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Imagine awakening from a concussion to find that your spouse has been replaced by an imposter. Besides a minor headache you have no other problems - just that one. A stranger is pretending to be your spouse. She looks, talks, and lives exactly like your spouse, but you know - deep down - she’s not your spouse. Of course it doesn’t make sense intellectually that your spouse was replaced by a double, but you absolutely feel that way.
Capgras syndrome is the name for this disorder, and it is characterized by a delusional belief that a loved one has been replaced by an imposter. The feelings of strangeness win out over the intellectual understanding that this person looks and acts identically to your spouse.
For those with Capgras Syndrome, a break in brain circuitry disconnects the facial recognition area from the limbic system. The face of a loved one usually elicits an emotional response - joy, excitement, love. But after a blow to the head (or other neurological issue), this feeling is no longer experienced. Patients see their spouse with their eyes, but they don’t feel anything. In fact, while the skin of a normal person shows evidence of physiological arousal (slight sweating) when the image of a loved one is viewed, the skin conductance of those with Capgras’ Syndrome stays flatlined.
Because Capgras’ sufferers see the exact person (“yes, she looks just like my wife”) but don’t feel recognition (“I know she’s not my wife”), a battle ensues between reason and emotion in the brain. You might expect them to get on with life, living with the intellectual assurance that this person clearly must be their spouse. When everyone around them insists “this is your spouse, not a fake!” – that should hold some weight. But the brain accepts emotional input as superior to visual/intellectual input, and the patient remains doubting.
Because the Capgras’ patient feels no connection with the loved one, the only rational explanation (to the brain) is that she must be an imposter, a double. And the mind tends to attribute sinister motives to the imposter: “What did she do to my real wife?!” which can lead to violent behavior. An elaborate story is fabricated out of a simple disconnect.
But Capgras patients are not always upset by the imposters. One man with Capgras reportedly confessed to his priest that he had repeatedly been unfaithful to his wife – he had been sleeping with his wife’s doubles.
As investors we are often confronted with what we know to be true intellectually versus what we feel emotionally. “I know this market is overvalued on a historical P/E basis, but I feel like it will still go up.” Even as experienced investors who know we should rely on the intellectual assessments, the pull of emotional reasoning - reinforced by the media - is strong. As you can see in our ETF model below, the best investing opportunities come when we trade against both the emotions and the intellect of the media. This week’s newsletter examines the battle of reason and emotion, how that plays out in events such as a potential Greek default, and the cycles of belief that drive ETF prices.
In his TED talk "How I held my breath for 17 minutes," magician and endurance performer David Blaine recalls several of his jaw-dropping performances. How magicians misdirect the attention and perceptions of groups has lessons for investors, which we will explain deeper in this newsletter.
We realise that you will think your own experience while watching magic is unique to you, but we know that, in general, everyone thinks in more or less the same way. Even as it gets harder to apply a technological edge, applying a psychological edge offers us nearly limitless possibilities.
~ David Blaine
Gustav Kuhn, a cognitive psychologist and magician, studies how magic tricks work. In one study Kuhn threw a ball into the air. When it came back down he caught it, and he threw it back up in the air, his eyes following it up. He did this twice, and on the third throw he pretended to throw it up while his eyes tracked the invisible arc of its course. Two thirds of the participants reported seeing the ball vanish in mid-air, even though it never left his hand. In a second condition, he pretended to throw the ball in the air, but instead of tracking it with his eyes, he stared at the ball in his hand. In that condition only one-third of the subjects believed he had thrown the ball into the air. Participants misperceived the actual event based on their expectations, as set by the magician.
One of the wonderful things about the art of magic is that it doesn’t really matter where the trapdoor is. That’s not the secret. The secret is that magicians influence what you think by using your own preconceived ideas of the world around you to amaze you.
~ David Blaine
According to Kuhn, "Even though the ball never left the hand, the reason people saw it leave is because they expected the ball to leave the hand. It's the beliefs about what should happen that override the actual visual input."
As humans we are hardwired to perceive patterns and to develop beliefs that even reality cannot shake. Magicians learn how to set beliefs, misdirect attention, and trick our senses. Some of their tricks parallel the ways in which markets collectively fool investors.
In today’s newsletter we review what we can learn from magicians, the untethering of the Swiss Franc (CHF), this weeks’ tech stock earnings, recent quantitative stock results, and when we should believe our market perceptions versus when we should doubt them. As usual it's a fairly long newsletter today, so feel free to skip ahead to the topics or images of interest.
It’s been over a decade since MarketPsych set out to decipher how sentiment impacts global markets. We dove into text-analytics in 2004 after we saw research indicating that - even when the overall payoff odds are known by investors, they will often choose investments with lower (or even negative) payoffs due to the words used to describe such investments. Such frenzies of excitement and despair about markets - leading to wealth-destroying investor behavior - are expressed in social and news media, and they seemed to us (and many others) to be correlated with market price patterns. We realized that price and fundamental data wasn't enough. We wanted to understand markets on the level of group behavior - consensus and the information flow that drives it.
One thing: you have to walk, and create the way by your walking; you will not find a ready-made path. It is not so cheap, to reach to the ultimate realization of truth. You will have to create the path by walking yourself; the path is not ready-made, lying there and waiting for you. It is just like the sky: the birds fly, but they don't leave any footprints. You cannot follow them; there are no footprints left behind.
After good preliminary results from trading social media sentiment on paper from 2006-2008, we ran the MarketPsy Long-Short Fund LP - the first social media-based hedge fund - from 2008-2010. There were some media reports on our fund with an interview here and an overview here. But while our trading was profitable - our fund beat the S&P 500 by 24% over its lifetime and it beat its benchmark by even more - our ability to keep our tech operations capitalized through the financial crisis was not. Turning away from fund management and into data distribution and research, we were fortunate to enter into a partnership with Thomson Reuters, pairing our unique style of analytics with their world-class project management, data handling expertise, and information flow.
As we look back over a decade of our development, we see exciting changes ahead. We're planning to release important new products in 2015, and every week we're finding novel insights into the role of sentiment and information in driving asset prices.
In today's newsletter we explore how sentiment impacts markets with examples from Russia, Crude Oil, and the Chinese stock market. We then explore how sentiment is itself dynamic. The best investing strategies differ in bull versus bear markets, and this excellent Thomson Reuters white paper reveals a dynamic technique to take advantage of this effect. We then explore how emotionality among investors, versus the analytical discussions of fundamentals, is actually one of the best predictors of stock prices. Goal setting for investors is far different than for people in other fields - we wrap-up with a guide to investment goal-setting for 2015.
Christopher Columbus had set out 68 days earlier confident that he could reach Cathay (China), but a series of bad omens had spooked the crew, and by October 10th they were mutinous.
They grumbled and complained of the long voyage, and I reproached them for their lack of spirit, telling them that, for better or worse, they had to complete the enterprise on which the Catholic Sovereigns had sent them. I cheered them on as best I could, telling them of all the honors and rewards they were about to receive. I also told the men that it was useless to complain, for I had started out to find the Indies and would continue until I had accomplished that mission, with the help of Our Lord.
~ Christopher Columbus, Wednesday, 10 October 1492
After setting out from Spain, they arrived in the Canary Islands to pick up supplies. There they received word that the Portuguese King had ordered the crew captured and imprisoned. Then after embarking from the Canaries, the rudder of the Pinta broke and they had to return to the islands for repairs. While on Tenerife, the island's volcano began to violently erupt - a new and frightening experience for the Spanish sailors.
They took to the seas again, and as the shores of the last of the Canary Islands faded out of sight, many sailors burst into tears, saying that "they were sailing off—off—off—upon the awful Sea of Darkness and would never see land any more" (Brooks, 1892).
The ships slowed in the Sargasso Sea - where there are few winds or currents - and drifted lazily through beds of seaweed and still waters for a week. The sailors became concerned that they would die, drift-less. Mirages of land raised hope and then dashed the crews' spirits.
Columbus soon realized that his calculations were incorrect - they had not found land where he thought they would. If Columbus returned to Spain without having reached land, he would face disgrace, imprisonment, or even death. He began to doctor the distances traveled in his logs, keeping one log of the true distance and one for his crewmen which showed less distance traveled. The sailors noticed that the magnetic compass no longer oriented itself properly to the North Star. To quiet their fears, Columbus lied and told the crew that the North Star had changed its position.
On October 10, 1492 the anxiety of the crew turned into mutinous fervor. To assuage his sailors' fears, Columbus took a gamble. He promised that if they did not sight land within three days, the ships would turn back to Spain.
Fortunately for Columbus and the sailors, landfall was made on the morning of Oct. 12, 1492. Columbus appealed to duty, cajoled, threatened, practiced deceit, and finally made a last ditch gamble, all to maintain his leadership in the pursuit of his vision.
Like Columbus, executives often face restive investors as they pursue their corporate goals. Sometimes they gamble their leadership on a specific outcome - Columbus' "just three more days" becomes their bet that they can turn around earnings "next quarter" or that a new product launch will be a hit. If they achieve their goal they are acclaimed, but if not their reputation may be destroyed.
The social psychology of how we perceive and respond to leaders has deep roots in the human psyche. Powerful positive social emotions about leadership - such as adoration and acclaim - are not far removed from blame and scapegoating. This month's newsletter examines human sacrifice, unfairly blamed leadership teams and their opposite - superstar CEOs, and predictive analytics of CEO comments and how those affect stock prices.
Hurricane Katrina struck the Gulf Coast of the U.S. in 2005, and it was followed by another powerful hurricane several weeks later—Hurricane Rita. After Katrina the media was saturated with vivid images of submerged residential neighborhoods, people stranded on their rooftops begging for help, and bodies floating in the brown water. Katrina was the most expensive natural disaster in U.S. history with total property damage estimated at $108 billion (2005 USD). At least 1,833 people died in hurricane Katrina and the subsequent floods. Insurers were liable for billions of dollars in damage claims, and they raised their premiums over 50 percent each of the following two years.
What we are betting on is that the perceived risk exceeds the actual risk. That’s fundamental to the theory of everything we do.
~Wilbur Ross, describing re-insurance investments after Hurricane Katrina
There was an increasing perception that category 5 hurricanes would devastate this area of the U.S. more frequently. An influential scientific study published in 2005 indicated an increasing trend in the rate of powerful hurricanes in the Atlantic, and Al Gore’s movie, An Inconvenient Truth, about the catastrophic environmental risks of global warming, was released shortly after the hurricanes struck. The 2005 Atlantic hurricane season appeared to imply that worst-case scenarios were coming to fruition even faster than predicted.
Savvy investors, especially reinsurers, smelled opportunity in the high risk perceptions. Both Warren Buffett’s Berkshire Hathaway and billionaire investor Wilbur Ross poured money into Gulf Coast reinsurance enterprises. In a Wall Street Journal interview, Ross explained such investments by stating, "What we are betting on is that the perceived risk exceeds the actual risk. That’s fundamental to the theory of everything we do." Fear irrationally drives up risk perceptions, and savvy investors locate such opportunities and exploit them.
On this Halloween/Dia De Los Muertos weekend, it's worth considering what we fear as investors. Zombie investments that never live up to their potential (a.k.a. value traps)? Ghosts in the machinery of Wall Street that bankrupt us in milliseconds? There are too many risks to track on Wall Street (and in life). Although we cannot understand or anticipate every risk, we can understand when others are going wrong in their assessments.
This month's newsletter is about risk perception, how high risk perceptions create opportunities for investors, and how to identify catalysts that indicate a reversal. We visit the recent decline in crude oil prices - predicted by sustained high risk perceptions - and we'll look at how risk perceptions predict global stock prices and individual stocks over long periods. To take advantage of excess risk perceptions, investors need the courage to doubt others' fear (captured by Wilbur Ross' quote above) coupled with the clarity and patience to identify the issue that, when resolved, will collapse the energy behind the fear - the catalyst.
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