, it can personally be identiﬁed.
2. Fear causes changes in how people think about and react to bad news(indecision, paralysis, building pressure, and panic). Thus, it often leadsto bad decisions.
3. Fear is different from panic. Fear is an anticipatory emotional state.Fearful people see many risks. Panic is reactive, and it is characterizedby an urgent pressure to act immediately.
4. It takes tremendous effort and fortitude to “keep one’s cool” when
frightened.
5. Other investors’ fear can be detected in the markets, often via an expe-
rienced reading of price dynamics.
People’s natural reaction to perceived threats is to get away from them.Yet most experts can coolly stand back, take a deep breath, and analyze thedangerous situation logically. The courage required to push back againstfear and the panic reﬂex is honed through experience, practice, and mentalexercise. The inner strength needed to look at all sides of an investment ob-jectively, including one’s own emotional reactions, is one of the key traitsof successful investors.
While it isn’t difﬁcult to be conscious of one’s anxiety, it is tremen-dously challenging to objectively question the merits of it when experi-encing it. Anxiety orients one’s cognitive resources toward preparation
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for the perceived threat, making deviations from such a train of thoughtextremely uncomfortable and effortful. There is also a socially infectiouselement to fear. In the markets, part of the reason it’s hard to fade (tradeagainst) fear relates to the collective changes in thinking and behaviorthat accompany it, which are often reﬂected in the media and amongcolleagues. If one can objectively observe investor anxiety, such as byusing mental training exercises, learning the signs of fear in market prices,and employing sentiment indicators, then it can be used to improveinvestment returns.
CLIMBING A WALL OF WORRY
It’s an old adage that the stock market “climbs a wall of worry.” Often,stock prices seem to rise while investors and the business media are fret-ting about one or another potential danger. However paradoxical, worryactually provides opportunity. The following Wall Street Journal quote,from June 1997, illustrates: “Market watchers and investors alike expresseda measure of awe—and a dose of trepidation—as the market scaled whatlooked to them like a sheer cliff.”2 While investors were nervous that themarket rally would falter, a growing sense of conﬁdence in the economydrove them to buy.
Intense fear is different from the worry that accompanies rallies.Strong anxiety cannot last long, though it feels interminable to shortsightedinvestors. Investors are biologically induced into short-term thinking by thestress hormones released during episodes of acute fear. Fear has the effectof inducing concrete short-term thinking with poor ﬂexibility in judgment.Following a fearful event, as stress hormone release abates, and the inten-sity of the fear subsides, investors start seeing bargains where they previ-ously saw only danger. In the short term, periods of high market fear usu-ally present excellent buying opportunities (such as the fear that precededthe 2003 invasion of Iraq).
Figure 9.1 is a chart of the S&P 500 (the SPY index) from June 2001 toFebruary 2002. Two sentiment indicators are superimposed on the indexprices. The ﬁrst indicator is the amount of fear expressed in the businessnews (the Nightly Business Report), while the second is the amount of joyexpressed in that broadcast. Notice how the stock market appears to risewhen the level of fear is greater than the level of joy. The market appearsto fall when joy is more prevalent than fear.
This is a “cherry-picked” example of a period in history where joy andfear levels correlated with market price trends. Usually, such correlations,while signiﬁcant in a statistical sense, do not provide for excess tradingreturns.
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Fear, Joy, and the S&P 500
S&P 500 SPY)
Fear Level
Joy Level
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Date
FIGURE 9.1 The levels of fear and joy in the Nightly Business Report around theSeptember 11, 2001, New York City terrorist attacks. The values are superimposedon the S&P 500 (SPY). Notice that when fear is dominant over joy, the market tendsto rally, and when joy is more prevalent, the market declines. This technique worksonly in emotion-driven markets.
DREAD IN THE MRI
“The key to making money in stocks is not to getscared out of them.”
—Peter Lynch
It makes sense, evolutionarily, that anxiety is such a powerful driver ofthinking and behavior. For our ancestors on the Serengetti, not heedingsigns of danger could lead to sudden death by crocodile or lion. Peoplewithout rapid panic reactions couldn’t last long. In fact, agoraphobia (fearof open spaces) runs in families. It is thought that this gene was preservedby those of our ancestors who experienced hair-trigger anxiety when walk-ing across an open plain (where they could be targeted by predators orenemies). Because of their hypervigilance, they presumably would be theﬁrst to escape the danger zone and continue their genetic lineage.
Anxiety is such an uncomfortable feeling that people will often acceptgreater short-term pain just to end an anxious waiting period quickly. Thereis a psychic cost to anticipating a negative event, which is a result of theattention and energy our minds devote to “dread.”
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Professor Gregory Berns at Emory University used functional mag-netic resonance imaging (fMRI) to measure neural activity as subjectsawaited electric shocks. Some individuals dreaded the shocks so muchthat, when given a choice, they preferred to receive more voltage soonerrather than waiting for a less painful shock later. These “high dreaders”showed greater activation in their brain’s pain circuits during anticipationof the shock. Even during an experimental condition in which they had noopportunity to hasten the delivery of the shock, the “high dreaders” con-tinued to display greater neural pain system activation. Such neural paincircuit activation implies that the “high dreaders” were mentally replicat-ing the anticipated “pain” of the shock as they were waiting for it.3 Theyaccepted greater pain in the short term just to end their ongoing (mental)suffering. The anticipatory pain truly was “all in their heads,” but to them,the experience of it was real.
As an event approaches in time, anticipatory fear intensiﬁes. Evenwhen an event’s expected probability and severity remain constant, antic-ipatory dread escalates as it approaches in time.4 When research subjectsare told that they will receive an electric shock at a speciﬁc point in time,their heart rate, galvanic skin response, and reported anxiety all increaseas that time approaches.5
“Chickening out” is one result of increasing anticipatory anxiety. Inone study, students were asked if they would perform mime routines infront of their class the following week for a payment of $5. Sixty-sevenpercent (six of nine) of the students who had agreed to mime chickenedout when the designated time arrived. Yet the students reported the sameprobability and severity estimates of possible negative consequences inboth weeks. Their objective observations of risk remained constant, buttheir decisions changed.
In a modiﬁed version of the above experiment, students who had re-cently watched a fear-inducing ﬁlm clip were signiﬁcantly less likely to ini-tially volunteer to tell a joke in front of the class the following week thanthose who had not seen the movie clip.6 Experiencing fear from an extra-neous source prevented risk-taking in other areas.
NATURE VERSUS NURTURE
Fear arises from several brain regions that together form the loss avoid-ance system. Long-term fear-based memories are recorded in the brain’samygdala (fear processing) and hippocampus (memory center). During pe-riods of high (but not extreme) stress, fearful memories are recorded ingreater detail in these structures.
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There are two fear-related pathways that travel through the amyg-dala. The fast pathway drives automatic, reﬂexive responses to threats—activation of this circuit occurs below conscious awareness and is not af-fected by prefrontal cortex inputs. Being exposed to passive threats, orwitnessing fear in one’s colleagues, can be enough to activate unconsciousfear.
Amygdala sensitivity is both related to past experiences and one’sgenetics. The short form (polymorphism) of the promoter region of theserotonin transporter gene (5-HTT) has been associated with susceptibilityto fear conditioning (after traumatic experiences) as well as increasedanxiety and emotional illness. This gene may be associated with greatervulnerability to life stress, such that individuals with this gene are lessresilient and more likely to develop anxiety disorders when exposed tointense threats.
Another way to measure the role of genetics versus environment inshaping emotional responsivity is to look at the prevalence of psychiatricdisorders in relatives. Anxiety disorders, even in people with identical DNA(identical twins), have less than one in three odds of simultaneous occur-rence. “Nurture” (life experience and environmental events) has the dom-inant role over “nature” (genes) in determining who ends up with anxietydisorders. This dominance of “nurture” over “nature” is true for most typesof anxiety: panic disorder, generalized anxiety disorder, and social phobia,among others.
While anxiety does have genetic contributions, one’s life experiencesand environmental events are most inﬂuential in determining whethersomeone will develop a full-blown anxiety disorder. For example, after alarge stock loss, one may become afraid of the markets for a brief period.This type of fear is “conditioned.” After one has been conditioned to beafraid of an event or circumstance, without concerted intervention, it cantake decades for that fear to be extinguished. For example, many adultslearned to fear bank savings accounts during the Great Depression, andsome Depression survivors put their money “in the mattress” for decadesafter the economy had recovered. Habits borne out of self-protection diehard. There is likely a lifelong interaction between biological factors (e.g.,genetic) and environment in the establishment and remodeling of networksinvolving fear and fear memory.7 Regardless of one’s personal sensitivityto fear, we can all use similar techniques to learn to manage it.
IT’S ALL IN YOUR HEAD
Neuroimaging data shows that cognitive techniques help manage fear. Inseveral fMRI studies, amygdala and limbic system activation are reducedafter individuals are trained to use cognitive fear-reduction techniques.
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When they are confronted with feared items (such as spiders) or events(such as public speaking), their fear circuits are less active than prior tothe training.
The placebo effect is a fascinating example of the prefrontal cortex’spower—demonstrating how beliefs and expectations alter how we experi-ence the world. Most people’s level of anxiety is reduced by placebos,8 im-plying that there is a signiﬁcant element of cognitive control that underliesfear. In one study, researchers placed a cream on the arms of experimentalsubjects before they received a series of painful electric shocks. In the ﬁrstcondition, participants were told that the cream was a highly effective newtopical anesthetic that would reduce the pain of the impending shock. Inanother condition, subjects were told that the cream was electrode paste,intended to improve the conduction of the shock to their skin. In fact, thecream was inert and identical in both conditions.9
About one-third of subjects experienced decreased pain when giventhe alleged anesthetic. For subjects who expressed less pain when giventhe purported “anesthetic,” researchers noticed a signiﬁcant reduction inactivation of their brain’s insula (pain processing) and increased activationin their prefrontal cortex (cognitive attentuation of emotional intensity).Increased activation in the prefrontal cortex predicted pain relief. Further-more, researchers found that prefrontal cortex activation reduced their in-sula activity in response to the shock (after it was delivered).
The researchers concluded that expectations of pain relief, workingthrough the prefrontal cortex, could control “even the most primitive andconserved of evaluative mechanisms: the visceral response to pain.”10These results demonstrate that how we think about danger, whetherelectric shocks or an impending bankruptcy, signiﬁcantly alters one’semotional experience of it. It is possible to profoundly alter physical andemotional experience by altering one’s beliefs.
EMPATHY GAPS
Jim Cramer, the celebrity investor cited in the opening vignette, illustratesthe challenge of managing intense feelings while losing money in aninvestment. Most investors have had experiences like Cramer describes,on some level, multiple times. If fear is so painful, why do investors leavethemselves vulnerable to it by trading “too big,” and not using protectivestops or price alerts?
There is a “projection bias” that unites how people feel today and howthey expect to feel in the future. That is, they project their current feelingsinto the future and expect to feel the same then as they do now.
In one study of people working out at a campus gym, everyone enter-ing and leaving the gym was asked to read a short vignette and answer a
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question in exchange for a bottle of water. The vignette described threehikers who had become lost in the dry Colorado mountains without foodor water. One follow-up question asked whether hunger or thirst wouldbe more unpleasant for the hikers. Another question asked whether, if thesubject were in the hikers’ position, they would ﬁnd hunger or thirst moreunpleasant. Of people entering the gym, 61 percent thought the hikers (andthemselves) would ﬁnd thirst more unpleasant. Of those leaving the gymafter their workout, 92 percent thought the hikers would ﬁnd thirst moreunpleasant. Those leaving the gym were projecting their own feelings ofthirst onto others.11 It is difﬁcult to imagine a future outside one’s windowof recent experience.
These ﬁndings suggest that if the markets are calm, investors will tendto project the tranquility into the future. Similar projections probably holdtrue for established bull markets, bear markets, and long periods of pricevolatility. Fearful investors often cannot take the pain, in part, because theyproject that it will continue indeﬁnitely. They sell in order to escape thepressure of declining positions—pain for which they can see no end.
During calm markets most investors don’t prepare adequately forvolatility. They cannot accurately forecast how they will feel and what theymight do in such conditions. They project their current sense of securityonto their future self. Some na¨ıve investors take on excessive credit riskbecause they see no threats on the horizon and they project an excellentborrowing climate into the foreseeable future. Investors caught with ex-cessive risk exposure during a credit contraction are the origin of the WallStreet adage, “It’s only when the tide goes out that you learn who’s beenswimming naked.” When credit dries up, those who took excessive risk,whatever their justiﬁcations, are exposed.
Many people intellectually understand that they will feel differentlyabout risk in the future, but they still do not prepare adequately for thoseconditions because they cannot feel now how they will feel then. Recall thecollege students who intellectually estimated the social risks of perform-ing a mime routine in front of their class. They then agreed to perform theroutine. Yet when the time arrived to perform, two-thirds of the studentsanxiously backed out even though their intellectual risk assessments re-mained constant. There are several techniques that can be used to reducethe projection bias.
PAIN RELIEF
Much of the battle in debiasing from fear lies in education, self-awareness,and courage, all functions of the prefrontal cortex. One’s ability to
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rationally evaluate and respond to threats, rather than reacting to internaltension or feelings, hinges on his or her ability to plan, control impulses,and make reasoned decisions. While the amygdala generates panicked re-actions, its activation can be modulated by activity in the prefrontal cortex.It is extremely difﬁcult to challenge fear, so courage is necessary.Courage underlies one’s attempts to ﬁnd counterexamples for everynervous assumption and inclination. As seen with the placebo effect, feargenerates a self-fulﬁlling prophecy of loss and ﬁnancial pain. Fortunately,everyone has the power to change their point of view and maintain anobjective perspective by consciously manipulating their thoughts, beliefs,and expectations.
Exercises such as cognitive reframing and “thinking through” alterhow one thinks about potential threats. Psychotherapies such as cognitive-behavioral therapy (CBT) use conscious thought manipulation (including“thought replacement”) to decrease anxiety. Further descriptions of thesetechniques appear in Chapter 22.
In the markets, many investors use sentiment scales, which measurelevels of market fear. Interestingly, by measuring others’ fear, they them-selves often don’t feel it as intensely, and they can be more objective whileothers are suffering. On sentiment scales, extreme fear readings serve asan indication that the market is likely to rebound. Investors who sell duringfearful market periods are likely to miss large subsequent rallies as the fearsubsides and conﬁdence returns.
INVESTMENT LESSONS
When investors anticipate further short-term losses before a stock recov-ers, and this is especially true for those with vivid imaginations and “highdreaders,” they will be compelled to sell out immediately in order to avoidexpending further (painful) attention on the bleeding position. On the ﬂipside, it is emotionally difﬁcult to buy a declining stock whose current share-holders are panicky.
When considering entering a risky investment, anxiety gives rise torisk-averse behaviors such as “hesitation pulling the trigger,” “secondguessing,” “analysis paralysis,” “reﬂecting,” “delaying,” and “fear of entry.”In fact, many investors want to see price “conﬁrmation” before feeling con-ﬁdent enough to buy. This may be a result of the projection bias in whichdeclining stocks are seen as likely losers and rising stocks are extrapolatedinto the future as winners.
On one hand, the stock market climbs a “wall of worry.” Most investorsavoid investing when anxious, preferring to wait until their uncertainty has
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cleared. As a result, they wait too long to invest and buy into rallies. Theirdelayed entry leads to subpar long-term performance. As with many thingsin life, doing the hard thing—exercising emotional courage and buying dur-ing periods of high anxiety—leads to better long-term outcomes.
One does not hear about the stock market climbing a “wall of panic.”During periods of extreme fear, the market falls sharply. The most apt ad-vice for these times is, “Don’t catch a falling knife.” For most investors,watching their portfolio values declining is extremely painful. As investors’pain collectively rises, many start “jumping ship,” selling out just to relievethe tension. Taking the pain now feels better than holding tight through amarket downturn.
During market panics, out-of-the-money put option premiums rise farbeyond rational levels, indicating that panicky investors, trying to hedgetheir portfolios, are buying puts in droves. The actual likelihood of a crashis overestimated by panicky investors, who are driven more by stress hor-mones than reasoned thought. Individuals with the temerity to sell puts topanicked traders can earn large returns.
OF HURRICANES, RISK PERCEPTIONS,AND OPPORTUNITY
Hurricane Katrina struck the Gulf Coast of the U.S. in 2005, and it wasfollowed by another powerful hurricane several weeks later—HurricaneRita. Katrina ﬂooded New Orleans. Vivid images of people stranded on theirrooftops begging for help, and bodies ﬂoating in the brown water that sub-merged residential neighborhoods, saturated the media. Katrina was themost expensive natural disaster in U.S. history. Insurers were liable forbillions of dollars in damage claims and they raised their premiums over50 percent each of the following two years.
There was an increasing perception that category 5 hurricanes woulddevastate this area of the U.S. more frequently. An excellent scientiﬁc studywas published in 2005 that indicated a strong increasing trend in the rate ofpowerful hurricanes in the Atlantic, and Al Gore’s movie, An InconvenientTruth, about the catastrophic environmental risks of global warming, wasreleased after the hurricanes struck. Because of representativeness, the re-cency effect, and the attention bias (see Chapter 19), many Americans wereafraid that such global catastrophes would occur with vastly increased fre-quency.
Savvy investors, especially reinsurers, smelled opportunity in the as-tronomically high risk perceptions. Both Warren Buffett’s Berkshire Hath-away and billionaire investor Wilbur Ross have poured money into Gulf
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Coast reinsurance enterprises. Reinsurance ﬁrms sell insurance to in-surance companies themselves, assuming the responsibility for massiveclaims that would bankrupt small insurance companies. In a Wall StreetJournal interview, Ross explained such investments by stating, “What weare betting on is that the perceived risk exceeds the actual risk. That’s fun-damental to the theory of everything we do.” Fear irrationally drives uprisk perceptions, and savvy investors locate such opportunities and exploitthem.
SUMMARY
In summary, fear prevents most investors from taking an optimal level ofmarket risk. People are especially afraid of anticipated negative events,and they sell in increasing force as the event approaches. Anticipating anegative event is so psychically painful that many people will sell for a losssimply to avoid having to “take the pain.”
Personal susceptibility to fear is primarily a function of environmentalinﬂuences, life experiences, and genetic background. Many investors areconditioned to fear stock market volatility after they lose money in shares.Because of their fear, many will be unable to stomach buying bargain-priced stocks during a declining or bear market. Unfortunately for them,it is during periods of high fear that the best short-term stock bargains arefound.
Many people cannot predict what they will do during stock routs orbear markets because they cannot empathize with their future selves.Rather, they project their current feelings onto themselves in those cir-cumstances, and they think, “I’m ﬁne with risk.”
Fortunately, automatic fearful responses to risk can be changed byconsciously modifying one’s beliefs. Many psychotherapy techniques nowexist to decrease ﬁnancial risk aversion.
The next chapter explores the physiological reactions to fear and stressthat power such cognitive distortions.
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C H A P T E R 10
Stress andBurnoutTraders Age in Dog Years
“I can put my hand on my heart and say I don’t getstressed out by the markets. . . . I’ve seen people getvery stressed, and if you’re stressed, you can’t dothis job effectively.”
—Christian Siva-Jothy1
S uccessful portfolio manager Jon Brorson was proﬁled in the Wall
Street Journal in the summer of 2006.2 He had made a good call forhis investors at Neuberger Berman in May 2006, shifting toward “de-fensive” stocks before the market took an 8 percent plunge that month.As the Wall Street Journal put it, “When the market cracked in mid-May,he was exultant, as his move to caution had put him ahead of the morebullish competition.” Yet Brorson remained defensive, missing the marketrebound in late summer and early fall of 2006.
Brorson was growing worried as the market climbed. The market’sprice action contradicted his expectations, and he felt that he was missingout. As the Dow hit new all-time highs, Brorson became increasinglydistressed—immersing himself in information via his two trading termi-nals, CNBC, and his analysts. Throughout September he worked longhours and slept poorly. As CNBC ﬂoor commentators called the market’smood “optimistic,” Brorson muttered disagreement, “Time to sell. Timeto sell.”3 Brorson and his associates believed that third-quarter earningscould disappoint, so they decided not to chase winners in the weeks beforeearnings, choosing instead to wait until late October to jump back in.
Brorson was experiencing escalating stress. Unaccustomed to fallingthat contradicted his
behind, he now found himself
in a market
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expectations and beliefs. He decided to allow an external criterion (earn-ings) make his timing decision for him. But he found himself psychologi-cally trapped—he needed his fund to at least stay even with the market, in-clining him to chase securities upward, while simultaneously trying to waitfor the anticipated negative earnings reports, after which he could pick upbargains. Because of his dilemma—being caught between his own expecta-tions and the contradictory behavior of the market—he was unable to relaxuntil either (1) the market sectors he disliked dropped or (2) he capitulatedand bought rallying stocks.
STRESS
“Stress is the condition that results when person-environmenttransactions lead the individualorto perceive a discrepancy—whethernot—between the demands of a situation and theresources of the person’s biological, psychologicalor social systems.”
real
—Edward P. Saraﬁno4
Stress arises out of the discrepancy between where one is and whereone imagines they should be – a conﬂict between their expectations andreality. If that difference is too large, for too long, chronic stress will phys-ically wear them down, leading to burnout. Anxiety, antagonism, exhaus-tion, frustration, distress, despair, overwork, and fear are all types of stress.There is an important distinction between different intensities of short-term (acute) stress. At low levels acute stress can be motivating: it stimu-lates activity, sharpens attention, and enhances goal focus. Additionally,brief episodes of high or moderate stress, such as experienced during anamusement park roller-coaster ride, can be exhilarating. However, at ex-treme levels, acute stress often induces an overwhelming “ﬁght-or-ﬂight”urge (panic).
Prolonged high stress leads to a number of negative physical and men-tal consequences. Such chronic stress impairs short-term memory and con-centration and promotes hypervigilance—too often leading to interruptedsleep, high blood pressure, and adverse metabolic effects. Chronic stresscontributes to accelerated aging, decreased immune function, depressedmood, apathy, and diminished energy. Eventually, chronic stress results in“burnout.”
Many traders experience chronic stress at work. A common saying re-lating traders’ stress to its physical consequences is that, “Traders age in
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dog years.” As if for each year of trading, that trader ages seven years. Therest of this chapter will examine investment stress, its neuroscience, con-sequences, and strategies for reducing its adverse effects.
CRAMER ON STRESS
On March 11, 2000, days from the