You have Gone Favre Enough!: Leading a Portfolio Comeback

The NFL is back and for the 18th consecutive year and so is Brett Favre.

I was watching the Jets in New York when the network went to a game update - Vikings vs. 49ers. Favres Vikings were down 24-20 at home to the upstart Niners. With time for one play remaining on the clock, Favre dropped back but was quickly flushed from the pocket. Scrambling desperately, with the final seconds ticking away, Farve stepped up and threw a pass about fifty yards on a line to the back to the back of the endzone. Miraculously, with two defenders all over him, Gregg Lewis plucked the ball out of the air and got two feet in bounds and - Pow! Lighting strike! - the Vikings had won the game.

The crowd at the Metrodome went nuts. His teammates mobbed him at midfield. And the sports cliches came poring in -- Brett Farve, the river-boat gambler! Farve, the old gunslinger! Hes done it again! It was truly an amazing comeback.

And because I am a geek, it made me think of investing.

If you’ve been in the game the last few years, chances are you have been losing too; your net worth that is. Yes, the major indices have rallied considerably in the last 6 months, but all in all those indices are still down approximately 40% from their highs.

Investors want a comeback. But how do you lead a comeback in these circumstances? What does it take to get your portfolio back on track?

The choice comes down to two major sports cliches that any NFL fan (sports fan in general, really) will recognize. Do you try to make make something happen? Or do you take what the defense gives you? The choice for investors is clear.

It can be very tempting to go for the latter and try to make a play. You know, like Brett Favre did. Youre down big. You feel restless, like time is running out, you have to make a play. In football these plays are often called Hail Marys. In investing they are called, well, Hail Marys.

It’s the same play. High risk, big reward, chuck the ball down field into heavy coverage and pray your guy is the one who catches the ball. That is essentially what Favre did. And in his case it was the right play.

When Favre threw his last second pass into heavy coverage, he had no alternative. Could his pass have been intercepted? Absolutely. (And knowing Brett Favre, there’s a good chance it would have been). But the clock was about to run out. He needed a touchdown to win. Not only was it an acceptable risk in this case - it was really no risk at all.

But for investors, even though the temptation can be overwhelming, trying to make something happen is the wrong call.

Football games have binary outcomes. You either win or you lose. (Yes, technically you can tie. But that is an extreme outlier). The object in any one game is to win, so sometimes you have to take risks you ordinarily wouldnt like to.

But investing success is not measured this way (e.g., 2 million dollars or die trying!) Framing one’s investments as all or nothing/win or lose is one of the absolutely worst traps an investor can fall into. It causes us to take foolish, reckless chances - the equivalent of throwing into triple coverage. In a football game with a minute left in the 4th quarter there can be nothing to lose on a play. In investing, it just feels that way. You can always lose 100% of what you have.

In addition to a win/lose framework a second difference is that the clock doesn’t run out on your investing - not like it does in a football game anyway. It is ticking, and thats part of the problem. Sometimes the clock seems to be ticking so loud that it’s all we can hear. But the bottom line is we do have more time left. We don’t know how much. In some cases decades, in other cases much less. But barring the most extreme and unusual circumstances, we are not in a position with our investing to say, I need to make 50% on my money by the end of the year or its game over.”

And even when our biological clock expires, our investments do not. They get, in most cases, passed on to the people we love, spouses, children, grandchildren.

The right way to lead a portfolio comeback is to take what the defense (read: Market) gives you. That is not a code for be ultra conservative. By all means take advantage of cheap valuations. Adjust your asset allocation. But let your choices be dictated by opportunities, not a desperate desire to make it all back on one play. You may find that the supposed long, slow climb back can happen more quickly than we expected - and without advanced warning. Those with broad equities exposure have seen just that in the last 6 months.

Maybe your comeback has begun. I hope it has. Or maybe you have been on the proverbial sideline. If the latter is the case, you may feel an even greater temptation to make something happen. Resist this temptation. Evaluate your goals. Evaluate your holdings. Evaluate your opportunities. And start making sound, measured decisions. Do it. Take what the defense gives you and you will come back.

There is only one Brett Favre.

And as any Jets fan will tell you, he led the league in interceptions last year.

-Dr. Frank Murtha

MarketPsych on TV

Been a little remiss in my blogging the past month, but I wanted to update folks.

I will be on CNBC Monday morning (supposedly between 10:30 and 11:00 AM) with Erin Burnett and Mark Haines talking about Fear and Market Bottoms.

So tune if you wish.

And congrats to Richard and the MarketPsy Asset Management crew who have been riding high through these turbulent markets. When it comes to secret formulas for deliciousness, there's Coca Cola, Kentucky Fried Chicken... and MarketPsy.

Pressure Valve: Letting off Steam

Have you ever seen a steam pipe explode?

I did. I was in Boston driving down Boylston. I heard an explosion, checked the rear view mirror and what I saw looked amazingly close to the above photograph.

Market crises can create the investing equivalent of steam pipe explosions. Investors get caught between two competing pyschological forces that build up pressure:

On one hand, uncertainty causes indecision.

But on the other hand, when we are anxious, we naturally feel a need to do SOMETHING.

The result of these two psychological forces work against each other until -- Kaboom! -- the pressure becomes too much.

It's a vicious cycle and it goes something like this: Do nothing (and suffer), do nothing (suffer some more), continue to do nothing (suffer to the breaking point) then PANIC!!! (do something rash).

It's a wealth killer.

We need a way to let off steam, so that the pressure doesn't build to the point of explosion.

Now, let it be said that we don't give specific advice to investors here at MarketPsych.

Nonetheless, there are some tricks that people often employ to relieve the pressure.

One of the best pressure valves we have is to sell a small percentage of certain positions to free up some cash.

This works on a financial level, but more importantly it works on an emotional level.

Why does it work?

1) It fulfills a deep-seated psychological need to do something, to take back control of our lives.

2) It creates something safe. It lets us know that at least part of the money that was at risk, is now safe. We have less exposure to pain.

3) It gives us freedom. We now have money that we can put to work on our terms. Emotional forces can no longer compel us to sell what will we have already willingly sold.

4) It's a hedge against regret. We all have the same nausea-inducing fears of regret: E.g. "The moment I sell, the market will bottom out" or "It's going to keep going down, and I'm going to hate myself for riding it to the bottom." Selling a small percentage mitigates this crippling fear.

5) It allows us to reframe crises as opportunities. We know that market panics create opportunities. The problem for so many people is they simply don't have the cash available to take advantage of those opportunities. The ability to engage other parts of our brain is another fear-fighting tool that helps put investors back on a healthy investing track.

How much is enough? 1%? 5%?... 20%? Only you can decide. Sit down with your advisor and see where you stand.

If you would like more information on our trainings, please feel free to contact us.

In the meantime... good luck out there.

Frank

Financial Collapse?

Seems that principles may be trumping common sense today with the failed deals to back Lehman and AIG. It's not wise for the Fed and U.S. Treasury to give a lecture about moral hazard on Deck 5 as the Titanic is sinking.

Only one group has the credibility to prevent the collapse of significant U.S. banks(and later others in Europe) -- the Fed and U.S. Treasury. It appears that fear of indulging moral hazard (a principle) is prompting the Fed "to teach banks a lesson" today by allowing Lehman to collapse.

Lehman was the oldest bank on Wall Street. Lehman was relatively trusted and honest. Although it's true that Lehman has been circling the drain for a year -- see our prior blog post.

The core problem is that government economists assume people are rational. They assume that lessons will be learned and trust will be acquired by the most honest.

I'm from a psychiatry background. I don't think I've ever met a rational person. People respond to some rational direction for a while, but over time they are more likely to respond to incentives. The incentive structures on Wall Street (dictated by the Fed, Congress, and the SEC) are seriously deficient in this understanding of endemic irrationality and the limitless nature of uncontained greed.

The initial prevention was to impose adequate regulations (in advance) that would account for the lack of responsibility and short-term incentive structures on Wall Street. People are people (especially on Wall Street), and they will grab as many cookies from the cookie jar as possible if the lid is left open.

Lecturing Wall Streeters after they get diabetes is not helpful. Their diabetes has become contagious, and is infecting anyone within sneezing distance.

Locking the cookie jar, or limiting the outflows, is the only prevention. But it's not a solution now. We all have diabetes now, and we need our financial insulin (so to speak). But the private sector has run out of insulin.

The counterparty risk of Lehman's intertwined web of positions is unknown ($2 trillion in interrelated positions?). And that will spook the markets for weeks if not months as the carnage is sorted out (if it can be). Worse, the markets will continue to suffer as the disease spreads.

One thing I haven't seen in my (admittedly short) lifetime is fear that swelled into panic that caused a global financial collapse. I still haven't quite seen it, but we're getting close if no one (ahem, FED!!!) steps up to back the sagging real-estate linked assets of AIG and Lehman.

When ideology trumps practicality at the highest levels of policy making, we're all in trouble.

The Hong Kong government supported the Hang Seng in 1997 to prevent collapse, and it profited handsomely when offloading those shares (bought on the cheap) many years later. There are precedents for government support to excessively fearful markets, to restore confidence. With mortgage-related assets so cheap (and no willing buyers of size), and with the goverment inextricably bound to insure the performance of many banks anyway (through the FDIC), it makes little sense for the Fed and Treasury to dither.

Safe Investing!
Richard

The Wicked Garden Effect (TM)

I don't know if you've noticed, but it's been a bumpy ride for "The Market" so far this year.

And by bumpy, I mean horribly nauseating.

Many of us have individual holdings that have dropped 20%.

And many of us have holdings that have dropped a lot more than that.

Now, if you managed to hit the eject button early on and have resisted the urge to grasp at the knives falling all around us, I offer you my sincere congratulations. You've held fast to Warren Buffet's first rule of investing, "Don't lose money."

But if you're Un-Buffet-Like (and most of us are), you may be holding some positions that are way down. And if you need to clear up some cash, you may be put in the unenviable position of having to sell stocks when you'd prefer not to.

The question becomes; which stocks do you sell?

Here's a question: Imagine you've got two stocks in your portfolio. Stock A is up 25% from your buying price. Stock B is down (ugh) 25% from what you paid for it. Given just this information, which one would you be most inclined to sell?

What does your gut tell you to do in this situation?

Go ahead and think about it for a moment.

I'll wait.
...
...
...

Which one did you pick?

If I were a gambling man (and I am), I'm going to say you picked stock B. Most people do.

Now, Stock B may indeed be the best choice to sell. We have no way of knowing in this scenario.

But reflect on the reasons, the inner justifications for your decision above.

You may find yourself thinking things like.."It'll come back" or "Now is a bad time to sell" or "I can lock up a gain if I sell stock A" or "Why didn't Dirk Benedict get more work after he did The A Team... he was cool as hell on that show?")

Sorry. Got a little off track on that last one.

The desire to sell the winners in our portfolio, but hold the losers is a phenomenon that we at MarketPsych call "The Wicked Garden Effect."

We call it that because it's the investing equivalent of clipping all the flowers in a garden, and watering the weeds. And in my book, this is the worst mistake investors make. Over time you are left with a garden that is overrun by weeds, and the flowers have long been gone. The effect is devastating.

You may recognize this tendency in yourself or even recognize a couple of accounts that have become like Wicked Gardens.

Behavioral finance would cite the concept of Loss Aversion as the culprit. And they'd be right. But I view it as allowing our emotional needs (e.g., to feel good about ourselves, to not be a "loser") to override our financial needs (e.g., to invest in the best companies, to make money.)

Unfortunately, the price for feeling okay about ourselves often comes at the expense of our returns.

How do you defend against the Wicked Garden Effect?

1) Be aware of this powerful tendency.

2) Use solid objective criteria on which stocks to sell. (This is tough. It requires research and thinking... do it anyway.)

3) Identify the emotional need behind the sell decision and get some leverage on yourself. The fool isn't the one who made a mistake. The fool is the one who can't admit it.

For those who are interested, MarketPsych does (fun and interesting) investing workshops, trainings and presentations that explore this and other concepts.

Happy Investing.

Frank

Negative Expectations at Their Highest in History

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

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

MarketPsy Capital

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.

Negative Market Expectations at a High

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 Fiddler's Green: Curse of the Adjustaholic

It was Blaise Pascal, the brilliant French mathematician, physicist and philosopher who said:

"All of men's miseries derive from a single source; his inability to sit peacefully in his room."

Pascal was not referring specifically to investing -- but he certainly was including it. We love to tinker, adjust and monkey with. At least I do.

My name is Frank, and I am an adjustaholic.

My affliction began early in my youth. I would fiddle incessantly with the old rabbit ear antennae on the "television set" in a futile effort to achieve picture perfect clarity on a 1974 Magnavox. I would indulge in impulsive, hare-brained schemes such as throwing the football in an effort to knock the frisbee out of the tree. And then throwing the tennis racket at the football.

By 5 o'clock the tree on my lawn looked like Dick's Sporting Goods.

Sure. I could have waited patiently for my dad to come home and retrieve the offending object. Could have for 2 minutes that is, before the restlessness set in.

I'm older now. I have an HD TV and I don't play much frisbee anymore. But I am still a fiddler.

It raises to mind a behavioral finance question: What is to become of the Fiddler's Green? I'm not referring to the traditional Irish song (which is great by the way), but to the financial portfolio of the modern adjustaholic. If you are an adjustaholic like I am, there are some days you have an urge to fiddle. Somedays you just wake up, get a cup of coffee... and you just really feel like buying a stock.

Any stock.

I'm gonna do it. I'm gonna buy... geez, I dunno... something in the IBD top 10! Like SYNL! And why not? It's # 1 on their list for crying out loud! What exactly does SYNL do? They print $$$ for their investors, THAT'S what they do! It's up to 45. Have you seen the chart! It's a rocket ship! Besides, I'll just cut my losses at 8% if it drops. (And I really will this time too.) But it won't drop! That's the beauty of it! You may say I'm joining a game of Musical Chairs at the Greater Fools Social Club, but they're playing the live version of Freebird - and they haven't even gotten to the guitar solo yet!

Do I really need to tell you what happened next? Suffice it to say I capped my losses at 8% this time. (Okay, 10%). And the fiddler loses some more green.

I recently had a conversation with my colleague, Dr. Peterson. I stated that we cannot change human nature, but that we could plan around it.

Dr. Peterson pointed out that the same human nature that bedevils our investing process is equally apparent in our planning processes.

He has an undeniable and somewhat depressing point.

Well, I still believe we CAN plan around human nature, but it is not easy. It requires honesty with ourselves and self-awareness. It requires having, at the ready, a behavioral alternative that is less self-destructive than placing a buy order. Sometimes it may require help. One of the best things a busybody investor can do is to have a partner - a financial advisor, a friend - someone they can call in his/her moments of weakness.

I'm serious. Alcoholics Anonymous, Gamblers Anonymous, Smokers Anonymous -- one of the most effective methods of stopping a destructive behavior is to reach out to another person when your will is faltering. It helps.

Pascal was right. I cannot sit peacefully in my room, the one with the computer in it... and the access to my brokerage account.

Next time I feel the urge to buy SYNL, maybe I'll call Rich. Or maybe I won't bother to sit in my room at all, and I'll go for a long, long walk instead.

IT'S HERE: Inside the Investor's Brain

After a year-long writing odyssey, it's with great excitement that I announce the release of my new book, Inside the Investor's Brain. You can purchase the book here: Inside the Investor's Brain: The Power of Mind Over Money (Wiley Trading).

The ability to manage your mind in the markets is necessary for long-term trading and investment success. This book teaches the science of achieving high investment returns through an understanding of the power of mind. Endorsements are here. I won't repeat the publishers's long blurb (here: Inside the Investor's Brain: The Power of Mind Over Money (Wiley Trading)), but below is the table of contents:

Introduction.

PART ONE. FOUNDATIONS: THE INTERSECTION OF MIND AND MONEY.
Chapter 1. Markets on the Mind: The challenge of finding an edge.
Chapter 2. Brain Basics: The building blocks.
Chapter 3. Origins of Mind: Expectations, beliefs, and meaning.
Chapter 4. Neurochemistry: This is your brain on drugs.

PART TWO. FEELINGS AND FINANCES.
Chapter 5. Intuition: The power of listening to your gut.
Chapter 6. Money Emotions: Clouding judgment.
Chapter 7. Joy, Hope, and Greed: Hooked on a feeling.
Chapter 8. Overconfidence and Hubris: Too much of a good thing.
Chapter 9. Anxiety, Fear, and Nervousness: How not to panic.
Chapter 10. Stress and burn-out: Short term pleasure, long term pain.
Chapter 11. Love of Risk: Are you trading or gambling?
Chapter 12. Personality Factors: What are great investors like?

PART THREE. THINKING ABOUT MONEY.
Chapter 13. Making Decisions: The effects of probability, ambiguity, and trust.
Chapter 14. Framing Your Options: Seeing the world in black and white.
Chapter 15. Loss Aversion: Cutting losers short and letting winners run.
Chapter 16. Time Discounting: Why we eat dessert first.
Chapter 17. Herding: Keeping up with the Jones’.
Chapter 18. Charting and data mining: Reading tea leaves.
Chapter 19. Attention and Memory: What’s in a name?
Chapter 20. Age, Sex, and Culture: Risk-taking around the world.

PART FOUR. IN PRACTICE.
Chapter 21. Emotion Management: A balancing act.
Chapter 22. Change Techniques: Going deep.
Chapter 23. Behavioral Finance Investing: Playing the players.

Notes.
Glossary.
Index.

It is my sincere hope that Inside the Investor's Brain will help you achieve investment (and life) success beyond your wildest expectations.

Richard