Contents
Stock Market Crushes
Markets Are More Than Simply Irrational—They Can Be Mean
Photographic Evidence: Scientific Evidence of Sentiment Predicting Stock Price Changes
Some People Get Rich by Selling High and Buying Low
Photographic Evidence: Predicting Coin Flips
A Hypothesis Masquerading as a Theory
Sell the Fads, Buy the Outcasts
An Instinct for Losing Money
A cartoon I saw posted over a trader's desk on Wall Street read, "Definition of a quandary: Should I sit back and watch the market soar or buy now and cause it to plummet?"
In some areas our natural tendencies take us to good outcomes. My wife's recent pregnancy comes to mind as one such area. During the early part of pregnancy, the growing fetus is especially sensitive to certain naturally occurring toxins(teratogens).
According to Margie Profet, who won a MacArthur Foundation "genius" award for her work on this subject, pregnant women are built to avoid foods that include fetus-damaging toxins (teratogens). 23 She provides evidence that pregnant women are nauseated by such foods, particularly cabbage-family vegetables like broccoli and cauliflower that have high levels of damaging compounds. If Profet is correct, then in the area of food choice, pregnant women ought to follow their instincts and eat whatever tastes good.
When it comes to investing, the message is exactly reversed. The trades that feel good tend to lead to losses. For example, my older sister Sue recently sent me an e-mail saying, "I have gone crazy buying stocks! ... No informed rationale for purchases, just a feeling. Reminds me of the slots at Vegas!" Sue's lizard brain was screaming at her to buy.
After almost a year of watching the market rally with only a small ownership in stocks, sister Sue was fed up. It was time for her to get in on the gravy train. Unfortunately, this impulsive purchase was timed for losses. In fact, within a few weeks of the e-mail, the stock market had its biggest decline in a year.
My buddy Doug had a similar experience recently. Doug appears in a few chapters of this book and has had excellent results overall (in the stocks chapter, you can read about the day he earned $500,000 in an afternoon of surfing). In early 2002, Doug did some careful analysis of a few firms that he knew well. He decided to buy some Nortel stock at around $1 a share. This turned out to be a great purchase as the stock went up steadily.
In the months after Doug's purchase of Nortel, I heard not a single peep from him about his successful investment. Then one day, the following note arrived with the subject line of "a little bragging." It read, "I was pushing Nortel big back at around $1. Well Nortel is over $8 today; up $1. Call me Warren :-)"
After months of watching Nortel stock climb, Doug's lizard brain made him send this e-mail at this particular moment. A Wall Street cliche is that "nobody rings a bell when it's time to sell," but this bragging e-mail was a perfect time to sell. Within a short period after the e-mail, Nortel's stock returned to $3, going down even faster than it had risen.
The message is that unfettered emotions are not the investor's friend. Doug's decision to buy was driven by analysis in his prefrontal cortex, his decision to gloat, by his lizard brain.
A recent study documented the physiological reaction that people have to market information. Professor Andrew Lo and Dmitry Repin wired up a group of professional traders. 24 With a setup not too different from a heart stress test, these MIT researchers were able to measure minute changes in body temperature, skin conductance, and a host of other variables. The traders they wired were trading real money online for an investment firm.
What happened to our wired traders when news broke? Lo and Repin report two interesting findings. First, all the traders—even the most experienced—had measurable emotional responses to news. Second, the more experienced traders had weaker emotional responses than their less-experienced colleagues.
These physiological responses may help us understand mean markets. When people see stock price changes or read about world events, we have physiological responses. If we act on those emotions, we tend to make precisely the wrong moves. In other words, we need to shackle the lizard brain in order to make money.
To be successful we have to damp down our emotional response (toward the lower response of the experienced professional traders in the MIT study) or we need to prevent our emotional reactions from impoverishing us. The "timeless tips" of Chapter 10 focus on ways to shackle the impulsive and unprofitable lizard brain trader who lurks inside us.
As the title would suggest, the Incredible Shrinking Man portrays the life of a person as he goes from normal size to tiny. As the protagonist continues to shrink he faces danger from a house cat and—when even smaller—from a spider. Eventually our hero realizes he cannot cower indefinitely. He confronts the spider, and even though the beast is much larger than the shrunken man, he kills it with a pin. After this victory, the movie ends as our hero prepares to leave his former house with a cocky walk and a blood-covered weapon slung over his shoulder.
Similarly, we reach the end of the first section of this book and push off into a dangerous and unknown future. The science of irrationality has proven that people make a variety of errors. Furthermore, markets do not always iron out those errors and people sometimes stampede into and out of markets at precisely the wrong time. Markets can indeed be mean, but because markets can be crazy, opportunities exist for profitable investments.
While markets are irrational, the profits are hard to obtain precisely because $100 bills persist in the lizard brain's financial blind spots. Just as we must use a mirror and other tricks to see into the blind spots on our cars, we need help to spot market opportunity. We have one tool so far and that is sentiment. We know that in order to make money, we must make the unpopular moves and attempt to constrain the lizard brain.