Reuters Money
Meditations on money mania: Why we gorge on the financial buffet
Are you a money maniac? While finishing up Michael Lewis’s “Boomerang,” his latest book on the financial meltdown, I was intrigued by a few of his observations on a cultural and psychological malady.
Since some of my academic training is in psychology, I’ll take a stab at what I think is going on. We spend (and eat) too much because the culture encourages it at every turn, but we have the ability to resist temptation. We’re hardwired to do the wrong thing, yet can still make rational decisions.
There’s also a part of the brain that Lewis didn’t really explore in much depth. I’m not sure what it’s called, but it involves conflating risk with the likelihood of financial success. Behavioral economists have many descriptions of these miscues. One might call it intentional and persistent denial.
Invest in the stock market through your 401(k) and forget about the risk to your long-term wealth! Use those multiple credit-card offers you get in the mail every week to borrow to the hilt! Get an extra 10-percent off at the department store if you sign up with their onerous credit plan!
We just can’t escape what I call “the buffet effect.” All of these financial goodies are laid out all the time for one seemingly low price. So we gorge on this table of plenty, only to later find out how empty financial calories can hurt us. Many of us just can’t help ourselves. That’s our culture. We’re not only in the land of plenty, we’re in the never-never land of too much.
When I eventually waded through Lewis’s perversely scatological insights on Germans and wondered if Icelandic men were really that overconfident that they could morph from fishermen to currency traders in a matter of weeks, I found a real nugget in the research of Peter Whybow a psychiatrist and neuroscientist.
Dr. Whybow, author of the more useful American Mania: Why More Is Not Enough, says it’s our “lizard brain” that is driving our overconsumption. After all, when we were living in caves (and much earlier), we hoarded food and firewood and worried about saber-tooth tigers. Now we substitute debt-driven obsessions for those primal concerns. Maybe we squirrel away credit cards because of a misperception of scarcity.
Investment pros are profiting from your panic
Don’t take this the wrong way, but everything you’re thinking and feeling about the stock market is usually dead wrong. And money managers appreciate that. Your missteps often help them profit.
It’s a basic premise of behavioral finance, that folks behave irrationally when it comes to their investments. People are panicking like the world is coming to an end? Time to buy. Your cabbie is giving you stock tips during a raging bull run? Time to sell.
Enter the investor sentiment reading. A few key metrics – like the American Association of Individual Investors Index, the Consensus Index, and Market Vane – track what you and I are feeling about the stock market, and convert it into numbers. For true contrarians, the findings are just as telling as more fundamental metrics like price/earnings or free cash flow. For example, if Mom and Pop investors are overly bullish or bearish, then it’s a flashing billboard to go the other way.
“It’s the perfect contrary indicator, and has been for a long time,” says Keith Springer, president of Springer Financial Advisors in Sacramento, California and author of ”Facing Goliath: How to Triumph in the Dangerous Market Ahead.”
“The public is always wrong. They always act on emotion – to buy when they feel the best, to sell when they feel the worst,” he says.
And right now, they’re feeling pretty darn glum. The AAII index is currently at 30.5 percent bulls, virtually unchanged from the week before. Once it’s below 30 percent, Springer starts getting an itchy trigger finger to buy equities. Spurred by Thursday’s massive selloff, with the Dow dropping a few hundred points to well below 11,000, we could see those numbers dip even further. And if it craters below 20 percent? A “screaming buy,” Springer says.
Sentiment readings aren’t that radical a concept. In fact, they can trace their lineage to the original value investor, Ben Graham, who famously held that Mr. Market is a fickle and irrational beast. He quotes different stock prices virtually every second, based on the whims of the moment, and smart investors can examine company fundamentals to identify seriously mispriced equities.
I disagree. It’s all the major hedge funds, mutual funds, speculators and currency traders. The yen is going up because traders borrowed them and now need to pay them. So all the assets they bought overseas are being liquidated. The yen carry trade still unwinding. Then we have speculators that used margins force to liquidate their trades. Then we have the shorts tanking the market. All feeding on itself. It has very little to do with mom and pops and joe and jane.
Investing and your brain: Why we hit the panic button
Weathering the storm has lost popularity points with investors in the latest round of market volatility, prompting some to wonder if panic and irrationality are the name of the new game.
Investors pulled $31.3 billion out of U.S. equity funds in the two weeks ending August 10, reaching outflow levels not seen since the stock market collapse of March 2009.
Finding the reason behind that seemingly irrational sell-off may require more analysis than most economists or stock market watchers can perform. Perhaps the motivations behind our investing decisions are actually a question better put to neuroscience.
“Certainly, economic fundamentals play a valuable role in the value of assets and the prices that things trade for. But when individuals are making buy-and-sell decisions they can be very influenced on what is going on in their brains, including emotions,” says Lisa Kramer, associate professor of finance at the Rotman School of Management at the University of Toronto. Kramer has done extensive research on how human emotion — specifically in relation to seasonal depression — influences financial decisions and financial markets.
“We’re prone to weighing recent information more heavily than more historical information. The fact that we’ve just been through a financial crisis in the last couple of years is looming large on our minds,” she says. “When we see things start to go south again in the market, we go to that bad place in our minds and I think that can drive us to act impulsively more so than we would have a few years ago before we lived through this kind of volatile period.”
This historical hangover, coupled with the understanding of the body’s risk/reward system, has lead researchers to hypothesize that an investor’s urge to buy or sell at the wrong time could be a by-product of our neural processes overriding reason.
Kramer explains if one were to do a functional MRI analysis while an investor was in the process of making a financial decision — let’s say whether to buy a stock or a bond — “you’ll find that the part of the brain that’s activated when somebody makes the risky choice is called the nucleus accumbens (NACC) and it’s activated when people are experiencing pleasurable, things like food or sex. The part of the brain that’s activated when people make the safe choice is called the anterior insula and it’s more associated with pain and fear,” she says.
When watching your investments can hurt you
Even though he considers himself a relaxed investor, who rarely does any trading, Meir Statman usually takes a look at his investment account at Vanguard at least a few times a week. By doing so, the Glenn Klimek Professor of Finance at Santa Clara University and author of What Investors Really Want ignores traditional buy-and-hold wisdom, which suggests that checking up on things a couple of times a year, and rebalancing if necessary, is plenty for most investors.
The 63-year old behavioral finance expert might sneak a peek at his portfolio if he’s working and needs a break, or after he’s checked his email. Like many people, he enjoys the satisfaction of seeing the little green numbers pop up when the market has done well. But he doesn’t obsess about losses on down days.
“As an investor, I’m kind of like a sail boat with its sails down, bobbing with the waves and taking things as they come,” he says philosophically. “A lot of people view following the market and their investments as a kind of pastime, like watching football, but don’t necessarily take any action in response. And that’s perfectly okay.”
What’s not OK is when emotional reactions to witnessing the daily market gains and losses get in the way of clear thinking, which evidence suggests happens an awful lot. During the 1980s, Statman co-authored a study that first documented the “disposition effect,” a tendency for investors to take gains off the table on winning transactions too hastily and reluctance to realize losses. In 2007, a team of researchers in Israel concluded that access to market performance information increases the odds that people will follow those patterns.
Other academic research, as well as statistical data such as the flow of money in and out of mutual funds, suggests that when the market rises for awhile investors believe it will continue on an upward path and pile in. Conversely, when the market drops, they assume such negative performance will continue and stay away from the market or sell their holdings. In either case, frequent quote lookups and portfolio peeking are likely to exacerbate these emotional reactions.
Charles Rotblut, vice-president of the American Association of Individual Investors, has noticed that interest in checking portfolios appears to wax and wane with the market tides. When the market is up, traffic to the association’s website spikes as investors check quotes more often and use portfolio management tools. When the market falls for an extended period, traffic to the website declines as investors take on a bunker mentality.
Despite ample evidence that many investors do the wrong thing at the wrong time, Rotblut says frequent monitoring of a portfolio is perfectly fine as long as you take steps to wring the emotion out of the process.
mgj, a few answers to your points:
HFT trading is a combination of market arbitrage (not truly timing) and queue analysis. It depends on massive amounts of data and high-speed computer processing, so it is not an arena in which individuals ought to be playing.
How are you supposed to know what a stock is worth? Look at the reports, consider the business model, and reach your own conclusions. Analyst opinions are largely worthless, but they do a nice job of organizing the data. Use it!
When a stock that I have faith in is dropping, I typically buy more. Worked very well in 2008-2009, as I dumped a ton of money into the markets near the bottom. But I wasn’t really timing the markets — I was simply investing in sound companies that were selling at rock-bottom prices. Didn’t have a clue whether the market was going to rebound or not, but I was quite confident that the stocks I was buying then would return double-digit profits over the next decade. (As you point out, they returned triple-digit profits in just two years.) You don’t need to have a market-timing mindset to take advantage of situations like that. Fundamental analysis is just as good.
As for “sell high, buy low”? That’s great advice, but most small-time stock watchers do the reverse because they DON’T look at the fundamentals. After a market has been plunging for a few months, they sell. Then after it has risen for a few months, they buy. You end up missing most of the gains with that approach.
Is wealth key to financial literacy in college?
Do you play the stock market? Have a diverse portfolio? Maintain a relatively low debt-to-income ratio?
If you answered “yes,” chances are you got a head start in college, where financial education is a critical — yet often overlooked — factor in your financial future.
A study from UCLA found that college students from a family with a household income of more than $200,000 are more likely to seek out sophisticated personal finance education than their peers whose household income is less than $100,000. Students from lower- to mid-income families, by contrast, are more interested in focusing on saving money and debt management. Those from families earning less than $50,000 are also more likely to seek out financial help than their more affluent peers.
The study also uncovered patterns in who seeks help in boosting financial literacy and who doesn’t — a key part of debt management and overall financial success, says Arman Davtyan, lead researcher.
“If young people learned the implications of their financial decisions then they would be more responsible with the debt they incur and in the way they go about their financial business,” he says. “I think a lot of their mistakes have to do with failing to realize the long-term implications of the decisions they make.”
Students from families that spoke openly about money admitted to feel better about their financial situations and tended to be more fiscally prudent. Those with little introduction to basic finances, such as budgeting, were more anxious.
The findings create a chicken-or-egg conundrum: “Is it the fact they don’t feel so good about their financial circumstances that prompts them to seek financial education, or is it the fact that because they seek financial education they realize they’re not in as good shape as they thought financially?” says Davtyan.
How to stop chasing investment rainbows
Robbie Raffish has a dark secret. Nothing too serious, but something that might require a 12-step program nonetheless.
She’s a performance chaser.
Like millions of other investors, Raffish has the tendency to jump in when things are going great, and to flee when things are tanking. It’s human nature, but it’s also a major portfolio drag. Take her position in IBM.
“In the fall of ’08, when it felt like everything was going to come down on our heads, I sold a big chunk of our IBM stock,” says Raffish, a married mom of two and head of the full-service marketing firm a.s.a.p.r. in Salisbury, MD. “Since then it shot through the roof, and I missed that whole gain. I only started buying back in two weeks ago.”
Raffish is hardly alone. After 33 consecutive weeks of outflows from domestic equity funds, the sector recently notched inflows of $335 million, according to the Investment Company Institute. This, after the S&P has already jumped over 80 percent from its March 2009 lows, and December alone saw a nifty rally of 6.5 percent. It’s hard not to think that performance chasers have already missed out on the easy money.
“Behavioral finance is full of studies showing that people do what has worked recently,” says Jeff Tjornehoj, senior analyst at fund research firm Lipper. “Investors latch onto momentum just as it’s starting to wind down. Just like with the dot-com boom, which will go down in history as the definitive moment in performance chasing.”
Look at the current moment, and despite all the Main Street anxiety generated by the Great Recession, the stock market has actually produced two stellar years in a row. In 2009 the S&P 500 spiked 26.5 percent, and in 2010 it rose 14.5 percent. Getting in on the tail end of that momentum presumably won’t be quite as lucrative.
5 abnormal-yet-profitable strategies for 2011
My theme for 2011 is how to be abnormal, which is a new geeky independence that ignores the markets. Stop following the crowd and tend to your portfolio and life goals. Ignore what’s being bloviated on the business channels.
In order to understand abnormal behavior, which in my definition will make you more successful, you first need to identify “normal” behavior.
In the eyes of a behavioral economist like Prof. Meir Statman, author of “What Investors Really Want“ it means we place a premium on winning and special knowledge of the markets, something that rarely happens to average investors.
“We want to beat Wall Street through active investing,” Statman says, “but Wall Street is more likely to beat us.”
It’s far-too-normal behavior to pick stocks, real estate or exotic investments that we think could be winners or pick funds that have run up good returns last year. Yet research shows that we have no idea what we’re doing and get needlessly burned. If you want to improve your returns, be abnormal, turn off your inner Cramer and heed the following:
Ignore stock picking. According to Bill Miller, CEO of Legg-Mason Capital Management, U.S. stocks are undervalued by 30 percent. The stocks he’s bought or wants to buy are bargains, but you’re unlikely to find such deals. Stick to broad-based index funds like the Vanguard Total Stock Market ETF (VTI), which take the guesswork out of picking individual stocks. You won’t have to guess which stocks are good values and which are sucker bait.
Stop thinking of homes as investments. If you need comfort and shelter, spend as much money as you can without getting into perilous debt. But don’t think that homes are investments. Home prices have a long way to go before we see a real rebound. They may have bottomed out in Southern California, San Francisco, Washington, D.C. , Minneapolis, Honolulu and Boston, reports the Local Market Monitor. Yet there’s more pain ahead in Arizona, Florida, Nevada and most of the industrial Midwest. Home values lost almost $2 trillion in 2010 alone. Job growth is essential for residential real estate to turn around in every market.
Old fashion ways of thinking are safest. Look at the young who run to grandma for shelter and money!!!
What investors really want: an excerpt
Meir Statman describes investors as normal, neither rational nor irrational, in his new book What Investors Really Want. Normal investors are investors like you and me, often normal-smart but sometimes normal-stupid. Readers of Statman’s book will recognize themselves in its mirror.
We want more from our investments than profits equal to risks. We want to nurture hope for riches and banish fear of poverty. We want to win, be #1 and beat the market. We want pride when our investments bring gains and avoid regret when they inflict losses. We want to save our money for retirement and buy a shiny new car today.We want to leave a legacy for our children. And we want to leave nothing for the tax man.
Statman relies on scientific research to uncover our wants, yet he describes them with stories and anecdotes. And, he points out the cognitive errors that stand in our way to what we want and the emotions that mislead us.
Here are a few new-year resolutions derived from What Investors Really Want:
1. I resolve to know what I really want from my investments and stop wasting my money on what I do not want. I will trade stocks only if I enjoy trading, knowing that, on average, those who trade stocks earn less than those who buy and hold stocks. (We often find it hard to admit our wants, even to ourselves. We have little trouble admitting that we buy sports cars for thrills, but we have much trouble admitting that we trade stocks for thrills. Yet logic and evidence indicate that, on average, those who trade often earn less than those who trade rarely. Ask yourself, are you really above average?)
2. I resolve to know that diversification among investments, such as stocks and bonds, is the equivalent of wearing seat belts. Diversification does not eliminate losses any more than seat belts eliminate accidents, but diversification mitigates losses as seat belts mitigate injuries. (Hindsight has great intuitive appeal. In hindsight it was crystal clear in 2007 that stocks would collapse in 2008. Yet the argument 2008 proved that diversification is futile is dead wrong. The alternative to diversification is picking winning assets. But those who aim to pick the next winning Berkshire-Hathaway might pick the next losing Enron instead.)
3. I resolve to know that neither exuberance nor fear is a good investment guide. Exuberance urges me to buy high and fear urges me to sell low. I will resist both urges. (Exuberance and fear are hard to resist. Exuberance leads us to foresee a world of high returns with low risk. Fear leads us to foresee a world with low returns and high risk. But in the real world high returns come with high risks and low returns come with low risks.)
What investors really want
Behavioral Finance expert Meir Statman has cast his skeptical eye on the world of individual investors and finds we invest just like we shop for a car or sunglasses — some of us are bargain conscious, some are looking for a chance to show off. In an edited version of an interview with Portfolioist editor Nanette Byrnes, the Santa Clara University professor talks about the ideas behind his new book What Investors Really Want:
Portfolioist: This is your first book for the everyman investor. Why did you decide to write for a general audience now?
Statman: I worry that we have moved from the cardboard image of investors as rational to the cardboard image of investors as irrational and lost the true image of normal investors in the process. Normal investors are investors like you and me, often normal-smart but sometimes normal-stupid. I wanted to describe normal investors as they really are, because investors who fail to understand themselves cannot help themselves, and advisors who fail to understand normal investors cannot help them.
Portfolioist: You outline three benefits of investing, and the tradeoffs among them. Can you explain?
Statman: The benefits are utilitarian, expressive, and emotional. Utilitarian benefits are the answer to the question, “What does it do for me and my pocketbook?” The utilitarian benefits of watches include time telling, and the utilitarian benefits of investments are mostly wealth.
Expressive benefits convey to us, and to others, our values, tastes and status. They answer the question, “What does it say about me to others and to me?” Private banking expresses status and esteem. A stock picker says, “I am smart, able to pick winning stocks.” An options trader says, “I’m sophisticated, willing to take risk and knowing how to control it.”
Emotional benefits are the answer to the question, “How does it make me feel?” Insurance policies make us feel safe, lottery tickets and speculative stocks give us hope, and stock trading is exciting.
A fantastic perspective, in an area that needs review from the typical analysis of the recent past.
The question I often ask myself when I hear of this fund or that fund, buying gazillions of bucks ‘worth’ of treasuries or euro-bonds. Would they invest their one hard earned in this venture?
So it is the beginning of an overdue and interesting discussion.
Thankyou
FYI, funny story – Iceland. Early in WW II the Brits needed to protect their N. Lant convoys so they invaded Iceland and built an airbase at Keflavik. Very quickly the relationship between the Brits and Iceies went very sour, and we ended up having to step in and take over the base (when the Brits left they dynamited their buildings in Reyk rather than turn them over to Iceland, there were still embedded fragments visible in buildings as late as ’72).
FF to circa ’72-73. The base at Kef is now key to ASW activity against Soviet subs in N.Lant, and Iceland is in the Cod War with the Brits (which consisted of the tug boat Thor sailing out to confront the RN frigates defending the cod boats against the Icelandic assault (throwing potatoes at the RN sailors (I AM NOT MAKING ANY OF THIS UP))). Anyway, Iceland threatens to turn the Kef base over to the Bolshies if they don’t get the Cod grounds. Nixon capitulates.
FF to financial collapse, and Iceland in hock to Brits, who have veto over Iceland entry into EU. There was a meeting in Reyk with a bunch of finance types in which Iceland tried to hardball repayment. One of the reps was a Russkie, and Iceland rep told U.S. rep in presence of Russkie that if they did not get relief they would turn Kef over to Bolshies. Russian rep looked at Iceland rep and replied that Russia had no interest in the air base at Keflavik. The Cold War actually ended that day, regardless of what history says.
It’s still going on, I saw an article about a month ago about Iceland trying to encourage Chinese tourism, and hinting that the base might pass to Chinese control.