw that prompted a cleansing "capitulation"). It was "cleansing" because it knocked the weak money out of the stock market. Now strong money remains, and the race to Dow 13,000 is on again.

Why does this "Buy high and Sell low" misbehavior happen, and why is it so predictable? It seems to be one of the many mysteries of market psychology.

Richard

The MarketPsych Fear Index has seen an uptick recently.

One reason I believe it has meandered of late is that a critical and catalyitc component was missing: The appearance of a nightmare scenario that the individual can; 1) experience viscerally, and 2) consider credible.

The Bear Stearns news today presented just such a scenario, and it sent a shockwave of fear through the markets.

We simply do not live in a world where "Modest CPI Numbers" can compete with "Wall Street Institution Imploding Overnight" in a market-moving contest.

If it sets off a "fear cascade" (think dominoes), we may just see Market Panic make it's first reappearance in years.

Getting my cash ready now...

    The MarketPsych Fear Index has been showing low Fear readings (see our Market Analysis page). This seems odd with stocks falling, the economy slowing, housing values falling, oil rising, and gold rising. Seems that inflation and low growth is coming -- a re-emergence of the old bogeyman: "Stagflation."

I double-checked this low reading by also looking at sentiment levels. Same result -- sentiment about the stock market is not so bad. I guess this makes sense considering the recent articles touting "Bargain stocks" and "Cheap shares."

The bad news, including falling stock prices, doesn't phase investors like it used to. It's like Learned Helplessness. Ironically, I'm worried by that lack of concern. It seems that investors are complacent about the bad news. As a long-time stock market investor, I've learned that we should take advantage of investor fear but avoid a complacent market.

Richard

    
Selling a losing stock shouldn't be hard. Yet many investors find that as bad news begins rolling in, they are in disbelief. The stock they loved has turned on them.

Take Starbucks (SBUX) for example. Last year the announcement that hot creamy drinks weren't selling as well as anticipated during the summer was a shocker to many star-struck (pardon) investors. I could hear the disbelief from investors in slow-motion withdrawal: "Starbucks can always keep growing and raising their drink prices, they just need to serve faster, colder drinks, fresher coffee, expand to Bhutan, etc..., can't they?" Yet, after Starbucks appeared on nearly every street corner, it should have seemed natural that growth had to begin slowing.

The Onion even noted in 1998 that Starbucks had begun opening Starbucks outlets in the bathrooms of existing Starbucks (see article here). To continue growing, Starbucks had to begin cannibalizing itself.

For most investors, the stages of coming to terms with a "Stock Gone South" are like those of someone dealing with other sad events in life. I cou;d even speculate that such stages might follow the logic of the Kubler-Ross model of the "Five Stages of Grief."

First, investors look for reasons why the bad news isn't really true or was maliciously fabricated by outsiders (DENIAL). If the bad news continues, then they feel ANGER (and maybe blame the management or "evil" short-sellers). Next they begin to negotiate (BARGAINING) with themselves, "I know this has been a great stock, but maybe I need to let her go for a while - I can always buy some shares again later." Unsentimental investors then sell, while the more sensitive types become indecisive - paralyzed with disappointment (DEPRESSION). If they make a habit of wallowing in self-pity, then they are likely to end up at the fifth stage of grief called ACCEPTANCE, whilst still owning the Stock as a hopeful "comeback kid" (though in reality it is likely to be sunburned pink (sheets) and panhandling for change somewhere near the equator).

At risk of jeers and taunts from those still in DENIAL, the same as is happening to SBUX might be happening to (drumroll please).... Google (GOOG)!!! Truth be told, GOOG actually looks relatively inexpensive under $450/share ... or am I too emotionally attached to see clearly? (Disclosure: I don't own GOOG shares...yet).

It might seem like an easy decision to cut GOOG loose and re-invest the money elsewhere. Unfortunately for investors there is an innate human tendency, called "the endowment effect," which unconsciously compels them to cling to familiar, fun, or long-held stocks. Associated with the endowment effect is a thought process that justifies continuing to hold a weak stock ("It's just a temporary setback;" "I'm a long-term holder;" "It's actually a good time to buy ... if only I wasn't already holding too many shares..."

We got some great evidence for the endowment effect at a training we ran for financial advisors last week. In our experiment we give out fancy "MarketPsych" pens to half the attendees (because we "forgot" to bring enough, oops!). We then decide to redistribute the pens using a market mechanism - for fairness sake. We ask those who received a pen to write down a price at which they would sell their pen (the ask), and those who did not receive a pen write down how much they would pay for one (the bid).

At our meeting last week there were NO transactions for pens among audience members, The average bid was $1.35 (which approximates the actual value of the pen). Remarkably, the average asking price was $8.80 (ranging from $3 to $15). The sample was small, and we usually see asking prices around $5, which is still remarkably high.

The high asking prices are a testament to the power of emotional attachment and its ability to cause overvaluing of those things we like (and those that are scarce). One way to increase the endowment effect, and widen the bid-ask spread, is to ask those who received a pen to describe the things they like about the pen, and to ask those without a pen to describe objective aspects of the pen. When we do that, the spread is even bigger.

So how can you fall out of love with SBUX, GOOG, or any other stock that is disappointing you? (And it usually is true that these stocks will continue underperforming going forward). Think of the objective aspects of the investment, not the ones you love to love. Don't think about how tasty frappuccinos are, think about the price to book value. Instead of remembering the pleasure you got the first time you Google'ed yourself, think of declining profit margins and ad revenues. It requires deliberate action, but it is definitely possible to toss aside your emotional baggage and learn to see stocks more rationally. It's just not very fun...

Happy Investing!
Richard

    
Our new spin-off asset management firm, MarketPsy Capital, was mentioned in a new Popular Science Magazine article. The fund will be using our ground-breaking linguistic analysis technology to identify and exploit psychological mis-pricings in stocks, currencies, and commodities. For more information, please contact Richard Peterson at richard@marketpsy.com.

    
"You have to have men who are moral... and at the same time who are able to utilize their primordial instincts to kill without feeling... without passion... without judgment... without judgment. Because it's judgment that defeats us."
Dennis Hopper playing Kurtz, in "Apocalypse Now!"

"You show them you have in you something that is really profitable, and then there will be no limits to the recognition of your ability."
Kurtz, the original rogue trader, in "Heart of Darkness" by Joseph Conrad.


With the loss of $7.5 billion by Societe General trader Jerome Kerviel, speculations about the psychology of rogue traders is in the news. How could one person end up losing so much of someone else’s money?

The psychological factors cited to explain Kerviel’s misdeeds range from the redundant (“he wanted to be a great trader”), to the fatalistic (“some people can’t help themselves”), to the pop psychological (“he was born provincial and wanted to prove himself as one of the elites” – see the WSJ), to the ultra-modern (“his brain is wired differently”). See Frank’s excellent CNBC “Closing Bell” appearance on February 7, 2008 for more about the brain and hard-wired “risk-seeking errors.”

I don’t know Kerviel, and even if I did, I wouldn’t speculate about his psychology. (Frank didn’t speculate on CNBC either, instead he mentioned some common brain-related investing errors).

Don’t get me wrong, speculating can be useful if it helps to establish the “profile” of rogue traders. And there have been some decent attempts in this regard. Financial firms, and their HR departments, have a vested interest in preventing the losses of billions of dollars because the proverbial mail-boy had "a hunch." Thus they use every psychological screening tool available to find and weed-out potential rogue traders.

Besides the obvious disqualifications for a trading job (a stint in prison, repeated personal bankruptcies, frequent stays at a high-rollers suite in Las Vegas, a penchant for fast cars and loose women (or men) at work), it isn't possible to find a consistent profile of rogue traders. But that doesn't stop us from trying.

The problem with profiling is that there are so few rogue traders and the vast majority of traders don’t become rogues. As a result, we don’t have the statistical power to find any simple profile.

So what do we have to go on in finding and screening out rogue traders? Many factors are cited, but the sample size isn’t large enough to really prove any of these factors.

Here are a few of the common themes found (See the excellent source article):
1) Most have previously had some record of success.
2) They believe they are better than average traders.
3) They base their expectations on recent prior events.
4) They think they can make up the losses by taking more risk or working harder.
5) Isolation is common (living in a city outside their native country).

For the statistical example, suppose that Kerviel, Hunter (Brian Hunter of Amaranth Capital), and Iguchi (Toshihide Iguchi of Daiwa Bank) all owned toy poodles named “Fluffy.” Given that 1) they have accounted for a sizable proportion of all losses incurred by rogue traders, and 2) it is (fairly) rare for traders to own toy poodles named Fluffy, there is a strong correlation between toy poodle ownership and rogue trading. But as everyone knows, correlation does not equal causation.

MarketPsych Disclaimer: While we do not know the pet ownership habits of any rogue traders, I think it is safe to assume that pets do not cause rogue trading itself. However, we could be wrong. There are certain species of Koi that do, in fact, release neuroactive chemicals from their tear ducts which induce rapid and frenetic trading among genetically susceptible investors. The same may occur following exposure to toy poodle saliva. We simply can’t say.

    The million/billion dollar question is when will we hit market bottom. A lot of traders and short-term investors are feeling the heat right now.

Ironically, bottoms are often hit when investors capitulate. If you're fully invested, the usual benchmark for when the bottom is hit is when you finally give in to that feeling that you're going to lose everything, and it's so painful that you just can't take it, so you throw in the towel and sell everything. I don't see capitulation yet. The sell-offs still feel somewhat orderly and gradual (though rapid).

If you're waiting on the sidelines with cash, it's often better to not "catch the falling knife", but to wait with buy-stop orders that trail the market, so when the rally occurs, yours is one of the first orders hit. Of course, when any rally appears, there will initially be a trickle of buyers, and then a stampede. It won't be easy to get a great price on a stop order that fills at the market price during an explosive relief rally.

No matter where you are, it's never useful to sell into a panic unless you sell a little bit ("throwing a maiden in a volcano") to give you mental breathing room.

Now is a good time to assess what powder you've got dry, and look for the opportunities. The opportunities will usually not be in the previously hot sectors. A stock screen using low P/E won't catch the drop-off in earnings expected in many companies that were booming last year. However, if you add low price to book as another screening criteria, then you might find better quality issues.

Volatility rewards those with patience and a clear mind ...

Richard

    If expectations drive stocks, then this graph should be of interest. As opposed to the MarketPsych Fear Index, this is a plot of the relative percent of negative expectations (subtracting out positive expectations, such as for market "recovery" or "rebound"). It looks like investors are expecting very bad news going forward. As you can see, investor expectations were relatively more positive in June and July 2007. The relative percentage is displayed on the left y-axis. A negative value actually indicates a positive balance of investor expectations.

As in our other graphs, this is a candlestick chart (in this case of the QQQQ - Nasdaq 100 proxy). The brown line is a 30-day exponential moving average of the balance of negative-positive expectations. It is derived from the results of a linguistic analysis of the financial press. Essentially, you are seeing the frequency of reported negative expectations attributed to investors.
Does this ugly graph mean it's a good time to invest? Well, we haven't crunched the numbers on this one yet, but we will soon....

    The last two years have been great for readers of financial literature. I've been thinking about doing a list of my personal favorites for a while. Today I completed Alan Greenspan's epic "The Age of Turbulence," which is a genuine classic. It tops my list:

1. "The Age of Turbulence" - Alan Greenspan. The best and classiest memoir I've ever read. It cements Greenspan in the Pantheon of last century's great leaders, and establishes a lofty benchmark to which future memoirists will aspire. I know many people feel frustrated by his hedges and equivocations when giving testimony in front of Congress, and frankly I wish he had asserted his opinions more strongly while leading the Fed. In any case, he is a survivor, and he lays out his meticulously reasoned economic judgment and political analysis over the past 40+ years.

2. "More Than You Know" - Michael Mauboussin. An innovative multidiciplinary approach to understanding financial markets. It is fantastic, and a revised version was just released. Mauboussin ecclecticism is sorely needed in financial theory, and Mauboussin delivers exquisitely formulated multi-dimensional analyses. The analogies he brings from other areas of research are truly eye-opening when applied to explaining paradoxes in the financial markets.

3. "Inside the House of Money" - Steven Drobny. An excellent collection of revealing interviews with top global macro money managers, conducted in 2005. It intelligently delves into the thought processes and psychologies of these high achievers, which sets it apart from more anecdotal collections.

4. "The Little Book That Beats the Market" - Joel Greenblatt. The best book I've read on the fundamentals of successful long term stock-picking. It covers the basics of business and stock valuation in an entertaining and engaging fashion.

5. "Fortune's Formula" - William Poundstone. Entertaining and very useful summary of the foundations of quantitative analysis. It describes the evolution and utility of the Kelly criterion, arithmetic vs geometric means in portfolio design, and the impact of return volatility in a fun-to-read and narrative style.

I'm often asked which books are ideal for getting acquainted with behavioral finance and investment psychology. I'll answer that question in another post.

Happy Holidays!

Richard

    What's your anchor? If you don't know, it could be costing you.

There were some fascinating (but expected) results during a training program Frank and I ran for financial professionals this week. We asked one-half of attendees whether the Dow Index was likely to close above or below 18,500 in 12 months. The other half we asked whether the Dow would close above or below 10,250 in 12 months. After this first question, we asked each group to estimate where they thought the Dow would actually close in 12 months.

This is a classic experiment in which the irrelevant number mentioned in the first question profoundly affects the predictions made in the next one. It's called "anchoring" because people anchor their expectations to a recently seen, but irrelevant, number. In this case we had a positive anchor (18,500) and a negative one (10,250).

Amazingly, the average prediction for the high-anchor group was 15,644.
With the low anchor it was 13,792

The low-anchor group predicted a Dow gain of 2% over the next 12 months, while the high-anchor group predicted a 16% return. That's a 14% difference in range!

We get a spread about this wide whenever we do this experiment, and virtually every audience is shocked to see the size of the difference.

Anchoring affects analysts (who anchor on the most recent earnings estimates of other analysts), portfolio managers (who anchor on analysts' expectations), and individual investors (who anchor on IPO and recent or 52-week high and low prices).

Many investors anchored on an expectation of a 0.50% Fed rate cut this week. Ooops.

When expectations are anchored, then they can easily be disappointed, leading to emotional reactions that further impair judgment. It's a slippery slope.

Always good to be sure where you're standing (and what your anchor is).

Just some thoughts for improving self-understanding.

Happy Investing!
Richard

    Has this ever happened to you?

Recently I sold half of a position (large drug company) that I had held for 5 years. Did I have a good reason? Not especially. I figured that as a solid company it was wort owning - I just didn't need THAT much of it.

But - as is always the case with Whack-A-Mole Syndrome (TM) - it immediately started to move up. In fact, it almost seemed that the stock had become aware that I had sold it and used that information as the catalyst to move up 3 percent over the next two days.

Then something weird happened; I found myself rooting against it.

As a rational, self-interested being I was struck by this reaction. After all, since I still owned the stock, every move higher was making me money. But every move up was also a stinging rebuke of my in retrospect completely arbitrary decision to dump half my shares. This resulting conclusion was inescapable; I literally found myself wanting to lose money.

Why would an investor ever want to do that??

It's simple. We invest for an emotional return that more important even then the financial return. In fact, money is never the goal of investing. It is the means to the end, a currency that buys us emotional states (e.g., feeling safe, feeling proud, feeling free).

Unfortunately, sometimes our emotional goals and financial goals are imcompatible.

Being aware of our secret reasons for investing The E.R.O.I (Emotional Return on Investing) is what helps us overcome our psychology and navigate through the emotional mindfield of equities investing.

Are there any times you felt yourself actually wanting to lose money? Feel free to post a response.

In the meantime, happy investing.

Oh! And check out Dr. Peterson's cool book for more great insights into how to become a better investor.

    All of our online financial psychology tests are now free! This offering should last for at least one year.

As part of our constant efforts to understand how beliefs, values, personality traits, and even cognitive processing skills (see the Trader's Brain Scan!) drive financial decisions, we've been gathering research data from thousands of users of our online tests.

Our tests are grouped according to interest and affiliation:
Tests For Everyone
Tests For Wealth Management
Tests For Investors
Tests For Traders

We are planning on publishing some of our initial results with collaborators at Stanford University's psychology department in the next few years (we'll write a white-paper once the results are ready). We've learned a lot about how the mind impacts financial success, and we'll be sharing those findings via our academic affiliations over the next few years.

Best wishes,
Richard

    The MarketPsych Fear Index is rising (it was already fairly high before today's selloff). Apparently there was a considerable amount of nervousness before the market opened today, and that nervousness escalated into outright fear by day's end. Maybe a front-page (C1) WSJ article about buying on dips sowed doubt in investors today. "When Crash Means Buy" - brings out the Chicken Little in me.

BUYING ON DIPS

There was no useful info in the WSJ article (such as when to buy on dips and when not to), except that it sowed doubt about what has seemed a surefire strategy. Essentially, since buying on the dips has worked so well for so long (definitely since 1987, excepting the 2 1/2 years for tech stocks after 2000), many investors have become used to increasing their position sizes every time there is a downturn in shares. The article is a little ominous, and certainly hit the market at an already nervous time.

SIVs are the newest "What the...?" to come to the attention of the market. And uncertainty is almost always a negative, especially when the cause is interminably murky and needs $100 billion bailout packages organized by the largest global banks. Once the damage of SIVs comes to light, then the market can rally again, but for now it doesn't look good that another hidden risk has emerged to damage the financial sector.

CHINA A-SHARES

If you've been a regular visitor to our website since it opened - which is doubtful :), then you've known that I've always been bullish on China, and even set up an Investing in China webpage in 2004 to facilitate research. As I mentioned last month, the market is topping now (though may have a little more juice until February, after which it's best to steer clear). Appears that Hong Kong H-shares are doing spectacularly as an arbitrage play. Also via the WSJ (fine journal, that).

As long as Hong Kong remains in anticipation of local Chinese monetary inflows (and as long as it hasn't started arriving), then that market (especially H-shares) will have upside pressure. Ironically, Chinese investors are having tremendous difficulty opening accounts in the one city where outflows to the Hong Kong markets will be permitted (Tianjin Binhai New Area), and the pilot program was ultimately postponed, so no Chinese cash has made it to Hong Kong legally yet. But that is the genius of the Chinese authorities. By announcing the impending program, the premium of A-shares over H-shares has started to dissipate. And if history is any guide (as when the Chinese gov't announced in late Feb 2001 that the B-share markets would open to local investors in June 2001), then the actual financial inflows from China will probably mark a medium-term top in both markets.

WHAT'S THE USE OF BEHAVIORAL FINANCE?

What's the use of behavioral finance? That's the motivating philosophy behind a wonderful organization in Los Angeles -- the Behavioral Finance Working group of the CFA society. Here's their discussion group online.

I was fortunate to give a talk to the group yesterday. I met some great people and got lots of new ideas about how to apply behavioral finance to several areas:
1. Defeating you own investing biases.
2. Helping advisory clients to understand and avoid making biased decisions.
3. Finding opportunities in the markets.
More about those in upcoming posts...

Happy Investing,
Richard

    
As if Boston wasn't brainy enough with 51 colleges and universities (see this list), the annual neuroeconomics conference was held there this past weekend. Excellent new neuroscience research gave the audience's grey matter some delightful brain candy to chew on all weekend. I'll just list a few of the fascinating findings below. There are many more that I will not mention for space reasons.

In an effort to break the conference's three days of presented research down into a bullet-point-speckled summary, I'll organize the studies in the three following categories:
1) How people, on average, make personal financial decisions. Such experiments manipulated conditions of risk, reward, punishment, and ambiguity or uncertainty in order to see what types of brain activity correlate with (or even better, predict), not-mathematically-rational financial decisions.
2) How people make social financial decisions. These are often simulated using strategic games played with others (or computers dressed as others) and are relevant to morality in general. Such decisions affect other people (and usually oneself) financially.
3) How people are different from one another in their financial decisions, especially in regards to the brain activity that leads to their different choices under similar conditions.

Under personal financial decisions, Peter Bossaerts excellent (and intricate) study of traders in a simulated market was one of the most fascinating. He found that excellent trading (in this case, based on "tape reading") did not appear correlated with mathematical ability. Rather, it required a unique ability to understand the minds and intentions of others (variously called "theory of mind" or empathy). His study is far too complicated to explain in more detail here.

Researchers at NYU demonstrated the behavioral (and some neural) consequences of loss aversion in an investment-type task. Interestingly, the NYU researchers asked subjects to view all their upcoming "investments" in terms of a portfolio to see if it reduced their loss aversion (it did, but not entirely). They also found that an individual's level of loss aversion correlated with a greater SCR response (arousal) to losses versus gains.

Researchers from the Soochow and National Yang-Ming Universities of Taiwan, in the Soochow Gambling Task, have continued to demonstrate that people prefer small high frequency gains punctuated by occasional large losses (negative overall expected value) to small losses that are occasionally punctuated by a large gain (positive ooverall expected value), even after they are told the odds and probabilities. See my book for more detail about this remarkable result.

Brian Knutson's group at Stanford found that priming subjects with a sexy photograph increased NAcc activation (in the reward system) and increased their willingess to take risky financial gambles, even though finance has nothing to do with seeing a sexy photo (I presume).

In a study at NYU using one of Paul Glimcher's tasks, adolescents were found to be more "ambiguity seeking" than adults, but more "risk-averse" than adults when they knew the odds of the gamble. Per the researchers, perhaps their drive to learn and explore overcomes an aversion to known risks that they might not be skilled enough to handle yet.

In the second category of studies, Paul Zak's group at Claremont Graduate University found that touch (a massage of Player 2) more than tripled the amount that Player 2s (in the Trust Game) gave back to Player 1s. And the amount of $$ returned was correlated with blood oxytocin levels (especially baseline level). Recall that in the Trust Game, Player 2 isn't obligated to give anything back to Player 1, so this is a pretty profound finding. The Trust Game is described in my book in some detail.

In the third caegory, studies on how people make decisions differently, it is clear that there are observable patterns of brain activation, circuitry, underlying personality styles, and patterns of behavior such as:
1) Intuitive versus reasoning problem-solving,
2) Those who succumb to regret aversion (avoiding organizing their finances, for example) versus those who plan for the future,
3) Impusive versus more deliberate decision makers,
4) Maximizing versus satisficing decision makers, and
5) Machiavellian (primarily self-interested) versus more cooperative decision makers.
The first four results (preliminary) were found by Scott Huettel at Duke University's Center for Neuroecnomic Studies.

Other researchers found that the ability to self-reduce one's level of fear (and one's physiological fear-resonse) was correlated with the thickness of a part of the brain (VMPFC) that inhibits the amygdala and appears to generate soothing thoughts. Also, thickness of the insular cortex correlated with an increased sensitivity to aversive (bad) outcomes.

One interesting mention was of prior studies indicating that one's score on a "Private Body Consciousness Scale" (one's degree of somatic preoccupation) correlates with an increased susceptibility to the placebo effect. Now if one supposes that marketing is in some way activating placebo-effect-type brain circuits (people feeling good about themselves for a product purchase or consuming a branded product, for example), then it might be true that brain activity predicting the placebo effect will also predict whether one believes that higher prices denote higher quality (and better taste). According to Hilke Plassmann at Caltech, they do. That is, people who scored highly on body consciousness, when they drank a wine they was priced higher (but identical) to a lower-priced wine, thought it tasted better (and this finding was correlated with specific neural activation).

Other researchers found that individuals' "risk-aversion" to financial gambles appears to have a broad brain ciruit which governs it and indicates a specific personality type.

I hope this laundry list of findings is interesting and useful for all who could not attend!

Cheers,
Richard