Inside the Investor's Brain

Just this week, I had to read this book and another as my library got one from Minnesota and the other from UW Waukesha and they both came in on the same day. Of course as they were both on some kind of special inter-library loan, I only had a little more than a week to return them. Still, what a great library, huh? I did not know I could get books from so far away. Now that I found this out, I should have to buy fewer books.

I think I will have to find a little light reading as this again was a tedious book but quite interesting in parts. Well, here are my notes:

Richard L. Peterson, “Inside the Investor’s Brain” (The Power of Mind Over Money), John Wiley & Sons, Inc., 2007

The author is a psychiatrist and a former trader who now holds seminars around the world for investment professionals. He has two web sites: www.marketpsych.com and www.richard.peterson.net.

The human brain is wired to make decisions in certain ways. Unfortunately, when it comes to the financial markets, the way we’ve been wired is not conducive to making money. This book explains the fundamental “hardwired” mistakes made by most investors and reveals the simple steps you can take to overcome these obstacles and improve your financial decision-making skills.

Pg. xv: If thinking could make everyone a great investor, then there wouldn’t be market bubbles and panics, addiction, or criminal greed. But we do have those problems—in part because the thinking brain evolved about 100,000 years ago, while the feeling brain is one of our most primitive endowments (something we share with our pets), and the two brains don’t always get along. How to manage them both in the wild world of the financial markets is the subject of this book. In the financial industry, most investment decision making follows a rational process until, often at crucial times, that process breaks down (bubbles, market panic (2008), etc..).

Pg. 29: In the markets, most investors take away lessons where none exist. They learned to avoid technology stocks after the losses of 2001, even though the bear market losses should have had little impact on non-Internet stock performance going forward. After suffering bear market losses, most investors wait for price “confirmation” before jumping back into stocks. They may even sit out the market until new highs are reached. Of course, waiting for confirmation means missing much of the price move, but that’s the price many people are willing to pay for enhanced confidence.

Pg. 68: Nobel Prize winner Daniel Kahneman postulates that there are two broad neural systems underlying decision making: the analytical and the intuitive. Analytical judgment is primarily logic based, while the intuitive system is rapid and feeling based.

Pg. 69: Traditional investment theory assumes that people use reasoning and objective analysis during decision making. According to traditional theory, investors slowly and mechanically judge potential outcomes, weighing their probabilities and their potential gains or losses, to arrive at a rational analytical decision. They arrive at a choice after a series of calculations—a “risk-reward analysis.” Yet, in a world where ultimate outcomes are uncertain and volatility can arise unexpectedly, investment practice is not as rational as theory suggests. Currently, however, there is no single coherent psychological theory to counter the assumption of investor rationality.

Pg. 82: The Disposition effect. In behavioral finance research, one of the most prevalent biases is the tendency to hold losing stocks longer than winning stocks. That is, most investors too frequently “let their losers run and cut their winners short.” This is called the disposition effect. Many academics believe that the disposition effect is due to the “fear of regret.” Selling a losing stock is tantamount to admitting that one was wrong. On the other hand, they sell winning stocks too soon because they fear that the stock will drop, giving back their gains, and they will regret not having taken their paper profits off the table while they had the chance. So whether one’s stocks are up or down, investors often make biased decisions in order to avoid experiencing regret.

Pg. 86: The decisive factor in risk taking is perception of control. Fearful investors feel insecure and out of control. As a result, during market decline, the fearful are more likely to sell out. Angry investors have identified the enemy and feel in control of the situation. They hold on to declining stocks because they are more certain of their position.

Pg. 126: During calm markets most investors don’t prepare adequately for volatility. They cannot accurately forecast how they will feel and what they might do in such conditions. They project their current sense of security onto their future self. Some naïve investors take on excessive credit risk because they see no threats on the horizon and they project an excellent borrowing climate into the foreseeable future. Investors caught with excessive risk exposure during a credit contraction are the origin of the Wall Street adage, “It’s only when the tide goes out that you learn who’s been swimming naked.” When credit dries up, those who took excessive risk are exposed.

Pg. 172: According to traditional economic theory, it makes no sense for someone to buy a lottery ticket. The “expected value” of a lottery ticket is about $0.40 for every dollar spent, meaning that the average lottery ticket buyer is losing $0.60 on each $1.00 investment.

Pg. 190: Prospect Theory. Loss aversion is one tenet of the Nobel Prize winning theory of decision making called prospect theory. Prospect theory is built on a foundation of simple psychological experiments that show how most people rely too heavily on frames, reference points, and anchors when making risky decisions. People perceive many financial decisions in terms of their frame—whether they are viewed as a potential loss or a potential gain. Reliance on frames and reference points causes systematic distortions in decision making. One tenet of prospect theory, loss aversion, explains that people typically overweight the pain of losses twice as much as the pleasure of gains when making decisions.

Pg. 194. Framing. When a decision is explained as a potential gain, then the brain’s reward pursuit system is engaged. When the decision is made in relation to what one might lose, the loss avoidance system is activated. The differential activation of these two motivational systems depends on how one predominantly sees the decision—as a potential opportunity or a potential risk. The different presentations of a decision, in terms of either what one might lose or what one might gain, is called framing.

Pg. 203: People’s propensity to become emotionally attached to items they own, such as stocks, is called the endowment effect. The endowment effect is an easily measurable result of loss aversion. While buy decisions are typically based on a consideration of objective information, sell decisions are often emotionally weighted.

Pg. 206: The equity premium puzzle refers to the historically high returns of stocks relative to bonds. According to economists, the average annual real return (i.e., the inflation adjusted return) on the U.S. stock market for the past 110 years has been about 7.9%. In the same period the real return on a relatively riskless security was 1%. The difference between these two returns, 6.9%, is the equity premium. Why U.S. bonds are so popular, even with a relatively low yield, is the puzzle. Individuals must perceive a significantly higher level of risk in stocks than has been shown historically for the puzzle to be reconciled with “rational” economic models. Obviously all long-term investments should be in equities but it is not going to happen for most people.

Pg. 263: Most trading desks are backed by a wall of liquid crystal display (LCD) monitors and television screens. Some of the traders intensely watching those monitors are unknowingly changing their neurochemistry. Studies of children and television watching indicate that increased daily television viewing time correlates with decreased attention span. American children aged one year old watch an average of 2.2 hours and children three years old watch 3.6 hours of daily television. For each hour above average that children watch TV at these ages, there is a 10% increase in the rate of diagnosed attention deficit-hyperactivity disorder (ADHD) when these children turn seven years old. This result is independent of the effects of home cognitive-environment. In children, watching excessive TV reduces attention span. This may be true for traders as well but has not been studied.

Pg. 266: One of the most pernicious memory biases is called the hindsight bias. The hindsight bias refers to the fact that most people think they “knew it all along.” After an event occurs, they think that they had predicted it would happen in advance, when in fact they did not. The danger of the hindsight bias is that it prevents people from learning from their mistakes. Journaling is the best way to avoid this bias.

Pg. 282: When groups of people from 1903 and every seven years thereafter are followed over time (the Seattle study), the earliest observed cognitive decline occurs for perceptual speed and numeric facility beginning at age 60. Inductive reasoning, spatial orientation, and verbal memory begin to decline by age 67. Verbal ability remains robust until age 81. In general, the declines are relatively minor until age 80, when they all begin a more precipitous drop. Young people’s generation of today generally have a superiority of skills relative to their grandparent’ generation except in the areas of verbal and numeric ability, which are inferior. The cause of these age-related deficits appears to be “Use it or lose it.

Pg. 318: Fear can best be translated into financial language as “risk perceptions.” When risk perceptions are high, so is the risk premium. Risk perceptions often deviate from actual risk due to the biases described earlier in this book: emotion (fear leads to overestimation of low probability catastrophes), time discounting (seeing an immediate danger), herding (investors observe each other for cues), uncertainty and mistrust (the veracity of government published statistics is ambiguous), and loss framing (default is seen as a risk not an opportunity). Over time, strategies that arbitrage risk perceptions can do very well.

In currencies, differences in risk perception are often reflected in interest rate yields. Currencies that are at risk of devaluation typically have higher-yielding bonds. Investors perceive risk of devaluation if they believe that the government may: (1) default on debt payments (bond yields); (2) significantly increase its money supply, which sparks inflation, or (3) devalue its currency via other means, such as deficit spending.

Pg. 321: Value stocks’ shares sell inexpensively relative to the actual, underlying worth of their physical assets (such as buildings, factories, equipment, patents, band, or market penetration), their projected earnings growth, or their cash flow potential. Three widely used financial ratios for measuring a stock’s value are: (1) the price-to-book ratio, (2) the price-to-earnings ratio, and (3) the price-to-cash flow ratio.