MarketPsych: Applying Behavior Finance

"The Facebook IPO": It's Here!

noreply@blogger.com (Frank Murtha, Ph.D.) — Sat, 19 May 2012 03:19:00 +0000

It's finally here!

More commentary to follow, but in the meantime a link back (video above, posts below) to a humorous take on this historic occasion.

http://blog.marketpsych.com/2012/02/marketpsych-films-facebook-ipo-part-i.html

http://blog.marketpsych.com/2012/02/facebook-to-have-ipo-worlds-colliding.html

Happy Investing.

And hey... let's be careful out there.

-Dr. Frankenstocks.

Cognitive Decline and Financial Decision Making: Advisor One Article

noreply@blogger.com (Richard L. Peterson M.D.) — Thu, 26 Apr 2012 20:22:00 +0000

As we age, our financial decision making changes. And more often financial advisors are being held liable for their clients' (impaired) decisions.

The MarketPsych team created the MEMRI script, described in this AdvisorOne article by Savita Iyer and in its full version in this pdf to help advisors improve client service.

We hope this simple 5-point MEMRI checklist improves advisors' abilities to spot developing problems in aging clients.

To learn more about financial decision making and aging, see a new study by Greg Larkin, Brian Knutson and others at Stanford. The study sheds light on the neuroscience of cognitive impairment in financial decision making among the aged: http://psych.stanford.edu/~span/Publications/gs12jn.pdf

Happy Advising!

Richard L. Peterson, M.D.

Trading on Social Media - Fox News Story

noreply@blogger.com (Richard L. Peterson M.D.) — Sat, 21 Apr 2012 19:36:00 +0000

A short and light Fox News report on trading on social media (and the data we generate for funds and banks) is here. They have some great stock footage of our friends Mike Waldron and Matt Pringle at Shoreline Trading!

We ran a hedge fund using our social media data from September 2, 2008 through December 31, 2010 - when we hibernated it due to lack of funding (despite the fund being up, it was difficult to raise money for it). The fund beat the S&P 500 by 27% over that period. We're planning to start trading again this summer. Please contact us for more information through the Contact form at www.marketpsychdata.com.

Happy Investing!
Richard L. Peterson, M.D.

Identifying Warren Buffett's Successor: Insights from Text Analytics

noreply@blogger.com (Richard L. Peterson M.D.) — Sat, 21 Apr 2012 18:43:00 +0000

MarketPsych Data analyzed Berkshire Hathaway's shareholder letters to determine who is most likely to be Warren Buffett's successor. Our results, and an excellent article about the project, appear in Jason Zweig's column in today's WSJ.

Using our software, which specifically detects emotive words and relationships, we identified the individuals who Warren Buffett referenced most positively in the Berkshire Hathaway shareholder letters from 1995-2011. Our software scanned for emotional references related to liking, being pleased with performance, and affection (what we called "Super-Positive") and references of a generally positive nature (what we called "Positive").

For individuals with more than eight sentiment-associated mentions in the shareholder letters, these two were the most positively referenced:
TONY NICELY (CEO of GEICO)
DANNY GOLDMAN (Venture capitalist - formerly CFO at Iscar)

For individuals with more than four mentions but less than eight, these two stood out:

JACOB HARPAZ (CEO of Iscar)

GRADY ROSIER (CEO of McLane Company)

So while we don't know who Buffett's successor will be with 100% accuracy, we do know that the above four individuals received high praise from Warren Buffett in his shareholder letters.

Check out marketpsychdata.com for more information about our market-leading financial textual analysis research.

Happy Investing!

Richard. L. Peterson, M.D.

MarketPsych Report: Regret, When to Sell AAPL, and Timing Bubble Tops

noreply@blogger.com (Richard L. Peterson M.D.) — Wed, 11 Apr 2012 01:00:00 +0000

Shorting Bubbles ... Ouch!

I have made my share of unfortunate investments over the years, but one in particular still bothers me. In 1998 it was very clear that the technology sector was in the midst of a historic bubble. There were many overvalued stocks – with no earnings, high debt, too-good-to-be-true stories, and extremely high valuations. I picked Amazon.com due to its high level of hype, and I sold short some shares.

A few months later I had lost 40% on that investment. Then a few months after that 80%. By the time I had lost 120%, I bought back my shares. (And good thing I did, the stock continued much higher before it finally peaked). I learned a lesson best-articulated by John Maynard Keynes: “Markets can remain irrational a lot longer than you and I can remain solvent.”

In the post-mortem analysis of that investment I looked back on my thought process. My conviction had been high, I knew I was right. Diagnosis: Overconfidence. And as a result of overconfidence, a weak risk-management plan. This trade changed how I think about trading timing and risk management. (It’s ironic how improving risk management always becomes urgent AFTER a big loss).

Steamrolled by the crowd, and my lesson learned, I turned to the study of timing bubbles. I wondered, how could I time the expansion and ultimate collapse of market sentiment around hot tech stocks like Amazon.com?

I decided to start by looking inward – what were investors in Amazon thinking (or not thinking) when they bought in? And what triggered the ultimate fall in the price? In fact, my senior research project in medical school was on “The Social Psychology of Bubbles and Panics” (I was extremely privileged to work with a pre-eminent researcher on impulse-control – Ernest Barratt, Ph.D.).

It turned out that expectations are key to bubbles, and expectations are rooted in the brain’s emotional circuitry. That circuitry is easily activated by extraneous events. In fact, researchers have found that completely unrelated positive events (movie clips, pictures of happy faces, pornography) prime us toward taking excessive financial risk (Read more in today’s Researcher’s Corner below).

We’ve had a similar sort of timing problem the past several newsletters. And from our research, we know that a key success trait of investors is good timing – rapid execution on high conviction ideas. Our monthly newsletter takes about 10 days from conception to publication, and during that 10 days our forecasts often become stale, rendering the monthly recommendations less profitable (e.g., the oil and copper short hints last month worked out a few days before publication – fortunately the decline in oil and copper prices continues).

Before we jump into how to time bubbles, first some housekeeping.

Recent Press

“Pro stock traders looking to Twitter, Facebook for tips.” Walter Hamilton. Los Angeles Times. March 30, 2012.

“The Financial Psychopath Next Door.” Sheree Decovny. CFA Institute Magazine. March/April 2012.

Bloomberg TV with Lisa Murphy on using social media for investing. March 3, 2012.

Bloomberg TV with Sarah Eisen on February 27, 2012 discussing using Twitter to predict the stock market.

List of Past Press.

New Newsletter and Speaking

To shorten the length from idea to recommendation, we are launching a weekly newsletter which will give you specific investment recommendations and less commentary. Click and fill out to receive our FREE weekly investment strategy newsletter (if you already requested the Newsletter, then this step is unnecessary).

In addition to our usual haunts of New York and Los Angeles, we will be speaking in Atlanta (Socionomics Summit), Las Vegas, and San Francisco in April and May – we’re look forward to catching up with our friends in those cities!

We’re hosting a one-day Optimize Your Investment Psychology training in London’s Canary Wharf on June 19^th, 2012. We will help you improve the performance of the most essential component of your investment decision making - your mind.

We deliver keynotes and trainings globally, and going forward our good friend Derek Sweeney at the Sweeney Agency is handling our bookings: Derek@thesweeneyagency.com, +1-866-727-7555.

We also do many free educational talks. Dr. Frank Murtha recorded this webinar on Conflict Management for the CFA Institute in late March: Dr. Murtha’s CFA webinar.

What Makes a Bubble?

After my medical school research into bubbles in 2000, internet investment chatter continued to proliferate, and sophisticated predictive analytics software became available to the masses. To capture these trends we wrote software to download all the social media discussions (and later all media and text about businesses) on the web. We identified expectations and emotional expressions about individual companies in these conversations, such as the level of positive expectations around Apple’s (AAPL) share price. Our analysis has now expanded to monitor over 1,000 influential factors including sentiments and macroeconomic variables in conversations about companies, countries, commodities, and currencies.

Recently we decomposed those factors into the ones prevalent at bubble tops, but not prevalent at bubble bottoms. We studied 6 bubbles in our sample (internet, housing, oil, and others). Using our bubble profiles, we created a probabilistic measure of the presence of bubbles in different asset classes, based on how people are speaking. For example, when positive expectations jump far ahead of reality, and when anger and fear are very low, we are likely to be in a speculative bubble. We combined 20 such factors into our “bubbleometer” index. See below for the 2-year Bubbleometer of the S&P 500:

Sure enough, this indicates a short-term sell-off is imminent. And lo and behold, due to the long production cycle of this newsletter, it already started! But never fear, you can sign-up for our weekly newsletter or use our free web services at www.marketpsychdata.com/tools/ to track sentiments and securities of interest (updated daily).

Is AAPL in a Bubble?

Apple has been in the news a lot lately – “Will it be the first $1 trillion company? When will the stock price hit $1,000?” - are common refrains in the blogosphere.

And sure enough we see the psychological hallmarks of a bubble around AAPL. See chart below.

Yet I believe that “this time is different.” Based on the Bubbleometer, AAPL is at its 2-year Bubbliest. So a short-term a correction is certainly possible/probable. Yet the long-term fundamental story for AAPL is reasonable, and valuation (often correlated with emotion) is the best long-term predictor of prices. Most people are inclined to think AAPL is bubbly because its stock is going up so fast. But in fact, AAPL is a relatively cheap stock by traditional metrics (P/E ratio, price to book, cash flow, margins, and on and on).

So why do so many people think it is in a bubble? For one, we all have a tendency to believe in mean reversion - “What goes up must come down” – which is a symptom of the Gambler’s Fallacy (thinking independent sequential events are mutually dependent). “What goes up…” is true about objects that no longer have any momentum behind them. But AAPL has more than momentum, it has its own fuel supply.

The other interesting fact about AAPL is how much money it is creating in paper wealth for investors in the United States (and the world). In the past 4 months AAPL has added $200b in notional wealth to the United States equity markets via the appreciation of its stock price (about $700 per person), not to mention the economic efficiencies reaped by Apple’s products and the success of Apple suppliers. Which raises an interesting - and important - question: Could AAPL be single-handedly pulling us out of our economic slump? If so, Steve Jobs, Jonathan Ives, Tim Cook, and the other A-players at Apple may have been our society’s best investment of the decade. I hope we will produce more like them going forward.

Inside the Quant Brain

Two weeks ago I moderated a panel of the hedge funds who are trading on text analysis and sentiment at the New York “Battle of the Quants.” FYI, here is a video of an interview with me about sentiment-based trading strategies from that event.

Sitting in the audience during the “Extracting Sentiment From News” panel, my friend Richard Brown - Head of Global Data Products at Thomson Reuters - was asked about the future of news analytics. He mentioned two hypothetical conversations read by news-crunching machines - one pessimistic and one angry. Both are equally “negative” according to news-analyzing computers, but they generate very different predictions for the future: “a sad person is more likely to hurt themselves, while an angry person is more likely to hurt others,” he noted. He’s absolutely right - regime change happens when people are angry (negative), but not necessarily when they are gloomy (also negative).

Once social anger crystalized in the Middle East, the Arab Spring began. This is the rationale behind our detailed interpretations of emotive sentiments and topics from the news Our GovernmentAnger variable, which measure the amount of anger expressed toward the government, is currently highest for media reports about (it’s obvious) … Syria. Next highest for GovernmentAnger are Sri Lanka, then Hungary, Israel, Bahrain, Turkey, Mexico, Nigeria, and the United States.

I noticed an interesting crowd reaction at the Battle of the Quants when Richard Brown mentioned sadness and anger. The crowd froze. The room felt uncomfortable. And no wonder – the crowd’s reaction is likely innate – talking about emotion actually primes us to feel that emotion. It is uncomfortable to talk about sadness and anger, because to relate to those words, we call up subtle memories of times we have felt the same – which is uncomfortable – our natural defenses shut down our processing – no more listening, perhaps some scoffing, and a wall of skepticism rises. It is perhaps this reaction that, in my opinion, will keep emotive text analytics as a long-lasting source of alpha. But no need to belabor the point about emotional priming, time to turn back to something joyful…BUBBLES!

Researcher’s Corner: Bubbling With Excitement

Research has shown that anticipation of making money activates specific neural circuits. We are emotionally primed – and our subsequent decisions are biased – after such simple acts as watching an emotional movie clip, reading a positive (or distressing article), or simply looking at our portfolio performance. There is already evidence that pornography (sexy photos) change financial risk taking and emotional faces do so as well.

Vernon Smith shared the 2001 Nobel Prize in Economics for his creation of an experimental asset market bubble in the lab. Smith found that experimental subjects will bid prices far beyond “rational” levels in his market environment. A recent twist on Smith’s bubble-model at the University of California at Berkeley found that the emotional states of the participants influence prices even more (and those emotional states can be manipulated by emotional primes). “Bubbling with Excitement,” a study by Shengle Lin, Terry Odean, and Eduardo Andrade indicates that seeing an emotional movie clip in advance of participating in an experimental market leads to increased risk-taking (bigger bubbles) and ultimately bigger losses for the emotional participants.

Source: Shengle, Lin; Odean, Terrance; Andrade, Eduardo. 2012. “Bubbling With Excitement: An Experiment.” SSRN:

Revisiting the Bubbleometer

The U.C. Berkeley researchers are clearly onto something. As noted above, we found that high levels of positive emotions (Joy and Love) and low levels of negative emotions (Anger and Fear) are correlated with Bubble tops (and price declines the following month). Our findings mesh fairly well with this graphic developed by Westcore Funds and reproduced by Bank of American Merrill Lynch (where we obtained it). In fact our findings have been discussed anecdotally for many decades:

So where is the bubbliest talk now? For economic sectors, we are seeing Bubble-talk from investors in Homebuilders, Energy, Environmental Services (waste management), and Social Media.

Interestingly, the countries we see with chatter indicating bubbly thinking include: Myanmar (did optimism about political liberalization run ahead of itself?), Qatar (Can it be this good, really? Maybe so if you have the world’s 4^th largest gas reserves), Netherlands, Peru, Dubai (a perennial bubble due to a testosterone-fueled refusal to stop building and admit defeat [Gentlemen, STOP the redundant construction already!]), and our warm and fuzzy neighbor to the north, Canada (Is their housing-bubble ready to pop as commodity prices fall? Affirmative), and Singapore (a Chinese contraction would leave Singapore vulnerable).

Talks in April and May

We love to chat with our readers about their experience with psychology in the markets, so don’t be shy - we look forward to hearing from you!

We have speaking and training availability. Please contact Derek Sweeney at the Sweeney Agency to book us: Derek@thesweeneyagency.com, +1-866-727-7555

Happy Investing!

Richard L. Peterson, M.D. and The MarketPsych Team

Book Review of "Behavioral Investment Management" (2012)

noreply@blogger.com (Richard L. Peterson M.D.) — Thu, 22 Mar 2012 16:58:00 +0000

Behavioral Investment Management: An Efficient Alternative to Modern Portfolio Theory by Greg B. Davies and Arnaud De Servigny (McGraw-Hill, 2012)

“People in standard finance are rational. People in behavioral finance are normal.”

Meir Statman, PhD, Santa Clara University

The above quote by Meir Statman captures concisely the thrust of the concepts explored extensively in this new book by Greg Davies and Arnaud De Servigny. They tackle what is by now a relatively widespread view that modern portfolio theory (MPI) has fundamental flaws when used blindly to build portfolios for individuals. However, rather than throwing the baby out with the bath water, they zero in with quantitative precision on the aspects of this developed theory that they counsel should be modified to reflect the fundamental truth of how humans process concepts and make decisions.

You should note that Greg is Global Head of both Behavioral and Quantitative Investment Philosophy at Barclays Wealth. Arnaud is the Global Head of Discretionary Portfolio Management and Investment Strategy at Deutsche Bank Private Wealth Management and Adjunct Professor of Finance at Imperial College Business School in London. Given their backgrounds, both behavioral and statistical topics are explored in this book with extensive use of quantitative methods (think lots of formulas). Be ready to don your math hat on when reading it.

The first 4 chapters review the concepts of modern portfolio theory (MPT), efficient market hypothesis (EMH), and expected utility theory (EUT). Additionally, they provide a detailed expose on the flaws when using them for individual investor portfolio optimization. They indicate that defining an optimum portfolio for an individual requires the investor -

Have a clear notion of their preferences for risk and return; and
Make assessments of expected risk and return of the investment assets reasonably accurately.

We may all agree, but finding clarity and agreement with clients on these two points is inordinately challenging.

The authors acknowledge that individuals have to make two decisions. First, what portion of wealth should be consumed in the next period versus saved to fund future needs. Second, how the savings should be optimally invested. The book focuses on the second question, but (our opinion) working through the process to identify answers to the first can be remarkably helpful in diagnosing some of the biases and normal emotional pitfalls addressed later in the book.

A few other insightful observations they suggest to “behavioralize” finance are:

· Time horizons are interpreted by people as emotional time horizons, not practical ones.

· Many people focus inordinately on a single investment decision versus its impact on the overall portfolio.

· Citing cumulative prospect theory[1], they explain that people focus inordinately on changes in wealth levels from current values versus their overall level of wealth (which should not be used to guide investment decisions).

· The explanation of the need to incorporate two mental systems (sometimes referred to as the preference for deliberative versus intuitive decision making process, or system 1 and system 2 thinking), they explain simply as the long term “rational” self and it’s short term irrational brother.

A few practical suggestions are provided aimed at offsetting these biases to mitigate reactivity:

· Express figures in annual or five year terms – in order to lengthen the time horizon for decision framing.

· Reduce the frequency of monitoring performance.

· Engage a process where investors pre-commit to a planned investment decision that will be executed automatically.

Chapter Five (which included contributions by Shweta Agarwal, a PhD student at the London School of Economics) contains several key concepts in the formulation of amendments to traditional asset allocation work. Specifically, the more tailored inclusion of risk in portfolio construction. The key change is to adjust the typical asset categorical risk factor (i.e., variance) to include an assessment of how much return (in excess of the risk free rate) it would take to justify an investment. This adaptive measure is termed behavioral standard deviation. The examples illustrate the portfolio construction decisions for nine asset categories of three sample individuals based on their personalized behavioral standard deviation (high risk tolerance, moderate or “normal”, and high anxiety/low risk tolerance).

The implication is that in a world of investment possibilities that include a myriad of non-normal performance possibilities (think skewness and kurtosis), we can and should identify an efficient frontier to maximize returns for each individual’s specific level of behavioral risk.

Chapters 6 and 7 provide insights on how to view the process of evaluating market dynamics and portfolio construction through the lens of behavioral implications. One interesting observation is that their data support the concept of monthly rebalancing of portfolios to align with strategic policy allocations. Additionally, the concept of more active and frequent assessment of expected returns and reshaping the optimized portfolio are inherent in their approach.

Chapter 8 tackles what are perhaps two most impactful set of issues in dealing with individual investors; namely, typical errors or biases, and inordinate dependence on unstable short-term preferences. The authors propose that both be removed from the process of portfolio optimization. While you may or may not agree with this conclusion, it is clear that addressing them is highly challenging. Our sense is that an emerging number of researchers believe that biases simply cannot be eliminated in individuals, but only recognized and marginalized when it is clear that they adversely impact the efficiency and effectiveness of the decision making process.

Strategies that they propose for addressing these issues are:

· Align decision frames with long-term objectives (to enhance the impact of a more realistic/longer time horizon).

· “Purchase emotional comfort”. The concept is that we might develop a range of proscriptive actions as salve to alleviate our burning emotions. The idea includes identifying costs relative to objectives. (i.e., maintaining a large cash reserve for peace of mind is balanced against the foregone returns in deciding how much “medicine” to take)

· Increase allocation to low-anxiety investments and engage downside protection strategies. All carry some costs, but may provide sufficient benefit to remove undue emotional influence on decisions. Specifically consider:

o Option strategies to eliminate far-left tail exposure.

o Funds that have a longer time horizon or are less frequently marked-to-market for valuations.

o Investments with narrow downside exposure to monthly losses.

o Funds that bundle a wide range of investments in their reporting (aggregation = less volatility).

o Dollar cost averaging for investments (particularly of value in connection with a large liquidity event).

o Avoiding information or media that is too focused on short-term or detailed asset price movements.

o Engaging a sign off process for big investment decisions that automatically incorporate deliberative thinking (perhaps by independent advisors). Alternatively, require a cooling off period prior to executing a decision.

The final chapter in their book includes ideas that from their perspective would help enhance the state of the wealth management industry by incorporating their ideas in tailoring the process more adroitly to client needs. Specifics are:

· Advisors are (typically) risk managers for their clients. This role requires more substantive attention to focus on appropriate tools to profile and diagnose client’s individual risk preferences and incorporate them into their consulting support.

· In this role, risks to be addressed are structural (markets/investment structures), emotional, and liquidity. Specifically in a world in which our demographics are shifting to enhanced concerns about managing living expenses over remaining lifetimes, this is an area of growing importance.

· Move from static asset allocation methods to those that are more dynamic. They note that the evaluation horizon for wealthy people is moving toward a 2 to 3 year horizon versus 5 to 10 as in the past.

· They foresee that firms adapting a more behaviorally focused approach to their client service process will result in significant competitive advantage.

While this book is not an easy read, it is packed with practical insights of great value. We believe it clearly delineates the pathway that future research and professionals should pursue. Also, it is a must read for advisors who recognize the value of incorporating a more substantive application of behavioral techniques in their client serving process.

[1] Kahneman and Tversky (1979), Tversky and Kahneman (1992)

Hope you enjoy the book!

Mark the Advisor

Middle Eastern Paranoia, Oil, and the Psychology of Playing Chicken

noreply@blogger.com (Richard L. Peterson M.D.) — Wed, 07 Mar 2012 23:42:00 +0000

When I was a boy in west Texas the neighborhood children enjoyed playing chicken, usually with speeding shopping carts. Two children were pilots and two children were bombs. The pilots dutifully ran their bombs up to full speed, released them, and … CRASH. Ideally your shopping cart remained standing after the collision, in which case you won. Fortunately, two shopping carts crashing sounds much more painful than it actually was. But this newsletter isn’t about the antics of bored suburban kids.

This month we look at a much more deadly game of chicken between Iran and Israel (and by proxy, the U.S.A.). Mirroring the escalating tensions, oil prices are up over 10% in the past five weeks. Higher oil and gasoline prices are already impairing our economic recovery.

This newsletter will examine Behavioral Game Theory as it applies to Iran and Israel. What is the best strategy to deter a foe who may be crazy, short of war? We will then look at the current sentiment snapshot of news and social media as it relates to Oil, Iran and Israel, which reveals some surprises about global mood and where the fear is this week. The psychology behind Oil’s recent price rise reveals whether the rally is sustainable (hint: fear is rarely sustainable in the short-term).

In addition to our usual haunts of New York and Los Angeles, we will be speaking in San Antonio, western Pennsylvania, a CFA webinar, and San Francisco in March – we’re look forward to catching up with our friends in those cities!

Cooler Minds: Fighting Fear with Facts

In evaluating any tense situation, the first priority is to get grounded in the facts. Iran now has the capability to create weapons-grade uranium inside a bomb-proof mountain near Qom. (U.S. experts do not believe a weapon has yet been assembled nor is within a year of being so). Iran provides weapons and training to Hezbollah, who battled Israel in southern Lebanon in 2006 (with surprising success). As part of sanctions, Europe and the United States have stopped taking delivery of Iranian crude oil and have frozen Iranian central bank financial transactions. From Israel’s side it is clear that a covert process of sabotage and assassinations is occurring against Iran’s nuclear enrichment program.

As far as rhetoric, there is more to consider like the public murals depicting bombing the United States. (but recall, statements are not facts, and are typically negotiating tactics or posturing for a secondary gain – think North Korea). Various members of Iran’s leadership have threatened to “wipe Israel off the map,” sponsor a second Holocaust, and make other unconscionably inflammatory statements. The Iranian leadership boasts that in response to a military strike against it it will close the strait of Hormuz to shipping (e.g., oil) traffic.

Israeli government statements indicate that for existential reasons (and I'm not talking about Sartre) Israel won’t allow Iran to possess nuclear weapons. Israelis also indicate there is 3-4 months before Iran’s nuclear development will be too far along to stop with a military strike.

Just Because You're Paranoid Doesn't Mean They Aren't After You

Now for our specialty - the psychological context. Keep in mind that excessive fear is paranoia, and paranoia is one of the most powerful types of fears, bolstered by one’s own feeling of isolation and often leading to self-destruction (e.g., Othello). Paranoia is present to varying degrees in most people – given that 15% of prehistoric humans met a violent death at the hands of another human, paranoia was an adaptive trait on an individual level. As strange as it may sound, through the emotional defense mechanism of projective identification the paranoid often induce others to treat them harshly or suspiciously. Yet on a population level, group paranoia often leads to irrationality and atrocities against the feared others through this same process of projective identification.

The Iranian revolution of 1979 overthrew a British and American “stooge” – a monarchy placed in power by the CIA and MI6 in 1953 by overthrowing a democratically elected Iranian Prime Minister. Iranians rightfully see themselves as past victims of American meddling, and the regime does not trust the U.S., Israel, or Britain. Iranian propagandists go so far as to portray Israelis, British, and Americans as sub-human, referring to them as “dogs” and “infidels.” Is the Iranian leadership paranoid about U.S. and Israeli intentions? From our perspective, of course. Might their paranoia drive them to develop the very nuclear bomb we are paranoid about them possessing? Yes, definitely, wouldn’t you want maximum deterrence against a proven enemy too?

See the image above of a mural from outside the former American embassy in Tehran. One of the requirements in paranoid terrorist psychology is to dehumanize the opponent, so normal human empathy is turned off. Predictor of action: If you don’t see another as human, you can hurt them with no sense of remorse (in fact, you feel righteous to do so because you are protecting your group).

Yet Israelis see an Iranian nuclear weapon as an existential threat (and the Iranian leadership has said as much). Given Israel’s history of near-annihilation on multiple occasions (not irrational paranoia), the military is not relaxed about this threat. Predictor of action: When backed into a corner, no option is off the table.

The Game Theory Behind “Playing Chicken:” Throwing Out the Steering Wheel

In a startling twist of fate, the father of Game Theory involving multiple equilibria in noncooperative games was John Nash, subject of the Academy Award-winning move A Beautiful Mind. Nash is a mathematical genius who won the 1994 Nobel Prize in Economics for his contributions to the field. However, in his early 20s he developed paranoid schizophrenia and spent many years in institutions.

During the U.S. debt ceiling stalement in July 2011, University of Washington Professor David P. Barash wrote an op-ed in the New York Times explaining the game theory behind the show-down over raising the debt ceiling. Many of his examples are illustrative of what the West is facing with Iran.

Dr, Barash explains that by playing chicken (as the Tea-partiers appeared to be doing over the debt ceiling talks) low-power players can extract additional concessions due to their “hardliner” stance. As he puts it, “The trick to winning is for one player to convince the other that under no circumstance will he or she veer off course.” Dr. Barash continues, “Another tactic, favored by the strategist Herman Kahn, is to “throw out the steering wheel,” to demonstrate that you are locked into a certain path and can’t swerve. “

In such cases of playing chicken, it is best to convince your opponent that either 1) you have no alternative course of action and so CANNOT compromise (“my constituents won’t let me back down”), or 2) you are stone-cold crazy and could care less about the consequences to yourself (“I will take you down with me if that’s how it has to be!”). Both of these strategies increase the negotiating power of a lesser player, but they also presume a rational analysis of the situation by that player. Sometimes your opponent truly is suicide-bomber-crazy, and you will always lose when playing chicken with such an opponent (as will they, but they won’t care).

The strategy Dr. Barash concludes with is the following: “In either case, whether you’re confronting a rogue elephant or a rogue nuclear state, the advice is the same: stop playing the game. Avoid the elephant or shoot it; politically isolate the rogue state or use military force to disarm it.”

So how do you know whether your opponent is strategically crazy as in the first two cases or crazy-crazy like a suicide bomber? (See Dr. Barash’s article or book to learn more). In the case of Iran, the key question is, is the leadership acting strategically to increase their bargaining power, increase their esteem among their own people, and perhaps even earn the international perks and payoffs that North Korea (food aid, energy shipments) and Pakistan (military “aid” and free cash) have earned? This seems plausible enough, but before moving on, we need to determine if the leadership of Iran is truly crazy.

Aside from a perhaps justified paranoia about foreign invasion, Ayatollah Khamenei and the Iranian leadership has excellent hygiene and don’t apparently speak to themselves in public. However, the leadership is generally comprised of lifelong religious scholars, and given the sometimes thin psychic line between communicating with Angels and believing the CIA is following you, this might actually be worrisome. But wait, the CIA is following them. In any case, what evidence is there for leadership insanity? None of which I am aware, although very clever people such as Stanford’s Robert Sapolsky have noted fascinating parallels.

So the first preferred strategy when dealing with such an opponent is to politically and economically isolate the country (done). Given the history of paranoia and poor relations between Iran and the West, and the absence of a legitimate political alternative to Ayatollah Khamenei and the Grand Council, it’s likely that isolation will not bring down the Iranian government. If isolation doesn’t work – and how long will we wait? - then either ignoring Iran (e.g., North Korea and Cuba) or a military assault (nuclear sites bombed by Israel in Iraq and Syria) is likely.

To prepare for a military assault, bolder internal attacks and discord-sowing are already occurring. Then the choice becomes to either 1) Ignore Iran’s nuclear program and hope for a Cold War-style stalemate, or 2) execute a series of focused military attacks to further delay the program. Given Israel’s existential angst and previous history of striking Syria and Iraq, military assault appears most likely. The only question is when.

What Do The Markets Think?

The spot Oil price is a good proxy for potential conflict between the Israel and Iran, as the Strait of Hormuz and oil facilities will presumably be threatened for some length of time. Since late January we’ve seen not only a climb in the oil price (and the stocks of energy companies), but also a divergence between the amount of fear expressed by energy stock investors versus S&P 500 stock investors. In this case, fear is good for the oil price and the profits of most energy companies.

We also see high the levels of fear and pessimism in country-related messages in social and news media expressed about Iran and Israel. One difference we see in social and news media is a high levels of predictions of a higher oil price in social media, but only neutral predictions in the news. When higher prices are forecasted in conjunction with high fear, we usually see a price slide over a few weeks (although, the fear and price may rise again as the Israelis make more preparations for an assault).

By the way, we’re also seeing high fear from investors in Copper, but in the case of copper, there is a good fundamental reason for fear, as China has ratcheted down growth projections. In such a case of fear with a rational basis, the price tends to continue a longer-term decline as the market gradually readjusts its expectations.

Extreme Event Modeling

Remember, the only way to prevent mistakes driven by fear is to be prepared. Run forward what would happen to your portfolio in case of an escalating war in the Middle East and a disruption to oil supplies (paired with a slowdown in the economy).

If you’re a financial advisor it’s worth preparing what you’ll say to clients when they angrily ask, “why are we still in equities, everyone saw this attack coming?!” (Ask us for tips about communicating with clients). Energy traders would do well to stress test in case of an oil shock, including what if the limited war grows to include missles back and forth from Saudi to Iran and a broader Sunni-Shia conflict. And keep in mind that after the initial shock, war often leads to stock price appreciation as government spending spikes and the defense industry revs up. Discretionary managers may benefit from Trading Coach Richard Friesen’s Extreme Event Exercise – reply to this email with “Extreme” in the subject line to learn more.

But all that being said, we truly hope for peace. Just remember to be prepared for the worst case (write down your plan), so you can go to sleep with one less potential train-wreck to ponder – we’ve had enough disasters to think about these past four years.

Talks in March and April

We have speaking and training availability for your firm or organization in late April. Please contact Dr. Peterson or Dr. Murtha for more information.

Happy Investing!

Richard L. Peterson, M.D. and The MarketPsych Team

MarketPsych Films: The Facebook IPO - Part I

noreply@blogger.com (Frank Murtha, Ph.D.) — Tue, 07 Feb 2012 18:34:00 +0000

MarketPsych's first digital film installment on the Facebook IPO from our "Bob and Helen" series for financial advisors.

Link HERE or click on Red Curtain Above.

Also a shout out to Melissa Lee of CNBC for noticing the deja vu of "new metrics" being trotted out in support of Internet stocks. (Nice to know we aren't the only ones who felt it.)

Enjoy.

(Note: It looks like ZNGA is beginning to reward it's shareholders. We wish them well.)

Happy Investing.

And hey... let's be careful out there.

-Dr. Frankenstocks
Frank Murtha, Ph.D.

Facebook to have IPO: Worlds Colliding

noreply@blogger.com (Frank Murtha, Ph.D.) — Fri, 03 Feb 2012 16:33:00 +0000

“Yeah, I know.”

These words came from my brother, Loring, and their significance was unmistakeable – worlds have collided.

My brother is an actor and filmmaker (quite talented too, www.mcquaidbrothers.com, http://twitter.com/loringmurtha). He is about as far removed from the world of investing as one can get. In fact, I suspect he couldn't name more than one holding in his managed portfolio.

But when I mentioned to him the other day that “Facebook is having its IPO. IPO stands for Initial Pub-“ he saved me the trouble, cutting me off with the statement above.

My brother is not an official MarketPsych Sentiment Indicator. We have REAL ones for that. But he might as well be.

It indicates that Facebook's upcoming stock offering is much more than a financial investment. It's a pop-cultural phenomenon - with all that that entails.

In a story that is perhaps apocryphal, Bernard Baruch said that he knew it was time to get out of the market (pre-crash) in 1929 when his shoe shine boy gave him a stock tip.

In a story that is definitely apocryphal, Baruch also said,"By the time your Mom learns the name of the band, they’re no longer cool."

Why? Because it means EVERYBODY knows. Stocks are like "Indie Bands"; part of their appeal is that not EVERYONE is rushing to see them.

Facebook's IPO will attract an entirely new class - indeed, perhaps an entirely new generation - to equities investing.

By the way, the last time my brother mentioned a stock to me it was Sirius Satellite Radio (SIRI) in 2007. Two years later you could pick up a share of SIRI for a dime. A piece of Bazooka Gum or ownership in the most revolutionary company in radio history? Your choice.

Will that be the fate of Facebook? I hardly think so. But as MarketPsych has long (and correctly) maintained, all stocks prices are the product of the aggregate psychology of the investing community.

What happens to that community when Worlds Collide? When the peaceful, orderly state of Financia is suddenly flooded with wild refugees from the nation of Facebookistan?

(Occupy Wall Street Types created chaos when they invaded the Financial District, imagine what will happen when they actually invade the Financial Markets?)

Strange, often tragic things happen when worlds collide. Just ask Independent George.

I didn’t say unpredictable. Just strange. My MarketPsych colleague and resident genius, Dr. Richard Peterson has created www.MarketPsychData.com to provide uncanny predictions utilizing social media analytics for just this sort of thing.

Ironic, don't you think? Using social media to forecast social media stocks?

Worlds colliding, my friends. Worlds colliding.

Happy Investing.

And hey... let's be careful out there.

-Dr. Frankenstocks.

Frank Murtha, Ph.D.

Facebook, Social Unrest, and the Predictive Power of Big Data

noreply@blogger.com (Richard L. Peterson M.D.) — Thu, 02 Feb 2012 21:13:00 +0000

Facebook, Social Unrest, and the Predictive Power of Big Data Feb 2012, v2, n1

The Value of Social Media (seriously!)

I tried to close my Facebook account once. Somehow I continued to receive “Friend” notifications in my email. So I tried to close my account again. The notifications still came. After the fourth attempted account closing, and more Facebook emails, I set up Facebook-to-trash email filter. But I’m the exception, Facebook is generally well-liked.

Facebook has a user population of 845 million - ranking it as the world’s third largest country (if it were a country). Apparently it got that population with some socially manipulative tactics such as emails titled “You have friends waiting” – subtext: “What kind of person are you to keep friends waiting?”). And that’s not to mention their North Korea-style user retention policies.

With a Facebook IPO imminent, this month’s letter focuses on crowd enthusiasm, IPO pricing, the emergence of Big Data and social prediction, and the power of social commentary to predict (drive?) the future. We next show our top ten list of countries with the most social unrest. In our Researcher’s Corner we report on the latest (and greatest) genetic study of traders published last week, and we discuss the science of slippery ethics and why no one has been held accountable for the financial crisis. And this week we offer a nod to Isaac Asimov for his prescient take on the emergence of “psychohistory.”

In addition to our usual haunts of New York and Los Angeles, we will be speaking in Chicago and the San Francisco Bay Area in February – we’re look forward to catching up with our friends in those cities! Next week we have 2 coaching schedule openings on February 9^th at 1pm ET and at 4pm ET - if you’re interested in one of those coaching appointments, please reply “coaching” to this email to reserve.

Facebook and the IPO Conundrum

Have you ever felt like you had to have something – like really must get some of it for yourself?

In honor of investors excited about the Facebook IPO (and their beleaguered financial advisors), Dr. Murtha created this terrific short video spoof of an investor discussing the "The Facebook" IPO with his financial advisor.

This fear of missing out is the feeling that promoters of IPOs work hard to instill. IPO excitement, seasoned with a dash of fear of not being involved, leads to increased demand for shares, higher investor risk-taking, and of course, a higher opening IPO price.

On the positive side, academic studies show that IPOs were underpriced an average of 22% from 1965 to 2005, which is good for those on the inside – those who get the initial share allocation. But the feeling of excitement engendered by IPO promoters (and often the media) drives many investors to jump into shares in the public market, typically on the first day of trading, where emotional reactions to volatility damage their returns. This data and graphics showing trader performance in Groupon (GRPN), LinkedIn (LNKD), and Pandora (P) shares on their first day illustrates the problem. Since these three IPOs in 2011, first day buy-and-hold investors have lost about 20% on average through the end of 2011. IPO excitement inspires rationalizations: “this time it’s different” (overconfidence) and “if I don’t buy now, I may never get it at this price again” (scarcity).

This is not to disparage Facebook as a company. Facebook is riding the crest of a revolution in communication, community-building, and social prediction. And with their enormous trove of data, they are sitting on very valuable insights.

Fortunately for the financial industry, the excitement surrounding Facebook is likely to rekindle individual investor interest in the stock market, and it may be one factor that drives a nice rally in the stock market this year (in tandem with a year-long real estate bounce and certainty about low interest rates).

Recent Press:

"The Extraordinary Popular Delusion of Bubble Spotting." November 5, 2011. Jason Zweig. Wall Street Journal.

"Women Make Better Investors Than Men, But Why?"

November 28, 2011. Ted Schwartz. ABCNews.com.

"Attack of the Acronyms"

November 26, 2011. Ben Levisohn. WSJ.com.

"Bull Market Bear Market Bring It On!" WSJ.com. October 15, 2011. Ben Levisohn.

List of Past Press.

Big Data and Social Prediction

At MarketPsych we are at the vanguard of social prediction in the financial industry. We developed predictive models that not only are monitoring the buzz about Facebook, but that use the characteristics of that buzz to predict (and trade) Facebook’s shares. We have spent decades modeling social data and trading on it - our MarketPsy Long-Short Fund LP was successful in using this data to outperform the S&P 500 by 27% from launch on September 2, 2008 to the end of 2010 (when we closed it). It’s not only our firm that does this - there is an entire industry of social prediction based on mining behavioral and psychological data.

But we and many of our customers have problems with Big Data – it’s unwieldy and noisy. Consider that our Macro data feed distributes 30 sentiment and topic data points every minute for major economic sectors and industries (40), Commodities (60), Countries (100), and Currencies (50) in two feeds (one feed derived from social media and one derived from news media). In case you didn’t do the math yourself (and I hope you didn’t!), we’re releasing 15,000 data points minutely. This data deluge is actually a summary of our core data. It is derived from 2 million daily articles, analyzed for the presence of 40,000 entities, and scored into 1600 sentiment and topic combinations – all condensed into the 30 Macro indices to render it “usable” by humans. Here’s the general idea:

Predictive analytics is occurring in every industry. One company - from whom I recently received a “we will hire anyone with a pulse who has statistical skills”-type email - Accretive Health (NYSE: AH) reports mining 1 billion health insurance claims in order to identify trends that can be arbitraged to reduce health care costs while increasing health care delivery. But this newsletter isn’t about Big Data companies per se, it’s about social prediction and how we can do better in our own decision making using the insights we are gleaning from social data. More about Big Data generally can be read in this McKinsey study and here is a great summary of companies in this space on Quora.

While it appears cutting edge, it turns out that social prediction using big data is old news.

Isaac Asimov and Psychohistory

The other day, after the fifth person in a week told me, “sounds like your data is recreating Isaac Asimov’s Psychohistory,” I decided it was time to investigate.

Now I’m not exactly a science fiction fan, but I do enjoy a good story regardless of whether it occurs in our solar system or Qo'noS. In high school I occasionally wrote book reports on science fiction novels (lenient teachers!). But it was largely a matter of finding Jane Austen a bit too stuffy , not a personal fascination with the other-wordly (Prime Radiant? Psionic Suppressions?), that drove such reading.

So today in Wikipedia I read, “Psychohistory is a fictional science in Isaac Asimov's Foundation universe which combines history, sociology, and mathematical statistics to make general predictions about the future behavior of very large groups of people, such as the Galactic Empire.” Cut off the Galactic Empire bit, and that is EXACTLY what we’re doing at MarketPsych. Go figure. I guess we’ll have to withdraw our “Universal People Prediction Device” patent application – Asimov beat us to it.

(I actually started reading the third book of the Foundation Trilogy in eighth grade. But as it’s best not to start a trilogy on the third book, and the concepts were obtuse to me, I put it aside. But I wonder if it didn’t plant a seed…)

Macro Indices: Country-level Social Unrest

In addition to economic sectors, stocks, and commodities, few people know that we also monitor social and psychological phenomena by location - cities and countries. For example we have indices of “Social Unrest” related to negative chatter about national governments, authorities, and business leaders in social media. It’s likely this data will prove to be predictive of social events, although we may not have enough unrest incidents (thankfully) to test it thoroughly.

Per an informed source, China experienced 160,000 significant social protest actions last year (from tens to hundreds of thousands of citizens participating). Many of these actions could be (briefly) detected in social media, but they were not revealed in news media due to Chinese government concern about social stability. As a result we are not only tracking news media unrest mentions (since these are censored), but perhaps more importantly, we pick up on psychological predictors of unrest in social media. Such predictors include expressions of anger and frustration towards authorities and mentions of personal hopelessness (a positive predictor of impulsive violence).

Here is our top ten list of Countries with the most buzz about Social Unrest in the English-language media recently:

1          Egypt
2          Somalia
3          Libya
4          Syria
5          Yemen
6          Sudan
7          Nigeria
8          Pakistan
9          Israel
10         China

While social unrest is related to social forces often out of our immediate control, we can gain control how we prepare for and manage ourselves when experiencing setbacks if we understand our propensities to reaction. Genetic and hardwired cognitive biases play a role in our responses to loss, as you can see in today’s Researcher’s Corner, but such factors are by no means deterministic. We can intelligently use our minds to make better decisions.

Researcher’s Corner: Trader Genetics

Our good friends Steve Sapra, Ph.D. and Paul Zak, Ph.D. Director for the Center for Neuroeconomics Studies and author of the forthcoming “The Moral Molecule” this week published a new study of trader genetics: “A Combination of Dopamine Genes Predicts Success by Professional Wall Street Traders.“

The authors took genetic samples from 60 Wall Street traders in 2008 before the market meltdown. They found that traders with genes conferring moderate dopamine tone were more likely to have longer careers as traders. The longetivity of traders (the study’s dependent variable) was correlated with fewer D4 receptors and also less catabolic (enzymatic breakdown) of dopamine, theoretically leading to higher tonic levels of dopamine and less variability per receptor over time. This dopamine environment might lead to more stability during the ups and downs of trading and should be correlated with behaviors such as less trading in volatile markets (which the authors found) and perhaps more emotional and analytical equilibrium.

The authors conclude: “Combining the personality analyses and genetic findings from the present study, reveals that our sample of traders are analytical, integrative, and can delay gratification. They have a genetic profile associated with balanced levels of dopamine.” As we gather more data we may see additional interesting results.

Researcher’s Corner: Blind Spots in Financial Ethics

Last Friday I attended a talk by one of my academic heroes – Harvard GSB professor Max Bazerman – on the subtle cognitive biases that underlie unethical behavior. He has a new book out called Blind Spots which is a fascinating account of his research. Bazerman introduced the topic by explaining that MBA students are taught ethics through case studies that profile high-impact criminal behavior, yet the vast majority of unethical behavior is not obvious or dramatic at first. It is subtle, gradual (slippery slope), and permitted to some degree by observing others. As he points out, the standard MBA ethics education – which focuses on high-profile criminal cases, but not common unethical behavior - is inadequate. In some ways Bazerman’s research gets at the underlying causes of the financial crisis and contributes to our understanding of why no one has been criminally convicted.

Bazerman provided behavioral evidence of such socially important biases as 1) The unethical practices of auditors - by which independent auditors are blinded by their desire for ongoing income into gradually “cooking the books” of their clients, 2) The slippery slope by which most unethical behavior progresses, as our minds gradually rationalize misbehavior, 3) The process by which observers will permit minor unethical behavior with no compensation or kickbacks at first, ultimately putting themselves in a bind as serious violations mount and they feel unable to speak up after a history of silence, 4) How people judge ethical violations as less “bad” than ethically proper behavior that ends with worse result, 5) People judge anything that personally benefits them as less unethical, 6) Losses accelerate unethical behavior – similar to the disposition effect – in which people are also more likely to break the rules to get back to even, 7) And amazingly to me, people judge others hiring a proxy to do their ”dirty work” as significantly less unethical than doing the dirty work oneself.

Some of these biases explain, in part, why rogue traders begin and can escalate their misdeeds – collaborators looking away with good results (at first) lubricating further off-the-books trades, a slippery slope of small accumulating losses accrues, and losses accelerate unethical rule-breaking (disposition effect), and finally the climactic blow-up occurs. The same process explains the social, financial, and government biases that gradually allowed the housing bubble and bank risk-taking to grow to huge proportions.

As Bazerman points out, simple self-awareness only slightly ameliorates most cognitive biases. Per Bazerman the best (and only proven) solution to such biases is to reform institutions to help us be less harmed by our biases – the “Nudge” example of Richard Thaler. I would add that 1) learning about the nature of biases and 2) gaining specific self-awareness of biased decisions - by working through bias examples in one’s own decision making including practicing alternative decision strategies – also appears to reduce biasing.

Escaping the Pull of the Herd

Given what we’ve learned above – that IPOs lure naïve investors in due to hype and fear, that big data and social prediction is altering our future trajectory, that researchers have identified that moderate tonic dopamine levels can prevent us for falling for such hype and volatility as that around IPOs (and thus be better investors), and that our biases and Blind Spots are prevalent and explain some social trends and events like the financial crisis. The result of all this data and new understanding is a science of prediction (once called PsychoHistory by Isaac Asimov). Given all this, what are we as investors to do?

Based on emerging evidence of the role of genetics and hardwired biases influencing decision making and performance, in combination with awareness (always a first step), external behavioral “nudges” are the best tools we have for setting up an optimal bias-lite decision environment. Secondly is practicing self-awareness and working through biases in one’s own decision making (at MarketPsych we have developed workbooks for this practice).

Let’s consider an example of how we can use our knowledge of biases to improve our decision making. We know from Bazerman’s research that financial losses predispose us to violate rules (e.g., not honoring stop-loss rules, anyone?). One solution to this misbehavior is to plan ahead – one can enter automated stop-losses at the time a buy order is entered, before they are put in the position of biased thinking such as, “Will this falling investment rebound? Of course it will. Clearly there’s no need for that silly little stop-loss at this level.”

For financial advisors one application relates to their increasingly common role as an emotional coach for their clients. Advisors often need a nudge to engage with clients when they themselves are feeling beleaguered by falling markets. Advisors can set up their daily routine to incorporate simple tricks like seeing clients in the mornings or have interactions scheduled after refreshing activities like exercise or enjoyable activities. (We have many more ideas for advisors – contact us for more information).

Talks in February

We will be speaking in the San Francisco Bay Area next week (two classes at Stanford and two progressive corporations) as well as in New York at a Risk Management conference and in Chicago in February 2012. Contact us if you’d like to attend or you are in one of those cities and would like to meet.

We also have speaking and training availability for your firm or organization in late April. Please contact Dr. Peterson or Dr. Murtha for more information.

Best Wishes for 2012!

Richard L. Peterson, M.D. and The MarketPsych Team

Books
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MarketPsych: How to Manage
Fear and Build Your Investor Identity

Inside the Investor's Brain:
The Power of Mind Over Money (Wiley Trading)

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Disclaimer
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Using Reason+Emotion to Forecast 2012

noreply@blogger.com (Richard L. Peterson M.D.) — Mon, 02 Jan 2012 20:48:00 +0000

2011: An Emotional Year

Needless to say, it was an emotional year in the financial markets, and most investors underperformed substantially. Since emotional markets are why we're here at MarketPsych, this month's letter will share our latest insights, lessons, and fascinating charts to help our readers going forward.

First of all, uncertainty is guaranteed to continue, with Europe's debt unresolved, U.S. political gridlock, and a potential hard-landing in China. Fortunately, as you read below, you will see that uncertainty is predictive - in a counter-intuitive way.

Before we launch into today's discussion - while our schedules are filling, we still have availability for consultations and trainings in the first two weeks of February, so please reach out if you'd like some personal or organizational attention.

The MarketPsych "Awards:" Not What We Thought

In December we launched the 2011 MarketPsych Awards: identifying the Most Trusted Bank (WTFC), Most Innovative Tech Company (SNPS), Most Loved Consumer Products (STKL), and others based on social media chatter in 2011.

But a word of warning for investors about these Awards. We ran a predictive analysis of what happens to top ranked companies going forward, and the results are mixed. In fact, past winners of the Most Loved Consumer Products award under-performed the market by -2% on average the following year, while least-loved consumer product companies outperformed by 10%. This effect - where loved stocks fall and the unloved rise - reflects an old Wall Street aphorism - a "great company" rarely makes for a "great investment."

So if loved companies aren't the best investments for 2012, then what does predict stock prices going forward?

Answering this question became our mission in December.

Our analytic team aggregated the past 13 years of social media chatter by year for 8,000 publicly traded U.S. companies. Then we identified the topics and psychological factors expressed online about the company that were most predictive of company stock prices in the following year.

Some Background: Over the past 8 years the MarketPsych team developed the most sophisticated financial textual analysis software commercially available. Every day we quantify hundreds of sentiments, topics, and tones in 1.8+ million social and news media articles.

For our study we examined a universe of about 2,000 highly discussed stocks, each year since 1998, with market capitalization over $1 billion. We ranked each stock for each year relative to all other stocks using our Big 21 Macro Sentiment Indices. We then grouped the stocks into deciles for each year based on their sentiment rankings and averaged the returns for each decile over the following year, from 1998 through 2010.

We compared returns vertically (stepwise across deciles),horizontally (across sectors such as Materials, Tech, Consumer, Healthcare, etc...) and over time to ensure consistency. Nonetheless, this isn't a rigorous study, and it is susceptible to over-fitting. We did it for fun and not for trading (we use a different in-house testing technology for investment strategy research).

Investors are Smarter When They Think...

Our indicator FundamentalStrength, which measures the amount of positive versus negative accounting mentions in social media was most predictive of future returns. Stocks in the highest decile of positive accounting discussions (FundamentalStrength) showed 14% out-performance, while the lowest decile showed -5% market under-performance. The results were even stronger for tech stocks, with the highest decile of tech stocks outperformingthe market by an average of 18% annually in the subsequent year, while the decile with the lowest FundamentalStrength under-performed by -7%.

Another index with interesting results was EarningsExpectations, which measures online predictions of positive versus negative earnings reports. The highest decile - with most positive earnings expectations - shows 10% out-performance versus the overall market the following year, while the lowest decile shows -3% under-performance.

...But When Excited, Their Predictive Power Lags

Our initial results indicate that investors analytically discussing company fundamentals in financial social media can be predictive of future returns, but does their expressed emotion also predict future performance? First, an investigation into the seasonal dynamics of investor emotion.

The Happiest Time of the Year

December IS the happiest and most optimistic time of the year for investors, based on our data. The red lines below are the average optimism for every year over the past 13 in social media (using the X-12-ARIMA method and courtesy Aleksander Fafula, Ph.D.).
To be sure we weren't just capturing mutual well-wishers on stock message boards and Twitter (Happy New Year!, etc...), we looked at the data again with only future-oriented statements - what we call Outlook (Optimism - Pessimism). December is at the top (although not as dramatically) in that graphic as well.

And what month contains the most distaste?
In addition to being low in Joy, September sees the highest average of hateful, spiteful and angry language over the past 13 years.

Forecasting with Emotion+Reason

Now back to forecasting with our Emotion Macro Indices. We have nine of them, including Anger Joy, Uncertainty, and others.

The most striking predictive results across sectors and years occurred for Anger (sadly a common emotion among investors these days) and Uncertainty. High Anger stocks (top decile) underperformed the market by -2%. Anger is generally reactive, so perhaps bad news is priced-in quickly. Stocks with little angry drama among their investors (or at least little anger expressed in social media) outperform the market by 10% in the following year.

Another "emotion" category - defined as such for the anxiety it provokes - is "Uncertainty." The high-decile Uncertainty stocks outperform by 6% annually - perhaps due to investor reluctance to invest until the uncertainty is resolved ("probability collapse" in the jargon). Low-decile uncertainty stocks - perhaps swarmed by overconfident and too-certain investors - underperform the market by -7% annually as their cherished stability is revealed to be more fragile than expected.

When the best of our indices are combined into a single ranking index, their predictive power increases and becomes more robust, The combination demonstrates 9% outperformance and -11% underperformance for the top and bottom deciles, respectively, over the following year. We then used this single index to organize predictions for 2012.

Predictions for 2012

(SEE DISCLAIMER - PLEASE DO NOT TRADE THESE - WE DO NOT HOLD POSITIONS IN ANY OF THESE).

Potential outperformers based on our basic analysis are the following:

1. Royal Bank of Canada (RY). Canada has strong banks, the U.S. does not, what can I say? Opportunity here (but beware commodity bubble in Canada).

2. Seabridge Gold, Inc. (SA). Gold miner - underperforming industry this year. Rebound candidate?

3. Tessera Technologies Inc. (TSRA). Semiconductor Equipment.

4. MGIC Investment Corp. (MTG) - Mortgage insurance (really?). Stock down, housing market is recovering.

5. Natural Resource Partners LP (NRP) - high dividend (7.9%) coal mine leaser.

For 2012 we see a few surprises as potential underperformers.

1. Yum! Brands (YUM) is at the bottom of our list, perhaps due to China exposure, where a bubble is predicted to deflate over the next year.

2. McDonald's Corp. (MCD) is the second from the bottom. Chipotle and other upstarts are eating MCD's lunch.

3. Delta Airlines (DAL), Procter and Gamble (PG), and one I struggle especially to write, CenterPoint Energy, Inc. (CNP) round out the bottom five. Centerpoint has a 3.9% dividend, positive price momentum, and a P/E of 6. It's REALLY difficult to consider selling CNP short as a good idea.

Many of these were totally unexpected (verging on psychologically disturbing) stock predictions.

After creating our ranking system, we decided to test FundamentalStrength tempered by Joyusing ETFs. In the following study, you can see our thought process in deciding how to investigate the role of emotion in financial prediction.

ETF Performance: Buy Strong Fundamentals With Low Joy Expressed by Investors

When we looked at the FundamentalStrength Macro Index (recall it is an aggregation of positive versus negative accounting-related conversation), we found that it had variable predictive capability- it was rendered less effective when positive emotion was associated with high values. Just as with the "Most Loved Consumer Products," investor excitement destroyed the predictive power of positive accounting news.

It turns out that when people are excited that they are going to make money, they have activation in the brain's reward system. After all, if we feel excited and happy, it must be coming from somewhere.

Importantly, that same excitement leads to a reciprocal deactivation in the "loss avoidance" areas of the brain. That is, when we're excited that we've found a good opportunity to make money, we become less able to detect risk. Just when we need it most, our ability to see and process potential dangers is turned down. All systems GO! with no ability to turn back. The following image demonstrates this effect in the lab.

We decided to explore this effect among investors, so we generated a hypothesis. Perhaps investors become too excited about the FundamentalStrength (accounting fundamentals such as earnings, returns, margins, balance sheets) for some sectors and industries, or perhaps their excitement about the sector causes them to project over-optimistic accounting results into the future.

To explore whether this was occurring, we gathered a group of the 40 most liquid long-only ETFsincluding sectors such as utilities and consumer staples, industries such as gold miners and clean energy, and indices such as the Nasdaq 100 and the Russell 2000.

We then looked at the performance of the ETFs over the next quarter for two cases. We looked at ETFs with an above average FundamentalStrength AND above average Joy (a.k.a. excitement, enthusiasm) VS. ETFs also with above FundamentalStrength BUT with below average Joy. The idea is that ETFs with happy investors are likely to have good news already priced in, and to have investors blind to risk, while the others are under-appreciated and more realistic.

Sure enough, we see exactly that effect among all ETFs with high FundamentalStrength - less-loved ETFs outperform over time.

The Best Leading Indicator

As we watch financial news, it is common for our unconscious emotional state to shift from news story to news story - across a spectrum from joy to anger to fear - depending on the message of each story. As these shifts occur, the brain shifts its decision-making from primarily neo-cortex (analytical) to primarily limbic (emotional). And most importantly, this shift to emotional decision making is unconscious.

After such a shift, our rational brain (neo-cortex) believes that it is responding to financial circumstances and information as before, but in actuality it has been "emotionally primed" and is reacting to events from within an emotional frame.

We can see the consequences of this effect in our own behavior. After hearing frightening news, we react with more caution, after joyous news, we take more risk. The effect is evident in today's MarketPsych Report research. When investors are using their neo-cortices to formulate analytical decisions based on earnings and fundamental data, their forecasts are generally correct. When they use emotion to guide their decisions - buying a stock because they feel good about it - they underperform.

MarketPsych coach Richard Friesen uses "Mind Muscles™" exercises to help clients build on their decision strengths. The "Awareness Muscle" exercise will teach you to become aware of when the locus of your decision process is shifting from the neo-cortex to the limbic centers. Email info@marketpsych.com with "Awareness" in the subject line and we will send you the exercise.

Richard Friesen still has sessions available on Tuesday, January 10th at 11am ET and 1pm ET and on Friday January 13th at 4pm ET.

Next newsletter we will introduce "Extreme Event Mind Muscles™" which will teach you what to do once you've become aware of an emotional shift. Given 2012's financial and political risks, it's important to plan ahead now - no one wants to be the deer in the headlights!

We also have training availability for your firm or organization in the first two weeks of February. Please contact Dr. Peterson or Dr. Murtha at info@marketpsych.com for more information.

Best Wishes for 2012!

Richard L. Peterson, M.D.

and The MarketPsych Team

DISCLAIMER

This material is not intended as and does not constitute an offer to sell any securities or a solicitation of any offer to purchase any securities.

The information of the MarketPsych Report is presented free of charge. THIS ADVICE IS WORTH WHAT YOU PAID FOR IT. It is no substitute for the services of a professional investment advisor. Investments recommended may not be appropriate for all investors. Recommendations are made without consideration of your financial sophistication, financial situation, investing time horizon, or risk tolerance. Readers are urged to consult with their own independent financial advisers with respect to any investment.

Past performance is no guarantee of future results. Screen and model signals and related analysis are for informational purposes only and should not be construed as an offer to sell or the solicitation of an offer to buy securities. Most financial instruments (stocks, bonds, funds) carry risk to principal and are not insured by the government. Anyone using this newsletter for investment purposes does so at his or her own risk.

Anger in the Markets

noreply@blogger.com (Frank Murtha, Ph.D.) — Mon, 12 Dec 2011 19:23:00 +0000

If it seems likes investors are little more angry these days, it's not just your imagination. MarketPsychData has the stats to prove it.

MarketPsych's Frank Murtha caught up recently with Dow Jones and offered some commentary on the subject and some suggestions for financial advisors in dealing with it.

HERE is a link to a brief video.

Happy Investing.

And hey... let's be careful out there.

Dr. Frankenstocks

Frank Murtha, Ph.D.
Co-founder of MarketPsych

Anger about the Federal Reserve is Rising

noreply@blogger.com (Richard L. Peterson M.D.) — Fri, 02 Dec 2011 22:26:00 +0000

Based on our analysis of news chatter, we're seeing a disturbing (in my opinion) trend - increasing anger expressed in references to the Fed in news media.

The below chart demonstrates Anger mentioned in all references to the Fed since 1985. You can see both the declining anger as the U.S. came out of the Volcker-induced recession of the early 1980s and the recent rise in anger associated with economic stagnation and political polarization.

The reason this anger is significant is because high levels of anger can drive drastic and often self-defeating behavior. This is true for individuals (e.g., suicide bombers) and also for crowds (e.g., the U.S. Congress considering abolishing the political independence of the Fed).

More to come about such social and emotional trends...

Richard L. Peterson, M.D.

Dead Turkeys: In the Short Term the Market is Dumb

noreply@blogger.com (Frank Murtha, Ph.D.) — Wed, 09 Nov 2011 13:49:00 +0000

My friend, Ian, once told me a story about domesticated turkeys. You know, the tasty kind. One night, during a loud rain storm the flock became unnerved. The crashing thunder frightened them. The driving rain disoriented them. The terrified poultry ran for cover. Panicked turkey after panicked turkey piled into a shed. Eventually so many crammed themselves in there, the whole flock suffocated.

When the farmer came out the next day he found an entire shed packed with dead turkeys.

(Note: I like to think there was at least one, tragic, non-conformist turkey who upon entering the shed and getting squooshed, began to question the wisdom and tried in vain to rally his turkey brethren., "Stop! Go back! For the love of God, man! This is madness!" In the movie version, "Turkeytanic!", I would give this part to Leonardo DiCaprio.)

If you've read this blog, you know that one of my favorite pastimes is watching the Yahoo Finance headlines change over the course of the day. (It's fun. Seriously. Try it.)

Yesterday, I watched the news that Italian Premier, Silvio Burlasconi would be resigning hit the Market. It caused a 100 point upturn and the media credited the impending change as a catalyst for positive movement.

Today I woke up and saw the following, "Uncertainty over Italy's Future Slams Markets". Money quote:

'"The positive impact of Berlusconi's promised resignation is being diluted by a lack of clarity on where we go from there," said Adam Cole, an analyst at RBC Capital Markets.'

Let me sum this up; The reaction boiled down to, "Hooray! he's gone!" to "Oh, sh*t! He's gone!" overnight.

Which brings me to my point; when we get stuck in a short-term focus - especially when we are hit with unexpected news - the Market is full of dead turkeys.

Our award-winning book, MarketPsych, is dedicated to helping professionals and laypeople alike overcome such pitfalls. And we frequently give talks and workshops on the subject (for more info contact us at info@marketpsych.com).

And my partner, Dr. Richard Peterson's amazing sentiment data over at http://www.marketpsychdata.com/ can give you the tools to not merely avoid mistakes, but help you profit from the folly of others.
We invite you to check out both.

Thanksgiving is coming, people. Don't be a dead turkey.

Happy investing, everyone.
And hey... let's be careful out there.

-Dr. Frankenstocks

Frank Murtha, Ph.D.

Co-founder of MarketPsych

Bubble-ometer at WSJ

noreply@blogger.com (Richard L. Peterson M.D.) — Sat, 05 Nov 2011 15:48:00 +0000

Our Bubble-ometer received coverage in Jason's Zweig's column in today's WSJ. The Bubble-ometer is hosted on www.marketpsychdata.com, where we have several free tools for investors based on social media sentiment.

The Bubble-ometer is simple in concept but has been predictive since it was developed as seen in these past Bubble-ometer posts: calling the late 2010 rally and identifying a Bubble top in June 2011.

We're working on a more complex version of the metric as can be seen in the second blog link above, which we're calling the "market risk index." We're also comparing sectors to identify arbitrage opportunties. Please sign up for our free monthly newsletter, and we'll keep you posted about these developments.

Happy Investing!
Richard

Investor Personality Test at WSJ

noreply@blogger.com (Frank Murtha, Ph.D.) — Wed, 19 Oct 2011 12:37:00 +0000

Hello, investors.

Thanks to a recent mention on the Wall Street Journal site by Jason Zwieg here (thanks much, by the way) we had a record number of people taking the test. So many infact, that it temporarily crashed our servers. We apologize to anyone who did not get their test results. The test should be up and running now. Thanks to all those who took an interest and completed the assessment. We hope you'll find your results interesting and useful. And please don't hesitate to reach out with any questions you may have.

Happy Investing.

And hey... let's be careful out there.

-Dr. Frankenstocks.

Frank Murtha, Ph.D
Co-founder of MarketPsych

The Fear Index

noreply@blogger.com (Richard L. Peterson M.D.) — Fri, 14 Oct 2011 22:43:00 +0000

The MarketPsych Fear Index has remained high despite the recent rally in the S&P 500. This is actually a very bullish sign for the next couple of months.

Investors "anterior insulas" are still "hot" from the unexpected and relatively traumatic selloffs of August, and as a result, most of those with a hair-trigger panic-sell reflex already exercised their right to sell at the bottom.

You can see the cumulative mutual fund outflows inspired by this fear in the following chart:

While uncertainty and volatility is virtually guaranteed for the next 12 months (pending election, further defaults in Europe, Iranian belligerence, etc...), we're likely to see an equity rally through year-end.

Happy Investing!
Richard

The Psychology of a Debt Spiral (and Positioning for The Next Stage)

noreply@blogger.com (Richard L. Peterson M.D.) — Fri, 09 Sep 2011 22:30:00 +0000

“All economic movements, by their very nature, are motivated by crowd psychology.”
~ Bernard Baruch

Bernard Baruch opposed the reparations terms of the Treaty of Versailles, knowing them to be impossible for Germany to fulfill following the destruction of WWI. I wonder how Baruch would handicap recent events, as German taxpayers summon the will to bail out the near-defaulting states of Europe's periphery (or rather let those countries default and then bail out their own banks directly).

We're in psychological terrain - confusion, declining confidence, political gridlock - that sets us up for a real economic danger not only in Europe, but also in the U.S. - a developed-world debt spiral. A debt spiral is a self-fulfilling prophecy of decreasing confidence leading to risk aversion, economic stagnation, and an ultimate debt default and/or collapse in the banking system. In the psychological literature there are a few insights to inform us about what may come next and what we can do to prepare.

Please CLICK HERE to join us for our Free Webinar on "The Psychology of a Debt Spiral (and Positioning for the Next Stage)" on Monday, September 19 at 4:15pm EDT.

In this 20 minute webinar we will touch on the psychological side of issues driving the current crisis:
1. What are the stages of a debt spiral?
2. What is likely to happen to European sovereign (PIIGS) debt?
3. Why financial stress goes on until "capitulation" occurs - even after fundamental uncertainties have been resolved.
4. Solving a debt spiral: The role of leadership, and how politicians can use psychological insights to improve confidence and the economy.
5. The best investment positioning in this climate.

MARKET PLUNGE
We're facing more than a routine correction in the markets. Despite excellent corporate earnings and 60-year lows in interest rates, equities have sold off sharply and are poised to decline further. The reasons for this trap are fundamental to a tipping point, and past that point psychological drivers - such as loss of confidence - take over.

LOSS OF CONFIDENCE

This loss of confidence is reflected in the angry public mood in the U.S. and Europe. When angry, people blame – some blame high frequency traders, while others blame the Fed, politicians, or even successful minorities or professionals (e.g., "bankers").

Chart of online investor anger (derived from social media linguistic analysis at marketpsychdata.com)

As investor anger grows, risk-taking and spending decreases. In fact, simply being exposed to another’s anger reduces spending and financial risk-taking (Winkielman et al., 2005, Trujillo et al., 2006). As a result, anger depresses a consumer economy and that country’s financial markets.

One result of anger is mistrust. And if investors no longer trust the goverment to turn around the economy, then who can they trust? This is the nagging doubt that ultimately collapses confidence and fuels a debt death spiral such as the one we are at the cusp of.

DEBT DEATH SPIRAL

In a debt spiral, increasing investor fear leads to decreased spending and investment, and thus a contraction in economic activity. Due to the economic contraction, government receives less revenue and is inclined to cut back spending further. Ultimately debts cannot be paid, credit collapses, and an economic depression ensues.

HONESTY IN LEADERSHIP
When confidence collapses politicians are forced to reveal, and voters are forced to confront, the truth about our current economic malaise. The truth contains unpleasant information: demographic time-bomb, underfunded pensions, public and private over-indebtedness, entitlement costs rising faster than economic growth, to name a few.

Naturally government officials (especially elected ones) are reluctant to speak honestly about the magnitude of the liabilities being faced nor to call for sacrifices. This reluctance to speak openly is defended as not wanting to stoke more fear that could accelerate the debt spiral. What we hear from politicians is characteristically benign – but does not address policies or procedures to deal with a debt default (which further weighs on confidence).

UNPLEASANT REALITY

Consider the estimated more than $100 trillion in future U.S. liabilities in the context of the current

U.S.

debt of over 80% of GDP. Most developed countries cannot pay back the money they owe without major structural changes (immigration, high inflation, currency devaluation), and eventually many will either stagnate or default. This has already happened in Greece, and may happen sooner rather than later in other European states. The default contagion is likely to spread to the U.K. and the

U.S.

within a couple years.

AUSTERITY VERSUS STIMULUS

Austerity will accelerate the “day of reckoning” since we already appear beyond the tipping point. This is what accounts for the market’s declines following the debt ceiling agreement. Fiscal stimulus is a "Hail Mary" - it will delay the day of reckoning and will stealth-tax everyone (except gold and some property owners) through inflation. However, if the stimulus is spent on truly productivity-enhancing projects (broadband internet access, high-speed rail, electric car infrastructure, an energy-independence “Manhattan Project,” breakthrough applied basic science research), then it has a long-shot of succeeding.

RESTORING CONFIDENCE

To restore investor confidence, trust in leadership must be restored. Honesty and forthrightness from leadership about our debts, with credible plans to address them, are necessary. There are lessons from the psychology of addiction that will indicate when the current crisis has finally run its course. The process of the economy and the markets hitting bottom is parallel to the idea of an addict hitting bottom. You can recognize “hitting bottom” when you see acceptance of the dire situation from political leaders, hear honest talk about mistakes made, see proposals of fundamental structural and policy changes to address those mistakes, and hear the “we’re all in it together” ethos expressed with sacrifices expected from all economic classes. In essence, when you see leadership with credible plans.

A long-term question is, will politicians be able to stand together when economic confidence collapses, or will opportunistic blaming continue?

EUROPEAN OUTCOMES

If European voters express support for closer political union – federalism – in Europe, then the fundamental Euro crisis may gradually be resolved. But that is unlikely based on the results of the recent election in the German state of Mecklenburg-Vorpommern. More likely Europe and the Euro will stumble along with more and bigger band-aids. As anger and frustration rises, political positions polarize and the choices become, by necessity, more extreme and unity less likely. Democratic voters are easily swayed by mis-information that resonates with their emotional states. So without steps made towards federalism in Europe, the Eurozone will continue to suffer, and some members may leave (if that were possible).

NEXT STEPS – INVESTING

If the crisis leads to a real collapse before the U.S. election of 2012, then look for coherent and forceful leadership before stepping into the equity markets. Although a big panic that creates values before then is also a good short term opportunity. Note the image to the left showing the collapse stage of the Nasdaq bubble - there were a series of short-term panics before the actual bottom was put in.

In particular, look for honesty about past mistakes, significant policy changes to prevent those from happening in the future, and the sharing of fiscal pain across classes. Also positive would be a stimulus that actually focused on productive investments, not just pork or taxpayer "relief".

The debt spiral and collapse of confidence are unfolding now, and equity and bond markets are likely to be suffering until mid-October. Consider gold and cash as safe havens (gold can still run dramatically before it peaks). There is no reason to “buy the dip” at these levels. There may be more dipping to come.

TRACK RECORD

We're happy to say that our big (and publicized) macro calls, based on sentiment analysis, have been correct in the past 12 months:

1. We called the market rally from September 2010 through April 2011.

2. We identified an equity bubble publicly in June 2011 and cited the risk to investors.

3. Dr. Murtha was on NBR on August 2nd explaining that a major correction is due (the day before the first crack in the markets).

4. We called a bounce "Turnaround Tuesday" off the Downgrade lows, to be followed by continued selling.

5. We even threw in a few one week buys during the savagery. BAC turned out very well, but HPQ lagged the market a bit.

We look forward to discussing these issues further at the webinar!

Happy Investing,

Richard

Buy on Hewlett-Packard (HPQ) for Monday

noreply@blogger.com (Richard L. Peterson M.D.) — Mon, 29 Aug 2011 05:57:00 +0000

HPQ heads-up: Our media analysis is showing a recent uptick in bullish forecasts on HPQ stock (following on a series of very negative comments after several unpleasant surprises and a 20% stock drop following recent earnings conference call). Such patterns generally lead to stock outperformance over the subsequent week.

See HPQ sentiment graphs here at marketpsychdata for more information.

Happy Investing!
Richard

Buying Bank of America During a Panic

noreply@blogger.com (Richard L. Peterson M.D.) — Wed, 24 Aug 2011 19:03:00 +0000

We don't usually (ever?) publicize trading signals AFTER they were made good, but I found this one interesting:
>> 20110824,BAC,B,7940,6.3,50000,1,63846,1327214649.6,3,20110829,smb_t3_v1,S3.hvix.Reboundnr1.hi.Volfd3.hi.Selloffnd3.hi.PR2.lo

What that code represents is one of our quant sentiment-based trading signals telling us to buy BAC (Bank of America) and hold for a week. The stock is currently up 9.76% today.

Yesterday we noticed our sentiment cluster showing GDX (Gold miners) as overbought and KBE (Banks) as oversold. Both of these have mean reverted. The current environment is excellent for mean-reversion based strategies.

In September we're launching a new newsletter in which we will be distributing our trading signals before the market open.

Happy Investing!
Richard

Holster that pistol - and load the Howitzer

noreply@blogger.com (Mark, The Advisor) — Tue, 23 Aug 2011 04:23:00 +0000

The harder the conflict, the more glorious the triumph (quote by Thomas Paine)

After the roller coaster rides of the last couple of weeks in the markets, many of us in the financial advisory business walk in to the office with knots beginning to form in our stomachs - and out at the end of the day looking for the closest martini bar. Our routine consulting methods seem ill equipped to address (not to mention resolve) the angst we encounter in the faces and voices of our clients.

For our advisor readers, the MarketPsych Insights team assembled the following list of steps we think are a handy reminder of time tested methods that are usually helpful.

1. Start with EMPATHY by exercising true listening skills and gently probing for emotional (and perhaps thoughtful) reactions to market gyrations, we serve a valuable role as sounding boards to relieve client tension. The most important aspect of this step is to shut up and let the client talk. Think of yourself as a steam valve. Every time you ask a question, or state an opinion, you are preventing high pressure steam from being released. Let the client unload; you may get new and valuable insights into their fears.

2. Be prepared to help them EVALUATE PERSONAL IMPACT of any changes in their wealth levels. Not only is this helpful in moving the discussion into more deliberative (i.e., less emotional) territory, but it also helps to extend the investment time horizon beyond short term whacks into longer term plans. In all of my recent client meetings, we review their financial security analyses to clarify what (if any) implications result from short term losses in value. People are usually better off than they feel.

3. Remind them that huge market volatility always brings OPPORTUNITIES. The key idea is to provide an inventory of solutions (investment or otherwise) that will add value over their investment horizon; if they are prudent enough to make decisive action now. Making decisions in tough times also provides clients with a sense that they have at least some control over their destiny, which is always a good thing.

4. Discuss process and methods to institute DOWNSIDE PROTECTION. You might institute something a simple as an agreed set of automatic triggers for communication or portfolio actions. These may include only communications, or perhaps move to more complex venues such as put options, or other portfolio protection measures. You may also explore identifying shifts in asset mix to more undervalued yield oriented strategies as well as the consequences of doing so for longer term planning. Again these measures provide the client with a broader set of tools to manage their emotional fears and feel a greater degree of control.

It is in times like these that we either strengthen our relationships with clients, or find them eroding. Spending more time in dialogue with clients in tough times is not only good for them, but it is good for you (and your business).

Mark, the Advisor

Quick MarketPsych Mention

noreply@blogger.com (Frank Murtha, Ph.D.) — Tue, 16 Aug 2011 16:33:00 +0000

MarketPsych gets a quick mentino over at the Smartmoney blog, courtesy of Kelli Grant.

MarketPsych Alert: Investors at Risk for Classic Investing Mistake

noreply@blogger.com (Frank Murtha, Ph.D.) — Wed, 10 Aug 2011 16:55:00 +0000

(First off- it you haven't read THIS , we invite you to do so. For one thing, it is so scarily accurate that you will not only want to subscribe to Dr. Peterson's Data Service, you will want to rent him out for parties. For another, it contains wisdom and stick-your-neck out prognostications for what to look for next.)

-------------------------------------------------------------------------------

Would you rather have flowers in your garden or a bunch of gnarly weeds?
Obvious answer, right?

Not so when it comes to investing. And at "crisis points" like this one (markets down another today and fear is getting higher than Timothy Leary at a Grateful Dead concert ), it puts investors at risk for one of the biggest investing mistakes.

When the market is as scary as it is right now, there's always a temptation to sell. Perhaps to avoid further losses, or maybe just to have more cash available to go bottom fishing when the dust settles.

(MarketPsych Note: The above sentence has just been voted the single worst mixed metaphor in MarketPsych Blog history.)

Awkward phraseology notwithstanding, at times like this many investors will look to liquidate some stocks to free up cash.

The temptation will be to sell the stocks in which you have the biggest gains. Here's the problem.

The stocks that have performed well have done so, because they are BETTER stocks. There may be exceptions, but stocks that go up are by DEFINITION better stocks than those that don't.

Here's MarketPsych's internationlly famous "Wicked Gardener" Analogy.

Your portfolio is a garden. Good stocks are blooming flowers. Bad stocks are weeds.

Many investors free up cash at times like this by clipping those beautiful flowers and holding - or in some cases watering (i.e. buying more of) -- those weeds.

By doing so investors systematically clear out their quality holdings, ensuring that what remains in the portfolio are lower quality, worse run, worse performing companies.

Be aware of not only of this temptation, but also the underlying motivation. When looking at positions to sell, ask yourself this; are you chosing the stock because it is the one you should going forward? Or are you really selling a stock because it hurts less than realizing a loss on a position? And be 100% honest.

Because if it's the former - good for you. If it's the latter, well, we can relate, but protecting your feelings comes at the cost of protecting your money. It's a recipe for long term investing failure.

So I'll make a deal with you:

You do what's right with your money.

I'll work on my metaphors.

And hey... let's be careful out there.

-Dr. Frankenstocks

Frank Murtha, Ph.D.

Downgrade! - The Psychological Terrain of What Comes Next in the Markets

noreply@blogger.com (Richard L. Peterson M.D.) — Mon, 08 Aug 2011 02:25:00 +0000

Investors are in the same conundrum as the human brain. The brain receives more than 1,000,000 sensory inputs every second. But the brain's owners (us) can't consciously pay attention to each of those inputs. During the latest crisis, investors are receiving tremendous amounts of information (mostly negative). How can they possibly make sense of it all?

Fortunately they can turn to the field of neurofinance for answers.

NARRATIVES

The brain's solution to information overload is to craft general feeling impressions and weave those impressions into stories - narratives - that serve as easily memorable summaries. These narratives provide a concise explanation of what has happened and what to expect going forward.

Over the past three months we've seen investors turn away from a narrative of recovery and towards the narrative of debt default and stagnation. In the narrative of recovery, large deficits and debts are expected to be repaid through growth - as happened to the U.K.'s debts after WWII.

But burdened by evidence of an economic slowdown, the recovery narrative for Europe and the U.S. collapsed over past three months, culminating in the downgrade of the U.S. AAA debt rating by S&P.

As a result, investors are looking for a new narrative to guide their investing, and what they see is political paralysis (in the U.S.) and political impotence (in Europe) in dealing with the economic issues.

THE DEBT NARRATIVE

The new narrative being adopted by investors - whose readjusted expectations have contributed to the price shocks we've seen over the past two weeks - is focused on the unpayable debt overhang the developed world faces. And the more it is recognized as unpayable, the more likely it will become unpayable through higher debt service costs - a self-fulfilling prophecy. That feedback loop is the real danger of the current narrative. Over the short term, this panic will play itself out, hopefully by mid-week, leading to a short-term (days) rebound which is likely to be prompted by a surprise announcement of QE3 or other government action after hours. However, long-term we're still in the throes of a fundamental problem with developed world economies - political impotence and excess debt.

EMOTIONAL CLIMATE

Anger is the by-product of the current narrative. Anger and Fear are qualitatively different. Fear is about the future and is often an overreaction. After a spike in fear and a plunge in the market, there is usually a rebound and a return to business as usual. Anger indicates a more fundamental reassessment of the investment environment. And now we're facing investor (and social) anger.

WISDOM OF THE CROWD

Based on our linguistic analysis of financial social media, you've seen in the past few blog posts images of very high anger and disgust among investors. Those emotions are feeding into expectations as well - it appears that investors' earnings expectations have been dropping for some time. In particular, you can see that expectations of earnings for S&P 500 companies have been slowly declining since February 2011 and are at their lowest level of the past 12 months. See the chart below:

WHAT'S NEXT?

For the short term, there may be a rebound by Tuesday or mid-week. The way panics tend to play themselves out, we see a follow through sell-off through Monday, then a stabilization, and then "turn-around Tuesday." So the odds are that we get a little bounce.

But longer term, this selling will continue to play itself out. There are really two alternatives to how we solve the huge U.S. debt overhang (increased taxes and lower spending are both required, but they still can't address the entire liability overhang). We can inflate our way out of it (increased spending and QE3), or we can try to improve our balance sheet by cutting spending (fiscal austerity).

Inflation is a stealth tax on everyone, while fiscal austerity is more obvious. At this juncture, the U.S. is likely to fake fiscal austerity while going the path of inflation. The U.K. is genuinely going with austerity (as is Ireland and Greece currently). However, it remains to be seen how long citizens can tolerate slow economic growth due to austerity. Eventually they are likely to succumb to the desire for short-term needs (jobs) - and vote in politicians who promise to increase spending despite the risks of inflation. In any case, it promises to be an interesting decade.

If you still doubt that market psychology matters, your doubt is likely to be tested again and again in the coming months.

There are still safe havens for investors - emerging markets such as Brazil, Chile, Peru, and Indonesia, and several African nations are emerging with credible investment environments.

Of course, in the midst of a crisis, we tend to turn away from what is unfamiliar (the familiarity bias) and pull our money closer to home. In the case of the current crisis, that is likely to be a long-term mistake.

Happy Investing!

Richard L. Peterson, M.D.

DOC HOLLIDAY...

noreply@blogger.com (Frank Murtha, Ph.D.) — Thu, 04 Aug 2011 18:04:00 +0000

... Just winked.

I commented on this on last night's Nightly Business Report, but the debt crisis has revealed a fascinating an unforseen shortcoming of the Market.

But first some perspective. Do you think for a moment that if we decided to raise the debt ceiling quietly and without any fuss that the markets would have blinked? I mean, it's been raised 74 times since 1962. Ten times since 2001!

What? Is the 75th time the charm?

Of course not.

And it's not like our national debt snuck up on us. A few miles away from me at Union Square there's a gigantic COUNTER revealing the national debt up in real time.

So what's the big fuss? Why did people, who could have shouted "DOWNGRADE!" in a crowded market any time over the last few years, pick this moment?

Here's the dirty little secret: The Market can't focus on EVERYTHING.

It just can't. The Market (i.e., the investing public) doesn't have the mental bandwith to factor in every variable. So it can only focus on a few issues at a time, usually the ones that appear most urgent or emotionally charged.

Avoidance works. And a problem isn't a problem until we decide it is. That's what makes a bubble. A whole bunch of people decide to ignore a problem... until they don't.

So instead of getting a relief rally for defusing the debt-ceiling time bomb with 1 second left on the clock, we got a renewed attention on some significant problems. The rose-colored glasses are off... the shades are on. And they have given people a dimmer view of our plight.

It's actually quite ironic if you think about it.

If we had chosen to raise the limit and ignore the problem - just as we've been ignoring it for years - August 2nd would have come and gone without incident.

When we decide to, you know actually address the problem for once... we are "at risk for a downgrade".

Hardly seems fair, really.

MarketPsych's Co-founder and resident genius, Dr. Rich Peterson, has a fascinating post below on what the implications may be. We invite you to check it out.

In the mean time, happy investing.

And hey... let's be careful out there.

(Seriously.)

-Dr. Frankenstock

Frank Murtha, Ph.D.