“The wise are instructed by reason, average minds by experience, the stupid by necessity and the brute by instinct”
We are wired to constantly seek reasonable explanation behind any market move. The financial press tries to acknowledge the demand for information by analyzing with microscopic precision every small market fluctuation. When there is nothing going on in the market, we read about how nothing is going on in the market. As James Montier points out: “When it comes to investing, we seem to be addicted to information. The whole investment industry is obsessed with learning more and more about less and less, until we learn absolutely everything about nothing. Rarely, if ever, do we stop to consider how much information we actually need to know in order to make a decision”.
Every day we are bombarded with more information than we could possibly assimilate. I divide the information in three categories:
– Information that is relevant to my investment approach: signals for opening or closing a position; factors that are relevant for the particular setups that I follow. First you need to define your market approach (value, momentum, mean reversion) and then figure out which factors are important for your style. For example the P/E ratio has little forecasting power for the momentum investor. Short-term price action is random noise for the value investor. Figuring out the right signals for your market approach is not as easy as it sounds. It takes experience – your own or someone else’s. Luckily there are enough people, who have studied the capital markets and have done their share of mistakes in order to come with the factors that really matter for each particular approach. You could accelerate your learning process tremendously by studying the underlying logic behind their approaches. StockTwits is a place where such people can be found– an online community, where traders/investors with different level of experience share links and ideas. This is the place where you could find experts in the desired approach and learn from them;
– Information that helps me to better understand the underlying dynamics of capital markets, but it is not relevant to my approach (it does not provide a signal for opening or closing a position); It is about concepts, explanation of setups, analysis of new trends and changing correlation between asset classes. It is useful, it helps me to better understand the big picture, but it does not impact my decision making on a day to day basis;
– Noise: irrelevant information that doesn’t produce a signal or contribute to my growth and understanding. The majority of the articles and press releases out there don’t teach you anything of value and should be irrelevant to your investment approach. A recent example is JPM announcement last Friday that according to their model “there is 60% chance that the market has seen the lows for the year and that S&P500 is likely to close at 1300 by year end.” I saw that announcement tweeted at least 10 times by different sources like it was a big deal. For me it was nothing more than irrelevant noise.
Wall Street is a house of mirrors. There is very little original thought that is usually copied and multiplied. We are afraid of uncertainty more than anything else and all, who possess the confidence to claim that they know the future, have a tremendous impact on risk appetite and price moves. It is important to analyze some of the major sources of financial information. Understanding their incentives is essential to understanding the underlying market psychology. Excluding regulators (who are not the subject of this post), I distinguish four major influencers of social market opinion:
– Analysts: historically they have been a lagging indicator due to their over-reliance on companies’ management guidance. The majority were positive on the US bond insurers right until the end of 2008. Sell ratings started to appear after 80-90% price declines in the stock prices. Ironically those downgrades almost marked the price lows for those stocks. Analysts as everyone else are victims of self-serving bias and as such are very careful what they say and write – losing the banking business of a major client has often led to unemployment:
“An acclaimed natural gas analyst himself, Olson was fired by Merrill Lynch in 1998 after Enron left the firm out of a lucrative underwriting deal. Enron specifically cited Olson’s lack of enthusiasm for its stock as the reason for the snub. He was soon let go, a lesson that was hardly lost on his peers.
I perceive no great change in the nexus between investment banking and research,” Olson said. “It still operates as an indirect route to banking business.”
– Journalists: They realize that ideas that spread have the power to alter perceptions of value and move prices. It is not rare to see a popular website to blindly repost a press release without checking the incentives and the credibility of the source. The success of report is judged by the price impact it has on the featured stock. Most of us still have the deeply rooted belief that if something is said on TV or appeared in a widely read newspaper or magazine, it must be true. Don’t outsource your due diligence; don’t stop thinking for yourself, but keep in mind that other market participants will be influenced by the media and their reactions will impact your positions. The fact that something is immaterial to you and your time frame doesn’t mean that it doesn’t have the potential to alter risk appetite and move prices;
– Financial advisors: the majority are nothing more than trained salesmen and saleswomen, who work on commission – meaning the more they sell, the more they earn. They are trained and incentivized to suggest particular investment products that are pre-approved in advance from their central office. The new requirement for fiduciary responsibility is just dust in the eyes. Advisors options to customize financial solutions are limited;
– Experts: we could learn a lot from seasoned professionals, who have a proven track record of managing money for a living. Many are down to earth and are willing to share their knowledge, because they realize that in capital markets you never stop learning, you never cease adapting and the more you teach the more you learn. With that in mind, try not to fall into the mental trap of following someone blindly. There are way too many important factors that you probably don’t have access to when you try to mimic experts’ positions – time horizon, position size, risk management, hedging strategy. What you could do is to figure out the thought process behind their decision making, the underlying logic behind their moves and then incorporate the learned into your own method. If all of this seems like too much work, you have no place managing your own money. Find someone with proven track record and similar to yours risk preferences and wire him/her your money. Concentrate on something you have a passion for. Money managing is a serious business; it is not a hobby.
It is not hard to learn to recognize profitable setups. The biggest obstacle for the average investor/trader is the huge disparity between knowing and applying that knowledge in the heat of the moment. This concept is called an empathy gap – the difference between how we believe we will act in a future moment and how we actually act when the moment comes. We make our plans, we pledge to stick to them, but when the time comes we often forget about our intentions and we get lost in the craziness of market jungle. You can’t imagine how often I have caught myself thinking about pursuing a trade that doesn’t meet the requirements of the setups where I have an edge. Sometimes I manage to catch myself. Sometimes I don’t.
If we lost money every time when we followed our emotions, we would learn quickly not to do it. The reality is that no matter how bad we are in investing or trading, we just won’t lose every time. The worst thing that could happen to us when we emotionally open an unintended position is to make money out of it. The human brain is wired to reward us for gains, especially when they are unexpected. It releases dopamine – the chemical of satisfaction, which subconsciously teaches us to follow the same approach next time. The point is that in this case our reward was a consequence of pure luck. Much thinking and preparing were not involved in the process. Some say that it is better to be lucky than smart. I disagree with that notion for the simple fact that too much luck leads to forming bad habits, which will chase you for the rest of your investment life. In the long-run accidental profits build dangerous habits that eventually lead to disastrous consequences. Focus on the right process and the good outcome will come naturally.
Confirmation bias is the strongest in the heat of the moment. We are wired to like people who think like us, especially when they provide insights that make our investing case even stronger and more logical. Learn to respect people who think differently than you do. Often you might learn a lot from someone who criticizes your position.
We suffer from a deeply rooted desire for instant gratification, which urges us to sell profitable positions way too soon. We are also risk averse, meaning that between winning a $1000 and not losing a $1000, most of us would prefer the later. As a consequence, we are likely to stick to our losing positions until we break even at least.
In the heat of the moment we are not as cool and rational as we believe we would be. Often people are much more emotionally driven that they expect. Research shows that even experience doesn’t help when decisions have to be taken under time pressure in the heat of the moment. Human biases trump experience. The keys to minimizing the negative impact of our biases are in preparation (battles are won before they are fought) and selectivity (fight only battles that you can win). Run your screens based the factors that are important for your approach and create a plan of action when you are in a cold state of mind. If you have a long-term horizon, it is a good idea to isolate yourself from the market noise. Stop checking the quotes of your stocks every two minutes and changing your mind by every new rumor or opinion.
Understanding the concept of empathy gap is absolutely essential. If you contemplate this concept, then you will be able to figure out the main source of your investing mistakes – you.
It is the peculiar quality of a fool to perceive the faults of others and to forget his own