D is for Disposition Effect

The Disposition Effect states that we're more likely to sell winners than losers but it also makes a more general statement. When things go well we tend to ascribe our success to our innate abilities – our disposition. When they go wrong we tend to blame external factors – our situation.  And the result is that we never learn very much.

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Portfolio Tracking Is For Losers

Abnormal Markets

If we can’t stop ourselves being biased by market information then we have the alternative of avoiding it.  The idea that we should cut ourselves off from our portfolios and limit our exposure to market news is anathema to the majority of us, but we’d probably end up wealthier as a result.

After all, as I discussed in Maladaptive Investing, most of our psychological biases are the result of normal behavior in an abnormal environment.  If you can’t change the former without a million years of adaptation then maybe we should accept the inevitable and turn off the tracker. 

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You’ll Never Grow Rich Taking A Profit

“I made up my mind to be wise and play carefully, conservatively. Everybody knew that the way to do that was to take profits and buy back your stocks on reactions. And that is precisely what I did, or rather what I tried to do…..They say you never grow broke taking profits. No, you don't. But neither do you grow rich taking a four point profit in a bull market.”

Jessie Livermore, Reminiscences of a Stock Operator

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Brains, Bulls and Lucky Tossers

The Wile E. Coyote Moment

With the great post-Armageddon bull market party in full swing suddenly everyone's an investment genius again. Back in 2008, when stocks were languishing at lows not seen since talking movies were invented, no one wanted to know. And, as usual when the bull is running, logic is taking a quiet break and considering early retirement.

Well, logic needn't bother. At some point people are going to look down and realize that they've run over the cliff edge again. The question is not if, but when, the Wile E. Coy moment will happen.  The trouble is that bull markets get people thinking they’ve got brains when mostly what they’ve got is hope.

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Keynesian Investing: Changing Facts, Changing Minds

Changing His Mind

David Chambers and Elroy Dimson have published a wonderful paper on Keynes the Stock Market Investor, which analyses John Maynard Keynes’ remarkable investment record as the effective Chief Investment Officer of Kings College Cambridge over a period of a quarter of a century.  It’s a fascinating insight into the evolution of one individual from underperforming, overconfident, macro-based and behaviorally biased to an outperforming, realistic, stockpicking rationalist. 

That this journey happens to have been made by one the last century’s most famous economists, and that it flies in the face of much of his own macroeconomic theory merely adds piquancy.  The lessons, though, are applicable for any investor, whether genius or not.

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Idiot Noise Traders

Who's Noisy Now?

In 1985 Fischer Black published a paper entitled “Noise”.  In this he argued that much of the irrationality in financial markets could be explained by people trading without information: essentially using various spurious signals to decide when to buy or sell. In fact there’s an argument that without such people markets couldn’t work at all. The downside of this is that it’s difficult to separate the noise from the information.

Black predicted that there would be people who spend their lives trading on noise – so-called “noise traders”; people that Paul Krugman calls "idiots". Unfortunately these idiots generate so much noise that it’s very hard to determine the real information, which would suggest that if we're not careful, at root, we’re all idiots.

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Are Traders Dumber than Drooling Dogs?

Salivating Spaniels

Given the ebb and flow of investor sentiment, often for no other apparent reason than the ring of the opening and closing bells of the market, it’s terribly tempting to compare traders to the salivating dogs from Pavlov’s famous experiment.  The dogs, of course, were trained to salivate at the ring of a bell in the expectation of a good meal.

Naturally, this would be demeaning, a gross insult to the intelligence of our canine friends.  Because it turns out that there’s quite a lot of good evidence that humans investors are, despite their superior intellectual capabilities, dumber than drooling dogs.

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Regret

Behavioural Biases (4): Regret

If you’ve ever done something and then regretted it you’re in the fine company of the rest of the human race. If you’ve never regretted anything then you’re probably a sociopath and need to stop attacking people with spatulas and get a nice quiet hobby instead. Something like misdirecting people into buying stupid stocks on internet bulletin boards should do nicely.

If you are fairly normal, however, you’ll be aware that regret is an unpleasant and queasy feeling which you’d generally rather avoid if at all possible. As ever, when it comes to finance, obeying the urgings of your intestines comes at a cost. In investment it pays it to pays to regret nothing: although it’s certainly true that pride comes before a fall in your portfolio value.

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The Death of Homo economicus

Active Stockmarket Investment is not for the Inexperienced

Economists and political philosophers from Adam Smith to John Stuart Mill long held fast to the idea of the human being as a rational creature, one wishing to maximise their own self-interest at least effort and risk to themselves. This creature – dubbed Homo economicus by its opponents – is some kind of perfect calculating machine, weighing up risks and rewards and making logical choices in its own self-interest.

Basically it’s what an economist imagines themselves to be. Like Mr. Spock without the ears, green blood, mind melding and curious eyebrows.

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