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Behavioral Finance

April 07, 2008

The Psychology of Risk

Each year millions of sports fans enter bracket pools for March Madness, the NCAA basketball championship.  Participants buy an entry or two for modest amounts like ten or twenty dollars.  Most who join in rarely, if ever, make even small wagers on specific sporting events.  March Madness  and the Super Bowl are different.

With tonight's championship game we have an opportunity to use the bracket pool to gain a little insight on risk and how it affects behavior.  The situation described nearly always arises when the championship game is to be played.

A Typical Case

Let us suppose that a player enters a large bracket pool for $25.  Through a combination of a few astute guesses and a lot of luck, our hero is in line for a useful prize.  If Kansas wins, he will win about $1500.  If Memphis wins, he will win about $1200.  A celebration will be in order either way.

When asked his opinion about the game, our ace handicapper tells us that it is a coin flip.  Why did he make the choice he did?  It was a close call, with no real reason to favor Kansas over Memphis.  Asked if he would make a bet on either team, our hero says "No."

Hedging, Anyone?

Let us now suppose that a friendly neighbor happens to be a big Jayhawk fan.  He offers to bet $150 with the lucky pool prize-winner.  The effect of this bet would be that the expected victory will be $1350, regardless of the outcome of the game.  Should he accept the bet?

Our experience, observing scores of friends and pool participants in these situations, is that they stick with their original entry.  They may think that it is "unlucky" to hedge -- a silly notion since they are locking in a set amount.  They may think that it does not matter, since they are in for a nice prize either way.

True enough.  The $300 difference may not seem like much when viewed in terms of the overall prize.  In a few days, however, when the contest has been forgotten, the result of the game will have a net effect of $300 in actual spendable money.  A week later, the winner will be making decisions about saving a few bucks in amounts much smaller than $300.  Even Doug Kass could fill up his Range Rover three times at the most expensive gas station in Palm Beach, Florida with the difference in prizes!

A Point of Comparison

By way of contrast,  let us suppose that our  pool  hero had failed to submit his entry on time.  Would he now be betting $150 on Kansas?

Conclusion

While the situation here is, of course, completely hypothetical (err--Go Jayhawks!!), the circumstances cited are quite real.  Some of the winning disparities are much larger.

A key difference between professionals and the individual investor is the ability to assess and limit risk and to realize that every result counts.

March 24, 2008

If you cannot pass this investment test, turn over the car keys

Here is a key question for investors and traders alike:  Do you want to be entertained by the colorful opinions of bloggers about what government should do or would you rather profit by understanding what they will do.

Background

We have highlighted the distinction between normative and empirical analysis -- opinions about what ought to be done versus the dispassionate study of behavior.  We suggested in December that the Fed was on a mission, using creative tactics.  We highlighted an excellent article from Abnormal Returns describing the difference between "Positive and Normative Blogospheres."  We have suggested that those offering opinions should first get some information -- at least reading some Fed briefings and old transcripts of meetings.

A Good Explanation

While doing research for our sister site, Election Stocks, where we analyze candidate issues and link them to specific investments, we came across a five-year analysis of the Iraq war.  We recommend checking out our comment on this subject, and the complete study.

Meanwhile, the explanation of the work provides an excellent insight into the distinction between those doing "politics" and those doing public policy analysis.  The report comes from a private sector group.  They make money by providing analysis, not opinion.  The following is the explanation of their mission, taken from the report:

The debate is over whether the invasion was a mistake in the first place, while the divisions over ongoing policy are much less real than apparent.

Stratfor tries not to get involved in this sort of debate. Our role is to try to predict what nations and leaders will do, and to explain their reasoning and the forces that impel them to behave as they do. Many times, this analysis gets confused with advocacy. But our goal actually is to try to understand what is happening, why it is happening and what will happen next. We note the consensus. We neither approve nor disapprove of it as a company. As individuals, we all have opinions. Opinions are cheap and everyone gets to have one for free. But we ask that our staff check them — along with their personal ideologies — at the door. Our opinions focus not on what ought to happen, but rather on what we think will happen — and here we are passionate.

Conclusion

The Stratfor description is exactly what makes public policy analysis valuable.  It is just what we are trying to do at "A Dash."  While we have opinions about what government should do, our mission is in helping investors understand past actions and predict future moves.

Those who do not understand this distinction are failing an investment Breathalyzer test.  They have become intoxicated with the  punditry and the debate over policy while losing focus on the cumulative effect of the many incremental policy changes.  These changes are starting to add up, (yet another future topic.)

Meanwhile, if you do not see the difference in these types of analysis, you should do the following:

Turn over your investment car keys to an index fund manager!

February 19, 2008

Investors Look at the Wrong Information! Why?

It is difficult to beat the market.  Individual investors who try to do so have, on average, results that are decidedly inferior.  And not just by a little.  It is more like half of the market return.  They try to time the market using all of the wrong methods.  They are afraid when they should be active.  They are "all-in" when they should be cautious.

We are developing some general themes -- common mistakes -- but our effort is one of building the case a step at a time.

An Example

Before departing on a long weekend of pure relaxation, we tried to leave investors with an insight that we felt was particularly valuable.  Our experience shows why getting perspective is important.

Earth to OldProf:  They do not get it! We posted an article on why accounting rules may be misleading investors.  We know that this is important for several reasons:

  1. It affects all of the financial stocks, an important key to the  market;
  2. General understanding of the issues is poor and reflected in the prices of many stocks:
  3. The financial write-downs get plenty of daily play, with each new story changing analyst estimates.
  4. The crucial element of understanding requires knowledge of accounting rules, the immediate effect, and the longer-term implications.
  5. The big mainstream media sources report each fact, but often do not provide an analytic framework.

With this in mind, we wrote about how the rules affected a key company, AIG, and the market impact.  Quite frankly, we hoped and expected that this would generate some interest and comment. Wrong! What were we thinking?

We checked this with our own small focus group and got a big yawn.  No one wants to think about FAS 157.  It is over the barrier of complexity.  If things get too technical, everyone tunes out, no matter how important the topic.

The focus group was correct.  We pay little attention to daily traffic at "A Dash" since we are not doing advertising, but we do periodic checks to see what resonates.  FAS 157 causes eyes to glaze over.  No one cares.

This myopia is empowering for those who take each issue to the lowest common denominator.  FAS 157 was a big story when the bearish bloggers saw last November 15th as a doomsday date like Y2K.  When it did not happen, the powerful writers in mainstream media did not point this out.  There is no accountability.  It is easy to make big predictions of write-downs.  And it is newsworthy, picked up by all of the popular media sources and financial television.

Conclusion

There is always a way to appeal to an audience without providing understanding.  Realizing this is the biggest challenge and the biggest opportunity for investors.

The credit market issues are difficult to understand.  Investors and traders are not really capable of making independent decisions.  Even if they work to get the facts, it also requires a solid analytical framework.

We shall pursue this with some other examples.  Meanwhile, we need to work on article titles!  Maybe if we had called the article DOW 15000 and included the Sports Illustrated swimsuit indicator, with a picture or two, it would have gotten more attention.

Understanding why FAS 157 is important is both more important and more challenging.

February 05, 2008

Another Round of Panic

Trading and investing are quite different things, a matter of time frames.

Today's trading was sparked by the ISM services report, something that has not attracted much attention in recent years.  The Market has focused more on the traditional ISM manufacturing survey, partly because it has a longer history, and a clear link to GDP.  For those who have forgotten that report, released two trading days ago, it suggested GDP growth of 3% as of mid-January, the time of the survey.

The ISM service release was surrounded by some controversy because of a change in the method of calculation and the early release of the data.  The ISM, in circumstances nicely reported by Kelly Evans of the WSJ,  admitted in a conference call that information might have leaked, so they announced the result before the opening.  We are always amazed to see that people do not realize that big traders can always find a way to play information when regular stock markets are closed.  Globex futures trading, anyone?

Significance of the Report

Most market participants realize that the service economy has assumed greater importance in recent years.  The large move in the index played into the recession fears of many.  As the market declined, this seemed to be confirmation of increasing recession odds.

The market and media reaction was that if many react to a piece of data, it must be right.   Let us look a bit deeper into this information.  When so many stampede, there may be a contrarian opportunity.

We have tested the ISM service series against employment changes and other economic data, and we find it to be pretty good.  When comparing it to the ISM manufacturing index we discovered that it did not add much information.  We now have a single data point where there is a significant divergence.  This would be nice to test, but there are not many other divergences to use.

Our review of today's news did not find anyone else who highlighted this statistical fact, or wondered about the meaning.  This provides an edge for our readers.

Other Interpretations and Advice

We realize that those with a predisposition to seize upon any evidence of incipient recession are touting today's number, even if they never mentioned it before.  Readers might want to compare the current interpretations from these sources with those from past months when the services figure was stronger than manufacturing.  There is a lot of selective perception at work.  Pick your favorite source and do a search to find out whether this number was ever highlighted when it was strong.

Briefing.com, an unbiased interpreter of information, reports as follows:

The data seem inconsistent with the harder figures on spending and investment and world trade which really provide the trends for domestic growth.  We also believe that the intent of this ISM index -- to reflect on growth for the entire economy outside of manufacturing -- is a mighty grand objective given the simplicity of the survey questions. 

For each component (e.g.  activity, employment, orders), the question to the survey respondents is simply, "Are conditions stronger, unchanged or weaker than the prior month?"

Gary D. Smith, who has a strong multi-year record of market forecasting, provides excellent daily commentary on his blog.  Unlike some other providers of links,  Gary cites information from every possible source.  He tells the "whole truth" without any cherry-picking of information.  Here is his take:

I continue to see the US Fed as now “ahead of the curve” and the odds of an intermeeting rate cut are rising meaningfully. The VIX is rising 8.0% today to a high 28.0. The ISE Sentiment Index hit a below average 102.0 and the total put/call is hitting an above average 1.12. Finally, the NYSE Arms has been running very high again all day at 2.47, which is also a positive. I still view the odds of a full retest or new lows in the market as unlikely and further weakness providing good entry points in favorite longs for investors.

Read the entire article to get the full context.

The Earnings Mythology

The recession hypothesis is getting an additional boost from commentators who claim that forward earnings are in decline.  Briefing.com has some great information on this:

According to Thomson Financial, fourth quarter 2007 earnings are expected to decline by 20.7%.  The main reason for the decline is the financial sector's whopping 105% decrease in earnings.  If the sector was removed, earnings would grow by 11.0%.  Homebuilders are also a drag.  For example, the consumer discretionary sector's earnings would grow by 7%, instead of declining by 15%, if homebuilders were removed from the calculation.

In general, we do not like throwing out the worst or best sectors from the overall S&P 500 earnings.  This might be an exception.  The last quarter is a bit unusual because of the forced write downs of mortgage securities.  Some believe that there are many more write downs to come.  We think that the FAS 157 losses might actually overstate the impact on these firms.  They voluntarily chose to keep securities on the balance sheet, probably because the expected performance to exceed current value in an illiquid market.  The jury is out on that question.

Meanwhile, the rest of the market sectors are not showing mean reversion, recession, or any other sort of earnings decline.  For example, Colin Barr's nice review of the Disney report highlights a good past quarter, and good future prospects.  This is a company that one would expect to be hit by consumer distress, if it were already an important factor.

Forward earnings will depend greatly upon how financial stocks rebound from current conditions.

Conclusion

Markets look forward.  Even in recessionary times, a fact not yet in evidence, forward earnings look through the recession, setting the stage for rebounds in stocks prices.

February 02, 2008

Three Business Decisions

One of the valuable things for us in writing a blog about a book, what we are doing at "A Dash",  is that we can see what is working and what is not.  By "working" we mean helping readers to understand something important that will be profitable in their investing.  This is not strictly a function of popularity of the article.  Reader comments are especially valuable.

It is a bit tricky, because the current audience in the investment blogosphere is much different from the one we will see in a year or so, when many new investors will turn to the Internet.  We are writing to the future readers, the audience for the book, where we will review many of the current blogs.  By contrast, the current roster of most popular blogs is aimed at the present.

Our purpose here is to illustrate something important, a concept which would have helped individual investors and traders alike last week.  To do so, we must find a different starting point.  So let us talk about three real public companies and important decisions they made.  All three companies are big names that you know.

Company A

The first company was engaged in a market share battle with a competitor.  Within the company came an idea for a new product that moved closer to the competitor's product in characteristics.  The idea was to skew toward a younger demographic and win market share.

Company A conducted field studies in the heartland, went through internal debate, and did extensive planning.  It worked up an advertising campaign.  With much fanfare, the product launch took place.

Company B

Company B was also fighting for market share.  Company B stimulates ideas from within, launching many of them as "beta tests."  Some work, some do not.  Those that work get further development.  Those that do not are dropped.  There is some internal planning and decision making, of course, but the hurdle for trying something is relatively lower.

Company C

Company C is in a business with some domestic competition and a lot of foreign competition.  The established business is threatened by changing circumstances, so it is in a struggle to maintain market share, revenues, and profits.

Company C was presented with an idea that might provide an immediate boost to sales.  The company did not know, of course,  whether the idea would work.  Since the idea came from outside the company, it was subjected to many meetings and reviews, including representatives from many different departments.  At each meeting, questions were raised from a variety of perspectives.  The company considered both the merits of the idea and whether it needed to use the outside source.

When the idea reached the key decision maker, it was presented not by those who proposed it, but by an internal manager who listened to the meetings and conveyed the ideas.

Reader Challenge

We could have chosen many cases for each of the three examples.  Readers are invited to nominate situations that they think might fit.  While we will reveal specific examples, there is no single right answer.

Here is the key questions:

Which method do you think works best?  Which approach is used by the most successful corporations?

Which method do you think best describes the behavior of major corporations?

Following Up

We shall return to this topic to show the relevance to current stock market issues.  The key idea is that understanding organizational behavior is important to successful investing.

October 10, 2007

Logic Test Solution

Spoiler --

This is the solution to yesterday's Logic Test.  Readers should check out the test before reading the solution.  The source of the problem (which we obviously modified) is poker expert Steve Zolotow.

Solution

We sympathize with several respondents who said, "I don't get kings that often and I am going to play them!"  That is a real-life solution, but this is a logic problem.

The key element is to evaluate what the first player might have said.  Here is a clear explanation from one respondent.  Nice going, Nemo!

The small blind is telling the truth.  Fold.

A bear would honestly claim to be a bear.  A bull would lie and claim to be a bear.  It is unknown whether the player to your left is a bull or a bear, but either way, he must have said "I am a bear."

Therefore the button was lying and the small blind was telling the truth.

Among respondent answers, David Lehman, a veteran CBOE trader solved the problem most quickly, in 45 seconds.  Other correct solutions came from regular readers RB and Eric B., with somewhat longer times.

In our earlier testing, there were two faster times.

Ralph Katz,  a top options trader and clearing firm owner, is currently competing in the finals of the Bermuda Bowl, the world bridge championship.  (In a future post we will take up the question of why so many top investors are also involved with bridge.  Hint:  Those thinking tea and crumpets do not understand the game).  Ralph asked one clarifying question and then announced his answer, taking less than twenty seconds.

The overall prize goes to young Ryan, Financial Analyst and Trader in our office.  He reviewed the conditions out loud and announced the answer.  Time:  About ten seconds.  (Note to hiring employers: You cannot coach speed!)

The Lesson

We suspect that many more would have solved the problem, or gotten it faster, without all of the poker trappings.  Suppose, for example, we had just posited three people making statements....

Something about presenting an actual poker hand throws people off track.

We suspect that similar things happen to those invested in a specific trading position.  There is a focus on one's holdings rather than the logic of the situation.  Discipline is lost.  We would love to see the problem presented to two different groups -- with and without the poker background.

This is a question for Dr. Brett!

Continue reading "Logic Test Solution" »

October 09, 2007

A Logic Test

At "A Dash" we are seeking ways to help investors and traders fight the traps described in the literature of behavioral finance.  One method, which we used successfully in the classroom many years ago, is to present problems wildly different from the main theme.  Later, we try to show the connection.

This problem came from two different sources. We will credit the poker source tomorrow, but the inspiration to present it came from The Trading Goddess.  Like many thousands of others we read her blog every day as a source of information and ideas.  What sets the blog apart is the originality and style of presentation -- educational and always .....entertaining.  (We congratulate two of the bloggers we also read daily, the inimitable Muckdog and Bullish Jim, on their selection by the Trading Goddess as contributors.  Nice recognition!)

Here is what caught our attention. 
Poker_2
This  image reminded us of the problem, which we have already tested on a strong group of very smart people.  It may seem familiar to you.  If so, you may be able to solve it quickly.  Keep track of your time.  Even if you do not play poker, you can solve this problem.  It has a clear answer.

Here is the situation:

You find yourself visiting Chicago and the Old Prof answers your request to find a poker game.  To help you play, you are reliably informed that the players -- all options and futures traders from the Merc and the CBOE-- are either bulls or bears.

The bears ( spoofed last week,  and the good guys now) are completely honest.  They always tell the truth in their statements, and they never bluff.  The bulls always lie and frequently bluff, although they might fold a worthless hand.

You are playing with three others, but you do not know whether they are bulls or bears.  You are the big blind, and when you look at your hand you are delighted to see two kings.

Trying to get a read on the table, you ask the next player whether he is a bull or a bear.  He answers, but you cannot make out what he says.  He folds.

The next player, the button, looks at you.  He says, "He told you that he was a bull."  The button now folds.  The last player, the small blind, looks at the player on the button and says,"You are a liar!  You are a lying bull."  She now looks at you and says, "I have pocket rockets (two aces, for the non-poker players) and I am going all in."

Does she have the hand in the picture?  Who is telling the truth and who is lying?  What should you do with your kings?

Please do not post your solution in the comments.  You can email me for recognition in tomorrow's post, where we will reveal the solution.  The range of answers -- all from very intelligent people, many of whom play poker -- include complete failure and rapid solution.  Keep track of your time to solve.

September 16, 2007

Avoiding Confirmation Bias

Sometimes an answer is easier to see if one steps away from the immediate problem, instead looking at an analogous situation.  This is a common teaching method, and one that we use frequently at "A Dash."

Background

Getting away from the immediate question helps to avoid what behavioral psychologists call the confirmation bias.  This tendency to see evidence as supporting one's preconceptions is very powerful.  We believe that even the leading market pundits, who are well aware of the phenomenon, fall victim to its power.

There is another important advantage:  Clarifying our objective.  So many prominent market commentaries claim not to make specific forecasts.  Frequently the authors criticize those who make specific and quantifiable predictions, pouncing on their errors.

We find this position quite remarkable.  If a market pundit is not trying to make some prediction, what is the value to readers?  Those claiming to have a "variant view" are making predictions.  The "variant view" idea involves even more complex predictions.  The author must make his own prediction, and then also prove that the market has not already discounted his widely-publicized idea.

The critical reader should ask whether these predictions are specific, quantifiable, and falsifiable.  If not, the argument is not useful for trading.

Bill Rempel's strongly-stated article on this subject deserves a wide readership:

There are some who would have it both ways. These people actively manage money! Perhaps for client accounts, where they buy or sell based on their technical models. Perhaps in mutual funds, where they decide whether to hedge with index puts, and how much hedging to put on. However, they try to have it both ways by saying “it’s not a prediction” or authoring articles about the fallacies of making predictions.

Please read Bill's entire analysis.  As we attempt to guide readers to the best sources on the Internet -- especially informing the explosion of new readers who have not joined us yet -- Bill's criteria should have a prominent place.

A Test of Confirmation Bias

Let us pretend that we live in Chicago -- something that means living and dying with "Da Bears."  [Giant fans and others can substitute their own team.]  We are interested in whether the Bears will win each game, each week.  We have many sources of information about Bears players, injuries, strategies, coaching, and most importantly, whether "good Rex" or "bad Rex" will be at the helm this week.  There are also many predictions from a community of experts.  Since we are fans, we have a lot of information and plenty of opinions.

This information can be our undoing.  We think that we know more and can parse information better than the real experts.  Everything that we see on TV, hear on talk radio, or read in the paper feeds our confirmation bias.  This is reflected not just in our interpretation of what we read, but also in what we choose to read.

An Alternative

Now let us suppose that we wished to predict the weekly result of the  Phoenix Cardinals, a team in which we have little interest.  Our  search for information  would be much more objective, including  a more open mind about expert predictions, sources, and data.

[It would be an interesting experiment for those like Scott Rothbort and Brett Steenbarger who have a ready audience, the appropriate intellectual interest, and the skill to conduct such tests.]

The Market Application

Let us imagine that a group of potential investors, abandoning the business of condo-flipping, decided to look at stocks with a long-term view.  These investors did not have any preconceived notions.  They had no market theory.  Their only question was whether to invest in stocks, and whether this was the right time.

In doing their research, they discovered that there was a community of experts.  These commentators had no allegiance to a particular viewpoint.  Their earnings were strictly based upon their results.  Poor performance, poor revenue.

The group of new investors might discover Mark Hulbert, who monitors the long-term performance of market advisory letters.  He identified the best and worst performers over the last ten years.  These groups of experts, unlike bloggers or pundits, cannot "fake it."  Revenues flow from performance.

The rookie investors discover the following from Hulbert (Barron's subscription required) -- a truly remarkable result:

The bottom line? None of these nine top timers are bearish. The average equity allocation among all nine is 92%. This is higher than where this average stood a year ago, as well as where it was in early May.

This 92% average is good news for the stock market in its own right, of course. But it's particularly bullish relative to the average forecast of the 10 stock-market timing newsletters with the very worst risk-adjusted performances over the last decade. The average recommended equity exposure among these worst performers right now is 0%.

In other words, the worst market timers are quite bearish right now, while the best timers are quite bullish. Rarely are we presented with a contrast this stark.

There are no guarantees. But to bet on a new bear market right now, you have to bet against the timers with the best long-term records and with those whose records have been awful.

Conclusion

There are many issues surrounding the prospects for stocks.  One needs to understand the worries, the probabilities, and how much current prices already reflect these concerns.

The intelligent investor reads a lot of information and has opinions on everything.  It is an easy question:

Do you think you are smarter and better informed than the consensus of all of the investment newsletter writers?

Or might  you be falling victim to the confirmation bias, spending a little too much time at your favorite bearish blog?

September 11, 2007

The Outcome Bias

Readers of "A Dash" know that we are not attempting to describe or explain every zig and zag of the market.  It is not that we lack opinions; it is just not our purpose.  By way of contrast, each day we write a market commentary for our clients on our private blog.  For our investors, we discuss what is currently happening with special attention to the positions we own.

Background:  Explaining the Daily Market

This daily exercise puts us in the position of the journalist, looking at the blank page and needing to write something intelligent to describe market action.  The journalist has no choice.  Something must be written.  Tomorrow's readers need an definitive explanation.

We have a choice.  We frequently observe that market moves were basically random noise.  Often we disagree with what we know will be the headline story in the next day's papers.  [For today -- Oil prices went up, despite OPEC supply increases.  There was a lot of futures buying driving a low-volume rally.  Some big player(s) wanted more exposure.  There is no real explanation.  Others will cite a "rethinking" of Fed moves.  Yada, yada.]

The Outcome Bias

One of the many useful contributions of the study of cognitive biases is the outcome bias.  When one starts with knowledge of the result, it is easy to find explanations and easier to conclude that one's own decisions would have been perfect.  There are strong psychological studies of this effect.

My non-trader friends often observe, after a volatile market day, how wonderful it must have been for traders.  It shows how little they understand.  The volatile day provides potential for a wide variation in results.  It all depends on how one was positioned going in.  For those with each position there will be successes and failures.

Long Premium.  This means that you own options which gain deltas (your favorable position gets bigger) as the underlying stocks move higher and lose deltas as the stocks move lower.  The trader takes "scalps" by selling short stock on the rally and buying it on the decline.  Even this trader may kick himself for "selling too soon" or not guessing the trading range correctly.  The actual traders with this position will do many different things, some getting the optimum result by selling at the top.  Others might wind up losers if they do not trade at all, expecting a big run rather than a trading range.

Long the Underlying.  Your stock (or index) rallies.  You get a big upward move.  Did you sell anything?  If you did, you can buy back lower.  If not, you have some explaining to do, since experienced traders always sell something into rallies.

Short the Underlying.  Your stock (or index) rallies in your face.  Your losses are mounting.  Do you throw in the towel?  Do you add to positions?  Either could be correct, but today, only one decision was right.  As in the other cases, some of those with this position make each decision.  There are many different stories, including those selling at the top.  Every trade has two sides.

Short the Premium. This is the toughest.  Suppose that a trader decided after last Friday's employment report to sell some index calls, expecting them to expire worthless.  A big rally like today's can cause calls to explode in value, making the position much larger than the  original planned size.  Should the trader bail out?  We know from experience that every trader has a price where he gives up.  If the trader does not have this price, his backer or clearing firm does.  Brett Steenbarger has a great discussion of trader fear, and this is one of the causes.  [searching for Adam Warner's recent great article on this topic.  UPDATE: Link added.]  Our experience with traders is that original position size is often too large, based upon what the trader hopes to gain, rather than the risk of loss.

An Experiment

In tournament bridge circles (a group including many leading traders and investors) we often give a problem "on a napkin."  It is called this because it involves card play, and is written down at dinner on a handy piece of paper.  Sometimes there is an obvious way to play the hand -- clearly best via expert analysis.  The person posing the problem hopes to get confirmation for his (losing) decision or admiration for his brilliancy from his fellow experts.  The problem is that some of those getting the problem may try (consciously or subconsciously) to gain acclaim from dinner companions by finding the winning answer on the particular deal.  That respondent may choose an anti-percentage action, just because of the problem setting.

This would be an interesting trader experiment.  We are not going to summarize the factors leading to today's trading, since the information is readily available.  Instead, let us imagine an experiment.  Perhaps Brett Steenbarger, who works daily with traders, or Scott Rothbort, who uses innovative methods in his classes, will give this experiment some thought and find an implementation.

Take a day like today, and some other big market moves.  Provide whatever information might seem to be relevant -- charts, economic fundamentals, earnings stories, breaking news -- to everyone in the test panel.

Tell them the news --  in advance!

Each participant gets to predict the market outcome knowing the news in advance.  The experiment could include a variety of situational examples with different facts.

The key point is one of our recurring themes -- the difficulty in predicting unlikely events.

We would expect a range of outcomes with very few coming close to maximizing the result.  We suspect that those with the "wrong" positions would do the worst, reacting to fear.  Those with the "right" positions would not come close to optimizing the result.  This expectation is based upon experience.  We have been there.

Individual investors who understand the advantage of staying with the normal odds -- and not trying to predict extreme outcomes -- can gain a significant advantage.  For the individual investor it comes down to understanding the difference in time frames and not being frightened by volatility.

July 21, 2007

More Homework: Interpreting What You Read about Market Action

One of the biggest traps for the smart investor or trader is the often persuasive commentary about recent market action.

When the Dow had a decline of over 1% last June, we highlighted this problem, calling it the biggest mistake of the individual investor.  As background, readers should go back and look at that article, written when the Dow was under 11,000.  The road was a little rocky for another month, but we all know how it turned out.

What about now?

Today's Barron's had a number of interesting insights into current sentiment.  Let us first look at this comment from The Trader column:

"We're at the point in the mature cycle where we all know excesses have been built up, and everyone is watching for signs that point to the end of the cycle [emphasis added]," says Jeffrey Kleintop, chief-market strategist at LPL Financial. "The market's perspective will get even more short-term from here, and the bull will be a rougher ride."

Our sense is that this is an accurate reflection of many hot-money managers, trying to time the end of  "the cycle."  Timing this cycle has been going on for three years, spurred by skepticism about Fed policy.  It began with the gradual increase in interest rates from an abnormally low rate.  These guys are shorter than they want to be and reacting to every data point.  Readers might wish to compare  this behavior with that described in our Blackjack article.

Contrast this with Warren Buffett's advice:  "You can't get rich with a weather vane."

Barron's also has an excellent article by Michael Santoli called The Missing Man.  Santoli provides a lot of information about how individual investors have not yet participated in a rising market. Readers should check out the entire article, but here are some key quotes:

Net inflows into stock mutual funds have been a trickle for most of the past few years, in many months turning into outflows. This is true even if one includes the money added to hugely popular exchange-traded funds. The Bank Credit Analyst, a research firm, points out that household-equity positions as a percentage of broad money-supply measures have been stagnant since 2004, and are on par with levels from 1995 or 1996, despite today's significantly lower interest rates.

That is actual data about the individual investor, not speculation about sentiment.

Richard Russell, the longtime market commentator and editor of Dow Theory Forecasts, described this situation in a note to his newsletter subscribers last week. "True, the little guy may be skeptical, he may be wringing his hands over the housing situation or the price of a dinner at his favorite restaurant or the cost of gasoline," he said. "But somehow the big picture, the stock-market boom, has eluded him. That will not last. The little guy will not forever resist the lure of the bull market. It's a question of timing."

Scott Rothbort, writing for RealMoney, the paid service of TheStreet.com and worth it, (full disclosure:  We now write for RealMoney, although regular readers know we have consistently endorsed this source) has an excellent article where he cites a new interest in the market within his circle of contacts.

We are very far from a top as measured by individual investor participation.  Check it out by looking at a typical CNBC commercial from the bubble era, Stuart teaching his boss to trade online.

Also from the anecdotal-evidence file, in the week when the Dow first touched 14,000, the prominent ad space on the back cover of Barron's shouted, "Short. And Simple," in highlighting the ProShares ETFs that let investors bet against the market.

So we also have individual investors now empowered to short the market based upon "feel" and what they read in the continual pounding from bearish Internet sources.  In another Barron's article Michael Santoli writes about bullish market predictions at the year's start as follows:

Those were consensus calls among the standard sell-side and long-only investment pros at the start of the year -- not, mind you, among the many wised-up, blog-scraping, doom-inviting macro bears out there who can tell you how many homeowners defaulted on their mortgages in DeKalb County, Ga. last week, but not why the Dow hasn't collapsed.

Conclusion

It is another case where the "smart investor" reading a lot of Internet information could make a big mistake.  The question is where to look and how to interpret what one reads.  Our next installment in this series will cover investment blogs and how to interpret them.

Individual Investors: Start Here!

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