This book explores the role emotions play in every aspect of financial markets, from how huge sophisticated markets price securities, to the conventional wisdom doled out by investment professionals, to the investment decisions made by individuals and professionals. Over the last 40 years, numerous studies in behavioral science have increasingly challenged the notion of humans as rational decision-makers. It is startling how difficult it is to find any significant amount of rationality in these studies! Markets are human institutions, so it is not surprising they too are driven by emotional decision-making.
While emotions are the focus, the analysis presented in this book is quantitative and objective in nature. My own background is quantitative, with degrees in mechanical engineering, management science, and finance. So as it became increasingly apparent to me that emotions play a central role in how securities are priced, I turned my attention to the behavioral science literature and how the impact of emotions could be objectively measured. This is a quantitative process that leans on many of the careful statistical techniques in current use by academics and higher-level practitioners. Whenever possible, I support my conclusions with my own large sample statistical studies as well as those conducted by other academics.
Emotional crowds and behavioral data investors
I present an alternative way of thinking about financial markets and how to go about investing in them. It draws upon the growing behavioral science literature as a challenge to the foundations and predictions of Modern Portfolio Theory. Viewing the world through the lens of investor behavior challenges much conventional wisdom regarding how to make investment decisions.
Throughout this book, I will focus on the interplay between two important groups: Emotional Crowds and Behavioral Data Investors. The story is set in the stock market, but its lessons are applicable to any market where Emotional Crowds play a dominant role. As information and events swirl about the market, Emotional Crowds respond by coalescing around the currently popular fearful or exciting scenarios. Humans are hardwired for myopic loss aversion and to herd, so it is not surprising that Crowds dominate, producing a stock market fraught with excess volatility and pricing distortions. Rather than making things safer, as in our evolutionary past, myopic loss aversion and herding instead destabilize financial markets.
Behavioral Data Investors (BDIs), on the other hand, step away from the Crowd and systematically determine where the market is providing opportunities, building successful portfolios based on their analysis. They release their emotional brakes and uncover the behavioral price distortions (and sometimes information opportunities) provided by Crowds. That is, Crowds and BDIs engage in a complex dance about the market.
Market events may exist for a short time, but the resulting emotions last well past the event that triggered them. Thus the emotional opportunities provided by the Crowd are measurable and persistent. BDIs know this, harnessing the resulting price distortions.
Power of releasing and harnessing
Successful investing is emotionally difficult. It often requires waiting for long-term results when your portfolio was recently pummelled, recommending an investment when others think it is a dog, investing when volatility is high, and often looking and acting different from the Crowd. To be a successful investor, you must make a conscious decision to control your natural reactions and instead focus on decisions that flow from careful and thoughtful analysis. Staying disciplined in an emotionally-charged, 24-hour news cycle world is a challenge.
I believe that releasing your emotional brakes and then harnessing the price distortions created by the cognitive errors of others are the two most important things you can do in building a successful portfolio. The primary focus of this book is how to avoid becoming part of Emotional Crowds and, instead, develop into a successful BDI. In short, release and harness. The motivation for doing so is simple: on average Crowds underperform while their counterparts, BDIs, reap superior returns.
Behavioral science has introduced new terminology that aids in this transition, with concepts such as representativeness, availability cascades, loss aversion, peak-end memory, WYSIATI (what you see is all there is), anchoring, mental accounting, myopic loss aversion, social validation, phantastic objects, and many more. An important step in releasing your emotional brakes is to adopt this new terminology. It gives you the ability to see emotional decision making for what it is and reduce the chance of being swept away by the Crowd.
To be clear, this book is not about banishing emotions, for they play a central role in decision making and, without them, we would not have survived as humans and would be unable to function today. Rather, this book is about mastering your emotions and at the same time uncovering the role emotions play at every level of the investing process. You can be a very spiritual and emotional person, as am I, while at the same time making investment decisions based, not on emotion and intuition, but on careful, data-rich analysis. Such an approach leads to success in the world of investing.
Along the way I will discuss why it is important to shed many a conventional wisdom and instead look underneath the hood to determine what is really going on. Often conventional wisdom is catering to investor emotions and provides the basis for industry best practices (read emotional catering). Digging into the data and seeing for yourself what is really going on often reveals quite a different story.
So the steps to become a BDI are:
1 understand the dynamics of Emotional Crowds;
2 understand how an emotional investor makes decisions;
3 release your own emotional brakes, the first step of which is adopting a new terminology;
4 avoid the emotional conventional wisdom of the investment industry; and
5 harness behavioral price distortions.
This brings up an important consideration when becoming a BDI. By its very nature, you are often thinking and speaking differently than the Crowd. If social validation is important to you, then this will be a very difficult transition to make. I have been in this role my entire career. My wife frequently reminds me that I am tough to take out in polite company, since my views are so often different from the typical person. I bite my tongue often in social situations, but my being this way pays off handsomely in the stock market!
A professional journey
In the early 1970s, I took a course that forever changed the way I thought about the world around me. It was a basic economics course taught by Professor Billy Hughel Wilkins. In his soothing Texas accent, he showed us how economists think about the world. What I found so fascinating was that many things did not turn out to be as they seemed. That is, conventional wisdom regarding economic matters and the United States in general were often wrong. By carefully looking at the evidence on important economic issues facing the US, we came to conclusions that were at odds with those frequently reported by the press and which were generally accepted.
This approach fascinated me and led to a career in which I seldom accept at face value what I am told about the economy and markets. Instead my modus operandi became exploring the underlying data in order to figure out what was really going on. I was struck with how often what was stated as truth about a situation was incorrect. I was hooked on the economist’s way of thinking from that time on and spent the remainder of my graduate program focused on the tools used for testing empirically the explanations put forward regarding the economy and markets.
Many years later I read Steven Levitt and Stephan Dubner’s Freakonomics, which fitted hand in glove with my own view of how best to understand complex issues. They explore everyday matters by uncovering relationships using data that virtually everybody else ignores when trying to understand what is really going on. They examine issues such as illicit drug-selling organizations and the decline of crime over the last several decades, coming up with often surprising and controversial conclusions.
Levitt and Dubner’s view of economics is that