Summary of Inside the Investors Brain by Richard L Peterson

Inside the Investors Brain by Richard L Peterson

“[John] had, I think, a profound ability to control the two emotions that commonly destroy traders—fear and greed.

In the media reports about the fund, the root causes of its rapid demise were identified as psychological. After several years of success, greed, hubris, and arrogance infected the partners’ decision making and impaired their communication. In investment management, mathematical genius may perform well in the short term, but it is no substitute for emotional intelligence.

In the midsummer of 1720, Newton foretold a coming stock market crash, and he sold his shares of the South Seas Company for a profit of 7,000 pounds. Subsequently, however, Newton watched the Company’s stock price continue to rise, and he decided to reinvest at a higher price. Newton then remained invested as prices started a precipitous decline. Soon panic ensued, and the bubble collapsed. After the dust had settled from the stock market crash of August 1720, Newton had lost over 20,000 pounds of his fortune. As a result of these losses, he famously stated, “I can calculate the motions of heavenly bodies, but not the madness of people.” Newton’s fear of missing out on further gains drove him to buy shares as the price soared higher. His inertia during the panic led to the loss of most of his assets.

Emotion plays too large a part in the business of mining stocks. Enthusiasm, lust for gain, gullibility are the real bases of this trading. The sober common sense of the intelligent businessman has no part in such investment.

While the focus of market manias changes, the psychology of speculators remains remarkably similar over the centuries. Mathematical brilliance and Nobel Prizes (in the case of LTCM), scientific genius (in the case of Newton), and creativity (in the case of Clemens) do not insulate against investment failure. As we’ll see in this book, accolades and success can actually impede investing success. In all three cases, as warning signs became apparent, the investors remained in an overconfident worldview, dismissing risks and turning their attention away from prudent money management. Then, as their wealth evaporated, they remained passive in the face of losses.

Emotions easily overwhelmed reasoning when money is at stake. When times are good, investors take them for granted and do not prepare for risks. When markets turn sour, they are not paying attention often holding on to their positions too long while hoping for a comeback or denying that there is a problem.

In many ways, the stock market is a collective estimation about the future of the economy. The stock market has no defined outcome and no defined time horizon. Prices in the financial markets both inform and influence participants about the future.

In order to find advantages in the markets, one must search for “diversity breakdowns.” Diversity breakdowns represent collective overreactions or under-reactions to new information, often leading to mispricings that ultimately correct themselves. Investment profits can be made both as the mispricings form and as they break down.

Damasio’s research implies that people need feelings to signal when to avoid losses in risky environments. When making risky decisions, there is a gap between what the emotional brain (the limbic system) knows about risk and one’s conscious awareness of the actual danger.

Because the reward and loss systems influence thought and lie beneath awareness, they often direct behavior automatically through subtle emotional influences on judgment, thinking, and behavior.

That caution is a good thing, because that’s how people learn to avoid unhealthy risk. In the markets, most investors take away lessons where none exist. They learned to avoid technology stocks after the losses of 2001, even though the bear market losses should have had little impact on non-Internet stock performance going forward.

After suffering bear market losses, most investors wait for price “confirmation” before jumping back into stocks. They may even sit out the market until new highs are reached. Of course, waiting for confirmation means missing much of the price move, but that’s the price many people are willing to pay for enhanced confidence.

Describing the mind in terms of brain circuits, personality traits, and genetic influences is deceptive. Individuals are not pieces thrown together into one predictable whole. Each person is different, unique, and incomprehensibly complex. They each nurture their own authentic interests, hopes, and aspirations. The human brain is the complex organ that gives rise to who we are, and its mysteries remain largely uncharted.

The reward system is the origin of several important financial biases. Increased reward system activation can generate optimism, overconfidence, and excessive risk-taking.

And it is a person’s interpretations of events that give rise to strong emotions. Emotions are subjective feelings that serve as easy shortcuts (or heuristics) for the brain.

This distinction between anticipatory and reactive emotions is important. Amateur investors often buy stocks based on their expectation of a price change in their favor. Anticipatory positive emotions are likely to bias this investor’s expectations and inappropriately diminish their risk perceptions. Investors often sell stocks in reaction to events, whether a bigger than expected profit or a piece of unexpected negative news. Such reactive selling is typically not in response to a rational plan, but rather emotionally driven.

Affect is a word that broadly refers to emotional experience. Feelings, moods, and attitudes are all affects. Shortcuts in the thinking process due to feelings are functions of “the affect heuristic.” A heuristic is a type of mental “short-cut,” where rather than objectively reasoning through a decision, individuals choose based on a “hunch.” The term affect heuristic was coined by Professor Paul Slovic.

Emotionally, the affect heuristic refers to the feeling “tags” that people place on complex judgments. For example, when asked about Google and IBM, an investor may feel (and subsequently think): “Google is good and exciting” or “IBM is old and boring.” Their thoughts arise from internal emotional tags that are attached to each concept. These tags serve as simple and rapidly accessible judgments. The affect heuristic allows for quick decision-making under conditions of time-pressure and uncertainty.

Strong anticipatory and reactive emotions alter judgment and guide decision making through a brain system that generates and monitors goal pursuit. A diffuse brain system called the comparator assesses whether one is making expected progress toward one’s goals. When expectations of goal progress are exceeded, happiness arises. When expectations are not met, disappointment occurs. The comparator underlies most human motivation and behavior.

The brain’s comparator assesses one’s actual goal progress against one’s expected progress. When self-monitoring, it is where one stands relative to expectations that determines which emotions arise and how one will consider a strategy for closing the gap going forward. The comparator is a feedback system that maintains motivation.

Goal avoidance refers to the function of the loss system, which motivates individuals to avoid or escape dangerous circumstances. When loss avoidance is successful, feelings of relief occur.

Alternatively, when success is measured according to an internal benchmark, such as an improved decision process or clearer judgment, then it remains an enduring motivation and leads to long-term excellence. Portfolio managers who focus on refining their decision process, stoking their curiosity, and developing a sound investment philosophy are more likely to be long-term outperformers. Chapter 22 discusses this issue in more detail.

Via the comparator, emotions arise when feedback about one’s expectations is received. The level of attachment to one’s expectations (ego involvement) determines the strength of his or her emotional responses to goal-related feedback. This explains the popularity of Zen- and Buddhist themed books for traders and investors. Teaching detachment from the outcome, not the process, is the goal of these books.

Outcome comparisons arouse emotions. Detaching oneself from outcomes reduces one’s emotional arousal and emotion-driven judgment biases.

Beliefs and Expectations: The Placebo Effect: Sometimes expectations of successful goal progress create a self-fulfilling prophecy. A belief in one’s ability to achieve a goal activates inner resources to support goal pursuit. Such success beliefs prompt supportive neuro-chemical shifts, which enhance mental and physical endurance.

The placebo effect is an important example of how one’s beliefs, desires, and expectations can align to change his or her state of being. When a physician gives a patient a medicine, it represents a belief that the patient will get better, which reinforces the patient’s internal motivation to regain health.

While the placebo effect can improve health based on a belief in a positive outcome, a nocebo effect is an ill effect caused by the suggestion or belief that something is harmful. In both the placebo and nocebo effects, the expectation of an outcome creates a self-fulfilling prophecy.

A stock’s P/E ratio generally reflects investors’ growth expectations. Ironically, stocks with low ratios (and low expectations of growth) often outperform those with high ratios over time. This is one tenet of value investing (see Chapter 23). One reason why value strategies work well is that investors’ low expectations are more frequently positively surprised, leading to increased positive emotion being associated with the low P/E stock, while high P/E stocks more often disappoint because the “good news” is already priced-in.

How investors interpret news and events depends on their underlying emotional outlook. Optimistic investors see a sharp price plunge as an opportunity to “bargain shop” for cheap shares, while pessimists view it as evidence that the global financial system is collapsing.

Interestingly, there are periods of time when strongly negative news doesn’t impact an optimistic market, and times when positive news cannot revive a bear market. During these periods, investors are succumbing, on a group level, to emotional defense mechanisms. Emotional defense mechanisms are a form of self-deception that distort investors’ interpretations of news that contradicts their strongly held beliefs.

Individual investors have their own emotional defenses and contortions of logic to contend with. Especially when under stress or when confronted with negative personal information, the brain has a tendency to cope by means of self deception.

Emotional defense mechanisms are the process by which the mind minimizes the negative emotions that arise from an unfavorable comparison. Negative emotion can be attenuated through distorted logic (rationalization), avoidance (denial), believing an internal feeling is also being felt by another (projection), or blaming circumstances out of one’s control (externalization). In an example of projection, when investors feel uncertain about the market’s future direction, they often believe their own disorientation is a result of “market uncertainty.”

More often than not, the source of the uncertainty is in the investors themselves. One example of externalization is retail traders blaming their market losses on “manipulators” rather than taking responsibility for them. Defense mechanisms operate unconsciously, yet they have a profound effect on the ability to perceive reality and develop accurate expectations.

·         The hindsight bias, rooted in memory, involves excessively optimistic assessments of one’s past accomplishments, often fueling further misguided endeavors.

·         The confirmation bias drives an active search for facts that support one’s opinions and beliefs, while contradictory information is ignored.

·         The projection bias involves misjudgments about one’s future needs and desires, arising from one’s belief that one’s current emotional state is similar to what one will feel in the future.

One defense mechanism, which is a type of rationalization, is called motivated reasoning. Motivated reasoning is thinking biased to produce preferred conclusions and support strongly held opinions. Like other defense mechanisms, motivated reasoning can be viewed as a form of emotion regulation, in which the brain moves one toward minimizing negative and maximizing positive emotional states.

Not only do people underestimate the likelihood of negative feedback about themselves, but even after they are presented with it, they tend not to believe it (and actively argue against it)! These results suggest that emotional defense mechanisms may be a neural process in which individuals are driven to find information or adopt beliefs that increase reward system activation (and reduce negative emotions).

People who engage in motivated reasoning perform more poorly on decision-making tasks than those who are less defensive about negative information. In conclusion, “A skeptical mindset may help people avoid confirmation bias . . . in everyday reasoning.” Actively confronting uncomfortable information led to superior decision making.

Courage is essential when facing uncomfortable negative emotions. During a bear market it is easy to think about the economy pessimistically—everyone is doing it. The goal in such a situation is to look for the positive aspects of the economy—the ones that are being overlooked. This requires balanced thinking, courage, and a willingness to look at all available information with equanimity.

George Soros indicated that one of the keys to his acumen is the ability to non-judgmentally think about why his investment reasoning process may be wrong (his theory of fallibility).

ANALYSIS AND INTUITION: Nobel Prize winner Daniel Kahneman postulates that there are two broad neural systems underlying decision making: the analytical and the intuitive. Analytical judgment is primarily logic based, while the intuitive system is rapid and feeling based.

Traditional investment theory assumes that people use reasoning and objective analysis during decision making. According to traditional theory, investors slowly and mechanically judge potential outcomes, weighing their probabilities and their potential gains or losses, to arrive at a rational analytical decision.

They arrive at a choice after a series of calculations—a “risk-reward analysis.” Yet, in a world where ultimate outcomes are uncertain and volatility can arise unexpectedly, investment practice is not as rational as theory suggests. Currently, however, there is no single coherent psychological theory to counter the assumption of investor rationality.

The human senses relay about 10 million times more pieces of information per second to the brain than can be consciously perceived. How can the brain possibly process all this data? The brain uses simplifications and shortcuts to facilitate information processing. The vast majority of our daily decisions are intuitive decisions - decisions made rapidly, automatically, and beneath conscious awareness.

Intuition and “gut feel” often underlie some of our most consequential decisions. Intuitive decision making is honed unconsciously, through experience, and it is the foundation of more than 90 percent of all decisions.

The study of “emotional intelligence,” pioneered by business psychologist Daniel Goleman, arises out of evidence that emotional competencies are more conducive to business success than purely intellectual IQ.

Researchers have found that emotions induced by one event will color how we think about other, unrelated situations. For example, in one experiment, participants who read happy newspaper articles subsequently made more optimistic judgments about risk than those who had just read sad articles

Yet the pitfalls of over thinking, strong emotional biases, and subliminal emotions render intuitive judgment excessively biased for most investors. Experience (gained through honest appraisals and rapid feedback) and emotional intelligence (specifically self-awareness) are the remedies that excellent investors use to fortify the intuitive process.

The research literature has identified many ways in which emotions alter the brain’s information processing and decision-making capacities. Emotional decision makers often become attached to information that supports their emotional state while ignoring contradictory evidence. Short term emotions and moods (all called emotion henceforth) arouse an inclination to take action. If an action is not taken, then the emotion will linger. Subconscious emotions will bias judgment and decision making very subtly until they are appropriately discharged.

It’s human nature to react emotionally when events do (or do not) go one’s way. Furthermore, nothing has to happen for someone to experience emotional reactions. The simple act of imagining possible outcomes, such as great successes or terrible losses, stimulates emotion. Most investors have felt nervousness during sideways markets,

elation during bull markets, and intense doubt and fear during sharp market downturns. Each emotion uniquely alters how investors think and what they subsequently do with their capital.

Positive emotions signal that life is going well, goals are being met, and resources are adequate. In these circumstances, people are ideally situated to “broaden and build.” Negative emotions, such as fear and sadness, are characteristic of a self-protective stance in which the primary aim is to guard existing resources and avoid harm. Each stance, optimism and pessimism, has characteristic effects on financial judgment.

Positive emotions prepare the individual to seek out and undertake new goals. Positive emotions, such as happiness, contentment, satisfaction, and joy, are characterized by confidence, optimism, and self-efficacy.

Happy people interpret their own negative moods and damaging life events with more optimism and respond to them in more positive, affirming ways than more pessimistic people. There is a positive feedback effect of good mood on well-being. Chronically positive people have better immunity and physical health than others.

Researchers have found numerous effects of positive mood on judgment. Subjects in a positive emotional state tend to reduce the complexity of decisions by adopting a simpler process of information retrieval. Happiness is associated with the greater use of cognitive heuristics (“shortcuts”) such as stereotypes. Positive people disregard irrelevant information, consider fewer dimensions, recheck less information, and take significantly less time to make a choice than people who are feeling negative.

During financial gambles, positive people choose differently than negative ones. When stakes are high, people in positive emotional states try to maintain their positive state and avoid substantial losses. In contrast, if stakes are low, joyful decision makers become risk seeking in order to benefit from the gain (though without wagering so much as to risk their happiness). In terms of behavior, happy people act to avoid the possibility of a large loss in order to protect their positive emotional state. So while happy people make more optimistic judgments, in situations where they foresee a reasonable likelihood of large losses, they avoid taking risk.

In behavioral finance research, one of the most prevalent biases is the tendency to hold losing stocks longer than winning stocks. That is, most investors too frequently “let their losers run and cut their winners short.” This is called the disposition effect (discussed in detail in Chapters 14 and 15). Many academics believe that the disposition effect is due to the “fear of regret.”

Selling a losing stock is tantamount to admitting that one was wrong. Feeling wrong inspires painful regret. To avoid regret, investors hold on to losing stocks while hoping for a comeback that will vindicate their initial buy decision. They sell winning stocks too soon because they fear that the stock will drop, giving back their gains, and they will regret not having taken their paper profits off the table while they had the chance.

Regret about a recent loss, even a loss as a result of a random event (such as the flip of a coin), drove people to irrationally reduce their risk taking. Making one’s own investment decisions is more emotionally gratifying than following a broker’s advice. Psychologists think sadness creates the desire to change one’s circumstances. Sadness-driven stock transactions are fueled by hopes of quick gains and offer a distraction from psychological pain.

Lerner found that participants in a disgusted emotional state were emotionally driven “to expel.” That is, disgusted people want to “get rid” of items they own, and they do not want to accumulate new ones. As a result of the experimental subjects’ disgust, they reduced both their bid and offer prices for the consumer items.

The “endowment effect” is a common cognitive bias in which people overvalue items they already own. The endowment effect causes the average seller to demand a higher price for an item than the average buyer thinks is reasonable. Inducing disgust led to the elimination of the endowment effect among both buyers (disgusted buyers lowered their average bids) and sellers (disgusted sellers lowered the average offer price).

In the case of sadness, Lerner noted that “sadness triggers the goal of changing one’s circumstances, increasing buying prices [bids] but reducing selling prices [asks].” When the researchers provoked sadness in the subjects, the endowment effect was reversed. That is, compared to people in neutral emotional states, people who had viewed sad movie clips subsequently valued items they owned less and items they did not possess more. Recall that disgusted people valued all items less, whether they owned them or not.

As levels of both anger and happiness increase in people, they report increasing optimism about the future. For angry people this optimism is presumably because they feel in control. Fearful people report increasing pessimism as their level of anxiety increases. Again, two emotions of negative valence (fear and anger) have different effects on future expectations.

Fearful people are averse to risk, while angry people are as comfortable with risk as happy people. The decisive factor in risk taking is perception of control. Fearful investors feel insecure and out of control. As a result, during market declines, the fearful are more likely to sell out. Angry investors have identified the enemy and feel in control of the situation. They hold on to declining stocks because they are more certain of their position.

Emotional individuals often have trouble predicting how they will feel in the future. They incorrectly assume that their future emotional state will resemble their current one. As a result, they imagine that their current preferences will remain constant into the future. Because they cannot accurately project themselves into the future and subsequently empathize with their condition, they have a bias of “projection” when planning for their future selves.

As a result of projection, most people under-appreciate their powers of adaptation to unforeseen events. Another error caused by projection is the exaggeration of the impact of attention-grabbing events. One remedy for the projection bias lies in maintaining a healthy skepticism when attributing “moods” to the market. Another solution is to better appreciate how one’s current and future emotional states alter one’s perceptions of financial risk.

When people first become aware of the emotional influences on their decision making, they often have difficulty with over- or under compensation. Increased vigilance and self-awareness can be effective for reducing the effect of weak to moderate emotions on decision making. It is helpful if one sets up techniques for emotion management in advance for self awareness interventions to be effective. When in a particular emotional state, one cannot clearly see how their thinking patterns have changed.

Others fall for scams because they were late entering the market and want to catch up with the winnings it seems everyone else is reaping. This greed and desperation make investors putty in the hands of those willing to take advantage of them. For an investor considering an opportunity, the idea of missing out overcomes the last remnants of resistance.

Among investors, greed leads to financial losses through overtrading, entering investments too late, and inadequate due diligence. It shares a biological foundation with psychological biases such as overconfidence, the illusion of control, and the house money effect. Greed that follows a series of profits is fuel for hubris. Broadly speaking, greed is a result of a convergence of factors: the desire for gain, the motivation to pursue opportunities, the disregard of risks, and a penchant for excess.

On an individual level, greed has deleterious effects on performance, yet greed is a common facet of human behavior. Can learning about greed improve one’s profits in the markets (to be sure, a greedy motivation)? For many investors, locating stocks with large profit potential and anticipating their high returns is one of the exciting (and occasionally addictive) aspects of investing. Managing the greed that accompanies a normal investment process is an enduring challenge.

Per Knutson in the press release, his findings “may also explain why casinos employ ‘reward cues’ such as free drinks and surprise gifts as anticipation of other rewards that may activate the NAcc and lead to changes in behavior.

. . . Insurance companies might employ the opposite strategy, using strategies that would activate the anterior insula.”

Emotions are part of both rational and irrational choice behavior. It’s the extremes of emotion that lead to excess. Intense emotions, such as greed and fear, are indicators that one is susceptible to the risk-aversion and risk-seeking

mistakes seen in the Kuhnen and Knutson study. Deliberate action to interrupt emotional decision making, even something as simple as taking a deep breath, may be the most efficient means for reducing excessively emotional decision making. Whenever you’re facing a big decision, and you feel excited, step back a moment and think it over.

For overconfident investors, risks are ignored and their belief in themselves is hypertrophied.

A third type of overconfidence involves one’s belief of control over random, independent events—called the illusion of control. Many people erroneously believe that they can control, predict, or somehow influence random events. The authors concluded that “An early, fairly consistent pattern of successes leads to skill attribution, which in turn leads subjects to expect future successes.”

There is also a tendency to blame negative outcomes on uncontrollable circumstances and to take credit for positive outcomes as a result of one’s foresight and expertise. Too often, people attribute success to their own judgment (and expert predictive ability) and loss to external forces beyond anyone’s capacity to forecast.

Based on this result, the experimenters argued that familiarity and choice lead to an illusion of control. Other researchers found that the illusion of control is actually an over confidence in one’s predictive abilities, not a belief that one can control the outcome. People are more attached to, and value more highly, their personal prognostications and stock picks.

When an action has yielded large rewards consistently, to the point of satiation, then one can shift his or her cognitive resources elsewhere. Soon, the risky activity will be undertaken with little attention paid to potential dangers.

For many people, there is an internal success thermostat. That is, when investors achieve their financial goals, then their motivation drops off. People need challenge to prosper, and when victorious at one activity repeatedly, the novelty wears off and complacency sets in. As a result of this complacency, risks are disregarded, and losses may suddenly ensue.

In great investors, confidence underlies resilience following losses, and it allows one to change strategy on a whim. Confidence lies atop an intrinsic sense of certainty and self-esteem, usually learned by successfully overcoming challenges, and confidence itself perpetuates success in many businesses.

Confidence is imperiled in traders who invest without a plan. Market volatility and unpredictability will quickly erode their self-esteem and unnerve them. Self-discipline and preparedness are necessary to maintaining healthy confidence.

Journaling can be an effective (if time-consuming) way of self-correction. Journaling involves keeping written records of one’s thought process (logic), subsequent decisions (actions), and outcomes (results). If one reviews his journal entries periodically, he may see patterns of thinking that underlie bad decision making.

The primary qualities he looks for when hiring traders as “passion and humility.” Passion is a product of a strong reward system (particularly the NAcc), and humility is an antidote to overconfidence. Furthermore, conscientiousness is crucial if one is to learn from mistakes and keep one’s passion well directed: “Integrity is the single most important thing to me in hiring.”

Anxiety is such an uncomfortable feeling that people will often accept greater short-term pain just to end an anxious waiting period quickly. There is a psychic cost to anticipating a negative event, which is a result of the attention and energy our minds devote to “dread.”

The placebo effect is a fascinating example of the prefrontal cortex’s power—demonstrating how beliefs and expectations alter how we experience the world. Most people’s level of anxiety is reduced by placebos, implying that there is a significant element of cognitive control that underlies fear. It is possible to profoundly alter physical and emotional experience by altering one’s beliefs.

When considering entering a risky investment, anxiety gives rise to risk-averse behaviors such as “hesitation pulling the trigger,” “second guessing,” “analysis paralysis,” “reflecting,” “delaying,” and “fear of entry.” In fact, many investors want to see price “confirmation” before feeling confident enough to buy. This may be a result of the projection bias in which declining stocks are seen as likely losers and rising stocks are extrapolated into the future as winners.

“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.

Ariely found that as task payoffs increased, motor skills increased, but cognitive skills decreased. Importantly, subjects performed worse at the mathematics task when more money was at stake. According to Ariely, this cognitive decline when under stress is due to a shift in decision-making strategy. Under stress, the brain shifts its processing and decision functions from “automatic” to “manual” control. “Manual” control implies that the participants are over thinking their task strategy. The brain’s realignment to a “manual” strategy is unconscious and very difficult to reverse once play has begun.

As stakes increase, investors have trouble using smooth intuitive decision making. When they realize that the amount of money at stake in their investments is larger than ever before, they can easily lose their focus and concentration. They inadvertently shift from automatic to manual cognitive control, and this shift ruins their ability to fluidly respond to market events.

Experienced traders do in fact have decreased stress responses to market volatility, but not improved performance.

Many people develop stress related disorders because they chronically do not discharge their stress-primed action tendencies. This may be one reason why exercise is so beneficial for health—it discharges the physical action potential.

One of the ugly sides of trading. While some traders achieve tremendous success, others take excessive and unsustainable risk. The thought traps that gamblers fall into are exaggerated versions of the cognitive biases that afflict many investors.

Some investors turn into gamblers during bull markets. They start making money easily. They increase their position sizes. They do well and feel invincible. Money comes to them effortlessly. They don’t realize how much risk exposure they have taken on. Then one day they find themselves rapidly losing, and they don’t understand what is happening. Because their “illusion of control” (see Chapter 8) has been reinforced by early gains, they continue with the same old strategy, and they lose more and more, until they’ve lost not only their paper profits, but also their principal. Education about mathematical probabilities did not change gambling behavior in one study, indicating that the decision to gamble tends to be an emotional, not an intellectual, process. Warnings that describe irrational gambling beliefs do decrease gambling behavior, which implies that irrational beliefs and expectations can be changed when they are directly contradicted (as can happen in psychotherapy).

Introverts are typically quiet, low-key, deliberate, and less engaged with the social world. Introverts are comfortable without much social involvement, and this is neither due to shyness nor depression; they simply need less stimulation than an extravert and are more likely to prefer being alone. Introverts agree with statements such as “Avoid crowds.” Introverts are motivated from an internal drive rather than from outside stimulation. That is, they generate motivation and excitement internally rather than seeking for external triggers.

Furthermore, it is crucial to remain “present” with what is happening in the markets. Rumination or deliberation about past events is self-defeating. Recalibrate yourself to each day, so that every position appears fresh, as if it was just opened.

Chapter 13; Liking something, regardless of mathematical outcomes, is called utility. Decisions made using “expected utility” rely on considerations of what people value qualitatively. Because the market future is fundamentally uncertain, most investors make decisions based on expected utility rather than expected value calculations.

Utility is a largely subjective phenomenon. Decision theorists say that a sense of utility comes from: (1) current feelings (moment utility), (2) the feelings one expects to have after receiving an outcome (outcome utility), (3) the process of making the decision itself (decision utility), and (4) one’s recall of past similar experiences (experienced utility).

The theme that runs through these various types of utility is feelings—utility is boiled down to how one feels about a decision and the expected outcomes. In the end, investors often pursue the decision that they expect to make them feel the best.

In a challenging decision environment such as the stock market, most people make systematic errors in their outcome probability and size estimations. These errors are often due to the biasing influences of feelings on the analysis of uncertain or ambiguous information. Perhaps surprisingly, even in perfect circumstances where all outcome information is known, investors still demonstrate biased decision making.

Brain imaging studies show a disproportionate effect of outcome size versus probability on decision making. As the size of a potential monetary gain increases, so too does reward system activation (specifically the nucleus accumbens).  Potential reward size is more emotionally arousing than proportional changes in probability.

The largest absolute reward ($5) was extraordinarily more exciting than the absolute $1 reward. That is, subjects were watching primarily the size of the potential reward, not the probability, even when they had equivalent expected values.

Professor Paul Slovic has found that emotion plays a leading role in distorting probability judgments. According to the “affect heuristic,” when the outcome of a gamble has a strong emotional meaning, people mentally overweight the size of the potential reward (or loss) versus its actual probability in their decision making.

When an outcome is possible but not probable, people tend to overestimate its chance of occurring. This is called the possibility effect. When an outcome is likely, people tend to underestimate its odds. This bias has been named the certainty effect.

For the most part, there is dissociation between intellectual judgments of risk and emotional feelings about risk. Emotions in uncertain or risky situations are more sensitive to the possibility rather than the probability of strong consequences, contributing to the overweighting of very small probabilities.

Emotionally, investors have stronger reactions if possible outcomes are more vivid or imaginable. Likewise, a vividly imagined possibility of bankruptcy, personal poverty, job loss, or market panic will generate the desire to sell any assets that carry such risks. The possibility of wealth and material success in an impulsive and inexperienced investor will lead to a strong drive to buy securities that appear promising.

Feelings of fear or worry in the face of decisions under risk or uncertainty have an all-or-none characteristic: they are more sensitive to the possibility rather than the probability of negative consequences. For example, the thought of receiving a painful electric shock is enough to spark intense fear in experimental subjects. The increasing vividness of a potential reward or catastrophe exaggerates the possibility effect.

AMBIGUITY AND UNCERTAINTY: “The fundamental law of investing is the uncertainty of the future.”

Most people are averse to uncertainty and ambiguity. People shy away from decisions about which they have insufficient information, especially when an alternative decision with more information is available or the decision maker has less information about a choice than others. People prefer to make decisions where they know the odds and the possible outcomes, and they avoid investing where the odds are unknown. With experience, they learn to infer the approximate odds in a situation.

AMBIGUITY IN THE MARKETS: “The future is never clear, and you pay a very high price in the stock market for a cheery consensus. Uncertainty is the friend of the buyer of long-term values.”

Stocks with poorer earnings quality (having more ambiguous information) have greater long-term returns than those with better (more transparent) accounting. As a result of aversion to ambiguous items on accounting statements, investors mistakenly avoid such stocks and miss out on greater long-term returns. The effect of accounting ambiguity may be to bias how investors feel about the stock in question. Investors with limited information about a stock are more likely to rely on their feelings when judging whether to buy or sell shares. In the case of poor earnings quality, those feelings are likely to be excessively negative.

A contrarian approach to sentiment improves returns in more ambiguous and uncertain stocks.

Emotion also plays a role in how investors feel about the “idea” or story behind a stock. Researchers found that emotion and imagery, aroused by the concept of a stock, bias predictions of stock performance. According to researchers, emotion and imagery may be the only judgmental bases on which individuals are able to rely when information about a financial offering is vague. Stocks with exciting stories cause people to forecast higher stock returns.

People are more willing to take a chance when other options won’t give them the payoff they want. During the Internet bubble, as investors and portfolio managers scrambled to catch up with their perceptions of others’ wealth, they may have felt a more acute need to take a chance for profit.

In other scenarios, psychologists have found that people tend to believe they can have what they want, regardless of evidence to the contrary. The intensity of one’s desire for an outcome increases one’s estimation of the likelihood he or she will actually get it. Their wanting creates overconfidence in their skills, which translates into an expectation of success.

In another study, participants told to expect an outcome that conflicted with their desires gave no weight to the evidence. They remembered information that supported their ability to get what they wanted, rather than the explicit information telling them to expect otherwise.29 If investors want to believe that a money-losing Internet stock is more valuable than one with earnings, then they will value it higher, regardless of the evidence. These studies demonstrate the “confirmation bias,” in which information supporting one’s desires is accepted, but evidence contradicting them is ignored.

Caltech researchers designed a monetary experiment to identify the different brain regions directing risky decision making (where probabilities are known) and uncertain decision making (where information about probabilities and outcomes is absent). As seen above, in prior experiments on risky decision making, participants were more likely to take risk when the probabilities were known versus when the odds were ambiguous.

Investors are uniquely susceptible to distortions in probability assessment, especially when events are novel or rare. The market future is uncertain, and information is too often ambiguous. Emotions play a large role in biasing low probability assessments.

THE TRUSTING BRAIN: When people hear ambiguous or uncertain information and must make a rapid decision, how do they assess if it is truthful? If they trust the source, then they are likely to take the information at face value. It appears that trust feels good, and people trust a news source when it agrees with their underlying political beliefs and biases.

Additionally, now there is some indirect evidence that it is important for financial advisers to be both physically presentable and financially generous (e.g., fee discounts) with clients in order to encourage trust and prevent emotional misunderstandings.

Zak may have uncovered a biological mechanism (oxytocin level) for such investor biases as the endowment effect (loving a stock), the urge to reciprocate financial adviser fee discounts, confusion between loving a company and seeing its stock as a good investment, and the home bias.

Because the future is intrinsically uncertain and market dynamics change, the past is a poor guide to the future. When assessing ambiguous or uncertain information, investors overestimate the probability of danger.

They often utilize the emotional defense mechanism of projection, which drives them to overestimate risk in ambiguous data due to their own fear.

Emotions such as fear also lead to the overestimation of the likelihood of low probability events that are vivid or emotionally weighted. Ego attachment to particular outcomes increases the severity of such biases.

Self-awareness of risk-perception biases is challenging due to the thought distortions that arise from unconscious emotions. One will truly think that the danger exists and will search for confirming evidence to justify their fearful risk aversion.

Trust appears to be strongly related to perceptions of risk, and investors perceive less risk in situations where they trust both the information they receive and the source delivering it.

Chapter 14; Most investors sell their winning positions too soon, thus “cutting winners short,” and missing out on greater long-term gains. According to some experts, selling winning positions too soon is a result of “seeking pride.” Others believe that cutting winners short is driven by the fear that one might lose what one has recently earned (“I don’t want to give it back”). As we’ll see in this chapter, selling winners too soon is one side of the psychological bias called the disposition effect.

THE DISPOSITION EFFECT: There is an old Wall Street adage: “Let your winners ride, and cut your losers short.” This saying is a warning against the cognitive bias of “loss aversion.” Loss aversion is characterized by a strong desire to avoid realizing losses. People are more sensitive to the possibility of losing money or objects than they are to the possibility of gaining the same objects or amount of money.

Loss aversion is at the root of a bias called the disposition effect. Researchers use the name disposition effect to describe the application of loss aversion to investing. Investors who suffer from the disposition effect inappropriately cut their winners short and let their losers run.

Loss aversion is one tenet of the Nobel Prize winning theory of decision making called prospect theory. Prospect theory is built on a foundation of simple psychological experiments that show how most people rely too heavily on frames, reference points, and anchors when making risky decisions. People perceive many financial decisions in terms of their frame—whether they are viewed as a potential loss or a potential gain.

Reliance on frames and reference points causes systematic distortions in decision making. One tenet of prospect theory, loss aversion, explains that people typically overweight the pain of losses twice as much as the pleasure of gains when making decisions.

The concept of loss aversion is not easy to understand. In Chapter 9 you read a study from Greg Berns at Emory University indicating that “dread” spurs individuals to take their losses as soon as possible. The “dreaders” paid money so that they could experience a feared electric shock sooner. On the surface, this result appears to contradict the disposition effect, in which people essentially pay more to avoid taking losses.

The fact is, in disposition effect experiments there is always a chance that the feared loss will not occur. When a loss is believed to be certain, as in the Emory study in Chapter 9, then people will actually pay more to “get it over with.”

In the markets, because the future is uncertain, the gap between dread relieving selling and loss-averse holding lies in one’s beliefs about how the future is likely to play out. Namely, if people think they have a chance to make their loss back, then they will hold on. However, when strong emotions take hold, they overwhelm the prefrontal cortex and drive thinking.

Strong fear, and the physiological effects of stress hormones, will predispose one to catastrophic thoughts of further declines and financial ruin. If an investor thinks their position is hopeless, or the stress of holding a losing position has grown too intense, then they will impulsively cave in to the sell urge. Panic selling occurs when further losses appear guaranteed or the tension of holding a loser has grown too high.

The disposition effect is particularly a problem for individuals who buy and sell investments based on price movements. When such investors are watching their profits and losses (P/L), and they are significantly profitable, they are more likely to see an uncertain future as dangerous to their wealth (potentially taking away their gains so far). When they are losing money in the investment, they perceive the future as a chance to make back their losses.

Page 191: A FATHER-SON STOCK SALE:

He understood that when one’s financial goal is achieved, and one does not expect significant further progress, it is time to change course. His son, having less market experience, was unaware of the cyclical nature of booms and busts. He had no sense of fair value for Cisco stock. Based on his limited experience, he expected this bubble to make him ultra-rich if he only held on a little longer. For the son, every stock price rally was expected and declines were terrifying.

For both men, it was their perspective that determined how they felt about their wealth. For the father, once he surpassed his financial goals, and the stock began to look overvalued, he was looking to sell. The son expected gains into the foreseeable future, and he was dismayed by sideways or downward stock price action. When declines began, the son couldn’t rationally factor the changing market conditions. The son was paralyzed by his inability to accept the decline when it began. Rather than selling out with an enormous profit, his shares lost 90 percent of their value, and he held on all the way to the bottom.

In any decision that involves a risk of loss, there is fear. The brain is exquisitely more sensitive to losses than gains—losses are weighted twice as heavily as gains—and decisions that can be taken to avoid realizing losses are prioritized. When operating with an existing gain (in the “gain” frame), the fear is that one will lose paper profits.

When operating under the shadow of an ongoing loss, there is a powerful avoidance mechanism, also driven by fear.

In the short term, the most ego-gratifying action for a paper gain is to sell for a profit. Capturing the gain relieves the fear of “giving back” what one has already earned and sustains a feeling of self satisfaction and pride. For a paper loss, the most ego-protective action is to hold on to the losing position, denying that it is a problem while hoping to “break-even.” Therefore, how investors deal with risk depends on the decision “frame.”

In academic parlance, most investors are “risk averse in the realm of gains” (so they cut winners short, preferring the certain gain), and they are “risk seeking in the realm of losses” (they prefer the gamble over the certain loss)). In the case of losses, the decision to hold on to a losing stock is inspired by the same bias that inclines people to prefer the gamble over the sure loss in Problem 2 above.

The preference for the risky gamble is assumed to be “risk seeking” in the realm of losses, and it underlies investors’ attempts to “dollar-cost average” into losers and hope for a “comeback.” In each case, loss-averse investors are trapped in the “frame” of seeing risks to their wealth, which biases their objectivity. Remember, loss-aversion describes the psychological process that underlies the disposition effect (cutting winners short and holding losers too long).

Many municipal governments demonstrate this type of flawed reasoning as more and more funds are poured into over-budget and poor-quality construction projects (e.g., Boston’s “big dig” highway project). The sunk cost bias is a result of hoping a losing idea will make a comeback, and it irrationally works against the retooling of moribund schemes.

FRAMING RISK: When a decision is explained as a potential gain, then the brain’s reward pursuit system is engaged. When the decision is made in relation to what one might lose, the loss avoidance system is activated. The differential activation of these two motivational systems depends on how one predominantly sees the decision—as a potential opportunity or a potential risk. The different presentations of a decision, in terms of either what one might lose or what one might gain, is called framing.

Dan Ariely, when teaching psychology at Harvard, informed two of his undergraduate classes that he planned on reading his original poetry to selected students. One class was asked if they would pay $5 to listen to

10 minutes of his poetry, and if not, they were asked to write down a monetary sum that would suffice. The other class was asked if they would take $5 to listen to 10 minutes of his poetry, and if not, they were asked to write down their price. All students either offered to pay (in the first class) or demanded to be paid (in the second class).

No one in either class wrote down a price of opposite sign (pay/take) from that presented. The expectations of these students were anchored by the framing of the decision situation Ariely presented. Framing studies show that how an investment is offered—think “golden opportunity” versus “risky and speculative”—skews decision making. At its heart, framing is the psychological process underlying loss aversion.

Interestingly, DeMartino’s results provide evidence that loss aversion is induced by the language used to frame a risky choice.

“Even being right 3 or 4 times out of 10 should yield a person a fortune if he has the sense to cut his losses quickly on the ventures where he has been wrong.”

Taking more risk when down is considered of the same ilk as not selling a loser—in each case one should cut the loss short, not hold it or increase its size.

In another interesting finding, the investors who sell their winners too soon are not the same investors who hold their losers too long. Weber also found cutting winners short is localized to particular individuals, while holding losers too long is a trait that is common across most investors.

LETTING WINNERS RIDE: Beware your rationalizations about selling a winning stock—chances are that you’re unable to identify how your own reasoning is distorted. If you’re guilty of the disposition effect, try the following techniques for minimizing the impact on your returns:

1.        Document your plan for each investment in advance. Know when and under what circumstances you will sell a stock. Don’t deviate from your plan. Keep the plan in your trading or tax records.

2.        When you feel yourself becoming fearful about a winning position, especially one that has had a terrifying pullback, don’t sell yet. Instead reevaluate your selling criteria. Did the position meet your profit target? Has something fundamental changed about the security that indicates you should sell now? If the price appreciation was rapid and psychology driven, then it may actually be a good time to get out, but you’ve got to consider such moves in your plan, in advance.

3.        As with the biases above, cutting your winners short is the result of short-term emotional influences overriding your rational thinking. Notice your emotional state after a position appreciates much more than your expectations. Are you afraid of giving back your profits (and feeling regret)? Are you worried that you’ll feel stupid if you don’t sell? Do you want to take the money off the table to feel proud of yourself, to show off to others, or to purchase something? There can be many explanations, depending on your life experiences and your recent financial progress.

4.        Be prepared for your short-term winners to give back some of their gains. You may want to utilize profit caps (or trailing stops) to take advantage of rapid price spikes, but be sure to be systematic about it. Reversals are very common after a rapid, large price rise.

5.        Don’t check your prices frequently! This is especially true for long-term investors and nonprofessionals. If you are trading in positions of one year average duration, don’t check the prices quotes daily. Checking too frequently leads to increased awareness of volatility, emotional reactivity, and a VERY high likelihood of overtrading. If you have an explicit plan in advance (see number 1 above), remember to follow it.

To prevent this inclination to “cut winners short,” professional value investors buy stocks that are steeply discounted from the company’s fundamental value. As a result, there is less short-term price risk.

The framing effect is the tendency to view investments as either potential opportunities (gains) or potential risks (losses). Depending on which stance one takes, their choices are likely to be different. In general, most people fear losing. In the realm of gains, they prefer to lock in gains rather than risking a loss of their profits. In the realm of losses, they would rather gamble for the chance to lose nothing than accept a guaranteed loss. This aversion to losses is true even when the potential gain is twice as great as the potential loss. This ratio of 2:1 preference for risk is called the lambda.

Many things change the value of lambda, including recent events (such as losses or gains), the framing of the decision problem, one’s personality style, and one’s experience with similar gambles. The loss frame activates these structures and deviates decisions to become more self-protective. Interestingly, people who are swayed by their fear of losses are often unaware of their intrinsic decision bias.

A number of steps can be taken to lessen loss aversion. In particular, investment plans and goals help people stay on track. Every day updating your investment perspective to the morning’s opening can reduce anchoring and reference point biases (such as feeling that one is “losing” or “winning” in a position). Keeping track of one’s level of fear about an investment can be useful as well, especially if it is pushing one off plan. The next chapter will examine in detail the financially destructive but prevalent behavior of holding losers too long.

Chapter 15; People’s propensity to become emotionally attached to items they own, such as stocks, is called the endowment effect. The endowment effect is an easily measurable result of loss aversion.

A few years of hefty profits and sagacious market insights do not immunize traders from the risk of total collapse. Risk management is key, yet it is often boring and restricts profitability. Firms that are trapped in a death spiral will often take far more risk to get out of their hole. Often, “doubling-down” works, and then an “addiction to risk” can become entrenched.

Loss aversion usually dissipates with experience, and the following tips should help yours along into the dustbin of history. Many of the tips are repeated elsewhere in the book.

1. When you reevaluate your investments holdings, consider preferentially selling some of the losers instead of the winners. Ask yourself, “All things being equal, would I enter this position today?” If your answer is “no,” then place it on your sell list.

2. Be aware of rationalizations or excuses you make in order to hold a losing position longer. Many traders who break their stop loss rules report that they wanted to “see if it would come back a little before I sold it.” Don’t believe yourself—while you were waiting for that retracement, you were rationalizing your poor money management. You didn’t want to take the pain. It takes a lot of courage to admit defeat. And you can’t regroup for the next engagement until you’ve taken the pain.

3. Beware of letting naked options expire worthless instead of selling them according to plan. It is easy to let out-of-the-money options or long-dated “low-risk” arbitrage positions sit, hoping for a comeback, rather than selling them for a loss. On a similar note, when shorting stock, be sure to have a stringent (and realistic) sell criterion.

4. Remember that you are more susceptible to loss aversion after recent or large losses of any nature. Be aware of losses and disappointments in your life and how these may affect your investing.

5. Humility is essential. Developing a reputation as an excellent or insightful trader could make you cocky. When you are eventually wrong, you’ll be less likely to admit it, for fear of damaging your reputation. Remember, the markets are always bigger than you.

6. Be sure to set and follow stop-loss rules. If you don’t have a defined money management system, then be sure to put one in place. See number 1 above.

House-money -> how does it contribute to bubbles? Often heard at casinos, where gamblers who bet more after big wins are said to be playing “with the house’s money.” They have not yet internalized their ownership of the winnings yet, and thus they aren’t as afraid of losing it.

Leitner displays no hubris or overconfidence in his interview—only an intense curiosity about the markets, humility, and a willingness to constantly reexamine his assumptions.

The professionals above use analytical detachment from profits and losses, engage in strictly disciplined selling of losers, and cultivate humility in order to prevent the emergence of emotional biases such as loss aversion.

Chapter 16; They simply cannot defer gratification. The difficulty people have in delaying pleasure is a result of time discounting. Time discounting describes the tendency to give in to immediate gratification urges—going for small short-term gains in the present while sacrificing larger future rewards as a consequence. What is fascinating about time discounting is that people intellectually know they will experience bad consequences from current misbehavior later, but at the moment of temptation their limbic gratification-seeking self overrides this warning while the prefrontal cortex looks on helplessly.

MAKING A KILLING IN THE OPTIONS PIT: In the markets, time discounting is most dramatic during investor panics. The immediate short-term gain being sought is relief from painful declining positions. According to Richard Friesen, a retired options specialist and former seat holder on the Pacific Stock Exchange, during periods of market volatility, emotional responses can become the major driver of risk perceptions and option values. At these times, investors may be more preoccupied with licking recent wounds than taking risk. As a result of the immediacy engendered by unforeseen crises, out-of-the-money options, particularly puts, gain large premiums.

This would seem to be the best time for option writers and premium sellers to exploit investors’ increased risk perceptions, but sometimes the market’s fear is contagious.

Ideally professional options traders are conditioned to maintain equanimity during periods that others perceive as dangerous crises. They should be able to maintain a long-term perspective even when others see the world with steep, fear-induced, discounting curves. According to Friesen, during market crises “we couldn’t sell option premium fast enough.”

As Friesen tells it, in the midst of the October 1987 stock market crash, he and his options trading colleagues were stunned by the irrational option values. The trick was to avoid going into shock while the entire financial system appeared to be heading towards a cliff.

On that October Monday, the trading pits were eerily tense, loaded with bids to buy puts, but with none of the floor traders willing to step in and sell them. Friesen recalls that one of his colleagues walked forward into the inaction of the trading pit and offered to sell options for an enormous premium. Panicked investors and brokers under orders to forcibly liquidate bankrupt accounts snapped up his puts. His selling price guaranteed that he would make money unless the stock market dropped by another 50 percent.

Soon his firm was doing the rational behavior of selling puts to emotional buyers. According to Friesen, “Trading at times like these is magic. You are standing on rational grounds and trading with a crowd in emotional panic. It is like an ‘out of the body experience.’ You know exactly what is going to happen, and can watch the prices collapse as trader after trader sees the truth you already knew.”

Imagine how the sugar is accelerating your aging process and weakening your immune system, predisposing you to colds and chronic illness.

Chapter 17; “When in doubt, get out,” as the old Wall Street saying goes. If you let your guard down just a little, Mr. Market will always make you the sucker.

Groupthink is the tendency for members of homogenous groups to come to the same (and often wrong) conclusion.

There may be some truth to that rumor after all.

Too often, we learn what to do in an uncertain situation from observing others. We wait for others to “confirm” the right course of action rather than assuming the responsibility to figure it out ourselves. Psychologist Robert Cialdini calls the search for confirmation “social proof.” Social proof provides a mental shortcut. Rather than having to think through each step of a problem, people can simply watch their comrades and follow their lead.

Why would anyone continue to identify with a style of thinking that had been proven wrong, much less try to spread the word? It is too painful for these proselytizers to accept defeat, so in a move reminiscent of loss aversion, they hold on for any sign of hope, and even try to gather new converts.

In the minds of die-hard believers, the greater the number of people who believe their doctrine, the more likely they themselves are to be correct.

Sometimes investors will feel compelled to follow a price trend. This is a type of “herding-by-proxy.” They know others are buying the stock, but they don’t know who. When a stock is trending, people are prone to believe that the investors driving the price move know the future better than them. They then “chase” the trend higher. Some investors wait for such price “confirmation” (favorable trend) before entering an investment.

An expected price movement “confirms” that one’s opinions were correct, and it now feels safe to open a position.

After further experiments, Asch concluded that people conform for two main reasons: because they want to be liked by the group and because they believe the group is better informed than they are.

At times, the available information leads investors to similar conclusions. When these conclusions are acted on, they cause market price movements. Some investors take their directional cues only from the market price action, which they use as a proxy for the actions of better-informed investors. An informational cascade occurs when someone, having observed the actions of those preceding, mimics their behavior.

“It is difficult to get a man to understand something when his salary depends upon his not understanding it.

Value and countertrend investing strategies are more characteristic of contrarians. Contrarians have the innate advantage of being able to search for opportunities away from the crowd. They often seek for solid investments in overlooked sectors. Every sector rotates into and out of popularity, given time.

Contrarians are also inclined to short emerging trends, which can be very painful. If you’re contrarian, be sure to identify clear signs of reversal or exhaustion before shorting a popular security or sector.

You MUST have definite rules for when to close out your positions.

Chapter 18: We have to be very careful to avoid statistical over-fitting, under-sampling, and self-deception.

Mean-reverting predictions affect professionals and respected academics alike. But why not amateur investors? Why are they susceptible to the “hot-hand” bias, not mean reversion? In the case of amateur investors, their memory recall and experience is relatively short. These investors’ attention is attracted to recent returns, which they then extrapolate into the future.

THE SOOCHOW GAMBLING TASK (SGT): Why did the experimental subjects select from the lower paying decks? The series of wins was seductive. In decks A and B, the satisfaction of winning occurred four times, while the pain of the loss only happened once per five cards. A series of wins is, in a way, addictive. Gains feel so good that investors will risk large periodic losses as an accepted consequence of getting the good feelings from a series of small gains.

In a way, these results are similar to predictions of loss aversion. Investors would rather cut their winners short, ensuring a small gain, and hold their losers too long, experiencing occasional very large losses. If single losses are twice as painful as single gains are pleasurable, then four gains are twice as pleasurable as one loss is painful (size notwithstanding).

Professional investors do not experience the aversion to small losses that the SGT participants did. Many professional traders have poor win-loss ratios, numerically speaking. They may lose on 80 percent of their investments, but their 20 percent of winning positions are so lucrative that they more than make up for their small losses. Essentially, great investors are willing to draw from decks C and D consistently, accepting a string of small losses as the price of doing business while holding out for the big winners.

Excellent investors don’t change their philosophy in response to a few losing investments. They know their edge in advance, and they understand that down periods are inevitable. Their high level of confidence in their judgment and methodology allows them to brush off small losses.

In the stock market, there are more days of large negative price movements than would be expected in a “normal distribution” of returns. This is called the fat tail or leftward skew of return variability. Put simply, there are more big daily price drops in the stock market than would be expected by chance. Yet most investors tend to overlook the likelihood of a large daily price decline, especially if it has been a while since the last one.

In the SGT experiment described above, subjects were not adequately afraid of infrequent large losses, and they were enamored with small short term gains. They essentially paid the experimenters so they would not have to experience frequent small losses, even with the possibility of occasional large gains.

To take advantage of investors’ preference for small gains ir-regardless of occasional large disasters, Nassim Taleb argues for a style of investing called catastrophe investing. Taleb may invest in markets where returns have been good for some time. In such markets, investors are accustomed to small feel-good gains year after year, and the implied volatility of options in these markets has dropped (often to excessively low levels). Taleb may buy put options far out-of-the-money. Taleb’s puts make money only if the market drops sharply within a given time period. Usually, he loses money on these puts.

Chapter 19: Information overload occurs when people are faced with too much information to process. When overload occurs, most people prefer to withdraw and avoid making a decision until they better understand the situation. If they cannot delay the decision, then they rely on how their feelings and memories. As a result, when too much information is present, people are more vulnerable to biases. Novice investors who have not prioritized the information they use in decision making are susceptible to overload.

The bias associated with overweighting recent events in one’s future forecasts is called the representativeness heuristic, and it is related to the “hot-hand” bias mentioned in Chapter 18. Fundamentally, the representativeness heuristic is a short-term memory bias in which simple, recent information cues are over-weighted in decision making.

This pattern of high estimates when things are good and low estimates when they are bad is consistent with the representativeness bias. That is, the professors derive their estimates not from an objective consideration of past decades, but rather from recent events in the markets.

BEATING THE HINDSIGHT BIAS: One of the most pernicious memory biases is called the hindsight bias.

The hindsight bias refers to the fact that most people think they “knew it all along.” After an event occurs, they think that they had predicted it would happen in advance, when in fact they did not. The danger of the hindsight bias is that it prevents people from learning from their mistakes. Unless they documented their forecasts in advance, they have no objective evidence that they did not expect the event to happen.

One possible explanation for the results is that people prefer to work with information they can easily process. These results imply that simple, cognitive approaches to modeling human behavior sometimes outperform more typical, complex alternatives.

It’s not only mutual fund names and clever stock symbols that draw investors. Concepts such as new economy reflected perceptions of a fundamental transformation in business, suggesting that the old risks of investing no longer applied. Internet and technology stock investors were often seduced by the novelty and limitless potential of the “new economy.”

Evolutionary biologists hypothesize that young single men are driven to try to capture more social and financial gains while young, thus taking more risk in pursuit of their goals. When older, men spend more time consolidating and leveraging their existing assets than seeking high-risk new opportunities.

What causes these age-related deficits? Given the strong results from a skill-training protocol, it appears that much of the decline can be attributed to a lack of use: “Use it or lose it.” Increasing prefrontal usage may improve the ability to learn and plan, thus minimizing age-related cognitive losses.

Novelty. Engaging in unique challenges and new activities can strengthen the brain just as well as specific exercises. The brain is like a muscle, and you can either exercise specific areas using software or books, or you can challenge the whole thing to explore and solve on a larger scale (or do both).

Chapter 21: To achieve greatness in investing, education is the first step. You’ve got to know what you’re doing in the markets. What is your strategy? Why is it superior? How will you manage volatility? The next step is a self-evaluation. Identify your strengths and weaknesses and inventory your resources.

Biases can seriously impair financial performance. They prompt portfolio managers and individual investors to overtrade, feel excessively optimistic, and hold losers too long. Financial analysts are particularly susceptible to social biases such as herding. Professional traders take too much risk after recent losses. Such biased behavior is rooted in the brain’s hard-wired cognitive and emotional systems. As a result of their deep subconscious origins, such biases are challenging to identify in oneself, much less to correct.

I saw no point in being the richest man in the cemetery.

Ego attachment to gains and losses induces greater emotional reactivity due to the comparison of short-term progress against expectations and goals. Detachment from outcomes and focus on the investment decision process improves emotional stability during volatility and yields greater long-term returns as strategy is gradually honed.

Page 291: Effect of Money on Behavior: Money Changes You

Unconscious emotions affect people beneath their awareness, yet they have profound effects on how people make decisions. In order to address and manage unconscious emotions, it’s useful to understand how they arise. Much of unconscious emotional experience is fueled by internal predispositions, while other aspects of emotional life are learned over time or experienced in reaction to events.

NEUROPLASTICITY: Where we can see the error of our ways, focus our corrective efforts, and practice with discipline, our brains will slowly rewire. Some hardwired biases can be mitigated via a process of neuronal re-sculpting called neuroplasticity. Neuroplasticity refers to neurons’ tendency to change their structure and function in order to adapt to the demands of new environments.

That opens up the tantalizing possibility that the brain, like the rest of the body, can be altered intentionally. Just as aerobics sculpt the muscles, so mental training sculpts the gray matter in ways scientists are only beginning to fathom.

The chief lesson of neuroplasticity is that with guided training, frequent practice, and self-discipline, the structure and function of the brain can be altered. Mental and emotional exercise is like athletic exercise. When directed effort is applied, the body and mind can be trained to facilitate achievement. Mental “athletes” don’t show their genius outwardly, until they are making decisions. Their prowess can be observed in their responses to new information, how they handle price volatility, losses, and gains, and in their analytic techniques and intuitive judgment.

Plan and anticipate, don’t react. Market Wizard Linda Bradford Raschke counsels, “Know what you are going to do before the market opens.” Mark Cook remarks, “Planning is the objective part of trading. Start with the worst case scenario and work from there. . . . Once you are in a trade, emotions take over, so the plan must be in place before the activity takes place.”

CREATING A DECISION JOURNAL: Some researchers believe that traders can learn to behave more rationally by recognizing and learning from their past mistakes. Journaling is the most commonly prescribed method. Documenting both the assumptions that drive decisions and the resulting consequences of those decisions provides valuable insight into patterns of strength and weakness in judgment.

After monitoring dozens of decisions, it is helpful to review the data you gathered. Look for patterns in your feelings and decisions. Because feelings distort how we evaluate information and assess consequences, observe whether your feelings had anything to do with your judgments.

This psychological decision journal template should be used as a complement to a standard spreadsheet format with quantifiable statistics such as style of trading (swing trade, day trade, long-term position investment), stop boundaries (both time and price), and objectives (price, news, time, or fundamental value).

Important data to measure include your expected risk/reward probabilities (based on historical analysis), expected and actual profit/loss per trade, number of long and short transactions, number of winning and losing trades, time spent holding losing trades versus winners, and the profitability of strategies in different market environments.

Biases can be detected not only in your responses on the psychological decision template, but also in the statistical data. For example, by comparing the duration of winning and losing positions, one can find evidence of loss aversion (holding losers longer than winners).

Having more winning trades during bullish or bearish markets may indicate that one’s strategy or decision process is biased towards periods of favorable sentiment.

Cardiovascular exercise is particularly beneficial for longevity. Exercise releases growth factors, both in the tissues and also in the brain, which enhances new neuronal growth and repair. Along those lines, a varying routine of exercise, in a playful or challenging context such as competitive sports, is especially healthy for the brain.

If you continue to own declining positions that are further depressing you, then think to yourself, given the current fundamentals and technicals, “Would I buy this position today?” If not, then you shouldn’t be owning it.

Self-analyzing what went wrong in one’s investment decision making, in a curious nonjudgmental way, tends to improve subsequent performance. – Imtiaz please start Keeping Notes . . .

Cultivating gratitude, visualizing your best possible self, and looking for the positive in your day will improve your sense of well-being.

Stanford University psychologist Carol Dweck has spent decades studying the role of mental attitude in success. She realized that while it is important to success to have an optimistic mental attitude, it is more helpful to be interested and curious in personal growth and learning. What motivates people to be curious and open? Dweck’s evidence suggests that one who tries to achieve a goal (such as financial gain or high investment returns) will experience worse outcomes than one who pays attention to learning and growing into the process of successful investing. Optimal goals should remain internal and in progress. Knowing that one can improve leads to higher achievement.

Chapter 23: Fear can best be translated into financial language as “risk perceptions.” When risk perceptions are high, so is the risk premium. Risk perceptions often deviate from actual risk due to the biases described earlier in this book: emotion (fear leads to overestimation of low probability catastrophes), time discounting (seeing an immediate danger), herding (investors observe each other for cues), uncertainty and mistrust (the veracity of government-published statistics is ambiguous), and loss framing (default is seen as a risk, not an opportunity). Over time, strategies that arbitrage risk perceptions can do very well.

That is, when looking out longer term, investors are overconfident in their ability to estimate future price ranges. When buying options for the short term, they are excessively myopic and fearful.

Brazil was faced with increasing interest rates due to a contagion of risk perception after a meltdown in the finances of its neighbor, Argentina. Though Brazil was financially stable at current interest rates, a significant rise in rates and drop in the value of its currency, the real, would have created conditions in which Brazil was unable to meet debt payment obligations.

Understanding this risk, speculators and risk-averse investors began to sell bonds. Their selling pressure gradually pushed interest rates higher. Interest rates were on the verge of surpassing Brazil’s ability to pay, and the risk of a debt default suddenly became real.

Whether Brazil would default hinged on the confidence of bond investors. If the mass of investors expected default, then their bond selling would drive interest rates so high that the government would have been unable to pay its interest obligations. If investors regained confidence in the Brazilian government’s ability to pay, then rates would drop, and default would be averted. Default hinged on the risk perceptions, and expectations, of market participants.

Value stocks’ shares sell inexpensively relative to the actual, underlying worth of their physical assets (such as buildings, factories, equipments, patents, brand, or market penetration), their projected earnings growth, or their cash flow potential. Three widely used financial ratios for measuring a stock’s value are: (1) the price-to-book ratio, (2) the price-to-earnings ratio, and (3) the price-to-cash flow ratio.

The price-to-book ratio measures the ratio of current share price to asset value. When the ratio is low, then a stock is relatively inexpensive, and when it is below 1, then a stock is selling for less than the value of all its assets. The price to earnings (P/E) ratio is another measure of value.

When a company’s current earnings are high relative to the share price, then the P/E ratio is low and the stock is relatively cheap. Subpar pricing happens for some companies, particularly if earnings expectations are low or its business is out of favor.

The lesson is that low-volume winners are most likely to continue performing well. High-volume losers are likely to continue downward. On a different note, small stocks tend to do better than large ones over time.

The financial markets deal not in realities, but in expectations, or more precisely changes in expectations.

They invest more in small company stocks due to their higher long-term returns. And they allocate more resources to lower-priced value stocks, which have higher expected returns than higher-priced growth stocks.

Currently, few people save enough for retirement, often due to a combination of several biases: time discounting

(procrastinating the pain of saving), inertia (indecision and doing nothing), fear of market risk (avoiding investing in the equity markets), and overconfidence (believing one can save more later).

Books:

Michaely, R., and K. Womack. 2005. “Market Efficiency and Biases.” In Richard Thaler (ed.), Advances in Behavioral Finance, vol. II. New York: Russell Sage Foundation.

Mauboussin, M. 2006. More Than You Know.

Damasio, A. 1999. The Feeling of What Happens: Body and Emotion in the Making of Consciousness.

MacLean, P. D. 1990. The Triune Brain in Evolution: Role in Paleocerebral Functions.

Spencer, H. 1880. Principles of Psychology.

Chang, H. K. 2005. “Emotions Can Negatively Impact Investment Decisions” (September). Stanford GSB. www.gsb.stanford.edu/news/research/finance shiv invesmtdecisions.shtml.

Aghajanian, G., and E. Sanders-Bush. 2006. “Serotonin.” Neuropsychopharmacology: The Fifth Generation Process. www.acnp.org/Docs/G5/CH2 15–34.pdf.

Grace, A. 2006. “Dopamine.” Neuropsychopharmacology: The Fifth Generation Process. www.acnp.org/G4/GN401000014/CH014.html

Reif, A., and K. P. Lesch. “Toward a Molecular Architecture of Personality.” Behavioral Brain Research, 2003.

Fieve, R. 1978. Moodswing: The Third Revolution in Psychiatry.

Norretranders, T. 1998. The User Illusion: Cutting Consciousness Down to Size. New York: Penguin Viking.

Kaufman, M. 2002. Soros: The Life and Times of a Messianic Billionaire.

Goleman, D. 1998. Working with Emotional Intelligence.

Niedenthal, P. M., and S. Kitayama (eds.). 1994. The Heart’s Eye: Emotional Influences in Perception and Attention.

Isen, A. 1999. “Positive Affect.” Handbook of Cognition and Emotion, ed. T. Dalgleish and M. Power.

Nofsinger, J. R. 2001. Investment Madness: How Psychology Affects Your Investing . . . and What to Do about It.

Hastorf, A. H., D. J. Schneider, and J. Polefka. 1970. Person Perception.

Drobny, S. 2006. Inside the House of Money.

Sapolsky, Robert M. 2004. Why Zebras Don’t Get Ulcers.

Bennett, W. J. 1996. The Book of Virtues.

Mauboussin, M. 2006. More Than You Know: Finding Financial Wisdom in Unconventional Places.

Hagstrom, R. 1999. The Warren Buffett Portfolio.

O’Creevy, F., M. N. Nicholson, E. Soane, and P. Willman. 2004. Traders: Risks, Decisions, and Management in Financial Markets. Oxford:

Steenbarger, B. 2003. The Psychology of Trading.

Soros, G. 1995. Soros on Soros

Soros, G. 2000. Open Society: Reforming Global Capitalism.

Fox, C., and A. Tversky. 2000. “A Belief-Based Account of Decision under Uncertainty.” In Kahneman, D., and A. Tversky (eds.), Choices, Values, and Frames.

Loewenstein, G., and J. S. Lerner. 2003. “The Role of Affect in Decision Making.” Handbook of Affective Science, ed. R. Davidson, H. Goldsmith, and K. Scherer.

Cialdini, R. 1993. Influence: The Psychology of Persuasion.

Warneryd, K-E. 2001. Stock Market Psychology.

Shefrin, H. Behavioral Corporate Finance: Decisions that Create Value.”

Schaie, K. W. 2005. Developmental Influences on Adult Intelligence: The Seattle Longitudinal Study.

McCall, R. D. 1997. Way of Warrior Trader: The Financial Risk-Taker’s Guide to Samurai Courage, Confidence and Discipline.

Murphy, S., and D. Hirschhorn. 2001. The Trading Athlete: Winning the Mental Game of Online Trading.

Steenbarger, B. 2005. “How Experts Make Decisions Under Uncertainty —Part II.” BrettSteenbarger.com, July 30. www.brettsteenbarger.com/articles.htm
“Investorama 2006.” Downloaded on December 1, 2006, from: www.lgtcapitalmanagement.com/cm/en/downloads/dok marktinformationen/Investorama 1206 en.pdf.

Bubble. An economic bubble occurs when speculation in a commodity causes the price to increase, thus producing more speculation. The price of the good then reaches absurd levels and the bubble is usually followed by a sudden drop in prices, known as a crash.

Comparator. The brain circuits used to compare expectations of goal progress versus reality. Feelings arise as a result of the comparison.

Discounting (time). The preference for smaller immediate rewards over larger, later rewards.

Emotion. In psychology and common use, emotion is the language of a person’s mental state of being, normally based in or tied to the person’s internal (physical) and external (social) sensory feeling. Feelings such as happiness, sadness, anger, elation, irritation, and joy are emotions.

Illusion of control. The belief that one can influence a chance outcome. Occurs when lots of choices are available, you have early success at the task (as in the coin-flipping example above), the task you are undertaking is familiar to you, the amount of information available is high, and you have personal involvement.

Limbic system. A deep, evolutionarily older system of brain circuits and structures involved in emotion. Major subsections include the reward system (nucleus accumbens), the loss avoidance system (amygdala), hormonal control (the hypothalamus), and memory centers (the hippocampus).

Loss aversion. In prospect theory, loss aversion refers to the tendency for people to strongly prefer avoiding losses than acquiring gains. Some studies suggest that losses are as much as twice as psychologically powerful as gains. Loss aversion was first theorized by Amos Tversky and Daniel Kahneman (winner of the 2002 Nobel Prize in economics).

Loss avoidance system. A fundamental motivation system in the brain, geared towards the avoidance of harm and potential danger. Consists of several subcortical structures related to negative emotion processing and response, including the amygdala, hippocampus, hypothalamus. Cortical structures include the insula and the anterior cingulate gyrus.

Momentum investing. A style of investing in which equities that have recently appreciated in price are purchased, with the presumption that they will continue to outperform over time. Academic research has identified the “momentum effect” in stocks that appreciate over the prior 6 months. These stocks are likely to have market-beating returns over the subsequent 6 to 18 months.

Motivated reasoning. Thinking biased to produce preferred conclusions. That is, we think about a problem in such a way as to logically lead to the conclusions we wanted to arrive at in the first place.

Option. A contract whereby the contract buyer has a right to exercise a feature of the contract (the option) on or before a future date (the exercise date). The writer (seller) has the obligation to honor the specified feature of

the contract. Since the option gives the buyer a right and the seller an obligation, the buyer has received something of value. The amount the buyer pays the seller for the option is called the option premium.

Overconfidence. There are several varieties: one type of overconfidence is the “better than average” effect. Researchers who ask subjects to rate their abilities, such as skill in driving, athletic ability, or running a business,

find that most people consider themselves better than average. Some individuals were found to overestimate the precision of their knowledge (mis-calibration). Others are overconfident in their belief in control over random, independent events—called the “illusion of control.”

Prisoner’s dilemma. A classic game theory scenario. The setup is along the following lines: Two inmates have made an escape attempt from prison, which was unsuccessful. On being separately questioned by the warden, the inmates must decide whether to “defect” (a.k.a. rat out, snitch) their confederate or “cooperate” and not give the warden any incriminating information. Highest payments go to those who defect when their confederate cooperates. Medium payment if both cooperate. Least payoff if one cooperates while the confederate defects.

Reward system. The neural circuitry directing desire and motivation. Extends from dopamine nuclei in the ventral tegmental area through the nucleus accumbens (NAcc) to the medial prefrontal cortex (MPFC).

Self-attribution bias. The tendency to attribute good outcomes to personal skill and bad outcomes to chance.

Ultimatum game. An experimental economics game in which two parties interact anonymously and only once, so reciprocation is not an issue. The first player proposes how to divide a sum of money with the second party. If the second player rejects this division, neither gets anything. If the second accepts, the first gets their demand and the second gets the rest.

Exercises:

Page 192: TEASING OUT THE PROBLEM

The following problems illustrate the psychological process of “aversion to a sure loss,” which often occurs during risky decision making and underlies the disposition effect.

Problem 1: Imagine that you face the following choice. You can accept a guaranteed $1,000 or take a risk. If you take the risk, the outcome will be determined by the toss of a fair coin. If heads comes up, you win $2,000. If tails comes up, you win $0. Would you accept the guaranteed $1,000 or take the risk?

Problem 2: Imagine you face the following choice. You can pay $1,000 now and the gamble is over, or you can take a risk whose outcome will  be determined by the toss of a coin. If heads comes up, you lose $0. If tails comes up, you lose $2,000. Would you take the guaranteed $1,000 loss or take the risk?

Of course, how you choose doesn’t really matter. Each option has the same expected value. Yet even so, most people feel inclined to take the guaranteed gain in Problem 1 and take the risk in Problem 2. In a similar decision situation, Nobel Prize winner Daniel Kahneman (working with Amos Tversky) found that 84 percent of subjects chose the sure gain in Problem 1, and 70 percent chose to take the risk in Problem 2.

During my seminars, I’ve found that audiences consistently favor the guaranteed gain (78 percent) in Problem 1, while themajority takes the risk in Problem 2 (72 percent). As one professional trader pointed out, “I can feel the inclination to reverse my choice between Problem 1 and Problem 2, so I assume it must be a problem.” He’s right.

What feeling inclines people to reverse such decisions? In any decision that involves a risk of loss, there is fear. The brain is exquisitely more sensitive to losses than gains—losses are weighted twice as heavily as gains—and decisions that can be taken to avoid realizing losses are prioritized. When operating with an existing gain (in the “gain” frame), the fear is that one will lose paper profits. When operating under the shadow of an ongoing loss, there is a powerful avoidance mechanism, also driven by fear.

In the short term, the most ego-gratifying action for a paper gain is to sell for a profit. Capturing the gain relieves the fear of “giving back” what one has already earned and sustains a feeling of self satisfaction and pride. For a paper loss, the most ego-protective action is to hold on to the losing position, denying that it is a problem while hoping to “break-even.” Therefore, how investors deal with risk depends on the decision “frame.”