Investment Psychology Explained

by Martin J Pring

  The media helped to build the guru's reputation during his climb to fame, but the symbiotic relationship can be equally destructive during his fall from grace. That an "infallible" guru is making mistakes is a newsworthy story in its own right.

  Some gurus reach the public's attention through a series of lucky calls and a transitory knack for self-promotion. Such personalities rarely have the analytical staying power to remain successful and soon fade into oblivion. On the other hand, the true guru is usually quite talented. He often develops a new theory, indicator, or philosophical approach that he improves over a number of years. Occasionally, he grabs onto the theories or approaches of analysts who have long ago passed from the scene, taking them to a new level of refinement. The method gradually catches on with a small band of followers and word spreads. The emerging philosophy and its success have an intoxicating effect on the followers, especially as the theory grows bit by bit in popularity, adding even greater prestige to the whole approach.

  Unfortunately, the markets are continually changing. What is popular in one cycle rarely works in the next. The legendary technician Edson Gould is a classic example. He had been in the analyst business for several decades, reaching the zenith of his popularity in the 1973-1974 bear market. The world at large first began to here about him through a famous interview in Barron's. I remember reading how he called the famous "last 100 points" as the Dow rallied from the low 900s to a new peak, at the time, of just over 1,000. Gould's predictions then called for equities to enter a devastating bear market that did in fact materialize. Gould's most famous indicator was the so-called three-step-andstumble rule. He argued that once the Federal Reserve raised the discount rate for the third time it was time to begin worrying about a new bear market. He also used some other indicators such as the Sentimeter, which basically measured the cost of one dollar's worth of dividends on the Dow Jones Industrial Average. By his reckoning when the Sentimeter rallied to the 30 levelmeaning investors were willing to pay $30 for $1 worth of dividends-the market was overvalued. This also was bearish for the market in 1973. Based on these and other analytical tools, Gould correctly predicted a low in the Dow of about 500. Bear markets, he argued, often cut prices in half. His original projection called for an August 1974 bottom, but the actual bottom in October was still pretty close to his projection.

  There is no question that a substantial amount of Gould's forecasting power derived from his many decades of study and practice. But there was also a significant element of chance. Sometimes prices are cut in half, sometimes in quarters, and sometimes in thirds. In this example, Gould clearly got lucky. Unfortunately, Gould faded from the scene almost as fast as he arrived. His three-step-and-stumble rule failed to work on such a timely basis as in the past. The market actually peaked in 1976 as participants, remembering that rising rates had killed the market in the 1973-1974 period, discounted the next rise before it really got underway. As a result, Gould's three-step-and-stumble missed the top and only came into force in the early part of the 1978-1980 advance. By this time, Gould was well into retirement age and never recovered his former glory.

  Joe Granville was a market guru of undoubted ability who combined his "revolutionary" theory of on balance volume with a tremendous talent for self-promotion. "Volume is the steam that makes the choo go" is how he described his approach. It is normal for volume to "go with the trend" (i.e., when prices are rallying, volume should be expanding and vice versa). The object of the on-balance volume indicator is to identify the subtle changes in the relationship that develops just before a market turning point.

  During the mid-to-late 1970s the market followed Granville's script to a T. He toured the world and drew attention to himself and his methods. Playing the piano and singing and appearing on stage in a coffin were some of the many stunts that he pulled. In early 1981, he turned bearish and the market declined 40 points in one day. This was a huge drop when it is considered that the Dow was trading at less than 1000 at the time. Then, in September 1981 at around the historical high in U.S. interest rates, his grip on the market began to falter. He was abroad at the time and had projected a major decline in the stock market. On September 26, 1981, interest rates peaked and stocks rallied. Although the market eventually went a little lower, September 1981 represented the bottom for many stocks. In the early 1980s, Granville was totally discredited because he remained bearish in the face of one of the biggest bull markets in history. Later on in the decade, he was able to regain some of his credibility, but he never again rose to the level of recognition that he had achieved at the turn of the decade.

  Both Granville and Gould were good analysts, but in the case of Granville, his ego undoubtedly got in his way. There is certainly an advantage in following a guru's advice in the early stages; but as his reputation develops, there is less and less chance that the advice will be profitable. The public will always have a certain fascination with the guru cult, but the lesson of history is that the guru is unlikely to make you rich unless you are clever enough to make opposite market decisions at the time when his personal grip on things is peaking.

  The Greener Pastures Effect

  One of the psychological snares that entrap all of us from time to time is the false assumption that we are missing the boat because our investments are consistently underperforming. At the end of every quarter Barron's, Money, and other financial magazines and newspapers report the performance of the top mutual funds. Naturally, they place great emphasis on the top performers. Statistics show that very few individuals have the good fortune to have invested their money in these funds, yet this publicity often leads us to believe that our investments are performing poorly. Before we make any ill-considered changes, we should remember that such funds are rarely, if ever, consistently at the top of the league. Often the funds on the list have achieved their position purely because their investment philosophy is in vogue or because they represent a particular market sector such as biotechnology or gold shares. These funds do not normally remain on the best performers list for more than one or two quarters, because their style or the sector they reflect can only outperform the market for a limited period. They naturally get the attention of the media because success makes news. After all, does the public really want to read about the fund managers half way down the list?

  If you get this "left-out" feeling, it is best to avoid the temptation of asking yourself, "Why didn't I invest in those funds?" If you do this when the funds are in the top-five performance list for the past quarter, the chances are good that they will underperform during the next quarter. This is not as true of funds that reach the top of the list based on five years of performance, because a long-term track record holds a greater likelihood that ability and not luck played the larger role in a good record of return.

  Even so, it is worth your while to examine the reasons for good performance over a long period just to make sure that the results were not unduly inflated by one very strong period. Another point worth checking is the size of the fund. It is much easier to obtain high returns with a small asset base of $10 million to $50 million than with one of $500 million to $1 billion.

  Part of the reason for this "greener pastures" attitude is that the financial community has recently become much more competitive with greater emphasis placed on performance. Rapid electronic communications have resulted in a corresponding telescoping of the time horizon for most investors. It is now much easier to dump a load of statistics into the computer and analyze the results in a flash. It is hardly surprising then that investors do not have the patience to stick with a nonperforming position when they can see all the fast-moving merchandise around them. Cocktail party chatter always revolves around the winners; losses and disappointments are forgotten.

  Is it little wonder therefore that many investors develop a complex that they are missing out on the action? However, does it make more sense to invest in a stock or a fund because it represents sound value and has good prospects or just because it has alr
eady moved substantially in price? A far better strategy is to look at the poorest performing funds and industry groups, recognizing that the worst is probably factored into their prices. Then ask this question: What might go right for me in these areas that others have not yet seen?

  Pride Goes

  Before a Loss

  Pride of opinion has been responsible for the downfall of more men on Wall Street than any other factor.

  -Charles Dow

  There are no statistics to back up this claim by Charles Dow, who was the founder of The Wall Street Journal. Anyone who has studied traders and investors in action, however, will know that this statement has substantial merit. It is surprising, therefore, that when I started to do some research on this aspect of market psychology, I could not find one reference to the subject in the index of any of the 30 or so books that I examined.

  Basically, pride of opinion means stubbornness and the inability to admit a mistake. In most of life's ventures, this attitude can temporarily obstruct relationships and the achievement of specific goals. In the investment world, such dogmatism is a recipe for disaster.

  After a long winning streak, almost every investor and trader falls into the trap of thinking that he is infallible. Unfortunately, the market has a way of exposing this weakness, and quite often a long run of success is wiped out in a fraction of the time that it took to accumulate the profit. Overconfidence and enthusiasm breed carelessness leading to poor market judgment and an inappropriate amount of leverage, since it is a human tendency to take on more risk after a run of success.

  Pride of opinion also can create problems when markets are falling, because dogmatic investors will often insist on maintaining their positions, even though the preponderance of the evidence shows that facts have changed. This haughtiness also contributes to the desire to break even.

  In Chapter 3, we discussed the importance of maintaining an objective outlook. A person's ability to modify an opinion if the background factors or conditions altered was cited as a key determinant in whether he could be successful or unsuccessful in the marketplace. Anyone who holds on to strong views in total contradiction to what is actually going on around him will certainly run into trouble.

  Market Operations as a Business Endeavor

  Every person engaged in market activity possesses a different psychological makeup, so pride of opinion as a potential weakness will appear in different forms and in differing degrees. Most people hold the view that it is relatively easy to make money when they initially get involved with markets. In the Introduction to this book, I emphasized that no reasonable person would expect to do well in any business or endeavor without first undergoing a substantial amount of training or gaining many years of experience. The same is true of the markets. Trading and investing in the marketplace should be viewed as any other business.

  We do not view this field as another business endeavor for two principal reasons. First, the cost and effort required to begin a trading or investing program are relatively low. We need only a little capital and a phone to call a broker or mutual fund company. After answering a few questions and filling out a questionnaire, we are ready to begin.

  That ease of entry is not the case in any other form of business activity. Usually, if we are applying for a job, we have to demonstrate that we have the requisite experience or qualifications. Starting a new business is also an involved process. There are government regulations to follow, credit checks to make, leases for equipment and office space to sign, employees to hire, and customers to attract. By comparison, entry into a financial market is a stroll in the park.

  The second reason people think that playing the markets is easy is that on face value it does look uncomplicated. All we have to do is buy low and sell high. The media also give widespread attention to the best performing managers and assets, rarely focusing on the losers. This leaves the neophyte with the distinct feeling that trading and investing represent mostly reward and very little risk.

  The notion that investing and trading are easy is inconsistent with reality. Successful practice of these arts requires a great deal of humility. Is it surprising that 90% of traders who open futures accounts are wiped out in the first year? If the average person knew ahead of time that the odds were very much against him, would he open up an account in the first place? If he were aware of this fact, surely he would conclude that a certain amount of study, reflection, and change in mental attitude were required to overcome these overwhelming odds.

  Some of the sharpest minds in the world have spent huge amounts of time and money in an effort to beat the markets. In effect, these bright, experienced, and well-financed professionals are trying to take money away from you. Is it little wonder then that most individuals lose money when they first begin to trade? This fact in itself indicates that trading and investing are far more complicated than first appears to be the case. Is it really likely that someone with a lot of enthusiasm but little experience will be successful against such formidable opponents?

  Not every market beginner is dogmatic, of course; nor is this rigidity the sole reason for the neophyte's lack of success. With your initial plunge into the stock market, however, you should be aware that pride of opinion is the first weakness that the market most likely will exploit. Consequently, it is the first one you must protect yourself against.

  You may feel that pride of opinion is a fault that you do not possess. If that be the case, ask yourself whether you could have trimmed or even avoided that last losing trade had your attitude been less cocksure. The markets do not give something for nothing. As R. W. Schabacker wrote in Stock Market Profits, "They offer their chief rewards, both financial and psychic, to those who approach it with humility, with a desire for knowledge and with the will to work and study." The following example shows how pride of opinion can be an important obstacle to a successful trading or investment program.

  Dogmatism in Action

  Some years ago a friend of mine was approached by a successful self-made businessman. This person-we'll call him Jack-had taken some large speculative positions in the commodities markets and was losing money at the time. He had known my friend, Bill, for several years and believed that he had a good feel for the market. Bill did not have a lot of experience in trading but had studied the markets for several years.

  Jack proposed that they set up a joint account to be run and operated solely by Bill and financed primarily by Jack. Jack also made it quite clear to Bill that he wanted to maintain close contact so that he could stay in tune with Bill's assessment of the markets. This was not for philosophical or educational reasons but because Jack also wanted this information to help him trade his personal account, which was still underwater. Bill was happy to agree to this arrangement because it gave him the opportunity to put his ideas into practice using Jack's capital to help him build some wealth.

  The arrangement got off to an excellent start, and the joint account made some substantial profits. Bill told me later that this was partly due to his own management of the account but that he probably owed more to the element of chance and the support and insight he was getting from Jack. They talked quite frequently, and over the short period in which they had been operating, Bill began to appreciate the astute thinking that had made Jack a successful businessman. Jack was also content because his personal account had also turned the corner and was now showing some substantial profits.

  After a couple more months, they both saw even greater gains. They were both taking great risks, but fortunately market conditions were extremely favorable. Commodity prices were booming, the partners were bullish, and nothing seemed to stand in the way of higher prices and the ensuing profits. Naturally, both individuals were elated with their success since the markets were confirming beyond a doubt their view of the world. At its peak, the joint account increased by a factor of about 30 in the space of just under five months.

  Bill tells me that, in retrospect, both he and Jack had been incredibly lucky to have beg
un their venture at a time when the markets were in an almost parabolic rise. Looking back on the whole venture, he also confesses that a substantial part of their success could be attributed to the fact that they took some unnecessarily large risks. Since their triumphs resulted far more from the element of chance than a disciplined psychological approach, it was not surprising that problems eventually occurred.

  In the first place, they had both become overconfident, believing at the time that playing the markets was easy. In the partners' minds, all you had to do was take a "correct" line on the market's long-term trend, then go out and take chances. If the market turned against your position, you could ride it out, because the setback was only temporary and the market would eventually turn back in your favor.