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Lesson 5: Market Psychology and Sentiment (Updated 11/29/2005 03:58 PM)
You're emotion in motion
My magical potion
You're emotion in motion to me
--Ric Ocasek
Objective
A primer on some human 'defects' that impede effective money management.
Emotion is the Enemy...
In this post, a Minyan emails Toddo that he is all 'twisted around' with his trading positions, and that he recently added exposure because he became impatient and that he was afraid that the market would rally without him on board. Words like 'impatient' and 'afraid' are expressions of human emotion are unwelcome visitors to financial thought processes. At the end of his reply, Toddo shares a familiar mantra of Minyanville: Emotion is the enemy when making financial decisions.
Why is emotion so detrimental to financial decision making? As Professor Succo notes in this fine example drawn from the 2005 Minyans in the Mountains retreat, emotion impedes clear thinking and causes people to take on more risk than they should when managing money.
Defective Wiring
Chart courtesy of StockCharts.com
We shared the above chart of the COMP in an earlier lesson. What caused the huge price run-up and subsequent decline expressed by the spike-like pattern in this chart? Although many factors likely contributed, we can confidently assume that human emotions played a significant role.
Greed, fear, impatience, complacency. Emotional responses that can get us into financial trouble. Emotions can cause us to be reward seekers rather than risk managers, thereby leading us to take on larger positions than than we should. Emotions can also cause us to stick with losing positions too long. The developing field of 'behavioral finance' has identified a number of psychological 'defects' that suggest that the average individual is not well wired to manage money. Let's take a peek at a few of these.
a) Taking More Risk When Losing
A distraught Minyan seeks advice from Toddo. Note his problem: he's lost money this year and he's desperate to 'make it back.' If you've invested in financial markets before, then perhaps you can relate. This individual's situation reflects a common defect in human 'wiring' that works against us in financial decision-making. Once we've lost money, we are often willing to take on more risk to try to get back to even. The tendency to take more risk when losing is part of what is known as 'Prospect Theory. In their seminal work, Kahneman and Tversky (1979) found that individuals take on more risk when they are losing money and less risk when they are ahead. If you think about it, this is the opposite what we usually should do. When operating at a loss, an individual should become more risk averse in order to preserve capital for better opportunities down-the-road (see Succo's example here). Todd's reply to the distraught Minyan: remove emotion from the decision making process, don't try for a 'quick fix', and wait for an edge. Sage advice for us all.
b) Anchoring
On the evening that I'm writing this, Procter & Gamble (PG) stock closed at a price of $55.96. If this is the first price of PG that you've ever seen, chances are that $55.96 will stick with you. You may even base future financial decisions on this price. For example, if at some point in the future you entertain buying PG, you might decide that you won't buy it unless the price goes lower that $55.96. The $55.96 price becomes an anchor--you are anchoring your future decisions to a particular price. An anchor is a reference point, and is often exerts considerable influence on subsequent decision making (e.g., Kristensen and Garling, 1997). While points of reference can be desirable, in financial matters they often cause folks to make arbitrary, irrational decisions. You might notice a relationship between anchoring and Prospect Theory a) above, since individuals tend to take on more risk as losses grow based on the position's price anchor.
c) Overconfidence Bias
Each of us tends to think we're better than average. In financial markets, participants commonly think they they can outperform market averages--often with poor results (Stone, 1994; Daniel et al., 1998). Think about it. There are 'macro' funds and institutions out there running billions out there with the resources (and motivation) to build the best information networks and analytical processes in the world. Yet, we often think we 'know' more than these folks. This would be humorous were it not for the financial consequences that often flow from this attitude. Does this mean that you should participate in financial markets? Not necessarily. It means that you need to 'wait for your pitch' and define your edge before putting capital at risk.
d) Framing/Selective Reasoning
As he shares some thoughts while managing a trading position, Todd notes (in the second bullet from the bottom) that he needs to constantly check himself to make sure that he's not engaging 'selective hearing'--listening only to arguments that support his position. This undesirable trait reflects a broader human 'defect' known as cognitive dissonance. As Professor Reamer elegantly explains here, cognitive dissonance refers to how humans deal with inconsistencies in their beliefs, and often results in 'selective' information processing that causes individuals (e.g., investors) to cling to their beliefs despite perfectly reasonable and factual evidence to the contrary. This process is sometimes referred to as 'framing'--as in framing all the facts in a way that is convenient to your point of view. Scott provides an example of framing based on a Mailbag question on Cisco Systems (CSCO). Framing can cause individuals to enter, or stick to, a financial position much longer than they should.
e) Running With the Herd
There's safety in numbers. This has been burned into our DNA from the caveman days. When it comes to financial markets, is running with the herd a good thing? After all, there can be a 'collective wisdom' to crowd behavior (Surowiecki, 2004) which helps underpin the 'efficient market hypothesis' (Fama, 1970). However, it has been long observed that crowds often get it 'wrong' (e.g., Mackay, 1852). Look no further than recent U.S. stock market history for a great example. A huge run up in stock prices in the late 1990's was followed by an equally breathtaking decline over the next couple of years. Making sense of financial market environments requires sensitivity to market phenomena that reflect herd behavior. We also need to be aware of the consequences and risks of running with the crowd, since prices tend to reverse when a trade becomes too crowded. Why so? Here's a rough model of one plausible herding mechanism:
- People observe a few individuals getting rewarded for their behavior
- A crowd grows as more and more people seek to join the herd for similar reward
- The crowd gains
power as more people seek the benefits of large numbers
- Once a herd loses ability to feed itself and its needs, the crowd dissolves, often quickly
Indeed, understanding the mechanics of herd behavior may be one of the most important tools in a market participant's toolbox.
Final Note
The list of 'defects' noted above is not exhaustive, but it offers some of the more common behavioral defects that often lead to financial decision-making breakdowns. Being aware that you possess them (you got them from your ancestors) is a good early step towards compensating for them. In the next lesson we'll discuss how to manage risk given these defects. (try the Quick Quiz down below to see what you've picked up)
References
Fama, E.F. (1970). Efficient capital markets: A review of theory and empirical work. Journal of Finance, 25: 383-417.
Daniel, K., Hirshliefer, D. & Subrahmanyam, A. (1998). Investor psychology and security market under- and overperformance. Journal of Finance, 53: 1839-1885.
Kahneman, D. & Tversky, A. (1979). An analysis of decision under risk. Econometrica, 47: 263-292.
Kristensen, H. & Garling, T. (1997). The effects of anchor points and reference points on negotiation process and outcomes. Organization Behavior and Human Decision Processes, 71(1): 85-94.
Mackay, C. (1856). Memoirs of extraordinary popular delusions and the madness of crowds. London: Office of the National Illustrated Library.
Stone, D.N. (1994). Overconfidence in initial self-efficacy judgements: Effects on decision processes and performance. Organization Behavior and Human Decision Processes, 59(3): 452-474.
Surowiecki, J. (2004). The wisdom of crowds: Why the many are smarter than the few and how collective wisdom shapes business, economies, and nations. New York: Doubleday.
Quick Quiz...
5.1) Each of the following is a typical consequence of emotional financial decision making EXCEPT
- taking on a riskier market position than prudent
- quick decisions out of fear of missing a market move
- ability to rationally process information
5.2) Amy invests $10,000 in the NASDAQ 100 Trust Shares (QQQQ). Over the next two weeks, the market drops. Amy goes online to check her account and sees that she is down $700 (%7) on her initial position. According to prospect theory, Amy will be tempted to:
- add to her position
- sell her position
- await further developments
5.3) Steve bought 100 shares of JDS Uniphase (JDSU) at $125/share in mid 2000. As shown in the chart below, JDSU share price started falling. Steve thought about selling his position a couple times, but decided to hold it in the hope that the price would return to $125 so that he could break even. Although the stock currently trades much lower, Steve still dreams of the day when JDSU hits $125 again so that he can sell.
Chart courtesy of StockCharts.com
Steve appears guilty of
- anchoring
- pessimism
- trading
- risk management
5.4) Most individual feel that they possess above average investment skills.
- true
- false
5.5) Heading back to our friend Steve (see question 5.3), in early 2001 JDSU stock price hit $50. Steve, nervous after seeing his initial investment fall by more than 50%, sought out research reports from Wall Street analysts who covered JDSU. He obtained 10 reports. Five of them were done by analysts who rated JDSU as a 'buy', three of them by analysts who rated JDSU as a 'hold', and two by analysts who rated JDSU as a 'sell.' Left to his own devices, Steve is likely to be attracted to:
- all of the reports
- the five 'buy' research reports
- those reports with a negative view on JDSU
5.6) Returning once more to Steve (questions 5.3 and 5.5), Steve purchased his JDSU shares in mid 2000 after learning that six of his colleagues had purchased the stock and said they were making a fortune. Steve's actions are typical of
- fundamental analysis
- contrarian thinking
- bearish assessment
- herd behavior
Answers: 5.1) c 5.2) a 5.3) a 5.4) a 5.5) b 5.6) d
