Collapse of Dreams
"[T]he values to which people cling most stubbornly under inappropriate conditions are those values that were previously the source of their greatest triumphs."
- Jared Diamond, Collapse: How Societies Choose to Fail or Succeed
New public policies that account for human (and elected official) psychological weaknesses are desperately needed. Fortunately, such an effort has begun. Read on to learn more.
But first, some housekeeping...
|Shorting Bubbles - Ouch!|
I've made many unfortunate investments over the years, but one in particular still bothers me. In 1998 it was very clear that the technology sector was in the midst of a historic bubble. There were many overvalued stocks - with no earnings, high debt, too-good-to-be-true stories, and extremely high valuations. I picked Amazon.com due to its high level of hype, and I sold short some shares.
A few months later I had lost 40% on that investment. Then a few months after that 80%. By the time I had lost 120%, I bought back my shares. (And good thing I did, the stock continued much higher before it finally peaked). I learned a lesson best-articulated by John Maynard Keynes: "Markets can remain irrational a lot longer than you and I can remain solvent."
In the post-mortem analysis of that investment I looked back on my thought process. My conviction had been high, I knew I was right. Diagnosis: Overconfidence. And as a result of overconfidence, a weak risk-management plan. This trade changed how I think about trading timing and risk management. (It's ironic how improving risk management always becomes urgent AFTER a big loss).
Steamrolled by the crowd, and my lesson learned, I turned to the study of timing bubbles. I wondered, how could I time the expansion and ultimate collapse of market sentiment around hot tech stocks like Amazon.com?
I decided to start by looking inward - what were investors in Amazon thinking (or not thinking) when they bought in? And what triggered the ultimate fall in the price? In fact, my senior research project in medical school was on "The Social Psychology of Bubbles and Panics" (I was extremely privileged to work with a pre-eminent researcher on impulse-control - Ernest Barratt, Ph.D.).
It turned out that expectations are key to bubbles, and expectations are rooted in the brain's emotional circuitry. That circuitry is easily activated by extraneous events. In fact, researchers have found that completely unrelated positive events (movie clips, pictures of happy faces, pornography) prime us toward taking excessive financial risk (Read more in today's Researcher's Corner below).
We've had a similar sort of timing problem the past several newsletters. And from our research, we know that a key success trait of investors is good timing - rapid execution on high conviction ideas. Our monthly newsletter takes about 10 days from conception to publication, and during that 10 days our forecasts often become stale, rendering the monthly recommendations less profitable (e.g., the oil and copper short hints last month worked out a few days before publication - fortunately the decline in oil and copper prices continues).
Before we jump into how to time bubbles, first some housekeeping.
|Shopping Carts and Playing Chicken|
When I was a boy in Texas the neighborhood children enjoyed playing chicken, usually with speeding shopping carts. Two children were pilots and two children were bombs. The pilots dutifully ran their bombs up to full speed, released them, and ... CRASH. Ideally your shopping cart remained standing after the collision, in which case you won. Fortunately, two shopping carts crashing sounds much more painful than it actually was.
But this newsletter isn't about bored suburban kids.
This month we look at a much more deadly game of chicken between Iran and Israel (and by proxy, the U.S.A.). Mirroring the escalating tensions, oil prices are up over 10% in the past five weeks. Higher oil and gasoline prices are already impairing our economic recovery.
This newsletter will examine Behavioral Game Theory as it applies to Iran and Israel. What is the best strategy to deter a foe who may be crazy, short of war? We will then look at the current sentiment snapshot of news and social media as it relates to Oil, Iran and Israel, which reveals some surprises about global mood. The psychology behind Oil's recent price rise reveals whether the rally is sustainable (hint: fear is rarely sustainable).
In addition to our usual haunts of New York and Los Angeles, we will be speaking in San Antonio, western Pennsylvania, a CFA webinar, and San Francisco in March - we're look forward to catching up with our friends in those cities!