Investment Psychology Explained

by Martin J Pring

  The most important thing is to satisfy yourself that your method works. This does not mean researching it back over a few months but making sure that it operated profitably over many different types of market conditions. This is far different from expecting it to work perfectly. We have already established that there is no holy grail. Every market participant, however, needs some kind of foundation for making informed and objective decisions. In practice, individual decisions should not be made in isolation or solely on gut feel, but as part of an overall approach. The outcome will then be a consistent series of rational judgments.

  The second principle involved in the adoption of a philosophy is comfort in its use. If you feel perfectly at home and enjoy your adopted philosophy or approach, two benefits will accrue. First, enjoyment implies interest. Interest in turn will encourage you to explore and expand your knowledge of the subject. Second, you will not be receptive when the approach signals the need for action. For example, you may be sold on the idea of buying stocks with low price-earnings multiples. However, if you don't believe in the approach wholeheartedly, it's a good bet that you will find a reason not to buy when all your conditions for purchase have been met. The very nature of a market bottom is that it presents a host of reasons for not getting involved. You will need total confidence in your adopted approach, otherwise you will be unable you to overcome the psychological obstacles placed in your way.

  An additional consideration is to make sure that your chosen approach is consistent with your temperament. Suppose, for example, that you like the idea of trading the markets on a leveraged basis using a simple 20-day, moving-average crossover system. You buy when the price crosses above the average and sell when it falls below. However, if you do not have the stomach to endure the losses that are bound to arise from losing signals, there is little point in your following the system because you will be certain to lose money. In a similar but opposite vein, you may find some appeal in the idea of buying low multiple stocks that are out of favor and waiting for them to appreciate over a long period of time. However, if you have a trading mentality and lack the patience to wait out the long time interval that is usually necessary between buying and selling, then this perfectly legitimate approach will not work for you, either. You should therefore make sure that your approach or philosophy is not likely to conflict with your personality. Bear in mind, it is much easier to change the methodology than your character makeup.

  Another factor worth consideration is your innate abilities and how they might be applied to a specific methodology. Everyone has a different character makeup, where strengths and weaknesses are emphasized in a unique combination. You need to examine your own balance because doing so will help you to choose an appropriate investment or trading approach. For example, if you have an affinity for tape reading or charts, it makes a great deal of sense to adopt a system that incorporates these tools. Alternatively, you may pay a great deal of attention to details and require a substantial number of facts before coming to a decision. In that case, use a methodology that takes advantage of those skills.

  The essence of any approach, whether from a trading or investing aspect, is to develop a low-risk idea. Only when you have figured out the odds of winning or losing can you approach the markets with any hope for success.

  Establishing a Plan to Maximize Objectivity and Minimize Emotion

  The first step in establishing a plan is to adopt a method for distilling a multitude of ideas into one low-risk one. In a sense, the methodology is the framework under which you will be operating. The next step is to set up a written plan that anticipates and overcomes the psychological conflicts that inevitably lie ahead. (See Figure 13-1.)

  The advantage of a written plan is that it enables you to be precise. Once it is written, you can easily review its various aspects to make sure that it is consistent, comprehensive, and logical. Having it laid out on a sheet of paper will also reveal whether it has any biases and make it easy to check whether you have taken all the steps.

  Most people object to a written plan on the basis that they do not like following rules or that they are far too "intuitive" for such a thing. Others, with the best of intentions, choose to postpone writing the plan, which, of course, never gets written. Intuitive market participants often make good moves but then give back their gains in a series of poor decisions. Results are therefore inconsistent and haphazard.

  The benefits of a clearly written and logical plan in such cases are self-evident. Those who do not like to follow rules and are unwilling to develop a written plan clearly lack the discipline for profitable market campaigns. Moreover, financial success in the markets requires consistency and you can achieve this only by religiously following a set of predetermined rules.

  The following quick test can help you decide your investment temperament and ability to take risks for the purposes of asset allocation. It was designed by William G. Droms, a professor of finance at Georgetown University. Value the seven statements on a scale of 1 to 5, from "strongly disagree" with a rating of 1 to 5 for "strongly agree." Then add up your points.

  1. Earning a high long-term total return that will allow my capital to grow faster than the inflation rate is one of my most important investment objectives.

  2. I would like an investment that provides me with an opportunity to defer taxation of capital gains and/or interest to future years.

  3. 1 do not require a high level of current income from my investments.

  4. My major investment goals are relatively long term.

  5. I am willing to tolerate sharp up-and-down swings in the return on my investments in order to seek a higher return than would be expected from more stable investments.

  6. I am willing to risk a short-term loss in return for a potentially higher rate of return in the long run.

  7. I am financially able to accept a low level of liquidity in my investment portfolio.

  The following are Mr. Drom's asset allocation recommendations:

  Equities include real estate, venture capital, international stocks, gold, domestic stocks. Fixed income investments include American and international bonds.

  Figure 13-1 Test for Investment Temperament and Ability to Take Risks for Purposes of Asset Allocation. Source: William G. Droms, Georgetown University.

  The establishment of a plan is not a one-step procedure unless by pure chance you hit on the exact formula. The chances are good that your plan will require modification as you learn more about yourself and how you deal with various market situations.

  One of the most competent market psychologists, Van K. Tharp, has worked with some of the world's most accomplished traders and has published a course called "Successful Investing" based on his experiences. The course is intended to help traders overcome their weaknesses. Tharp states: "Most people tend to avoid working on themselves. It's too painful. Instead, the issue they have with themselves (e.g., security, self-worth) becomes an issue they have with the market (e.g., profits, losses) . . . . [the trader] simply transfers his problem, transmutes it and then has the same problem [but with a different manifestation]." As an aid in overcoming these very human problems, Tharp recommends that his students establish a plan that involves what he calls "the ten trading tasks." His ideas are essentially meant for traders, but the principles are equally valid for investors and others with a long time horizon. Tharp points out that your mental state and the kind of preparation you undergo before you put on a position will determine whether you are likely to win or lose on a consistent basis. Remember the task of developing a plan is to help you to become as disciplined and objective as possible.

  Tharp's steps are a good basis on which to formulate a written plan. Seven of these steps are listed next.

  Step 1. Self-Analysis

  If you are planning to take a run on a familiar track and want to beat your previous record, logic would tell you not to attempt such a feat if you are sick with a fever. You would be much better advised to make the attempt when
you were at your physical peak. The same principle holds true when dealing with markets. If you are psychologically run down due to illness or personal problems, the chances are that you are not going to be able to withstand the psychological turmoil that the markets will cause you. You will still be able to make decisions, but your confused state will reduce your ability to make sound ones at the margin; and it is at the margin that the dividing line is drawn between winners and losers. Consequently, whenever you feel overly stressed because of factors outside the market, you are advised to stay away or to make as few decisions as possible until your condition improves.

  We learned in the section on crowd psychology that going against the crowd at the right time can be very profitable. These types of decision by their very nature demand great courage. Anyone who has experienced a profitable trade or investment from such circumstances knows that they are usually the most rewarding. This approach does not come without its contradictions, though. How do you know whether your discomfort in making these difficult decisions stems from simply going against the crowd or whether it's a result of an emotional family dispute?

  One obvious solution is to reexamine the contrary case to see whether it makes sense. Tharp also suggests that people should develop a rating scale from 1 to 8 depending on how you feel about yourself on the day in question. Under this system, 1 is terrible and 8 is great. The idea is to spend a quiet 30 seconds in deep thought as to where you stand on the scale that particular day. Over a period of 30 days, you should then compare your daily ratings with your trading performance. Working on the assumption that there is a rough correlation, you are then in a position to establish an objective standard below which you should not trade. The principle of this method can be applied to market participants with a longer time horizon, but clearly the control period would have to be much lengthier as well.

  Step 2. Mental Rehearsal

  Whatever task you intend to accomplish, the odds of success will be greatly enhanced if you can rehearse it first. In this way, you will be in a better position to anticipate potential problems and will find its execution to be more or less automatic. If you can anticipate problems before they arise, your odds of successfully dealing with any that materialize will be much higher.

  Before I give a seminar, for instance, I will typically go through the lecture mentally in my hotel room prior to the actual delivery. Then, if I find that things don't flow in the manner in which I intended, I can make changes. At this stage, I also try to anticipate questions that participants might throw at me. I cannot prepare for all eventualities in this way, but at least I can have confidence that I have mastered my material and am therefore in a better position to deliver it more confidently.

  In the marketplace, a trader may anticipate that the market will go against his position. If so, under what conditions should he take losses, or at what price should he set a stop-loss? By mentally rehearsing all the possible alternative outcomes, this trader is then in a more objective position to deal with them and not be knocked psychologically off balance by an unexpected setback.

  Step 3. Developing a Low-Risk Idea

  We established earlier that the vehicle for establishing low-risk ideas was your chosen investment or trading approach. To carry out these ideas, you will need some information on which to base your decisions. If you follow charts, then you need the latest data either from a data vendor, so that you can plot it on a computer screen, or from a subscription chart service. If your forte is stock picking through fundamental analysis, then you need the data to help you to arrive at a sound decision, and so forth.

  In developing these ideas, it helps to isolate yourself from the views of brokers, colleagues, and friends and to come to an independent conclusion. Too much contact with the media can also be a potential problem, since it can easily sway your perceptions away from your chosen objectives. Also, make sure that you have all the facts necessary to make that decision before proceeding. It is amazing how our natural biases perceive that the glass is half full, when in fact it is half empty. A few more facts can often help to offset any structural bullish or bearish biases that you may have.

  Step 4. Stalking

  Once a low-risk idea has been established through the chosen methodology, the next procedure is to set out the kind of conditions in which it can best be executed (i.e., when the odds of success are greatest). A guerrilla band may come to the conclusion that a low-risk place to attack the army is in town A, but they must then choose a time for the attack. In this case, a public holiday, when the army is celebrating, would greatly increase the odds of success. The element of surprise has been known to militarists from time immemorial, and stalking has been a trademark of predators as well. This idea of choosing when to fight the battle is also relevant to market participants.

  Once you have chosen the low-risk idea, the task then becomes one of establishing the most opportune time to act. It may be right now or it may be later. Each situation has its own answer. A technician may decide that a stock is under longterm accumulation but is short-term overbought. In that case, the stalker's task is to wait for a correction to result in an oversold condition. A fundamentalist may come to the conclusion that XYZ Company is cheap, but that they are going to come out with some poor earnings. Better to stalk the investment until the bad news comes out and the price of the stock is temporarily driven down. It may well be that the markets' response to that news is very poor (see Chapter 9). In this case, the stalking should continue until the stock acts better. Alternatively, the exercise may be abandoned at this point in favor of a more attractive candidate.

  Step 5. Action

  Once the guiding criteria have been established and the required conditions have materialized, it is important to take action. The market will often move quickly at this point so it is important that you act decisively. If you have done your homework, you will have a fairly good idea of what your potential loss will be should the market go against you. In particularly volatile or "fast" markets, it is usually a good idea to place limits on your orders. Limit orders put a cap on how much you are willing to pay for an item. For example, you may have been stalking Company ABC and decide to buy on the day the earnings come out. It may well be that the results are better than the market expected and an order imbalance causes a delayed opening. If you have been doing your homework properly, you would have already established a ceiling price for your low-risk idea, so you need to incorporate this price in your purchase order to make sure that you do not overpay. Remember, even if the stock "gets away" from you, there will always be another opportunity at a later date. Do not under any circumstances allow the emotion of the moment to interfere with a well-thought-out, logical plan.

  Step 6. Monitoring

  Complacency is the enemy of traders and investors alike. Once the initial position has been taken, there is a temptation to relax in the belief that the task has already been accomplished. Of course, it is not over until the position has been closed out with a profit or loss. The nature of the monitoring task will depend to a large degree on the time frame under consideration. If you are a day trader, then 10 trading tasks will be executed perhaps two or three times a day. For the long-term investor, the process will be slower. Even for a person taking the long view, it is still mandatory to follow your position. Many people think that the long-term is a comfortable place to be and that they can hide from the market and not worry about their position. Nothing could be further from the truth. Tharp divides the monitoring process into detailed monitoring for traders and overview monitoring for others with a longer time horizon.

  Detailed Monitoring. If the low-risk and stalking exercises have been correctly completed, the trade should move into the profit side more or less right away. Tharp suggests traders should rate the trade to see how it "feels" in a manner similar to the rating exercise in Step 1. This time instead of "1-8," the benchmarks are "easy to difficult." He suggests that the trader undertake this rating three times a day for the first t
hree days at the opening, close, and midpoint of the trading day. If the trade does not feel "easy" after the third day, it will probably turn out to be a bad one.

  Overview Monitoring. This level is more suitable for long-term traders and investors. This type of monitoring involves a periodic review of the broad trends in the market or stock in question. Is it responding favorably to good news? Is there any change in your outlook for the economy? Is the technical picture still strong? During this process, it is important to make sure that you can remain as objective as possible. The natural tendency is to emphasize the favorable aspects and turn a blind eye to the negative ones. Expectations have a tendency to be based on hope rather than rational arguments supported by solid facts. Therefore, do not under any circumstances interpret signals according to your expectations. Try as best as you can to look at them objectively. Pretend that you do not have the position you hold and see how it looks from that aspect.

  As the monitoring process gets underway, survey the overall environment. As market events unfold, compare them with your original plan and study the implications of these events. You may find, for example, that the market moves against you, bringing the price back to a breakeven point. This need not be an unfavorable sign. Perhaps the news is unexpectedly bad, and the market sells off but holds at support and rebounds. A market that can do this is in good technical shape and should give you encouragement. On the other hand, a stock that sells off on a surprisingly good earnings report is to be questioned, and so forth. The monitoring process is no more than one of risk control. It is telling you to stay with a position, or it throws up reasons why you may need to sell. If you substitute monitoring for complacency, this healthy second process of self-enquiry will result in a far sounder campaign.