Psychology of Markets

[brosin]

To build off what was being discussed in the wrap today, I think it would do us all a whole lot of good to talk about psychology and emotions when it comes to investing, tradings, and financial and economic markets in general. There are so many years of experience and knowledge here in trading and in life -- they should not be viewed separately I don't think -- that it would be great to hear some thoughts.

My take is that we are the 'market' - each of us. Indirectly or directly, our actions do have an effect. Everything is reflexive in the sense that you can't look at the whole as something objective, because we're seeing it from within it. It is impossible to truly view something that you are involved in objectively, because your view of it is already shaped by fundamental biases. Soros work on reflexivity is superb - I'd suggest reading his Alchemy of Finance. It talks about how irrational and disconnected markets can become - it talks about deflationary spirals where fear can feed upon fear to become its own worst enemy (nothing to fear but fear itself). He also talks about inflationary spirals (bubbles). Since everything is reflexive, I believe that with positive thinking, things will continue to evolve, the financial world will continue to grow, we will progress, etc. That's why at the core, I am a bull - I'm an optimist. But at the same time, I do recognize that pessimism is its own worst enemy and that fear is often stronger than greed. Had I never read Soros, I probably would have lost it all in 08 rather than make more than should've been possible. (Not that I haven't given alot of it back ...)

As for investing, I really do believe long term buy and hold is the safest bet. The caveat is that you have to buy and hold the right things, which is always the hardest part. Bottoms and tops get formed exactly how they sound - bottoms when *no one* wants to buy anything, and tops when *no one doesn't* want to buy anything (I don't think we're anywhere near that latter point after getting to the brink of the former point, but I digress).

Trading - I don't know. Part of me thinks it's a million to one shot trying to successfully day trade. The market is designed psychologically to shift money from the impatient to the patient, and day trading seems to be as impatient as it gets. Now this is assuming of course that you're a human and not a computer that can see things and act on them almost before they happen. But it seems like some people do make money - maybe a very small %, so I'm not sure. It just seems like the faster you try to make money, the faster you lose it. If you try to make money slowly, or actually don't even worry about making money (thinking many years ahead), that's when it seems to work for me.

[timber]

i agree brosin....however i think it make sense to learn every trading technique out there....i hold most of my stuff long term....but i do day trade like crazy too in my trading accounts...i think i do ok day trading....the reason why im down this year was not the daytrading it was the holding that killed me...lolol

[brosin]

Day trading is just so tough to stay balanced. You can gain a little every day for 2 months, and then wipe it all out and more in 2 days.

[benvestor]

The stock market doubling in about a year is somewhat troubling..

The market being at the level it was at in 04' is insane. Unemployment was sub 5% and GDP was around 4% for that year.

Oil is now even pricier.

Banks are now regulated again, and most likely going to be taking some liquidity out of the market, through share price and through their own funds (hedges etc)..

I think perhaps some entities went "balls to the wall" in pumping the market and others followed.. that is definitely the common mentality of the market- follow the herd driving prices up and then eventually down.. and down fast and hard

[brosin]

True about stock market doubling, but it was quite irrational that the stock market lost $1 trillion worth by being halved within 18 months. Or maybe it wasn't. I think somewhere in the middle is where we should be, which seems to be the case at this point or thereabouts.

[graysky]

Great post Bros...

Oddly enough, I was bearish around all along the climb to 1200 in Aptil'ish

Not dure why, but turned bull and bought what I thought were beaten down stocks at that time...

PMI avgd $5 and MPG @ $3.70

said F it and think long term...

Long story short, quite a few averages down and a sweaty day of capitulation made me realize what I thought was 'smart investing' was wrong...

Somewhat scarred... Bad timing? Wrong stocks?

Either way, went back to my day trading Fas/Tza/lvs/x

I was +30% April... Bought thinking long term value and gave away all gains...

More or less, lesson learned and finally back in the positive % this year mainly playing FAS from 17's to 23 and TZA quite a bit these past few weeks...

All credit to the day/swing as that's all that seems the market has to offer...

Btw, in Naperville... we should catch up sometime...

Great posts, keep em coming

[graysky]

Further, I don't believe that buy and hold is the best decision *right now* given current market condition...

I'm still calling for that full impulse sell causing full capitulation, thinking they run/test and or drop below 1000 before the real reversal back to true bull...

1060 ST

if that breaks, 1014... 993...

World/market psychology is prime for the "W"

Big event...

There is no faith, hence the volume

They have to crash IMO and provide a renewed faith/trust in going long once again...

[brosin]

I agree with that Gray - or at least not jumping in head first at this level.

I was lucky in that I started my IRA in Feb 2009 - those are the LT buy and holds for me, but only because for the most part, I got some pretty great entries. Some holdings have been 2010 turds though.

[brosin]

Taken from Mishkin p 173-174:

(Emphasis is all added by me)

BEHAVIORAL FINANCE

Doubts about the efficient market hypothesis, particularly after the stock market crash of 1987, have led to the emergence of a new field of study, behavioral finance. It applies concepts from other social sciences such as anthropology, sociology, and, particularly, psychology to understand the behavior of securities prices.

As we have seen, the efficient market hypothesis assumes that unexploited profit opportunities are eliminated by "smart money" market participants. But can smart money dominate ordinary investors so that financial markets are efficient? Specifically, the efficient market hypothesis suggests that smart money participants will sell when a stock price goes up irrationally, with the result that the stock price falls back down to a level that is justified by fundamentals. For this to occur, smart money investors must be able to engage in short sales; that is, they must borrow stock from brokers and then sell it in the market, with the aim that they earn a profit by buying the stock back again ("covering the short") after it has fallen in price. Work by psychologists, however, suggests that people are subject to loss aversion. They are more unhappy when they suffer losses than they are happy when they achieve gains. Short sales can result in losses far in excess of an investor's initial investment if the stock price climbs sharply higher than the price at which the short sale is made (and losses have the possibility of being unlimited if the stock price climbs to astronomical heights).

Loss aversion can thus explain an important phenomenon: Very little short selling actually takes place. [/i]Short selling may also be constrained by rules restricting it because it seems so unsavory for someone to make money from another person's misfortune. The existence of so little short selling can explain why stock prices are sometimes overvalued. That is, the lack of enough short selling means that smart money does not drive stock prices back down to their fundamental value.

Psychologists have also found that people tend to be overconfident in their own judgments. As a result, investors tend to believe that they are smarter than other investors. Because investors are willing to assume that the market typically doesn't get it right, they trade on their beliefs, rather than on pure facts. [/b]This theory may explain why securities markets have such a large trading volume -- something that the efficient market hypothesis does not predict.

Overconfidence and social contagion (fads) provide an explanation for stock market bubbles. When stock prices go up, investors attribute their profits to their intelligence and talk up the stock market. This word-of-mouth enthusiasm and glowing media reports then can produce an environment in which even more investors think stock prices will rise in the futures. The result is a positive feedback loop in which prices continue to rise, producing a speculative bubble, which finally crashes when prices get too far out of line with fundamentals.

The field of behavioral finance is a young one, but it holds out hope that we might be able to explain some features of securities markets' behavior that are not well explained by efficient market hypothesis.

[brosin]

Very thought provoking piece by Barry Ritholtz that applies for this thread:

www.ritholtz.com/blog/2010/08/linguistical-differences-competing-market-theorists/

Linguistical Differences Amongst Market Theorists: Efficient Market Practitioners vs Behavioral Economists*
Ever listen to how people speak?

I don’t mean their verbal tics or habits (“um”), I refer specifically to the words and phrases they choose to use. The way they deploy language can be quite revealing about their beliefs, training, and thought process.

Consider, as an example, the bond market. The discussion of late have been about whether or not its a bubble. This has come up quite a bit in conversation lately (see this and this), and have been fascinated by the different ways people have described the situation.

Consider the following overheard phrases, each of which come from traders, fund managers, and strategists:

The first two reflects a certain belief in the rationality of markets: “Bonds are pricing in a deflationary outcome” is how one strategist described it. Another (quoted in MSM) said that “the fixed income market is discounting a double dip.”

But a fund manager described it quite differently, relying on language of sentiment: “Traders fear an economic slowdown.”

The actual language used suggest a clear theoretical underpinnings: The first two speakers are likely adherents of the efficient market hypothesis (EMH). They consider market action to reflect the collective knowledge of all participants. Hence, the interest rate action is only the collective wisdom of the crowd, as more economic information works its way into bond prices. The crowd (of course!), will be more right versus than any single individual.

Truth be told, crowds have not appeared particularly full of wisdom over the past few years. They seem to act like lemmings, engaging in group think. If the EMH proponents are honest, they will admit this theory has flaws.

The second is a behavioral economics approach: It considers the irrational and emotional processes of the human participants in the markets. But traders who adhere to this philosophy will have to admit that the majority of the time, trader emotions remain in mostly in check. Behavioralism only seems to create actionable insights at market extremes.

I find its helpful to deploy both theories. During the meat of any market move — call it the middle 60-80% — the crowd is the trend. That is when deferring to not the crowd’s wisdom, but their collective muscle, is the most lucrative.

When the crowd morphs from a peaceful assembly to a mindless mob, that is when the behavioral aspects kick in. The contrary bet can be placed once extremes in emotions are visible in market and sentiment data.

What does your language say about the way you think . . . ?

* Isn’t that a great headline? I made it up, but it sounds like it should be an academic research paper from HBS or one of the Fed Research departments . . .