Fearless Forecasting: How Low Can You Go?

It's official. The DJIA dropped 20% from its highs last October.

In other words, the Bear is back.

Whenever we hit a nice round number (e.g., "Dow 10,000) or experience a round number move (e.g., "Down 20%) it leads to a big picture discussion of where the market has gone... and where it will go next.

That means "market predictions".

In an earlier post, I observed that employing a black-tailed marmoset to throw darts at a board would prove just as useful an exercise (and an infinitely more entertaining one.)

It may be useful in at this time to review two major causes of precisely why.

One major cause is something called the Gambler's Fallacy, a miscalculation that ironically tends to afflict more market savvy investors (pros) than casual investors (amateurs).

Quick Example: Say you're at Mohegan Sun (where I was last week) and you're observing the roulette table. The wheel turns up "red" results 7 times in a row. These results don't fit with our mental schema. We know that the odds of a ball coming up "red" vs "black" at a roulette table is roughly 50%/50% (47.368/47.368 to be more precise). Our brain says something to the effect of "Black is due"! And we feel the urge to bet (overbet?) on a black result next time. Of course, the odds of the wheel yielding a "black" result are the same as ever - roughly 50/50. But it feels like it should turn up black, and that feeling overrides our rationality.

This is the classic manifestation of the Gambler's Fallacy - the notion a series of independent events yield useful information about predicting future independent events.

Pretty elementary stuff, I grant you. So why should something so obvious effect even top Wall Street Strategists?

Because the same tendency reveals itself in Market Predictions.

Hersh Shefrin, in his landmark book, Beyond Greed and Fear, provides a relevant example. At the beginning of 1997, Barron's interviewed chief strategists from top Wall Street firms, requesting 12 month market predictions.

On June 20, the market had risen 19.7% for the year to 7796, well above every strategist had forecasted.

A chief strategist for Smith Barney said in response, "We've all been humbled".

When Barron's asked the strategists for revisions predictions in late June, the average prediction was for the DJIA to drop 10.3% by year end.

Point of fact, the DJIA close slightlty higher for the year at 7908.

So despite all we know about market tendencies to move higher, the experts predicted a steep, upstream move in the opposite direction.

Why did they do it then and why do they continue to do it?

The answer is the investing version of the Gambler's Fallacy, that template driven interpretation of regression to the mean. We know the Dow tends to go up on average 9% or so every year. And we have a strong desire to fit predictions into that template.

But there is nothing magical about a calendar year - it's just a handy way of charting time. And if stocks tend to go up 9% or so every 12 months, than regression to the mean demands we predict that stocks will go up 9% or so every 12 months - not that they will reverse themselves according to our schedule in order to provide yearly averages.

Now, I'm not throwing stones here. Believe me, I'm not. I'm wrong constantly. And certainly all the participants were wise and learned professionals whose opinions are worthy of respect. But that's part of what makes this so fascinating.

Even they (especially they?) are not immune from the same impulses that drive roulette players to overbet because they think "red" is overdue or because a single digit number hasn't popped up in a while.

And - I can't help myself, I'm gonna say it - the other factor is no, (gosh darnit) they were not humbled, despite declarations to the contrary.

Wrong? Yes. Embarrassed? Perhaps. But humbled? No way.

A crucial component to being humbled is admitting you are wrong.

By prediciting a 10% reversal, the experts adjusted their predictions to support their original predictions.

Trying to prove you were right all along is not humility. It is the opposite of humility.

So with a bear market here and the inevitable market predictions to come, what are some things for investors to keep in mind?

1) Stay ready.

2) Stay humble.

3) Recognize the mathematical illusions inherent in regression to the mean.

Happy Investing.

Frank

MarketPsych Says Let's Make A Deal!: What Would It Take To Buy You Off?

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

But what kind of an investor are you?

Do you invest for to get a financial return or to get an emotional return?

(Okay. That's a trick question. We invest our money for both reasons.)

But getting back to you for a momemt, what is your style? Which kind of return is most important to you?

Here's one way to get an insight; ask yourself this question:

Imagine that we at MarketPsych can magically guarantee you an average annual return on your investments, but in exchange you will forfeit your right to ever invest your own money again. In another words, for agreeing to keep your paws off your investments we will (again, magically) guarantee you ____ % per year.

Let's Make A Deal: How high does that percent need to be in order for you to agree to the bargain?

(MarketPsych Legal Counsel Disclaimer: The above is meant to be a playful exercise in the hypothetical. In no way is MarketPsych actually offering this deal. In fact, despite Richard's launching of MarketPsy Capital, which we are confident will be a big success, it is always irresponsible and unethical to guarantee market returns. Moreover, MarketPsych does not engage in wizardry, magic, alchemy or any other occult arts. Although Frank does own "lucky socks".)

Now, we know that the average return for "The Market" over time has been close to 10%. (Note: There is still some disagreement on this. How do you define "The Market" -Dow Jones Industrials? S&P 500? Russell 5000?)

But we know over time, major indexes have yield on average close to 10% For the sake of argument, let's call it 9%.

So if 9% is the average, what would it take to buy you off and have you completely delegate all investing to someone else (a financial advisor, for example).

Some investors will immediately say - "I'll agree to the bargain for 9% per year. After all, it's a reasonable return, a "fair" return."

Some investors will say - "Heck, I'll sign up 7%! If the return is guaranteed, I'll never need to worry again. It's worth a "below average" return for the peace of mind."

Some investors will say - "I need more. I like investing money. I enjoy it. And I think I can do better. I need 10%... 15%... 25%! to make it worth my while."

A rare minority will simply never go for it, at any price.

So ask yourself that question. No matter what your answer is; it will be revealing.

It calls to mind a true story of an avid poker player who also happened to be a day-trader. Let's call him, Mr. B.

Mr. B was losing at poker. He'd bluff too much. He'd play ill-advised hands. He'd refuse to fold. Fact is, he sucked.

He became sick of losing, so he hired a professional to teach him how to play winning poker. And lo and behold, it worked. After a few lessons, Mr. B began to see better results. He found himself making a little money, and slowly began to build a bank roll.

And after 2 months, Mr. B quit playing.

Why?

"Too boring," he said.

So was Mr. B playing the game for financial reasons (like he thought), or was he playing for something else, to satisfy emotional needs?

And what exactly were these emotional returns that he valued above financial returns?

Knowing the answer to the above question in red is a great first step to knowing where your investing values, strengths and vulnerabilities lie. All other things being equal, such knowledge makes you a better investor.

We also offer you another deal, to come to one of our Professional Seminars (there's nothing else like them out there - don't be fooled by imitations!) whether one designed for everyday investors, or for investing professionals.

Cheers.

How To Scare the Pants off an Investor

Fear may drive the markets. But when it comes to scaring investors, most people are amateurs.

Take all these doom and gloomers you see on TV. I bet they think they're reeeeeeally scary. With their "GDP numbers" and their "recession forecasts".

"Well, Sue, it's pretty bad out there. In fact, we've upped the likelihood of recession from 45% to 52% by Q2." (Pause for reaction).

Is that supposed to scare me? To you, I say, "Ha, would-be fearmonger! You've got nothing! I've seen Barbra Streisand movies that are scarier than that!"

(Actually, I find all Barbra Streisand movies utterly terrifying... perhaps that's a bad example)

You know why their analysis isn't scary? Because it's not emotion... it's math. I mean, you're not even engaging the right part of the human brain! (Dr. Peterson's opus is the definitive source on that subject).

"Uh, wait. There's a 52% chance of recession... but only a 76% chance of that. And that's only if LIBOR drops under 4%... Hold on, let me get my calculator." I mean, honestly.

Math is only scary when you're in 5th grade and are asked to go up to the blackboard and do long division problems in front of the class (and you know Mrs. Schecter picked you because she caught you passing notes to your buddy, Rob earlier in the day).

You want to know how to really scare the pants off investor? You want to really know how to get the stampede started?

First off, ditch the math. The odds of experiencing a loss don't scare people; it's the amount of that loss that scares people. This is the first crucial step toward sewing fear. Ever seen that show, Deal or No Deal? (e.g., I know my odds, but I could lose a guaranteed $300,000). It illustrates the difference beautifully.

And it's not just the degree of loss. Even that's still numbers, and number is the language of math. It's how those numbers will impact the quality of the investors' lives that generates the fear.

Investors have to imagine what they will feel like when the loss changes their lives. That's what turns their stomachs.

Also, fear is personal. You want to scare investors? You gotta make it personal.

You pictured sending your beloved son to an Ivy League School. You pictured walking across the quad and soaking in the beauty of the gorgeous Georgian style buildings and 300 year old Elm trees. How proud you would feel. Nothing but the best for your son! But...

There's no way you can afford that now. Your vision and his dream have been crushed. Instead, imagine the sense of shame and longing when you pull up to that shabby dorm at the state school with it's ugly utilitarian architecture. The best companies barely even recruit there. He'll never get the opportunities there you envisioned for him.

(MARKETPSYCH LEGAL COUNSEL DISCLAIMER): State schools provide excellent educational experiences. The quality of education is often superior to that of private colleges. In fact, Marketpsych founders have attended public schools, proudly. Moreover, many state schools have lovely campuses. They are not necessarily ugly or utilitarian, with the exception of the State University of New York at Buffalo's Amherst Campus which was apparently outsourced to the Soviet Ministry of Architecture in 1971.)

Not scary enough yet? Fine. You know that 0ctogenarian who was behind the counter at that chain book store? Remember the twinge of pathos you felt? Well guess what? You're going to be that guy because you can never afford to retire. Every morning you will put on your uniform, get the bus to the mall and spend all day on your aching feet squinting at book prices because your eye sight "isn't what it used to be". At lunch you will get a half an hour to eat the bologna sandwich you made that morning. You will be doing this the rest of your life.

I think we're getting warmer.

Lastly, add some regret. (i.e., And not only did this awful thing happen... but it was all your fault!)

Of course, different investors imagine different worst case scenarios. But we all have them. Wheyn you create the connection from how their investing loss would lead to that terrifying reality, and the investor actually pictures themselves in that situation and feels what it would feel like... that's when you really.

Fifty-two percent chance of a recession?

Whatever, math-guy.

Talk to me when we get to the catfood.

The Market Prediction Game: Here We Go Again...

There's been a lot of activity in the markets so far in 2008. We've seen uncommon (though harldly unseen) volatility. And with volatility comes one of "The Street's" favorite pastimes; The Market Prediction Game.

But how do these predictions tend to pan out? With talking heads doing their talking thing everyday, it's hard to keep track of the daily (hourly?) deluge of prognostications.

But when we do collect the information, it is telling. The Wall Street Journal surveyed top economists semi-annually, to get forecasts on what bonds were going to do over the next 6 months. The data go back to 1982.

The experts (intelligent people all, to be sure), were wrong in the predictions of the direction bond yields 66% of the time. That is to say, when asked 6 months from now will the yield on a 10 Year Treasury be A) Higher or B) Lower... they got it right 1 out of 3 times. (Source: Davis Advisors)

Do you realize how bad that is?

Employing a black-tailed marmoset to throw darts at a board marked "higher" and "lower" would be a better predictor!

MARKETPSYCH LEGAL COUNSEL DISCLAIMER: Marketpsych.com does NOT promote or otherwise endorse the practice of marmoset dart throwing. Sure, it's fun. But that's beside the point. Arming small, wiry primates with sharp objects for throwing is dangerous and most likely illegal in the US (with the possible exception of licensed establishments in the state of Nevada). Marketpsych partners are NOT responsible for damages suffered by those engaging in this activity.

The fact is, human beings are notoriously lousy predictors of future market events. A study by George Wolford and associates at Dartmouth College found that even rats and pigeons outpeform humans in short-term market prediction. (No word on marmosets).

This does not mean the market doesn't have cycles, or that patterns don't emerge. Indeed, to be wrong 2 out of 3 times (as the economists were on bond yields) lends credence to the notion that the predictions are NOT random. It points to the central theme of short-term reactivity that seems to dominate investing patterns - something we call Whack-A-Mole Syndrome. (TM)

My colleague, Dr. Richard Peterson, has written about it here in his superior book, and even developed the Marketpsych Fear Index which tracks how investor emotion is often an inverse predictor.

But the point is you don't need a crystal ball to be a succesful investor. You need a few simple but undervalued qualities. 1) The ability to recognize companies with proven records. 2) The ability to recognize when their stocks are at an attractive valuation vs. earnings. 3) The discipline to invest your money in them... and not monkey with it. (pardon the pun).

But we can't help ourselves. With so much information available, with so much money on the line, we love to engage in the Prediction Game. (By the way, Pats 34 - Giants 14 - you heard it here first!).

The Market Prediction Game reminds me of the end of the classic 80's flick, War Games (starring a young Matthew Broderick), when "Joshua", the American military super-computer aborts a nuclear launch on the Soviet Union because it realizes that it would result in mutually assured destruction. The computer learns the folly of the eponymous "War Game".

"Strange game. The only winning move is not to play."

Indeed, Joshua. So don't play.

How about buying some great companies cheap?

Or perhaps a nice game of chess, instead?

Hail to The Redskins! (Curse); Hail Victory!! (For the incumbents)

Did you know that when the Redskins LOSE their LAST HOME game, the INCUMBENT party has LOST every presidential election since 1936? Isn't that spooky!

Well, not really. It's more silly than spooky, I think we can all agree.

Plus, George W. Bush ruined the streak in 2004, so the "Redskins Curse" is over.

For those who are interested, Snopes (the site dedicated to debunking or validating urban myths) has more on the subject.

But it's still fun to see how our superstitious minds can craft tales of curses and omens and lucky charms that predict the future.

Let's take a look at the Redskins curse in greater detail for a moment and see how Behavioral Finance would explain the development of this myth?

Q: Why the Redskins?

A: The Availability Bias. We tend to use the information that is most handy when we make decisions/predictions. Washington is a political town where people pay more attention to elections. The 'Skins are the local team. It stands to reason that they'd notice a political or 'Skins related anomaly. (In Green Bay... not as much.)

Q: Why the last home game?

A: The Recency Bias. In a series of events we tend to remember the events that occurred in the beginning and, even more so, those that occurred at the end. (Let's face it, who could remember the statistic if it occured in week 5 of the season?) Plus, we remember events that carry greater emotional weight. Home games are more likely to be attended by the politically interested fan base. When you leave a stadium, you remember a win - as well as a loss. (Epecially if that loss was to the &*$#*@! Cowboys).

Q: Why did Redskins Curse exist at all, why the anomaly?

A: Probability. We know that the incumbent party has a natural advantage. We also know the home team in football has a natural advantage (usually at least 3 points according Las Vegas). It should come as no surprise that two events will tend to occur simultaneously when the probabilities are greater than 50%.

The question of predicting future events based on past events is an important issue for today's trader given the popularity of "back-testing" strategies (plugging in your future strategy to past events to see if it would have worked). Numerous online brokerages currently touting this method as tool for validating trading models. And it can be. But there is a fine line between back-testing and data mining. The key is recognizing that correlation does not equal causation.

Since the Redskins Curse is dead. I think it's time to come up with a new, cool curse. Doing so means engaging both sides of the brain. MarketPsych has provided a model below.

The Pittsburgh Steelers Curse for Democratic Candidates

STEP 1: Mine The Data (Left Side of the Brain - The Correlation)

First, you're going to need a stat, a several standard deviation event that makes for an interesting coincidence. Fortuntately NFL records provide a mountain of data in which to go mining. As you would with a stock screen, sort through every Steelers season on election years since 1936. Eventually, the screen will turn up some anomaly - a particular week, a particular stat - that has consistently correlated with Democratic Party victories. Let's say that this particular data holds up for week 7. (I.e., When the Steelers LOSE the 7th game they play in a season, the Democrats always LOSE the presidential election.) Got your stat? Good. Proceed to step 2.

STEP 2: Create A Narrative Around It (Right Side of the Brain - The Causation)

The left side of the brain will do the math. But the right side will "tag" it with a story. (More on this and other fascinating brain explanations in my colleague Richard Peterson's brilliant book.) The story needs to create some sort of plausible context that would support a potential reason for the anomaly. And the spookier, the better. Sometimes, the numbers do this for us. (Lucky number 7, hooray! The number 13, booo!). But there are many ways to create a deeper meaning for the numbers. Use your imagination! Tie it to a disgruntled player (maybe he wore #7 !) who's uncle was the Republican nominee. The Steelers traded him on week 6 and ever since that fateful day....

Personally, I like this one: The owner (Who owned the team before Art Rooney?) was an enthusiastic supporter of Franklin Roosevelt, and invited FDR into the locker room to address the team on week 7 back in 1936. FDR, fine orator that we was, gave the 'boys a major pep talk. He ended it with a promise. He told the assembled players that "If you win today, I'll guarantee you a victory in November... as well as lower taxes on steel products, moustache wax, and Polish Sausages!" (Hey, all politics is local, y'know?) Well, don't you know the Steelers rallied to defeat a powerful Chicago Bears team with a miracle last second pass. And ever since that fateful day...

Feel free to create your own. Just don't bother using the Jets. The whole franchise is already cursed.

For Smooth Sailing, Winch up Your Financial Anchors

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

THE EROI (Emotional Return on Investing)

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.