Why Stocks Tend To Decline Much Faster Than They Rise

The chart of Caterpillar (CAT) stock from 2002 to 2008 is an example of a cyclical stock that people became enthusiastic about and then subsequently sold in a panic.  Notice how the stock steadily rose from the end of 2002 to the beginning of 2008 and then gave up a substantial portion of those gains in less than a few months.  People generally feel twice as much sadness or pain when something is lost than when something of equal value is gained.  Humans have evolved to be this way, because when the world was more resource constrained, our ancestors’ survival depended much more on keeping what they had than getting something new.  The emotions that arise from loss are from parts of the brain that evolved much earlier than the parts responsible for rational thought.  This is the main reason why stocks go down faster than they go up.  People tend to get depressed and want to capitulate much faster than the time it takes for them to get euphoric.  Furthermore, as a stock rises, many people quickly sell to lock-in their gains.  The shareholder base gradually transitions from distressed and value investors, who contest momentum, to growth investors, who typically invest hoping to ride a trend.  When a stock goes down and its momentum shifts, the only people that would be interested are the distressed or value investors.  Since these types of investors tend to be less impulsive and generally more risk averse, they are usually slow to accumulate shares.  After all, they know that betting against a current trend often results in initial losses.   Distressed or value investors are in no rush to build fully-sized positions.

The above is an excerpt from my book: The Emotionally Intelligent Investor: How Self-Awareness, Empathy and Intuition Drive Performance

A Brief Example Of How To Use Empathy To Get An Investing Edge

The ability to be in the shoes of other investors and feel what they are feeling is an indispensable weapon in the investor’s armory.  Paul Tudor Jones, a billionaire hedge fund manager, affirms that it is less important to understand news than to anticipate the market’s reaction to it. The best way to do so is through empathy.  For example, in early 1990, Jones empathized with the tremendous pressure Japanese fund managers were under to return at least 8% per year.  While it may seem like an aggressive expectation in today’s market, the average Japanese household in 1990 had become accustomed to making at least 8% per year.  Any manager who under-performed that hurdle rate ran the risk of losing his job.  So when the market sold off 4% in January, the Japanese portfolio managers had a choice: they could keep their jobs and still make the 8% minimum return by reallocating aggressively into bonds or they could take a risk on trying to outperform by buying even more equities. [i]  By putting himself in the shoes of the average Japanese fund manager, Jones realized that most of them would not want to risk their jobs.  Consequently, Jones correctly bet that the Japanese stock market would suffer a major correction.

Please see the Disclaimer associated with this blog.  Paul Tudor Jones was not contacted for this and opinions are my own.

[i] Sebastian Mallaby, More Money Than God: Hedge Funds and the Making of a New Elite (Penguin, 2010)

What Most Hedge Fund Leaders Do Wrong

First, let me start off with the disclaimer that while I was a managing director at a multi-billion dollar hedge fund for eight years, I have never actually run a firm.  That being said, I have personal relationships with portfolio managers and analysts at many of the world’s largest hedge funds and believe that most of the leaders of these investment firms do at least one thing very wrong: they do not recognize the importance of their own moods.

There is a tremendous amount of academic research on how mood impacts investing decisions.  When we are happy, we are more inclined to take risks.  When we are euphoric, we can become overly impulsive and overconfident.  When we are sad, we become more risk averse.  When we are depressed, we tend to want to change our lives.  This can result in irrationally undervaluing what we own and overvaluing what we do not have.

A firm’s overall mood fluctuates in correlation to how well or badly it is performing.  When a firm is doing well, the firm’s analysts and portfolio managers will be happier and will ordinarily take on more risk.  Similarly, when a firm is doing poorly, these same employees will be sadder and more risk-averse, all things being equal.  Because markets tend to follow boom and bust patterns, this is usually the opposite of what they should be doing.  Leaders should take advantage of their influence to actively regulate mood swings.  Academic research suggests that the mood of a leader of any group is extremely contagious.  A leader’s mood quickly gets transmitted throughout the rest of the organization.  Therefore, leaders should proactively lift spirits after losses and be more morose when business is going well.  They should put the focus on mistakes and the role of luck during the good times, and on what is being done well during the bad times.  Most CEOs and CIOs do the exact opposite.  They usually make employees feel even worse than they already do for losses, and they overly praise employees for good decisions.  Instead of regulating mood’s impact on rational decision-making, they amplify it.

If you liked this post, you may like my recently published book: The Emotionally Intelligent Investor: How Self-Awareness, Empathy and Intuition Drive Performance.

Daniel Kahneman is Wrong (at least when it comes to investing)

Kahneman’s latest book, Thinking, Fast and Slow, is a must read for anyone interested in how people make decisions. The key takeaway from the book is that there are two different systems that work in parallel. The fast system is based on emotional brain processing and the slower system is based on reasoning. Most of Kahneman’s academic research revolves around how decision making gets corrupted by biases of the fast system. For example, the fast system is biased to believe statements while the slow system can be more cynical. When one is in a happy mood, the slow system, which consumes a fair amount of resources (oxygen, glucose, etc.), puts its guard down and you rely more on the fast system. This is why you are more likely to believe a lie when you are in a happy mood and why you tend to be more cynical when you are sad. As a professional investor, I can relate to this. I find that I am more likely to take risks when I am in a good mood and become more risk-averse when I am in bad mood. While most of Kahneman’s own research revolves around how “fast thinking” causes people to make mistakes, he does recognize that the fast system can actually be better for some situations. For example, chess masters can intuitively and quickly make very good logical decisions. They do not have to slowly evaluate a number of options. Rather, by recognize patterns, they can quickly come up with solutions to chess problems using the fast system. Firefighters and soldiers may also be better off making split second decisions based on what their gut instincts are telling them.

I humbly disagree with Kahneman, a Nobel laureate, and some other prominent psychologists when it comes to “fast-thinking” and investing. They argue that the stock market is too complex and random for intuition to be developed. They believe that the randomness causes people to build incorrect association biases. This argument is flawed.  While the overall market may seem complex and random, there are many patterns within it that recur frequently. The best money managers recognize patterns developing ahead of most. They also can develop useful intuition because they are honest with themselves about the role luck had in their success.  The intuitive decision-making that is involved with investing is much more complicated than other types of decision-making. However, that does not mean that we should abandon trying to better develop and use gut instincts when we invest. Some psychologists, like Gary Klein, also cite the fact that a large percentage of mutual funds underperform market indices every year. To them, this is proof that intuition built from investing experience does not translate into better decision-making. While it is true that most mutual funds underperform, a small percentage outperform consistently, which suggests to me that there is a handful of investors that have a “secret sauce.” Moreover, the fact that many of the statistically best investors seem to come from places where they had similar training (i.e., disciples of Benjamin Graham, Julian Robertson, etc.) implies that the “secret sauce” can be learned.

If you liked this post, check out my book: The Emotionally Intelligent Investor: How Self-Awareness, Empathy and Intuition Drive Performance.

How Buffett RELIES on His Emotions

The consensus opinion on Wall Street and on Main Street is that investing success comes from blocking out emotions and making purely rational decisions.  In this short article, I will try to convince you that this view is flawed.  While there are many emotional biases that lead to investing error, tapping into certain feelings can very often also be beneficial.  Instead of blocking out all feelings, Warren Buffett actually heavily relies upon at least two helpful emotional brain processes: intuition and empathy.

Intuition is not some sort of magical sixth sense.  Instead, it is a complex feeling that arises from pattern recognition.  Chess grandmasters usually know their next move within a few seconds.  Instead of suppressing their emotions, they first utilize gut feelings regarding their best possible move depending on how the pieces are laid out on the board.  The intuition is the result of years of study and practice.  These grandmasters then use their reason to make sure the move is safe.  If the initial gut instinct is found to be flawed, they start the cycle again with another intuitive feeling.[i]  There are too many possible moves for chess to be played any other way.  Many of the best investors seem to do something similar.  For example, Warren Buffett does not start his investment process by comparing a bunch of possible investment alternatives.  He does not heavily depend on quantitative screening tools.  Instead, Buffett intuitively gravitates towards a company he finds interesting and understands.  He then analyzes the company, its industry, and its valuation to determine if the investment makes sense.  If it does not, he moves on to the next company his intuition leads him to analyze.  If the potential investment seems safe or attractive, Buffett refers back again to his intuition regarding the management’s competency and trustworthiness.  He also utilizes gut instincts with position sizing, overall market exposure, and in sensing danger.  For example, he doesn’t completely analytically decide that one investment should be $1 billion while another one should be $300 million.  A significant part of that decision is based on intuition.

Buffett famously advises “to be fearful when others are greedy and to be greedy when others are fearful.”  This statement implies a reliance on empathy.  Empathy is the ability to put oneself in another person’s shoes and feel what they are going through.  Buffett’s investment choices are directed towards companies and industries where he senses others’ fear. Buffett knows that every buying decision he makes is associated with someone else choosing to sell.  While it is true that feelings like fear, sadness, shame and regret can lead to behavioral biases, which negatively impact decision-making, successful investing also involves utilizing empathy to take advantage of others making these common mistakes.

In summary, Buffett shows us that investment success does NOT come from blocking out emotions.  Rather, it comes through having the self-awareness to know which feelings are helpful and which are hurtful to your decision-making process.  It also requires the deliberate cultivation of relevant intuition.  Just like a chess grandmaster, Buffett’s intuition did not develop overnight.  It is the result of years of experience and study.  Finally, success depends upon developing the social awareness to be able to recognize when others ARE making mistakes because of some of their emotions.

There is much more on how to successfully develop and safely utilize intuition and empathy in my book titled, The Emotionally Intelligent Investor: How Self-Awareness, Empathy and Intuition Drive Performance.

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[i] Garry Kasparov, How Life Imitates Chess: Making the Right Moves – from the Board to the Boardroom (Bloomsbury USA, Reprint Edition 2010).

Note: Please see the Disclaimer associated with this Blog. I have never met Warren Buffett. The above text is my own opinion.

WHY Technical Analysis Works!

Most technicians who write about their methodologies think that people should follow them just because of the results.  They spend very little time explaining why chart reading seems to work.  In this short blog post I try convince you that technical analysis is useful because of our behavioral biases.

A support level on a stock chart is the result of our bias to sell winners too early and our inclination to make associations with prior positive outcomes.  Imagine several people, who originally bought IBM near $160 and sold it at $180.  They each experienced a positive outcome.  Most of these people will create a mental shortcut that associates buying IBM around $160 with a positive feeling.  Therefore, $160 becomes a support level.  In fact, this association can be so powerful that they can ignore facts such as a deteriorating outlook for the company’s fundamentals or negative changes in the economy.  Likewise, a resistance level on a stock chart is the result of the human self-defense mechanism against feeling the shame of being wrong.  A resistance level is created when there are many holders anxiously waiting to sell for a lucky escape once they get back to a price that would yield a ‘break-even’ result or a slight gain.  Imagine many people, who bought shares of Research in Motion (RIMM) at $15 because they were hopeful the company would turn its business around with new product introductions.  After RIMM’s new products got bad reviews, some of these people sold, causing the stock to drop sharply.  Those who didn’t exit, likely now feel stuck.  They desperately want to avoid the shame that comes from selling at a loss, so they continue holding on to losing positions.  They hope for a bounce back to $15, so that they can exit and break-even.  Thus, $15 becomes a resistance level.

Another common technical principle is that the stock market tends to bottom out as fewer stocks in the market make new lows.  This “market breadth” rule makes sense when one considers the human bias to overly focus on a “win/loss” ratio.  Most of us are biased to look at the number of times we are right versus the number of times we are wrong.  Of course, this is absurd.  In investing, you can have many winners which can be more than offset by a single loser.  Nevertheless, when people see that most stocks in their portfolios are not making new lows, they tend to get a little happier, even if they are still losing money.  The improved mood generally leads to increased risk-taking (There is a lot of academic research which shows that risk appetite rises as people become happier).   Mood is also contagious, so when some get happier, others are likely to follow with increased risk-taking.  The shift in mood among many market participants eventually leads to an inflection from a bear market to a bull market.

Technical analysis (chart reading) can be helpful to most, if not all, types of investors.  It works because it takes account of investor psychology.  A chart can tell you a tremendous amount about what the current shareholders of a security may be feeling.  It can be a visual manifestation of many behavioral biases.  If you are an investor, who compares chart reading to astrology, you are missing out.  I know, because I used to be in your camp.  Similarly, traders, who focus too much on esoteric patterns without understanding what the chart is actually telling them, are also often using technical analysis incorrectly.

Much more on this topic, including a discussion of several other chart reading principles, in my recently published book: “The Emotionally Intelligent Investor: How Self-Awareness, Empathy and Intuition Drive Performance” available at http://www.amazon.com/The-Emotionally-Intelligent-Investor-self-awareness/dp/0615688322

-          Ravee Mehta, Investor and Author

-          Follow me on twitter @ravee_mehta

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Buffett vs Soros

Warren Buffett and George Soros are both great investors, but they are different in almost every respect.  Soros is impulsive while Buffett is conscientious.  Soros is a philosopher while Buffett is a practical Midwesterner.  Soros is more emotionally sensitive than Buffett.  Soros knows that losses can impair his judgment, whereas Buffett knows that one of his strengths is to be “greedy when others are fearful.”  Their success comes from the main thing they both have in common – high self-awareness.  They are both introspective enough to have adopted investment approaches that fit perfectly with their personality traits, motivations and weaknesses.  Warren Buffett is a legend.  However, if George Soros tried to be like Buffett, he would very likely have been a failure.

Soros is a trader while Buffett is a long term investor that looks for investments he can hold forever. Investment horizon is a by-product of motivation.  Buffett enjoys learning how businesses operate and loves finding new businesses with sustainable competitive advantages.  He likes to be a long term partner with management.  On the other hand, Soros’ motivation is derived from his love of philosophy.  He views investing as a means for testing his theories.[i]  Therefore, Soros does not necessarily have an investment time horizon.  If he realizes he is incorrect, he may reverse his position the day after it is initiated.  At the same time, Soros could be in the same investment for years, as long as his theory concerning it still proves valid.  Buffett has a lower tolerance for ambiguity than Soros.  While Buffett walks away from any business he does not understand, Soros views uncertainty as part of the opportunity.  Both investors are excellent in avoiding overconfidence, but they do so in different ways.  Buffett utilizes a partner, maintains a humble lifestyle and is relatively even-keeled emotionally.  Soros is constantly on the lookout for the flaws in his thesis and is highly open to the ideas of others.  While his mood and emotions seem to fluctuate much more than Buffett’s, Soros uses his relatively high self-awareness regarding his emotional and even physical states to his advantage.  He sometimes changes his views at the onset of acute back pain, for example.

Like Buffett and Soros, we each need to tailor our investment style to fit our own personal attributes and tendencies.

If you liked this post, you will probably like my book “The Emotionally Intelligent Investor: How Self-Awareness, Empathy and Intuition Drive Performance” available at http://www.amazon.com/The-Emotionally-Intelligent-Investor-self-awareness/dp/0615688322

- Ravee Mehta, Investor and Author


twitter: @ravee_mehta

[i] Richard L.  Peterson, Market Psych: How to Manage Fear and Build Your Investor Identity (Wiley, 2010).

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