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A Study in Human Psychology

March 7, 2007 by 2 Comments

The stock market is a study in human psychology with human emotion driving all market action. The market acts as a pendulum, which swings with emotion and psychology. These emotions can include but are not limited to greed, fear, hope, excitement, sadness, etc. Since the market is fueled by humans, these emotions never change. As Jesse Livermore once pointed out; the names change, the players change and the prices change but the patterns always repeat because they are patterns based on human emotion.

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Emotions can and will determine your success or failure while trading the stock market. When you learn to control emotions, you are at least half way towards winning the battle. Without control of your emotions, no matter how successful a system or set of rules, consistent profits will be difficult to obtain.

The stock market is not the only place in life where human emotions are constantly flowing and can be followed or charted. While driving in the car over the past few weeks, I have heard human emotions at their highest and lowest levels while listening to sports talk radio. I am in the NY metropolitan area so the main subjects are the Yankees, Mets, Giants and Knicks. It amazes me to hear callers on a day after their team loses versus callers on a day after their team wins (many times the same exact callers).

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I want to present two examples of human emotions at their best. One from the stock market and one from the sports world; the same emotions surface but they take place in different entities.

Stock Market Example:
How does the average investor react after buying a stock that:

a. Goes up in price:
b. Goes down in price:

When scenario ‘A’ takes place, most average investors will start to hope that it keeps going up but as the stock continues its advance, fear starts to overcome their emotions. They now fear that the stock may come back down and they will lose the current profit. On up days, the investor feels like a genius but is scared to allow the profit to deteriorate so he looks for every reason to sell and hate the stock. On down days, the investor has all the hope in the world that the stock will recover and he loves the stock even though it is telling him that his judgment may be wrong. As a result of these emotions, they will sell the stock with a small profit with no other reason justifying the sell. The investors kicks himself when he sees that the stock he sold for a small profit is now trading 50% higher without any major selling violations along the way.

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In scenario ‘B’, the investor starts to hope that the price will rebound and the negative action is temporary. The proper research was done and the investor believes that he has a great stock and it has to be successful (the market is wrong he thinks to himself). The investor starts making excuses as to why the stock is now in negative territory. He continues to hope for a recovery and will actually purchase additional shares at the lower price by averaging down. By averaging down, he convinces himself that the entry price is now more favorable with a potential for a larger profit. The stock continues to slide and he keeps hoping for a rebound and may buy more shares by putting good money after bad.

As the stock slides, he promises himself that he will sell on the first rebound to get out with minimal damage. Finally, the stock is up a few percent but volume is higher so he talks himself into holding onto the stock because this is the start of a rebound. Emotions play with his mind and he completely ignores his rules and system. As the rebound dries up, the downtrend continues and he is now just looking to get out on the next rebound. The rollercoaster will continue until he can’t take it anymore and probably sells near the bottom. He finally sells for a large loss and walks away with his tail between his legs.

Sports Talk Radio Example:
How does the average sports fan react and feel after a win or a loss by their team:

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a. Their team Wins:
b. Their team Loses:

In scenario ‘A’, fans will call up the radio station and explain why their team is the best in their division and how they are going to win it all. Some fans suggest that the coach should be given a contract extension and the management is the best in all of sports. Other fans are already talking about a dynasty and a championship next year before even reaching and winning the championship game this year. Players should get contract extensions and everyone is an MVP candidate. Nothing can go wrong because their team just won (one game – that’s all).

In scenario ‘B’, fans will completely flip flop from what they were saying last week, last month or even last night. The change of emotion is absolutely amazing when listing to sports talk radio on a daily basis. Yesterday they were crowing the team champions and today they explain why the team is a bunch of bums that won’t make the playoffs. The coach should be fired, the general manager is garbage and everyone should be traded.

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By listening to the radio, I can hear human emotion whip around the same way it does on a daily chart when news hits the wire. Looking at my charts last night; I can see human emotions and reaction over the past week. Up and down with wild swings and great volatility. The newspapers are spilling over with articles from talking heads about what is happening. The evening and local news stations are now featuring so-called experts on the market after the 400 point slide. They have every Tom, Dick and Harry claiming to be an expert on knowing why the market dropped, how the glitch happened and where the market is headed. I wonder what these fools will say if the market gains 450 points today; I bet they will completely flip-flop like the sports fan.

Human emotion is amazing and I would love to study psychology on a higher level because it fascinates me. Watching the market, playing sports and listening to sports talk radio gives me a front row seat as to how most people react to nonsense. I never realized this until I started to trade but people are neurotic and change their thoughts as quickly as the second hand changes on a clock. I see these reactions at the poker as well but the clearest change in human emotion must be on the radio. Try it out and listen to how fans can switch from one extreme to another in the matter of one day and one win or loss.

As Jesse Livermore said: “There is nothing more important than your emotional balance”

But even he couldn’t follow his own advice in the end. Maybe because he was only human!

Market cartoons courtesy of www.jsdykes.com

Filed Under: Education, Psychology, Sports

Baby Boomer Bust is BULL

November 29, 2006 by Leave a Comment

This article was originally written last summer but I wanted to bring it to the top of the blog after reading Bill’s lastest post over at No DooDahs.
“Boomer Bust?” I Don’t Think So!

I couldn’t agree more and can’t wait to read his full argument!

July 14, 2006:
Falling_DollarTheorists make money selling books that sell fear while investors and entrepreneurs make money by following their ideas with money and hedging against a possible crisis. I learn from history and history shows us that these “crisis” books will always sell during tough times. Readers eat up this garbage because most people are trapped in the rat race working their asses off just trying to stay afloat. Their attitudes are typically piss-poor and they love to read about huge negative events (especially a crash that may hurt others).

Also notice how the same authors try to write books when the market starts to go back up again. For example, Howard J Ruff was writing about the crisis in 1979 through 1982 but then started to write about how to invest as a serious investor in 1987. Guess what: he was on the wrong end of the crisis in 1982 (the tail end) and the wrong end of the boom in 1987 (crash later that year). These “fools” are always late to the party and sell millions of books to the “average” person that engrosses themselves in fear!

These people, both now and then are not very accurate, they sell garbage in my opinion and I ignore it at all costs! I just hope many of you can do the same and make decisions based on what “YOU” see and not based on book sellers! Invest for now, ignore the garbage but be prepared for worst case scenarios by taking necessary steps but don’t radically change your life based upon the writings of a few authors that probably don’t invest themselves.

Books from the Past:
Crisis Investing: Opportunities and Profits in the Coming Great Depression by Douglas Casey (Hardcover – Jul 1980)

Crisis Investing for the Rest of the 90’s by Douglas Casey (Hardcover – Oct 1993) – WOW was this wrong in 1993!

What the smart money is betting on in 1985: By Doug Casey by Douglas R Casey (Unknown Binding – Jan 1, 1985)

The Coming Currency Collapse and What You Can Do About It by Jerome F. Smith (Hardcover – Sep 1980)

Profits from silver by Jerome F Smith (Unknown Binding – 1983)

How you can profit from the coming devaluation by Harry Browne (Unknown Binding – 1970)

You can profit from a monetary crisis by Harry Browne (Unknown Binding – Jan 1, 1975)

How to Prosper During the Coming Bad Years – A Crash Course on Personal and Financial Survival by Howard J. Ruff (Mass Market Paperback – 1979)

How to Prosper in the Coming Bad Years by Howard J. Ruff (Mass Market Paperback – Jul 1981)

Making money: Winning the battle for middle-class financial success by Howard J Ruff (Paperback – 1986)

Howard Ruff’s crash course for the serious investor by Howard J Ruff (Unknown Binding – Jan 1, 1987)

How to Prosper During the Coming Bad Years by Howard J. Ruff (Paperback – April 1984)

Books from Today:
The Coming Collapse of the Dollar and How to Profit from It : Make a Fortune by Investing in Gold and Other Hard Assets by James Turk and John Rubino (Hardcover – Dec 28, 2004)

The Coming Economic Collapse : How You Can Thrive When Oil Costs $200 a Barrel by Stephen Leeb and Glen Strathy (Hardcover – Feb 21, 2006)

Defying the Market: Profiting in the Turbulent Post-Technology Market Boom by Stephen Leeb and Donna Leeb (Hardcover – Jun 3, 1999)

Empire of Debt : The Rise of an Epic Financial Crisis (Hardcover) by William Bonner, Addison Wiggin (November 11, 2005)

The Great Bust Ahead: The Greatest Depression in American and UK History is Just Several Short Years Away. This is your Concise Reference Guide to Understanding Why and How Best to Survive It (Paperback) by Daniel A. Arnold (November 25, 2002)

Image courtesy of Mirrorimageorigin.collegepublisher.com

Piranha

Filed Under: Psychology, Wall Street

Talking Heads at it Again!

October 4, 2006 by Leave a Comment

As we all know the DOW set a new record close by finishing at 11,727.34, surpassing the prior closing high of 11,722.98 set back on January 14, 2000. The index was up 0.5% or 56 points as crude oil fell to a 14-month low based on assumptions that lower energy prices may boost consumer spending and hold off an economic slowdown. The NASDAQ was up 0.3% to close at 2,243.65 as it is still miles away from all time high that was set back in 2000 at 5,132.50. The S&P 500 closed at 1,334.11, up 0.2%, as it is within a short distance of its all-time high of 1,553.11.

With all of the excitement surrounding the new closing high, I would like to focus on what the “Talking Heads” are saying. What is a talking head? Please see a post I wrote years ago titled: Ignore “Talking Heads” because they are usually wrong!

Here are some quotes from talking heads today:

  • “Now that you have a definitive new all time high, the fact that it is the Dow and the most recognized index, that is the type of thing that will shine the spotlight on the market,” said Charles Carlson, who oversees $105 million at Horizon Investment Services LLC in Hammond, Indiana, and who wrote “Winning With the Dow’s Losers,” published in 2004. “This could get people interested in stocks.”

Read that last quote! “This could get people interested in stocks”. The only people that get interested at this point in time is dumb money! When “people” such as your mother-in-law, the barber and the taxi driver start talking about the DOW and its all-time high; it’s probably time to get ready for a huge blow-out where smart money takes advantage of dumb money and laughs all the way to the bank. Be careful out there because the wheels will fall off when “people” get interested in stocks.

Another ‘talking head” on a major financial site:

  • “Investors are concluding that the economy is in for a soft landing,” said Hugh Johnson, chairman of Johnson Illington Advisors. “They expect the good news about the decline in oil prices to offset the negative impact of a deteriorating housing market.”
  • “What’s most interesting”, Davidson said, “is not that the Dow has broken through to a new record, but that it has taken the market this long to get to a point at which stocks seem to be fairly valued relative to earnings expectations.”

Who cares, analysts were saying Enron was a buy and fairly valued at $60 before its infamous decline. By the way, talking heads recommended Enron all the way to $12 per share from $60.

  • Scott Wren, senior equity strategist at AG Edwards was cautious about the importance of the Dow’s milestone. “It’s probably of more significance to the retail investment community than it is to the professionals,” he said.
  • “But I do think its a psychological plus and one that could spark some interest and maybe bring a little bit of sideline money into the market.”

From MSW Money:
Twenty-three of 30 stocks in the Dow were higher on the day along with 304 S&P 500 stocks.

  • The rally is a reflection of investor “belief in the sustainability of growth,” Maury Harris of UBS Securities told CNBC’s “Power Lunch.” While the economy may be slowing, it will be a modest pullback at worst, he said. And, added Peter Hooper of Deutsche Bank Securities, investors believe the Fed won’t be cutting interest rates but will step in to support the economy.

When I hear things like this, I start to lick my chops and get ready to short the hell out of the market. These talking heads don’t know what is going on and continue to pump a market and economy that is extremely extended and due for a pull-back. I really don’t know when that correction will start but it will and I am jumping on at the first signal. To be honest, it could take, three days, three weeks or even three months – I don’t know but when it does happen, I put my cash to use!

As many traders have noted, such as Trader Mike, the $SOX or semiconductor index is performing poorly which usually casts some foreshadowing of what’s to come. In addition to the $SOX acting poorly, small caps and other bull market leaders are not stepping to the plate to propel the indexes higher. The NH-NL ratio is weak and is not participating in this rally run and that sends the largest red flag in my opinion. Without the support of small cap growth stocks, you wouldn’t expect this rally to continue. I have been bearish on the Ticker Sense Blogger Sentiment Poll for the past four weeks as the market has moved higher and remain that way.

Some sectors acting poorly on Tuesday were energy stocks, computer hardware and gold stocks. Sectors moving higher Tuesday included airlines (they typically move higher when oil stocks move lower), brokers and some medicals.

Marvel Technology (MRVL) led the semiconductor group lower as it gapped-down and closed with a 12% loss on the largest daily volume in months. The stock is back below its 50-d moving average and is well below its 200-d moving average. The proper CANSLIM short should have come when the stock failed to recover the 200-d m.a. back in mid-June. Similar to the stocks listed on last night’s MSW screen, MRVL can be a poster stock for what to look for in possible shorts.

I have included some charts of the major indexes which shows why I am looking for a pullback and why my screens are focusing on potential shorts.
Piranha

Filed Under: General Market, Psychology, Wall Street

Thinking instead of Acting

August 11, 2006 by Leave a Comment

I was reading another post on a forum and came across another interesting topic. The guy making the post responded to my piece on the TICKS and said this:

“One big problem with technical analysis and the use of indicators is that it confuses causes and effects. The move of the NASDAQ is the cause, the movement of the indicator is the effect. The NASDAQ doesn’t fall because the indicator says so. The indicator says so because the NASDAQ has fallen (please note the past tense). Nature works in a very predictable way: you cannot manage the effect (investing based on the indicators) without first managing the cause (figuring out why the NASDAQ moves in a certain way).”

Here is how I answered this person:
You are correct that technical analysis is the effect but I am not trying to get in at the bottom or out at the top. I catch the trend and technical analysis will always give you the underlying trend and that is where my money is made.

Using the indicators (lagging or not), I always know the trend and will place my trades with that trend. I am not always right but I use several position sizing strategies to hold my risk to a minimum which allows me to capitalize on my winning trades and cut the losers quickly.

By trading with the trends, I could care less what the “true” cause is for the movement (that is a waste of time). All I need to know is the direction the market is moving in. Nature may be predictable but the market is not so knowing the cause is useless because causes are always priced into a market in advance. I buy the trend and look for the cause in the news in the following days, weeks or even months. In my opinion, causes are old news by the time they become known!

Too many times, I see people think too deeply into the market and always miss the move because they need to know the reason why the market is moving. I don’t care why it is moving, I only care to know if and when it is moving so I can get in or out of my positions. As I said above, I will look for the “cause” or reason when it hits the headlines in the future!

Piranha

Filed Under: Psychology

Simple Thinkers

August 8, 2006 by Leave a Comment

Have you ever been on a message board, forum or in a discussion where a person tells you that earning ‘X’% per month would make you the richest person alive in ‘X’ number of years. For instance, I recently read a post by a forum writer that said:

“If you ever find such an investment you should immediately reinvest all got.

Month 2 you would have $20K producing $20K a month.

By the end of your first year you’ll have over 20 millions bucks and at the end of year two you will be by far the richest man alive.”

The question posed earlier in the thread said:
“Are there any ways that could earn $10K per month consistently”

To some people, $10,000 per month is peanuts but to others, it is a large sum of money; something so inconceivable that they bark about all the reasons why making this type of money is impossible. To be honest, it’s only $120k per year; not that impressive in New Jersey anymore!

What struck me the most about this post was the fact that the responder was using such elementary thinking when answering the question. By using proper money management techniques, an investor would never risk their entire stake on one investment because it was returning a specified amount or percentage each month. If I am trading with a positive expectancy system that is averaging a return of $10,000 per month, why would I double, triple or quadruple my risk just so I could make more money. Non-investors are always thinking about the up-side potential and never worrying about the downside. Maybe the person earning $10,000 per month has formulated a system with positive expectancies and a quality position sizing technique that allows them to make this sum without risking too much of their original capital.

If the investor were to double the size of their bet or increase it even further, they run the risk of ruin on one bad transaction; therefore, becoming the richest “person” in the world in not an option by doubling-down the size of the specific bet or business strategy. It sounds to me that the person responding to this post is a roulette player that believes that doubling each bet after a loss will allow them to break even which couldn’t be further from the truth.

Be aware of the “talkers” on the web and don’t buy into everything they say because much of the crap I come across is that: “crap”! Just because someone has an investment strategy that pulls in $10,000 per month does not mean it is as simple to double up on the original investment in order to bring in $20,000 per month and then repeat the process to bring in $40,000 per month (eventually making you the richest person alive in a few years). I highly doubt the responder in this post has ever studied probabilities, risk, reward, expectancy or any other mathematical logic before giving his two cents. I will also assume that he is the type of investor (or gambler) that always has a hot tip and will bet the farm on that tip because he sees the potential of profit on the other side of the fence rather than the possible loss (risk of ruin) by risking too much.

Try out this logic: Ask 10 friends or family members which situation they would choose if given the opportunity:

  1. Risk 90% of their net worth for a 5% chance of multiplying it 50 fold
    or
  2. Risk 1% of their net worth for a 70% chance of doubling it.

What would you choose? And Why?

I think many of you know which number I would select based on my past blog entries and my investing style.

Steer clear of internet TALKING HEADS & SIMPLE THINKERS!

If you are interested in reading high quality material on the web, take the time to visit my blogroll and links section on each sidebar. No talking heads here!
Piranha

Image provided by: http://www.scholarnet.co.nz/flo/savings_item1.php

Filed Under: Psychology
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