ine degree from the University of Texas Medical Branch, with honors.He completed psychiatry residency training at San Mateo Medical Center in2004, during which he was engaged in postdoctoral neuroscience researchat Stanford University.
After completing his undergraduate studies, Dr. Peterson designedstock forecasting software and traded futures for an investment partner-ship. Thereafter, he investigated the role of emotions in ﬁnancial decisionmaking both during medical school and neuroimaging research at Stanford.Dr. Peterson has published scientiﬁc papers in economics, ﬁnance, psy-chology, and neuroscience journals. He is an associate editor of the Journalof Behavioral Finance and is on the board of advisers of the Social ScienceResearch Network (SSRN) in the experimental and behavioral ﬁnance area.He is a member of the Society for Neuroeconomics, the Institute of Psychol-ogy and Markets, and the American Psychiatric Association.
His primary professional interest is the role of emotion in investmentdecision making, and speciﬁcally, the arbitrage of neural-based anomaliesin the ﬁnancial markets. His long-term fascination with the markets grewout of his early investing (since age 12) and futures trading activities, andit continues with the application of psychological principles to investmentstrategy development. He plans to launch a quantitative psychology-basedhedge fund in early 2008.
Dr. Peterson lives in the Los Angeles area with his wife and daughter.
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T his introduction contains three vignettes about famous ﬁnancial
mishaps: the late 1990s hedge fund Long-Term Capital, Sir Isaac New-ton and the South Seas bubble, and Samuel Clemens (a.k.a. MarkTwain) and the 1860s silver fever. There is a lot to be learned fromsuch ﬁnancial failures—both in the accounting facts and historical cir-cumstances, but also in the psychology underlying the protagonists’ faultydecision making. Reading the stories that follow, take note of the in-vestment choices of the main players as their success, and conﬁdence,grow.
BRAINS OF STEEL . . . ARE NOT ENOUGH
In February 1994 the most esteemed hedge fund in history, up to thattime, opened for business. Long-Term Capital Management (LTCM) wasextremely secretive, though it was widely known that the fund’s part-ners included brilliant academics and extraordinarily successful traders.LTCM’s partners included Myron S. Scholes and Robert C. Merton, two No-bel Prize winning economists (one awarded in 1997) who were renownedboth on Wall Street and in academia.
The founder of Long-Term Capital was John Meriwether. Accordingto Michael Lewis, author of Liar’s Poker and a colleague of Meriwether’son the bond desk at Salomon Brothers during the late 1980s, “[John] had,I think, a profound ability to control the two emotions that commonlydestroy traders—fear and greed—and it made him as noble as a man whopursues his self-interest so ﬁercely can be.”1 Meriwether not only kepthis emotions under wraps, but he was also roundly acknowledged asintellectually brilliant.
Furthermore, Meriwether had proven to have high conﬁdence in hismarket opinions. If he believed that an opportunity in the markets wouldgo in his direction, and instead it moved against him, he might increase thesize of his bet. He used mathematics to determine fair values of securities
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and spreads. If his models identiﬁed a mispricing, he had conﬁdence that itwould return to fair value over time.
LTCM’s launch was the largest in history at that time: $1.25 billion wasraised. While LTCM’s fees were above the industry average (taking 25 per-cent of net returns), the proﬁts over the fund’s ﬁrst four years were large,seeming to justify the high fees. By April 1998, $1 invested in the fund at itsinception in 1994 was worth $2.85 (after fees).
Unfortunately for LTCM, mathematical genius was insufﬁcient to reapconsistent proﬁts. Other traders ﬁgured out many of LTCM’s strategies,piggybacking on their trades, and LTCMs proﬁtability began to erode. Themathematicians at LTCM looked for new markets in which to apply theirbasic models. They made assumptions that those new markets operatedsimilarly to the old. Gradually, they grew greedier, took increasing risk,and spread their positions too widely. The founding partners bought outa large proportion of the original investors’ capital so they could increasetheir own stakes in the fund.
After April 1998, LTCM’s performance began an accelerating slide.Within a period of ﬁve months, from April 1998 to September 1998, LTCMlost 90 percent of its assets and could not meet its margin calls on the $1.3trillion in outstanding positions it held. Many large Wall Street banks hadloaned securities to LTCM on thin margin, and now some of those bankswere threatened with catastrophic losses if they liquidated the fund’s heav-ily in-the-red positions and triggered a “run on the bank.”
Five months after the fund’s peak, the original dollar invested in LTCMin 1994 was worth $0.23, and the fund’s collapse had nearly caused themeltdown of the global ﬁnancial system.2 Financially, LTCM’s collapse wascaused by excessive leverage in illiquid positions. But how did these con-ditions come to be?
In the media reports about the fund, the root causes of its rapid demisewere identiﬁed as psychological. After several years of success, greed,hubris, and arrogance infected the partners’ decision making and impairedtheir communication. In investment management, mathematical geniusmay perform well in the short term, but it is no substitute for emotionalintelligence.
CALCULATING THE MADNESS OF MEN
Sir Isaac Newton was one of the most inﬂuential scientists in history. Helaid the groundwork for classical (“Newtonian”) physics. He was the ﬁrstto demonstrate that the motions of objects on Earth and the movementsof the celestial bodies are governed by the same set of mathematical laws.His investigations into optics and sound formed the basis for centuries of
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research. Unfortunately, Newton’s scientiﬁc acumen did not improve hisinvesting decisions. On the contrary, he lost much of his wealth in thelargest stock bubble of his age.
Like many members of the British aristocracy in the early 1700s, New-ton owned shares of the South Seas Trading Company in 1720. The SouthSeas Company was organized with two missions: (1) as a monopoly overBritish trade with the Spanish colonies in America and (2) as a converterof British government annuities into long-term debt. The South Seas Com-pany initially had a legitimate and proﬁtable business monopoly courtesyof the British government. Furthermore, the Company was repeatedly suc-cessful in raising money on the British stock market for proposed ex-pansions of its operations. As a result of their success, a series of cor-porate competitors arose and the Company’s monopoly was placed injeopardy.
Following the lead of the South Seas Company, joint-stock compa-nies proposing a wide range of speculative ventures formed and began toraise money through share sales. Public enthusiasm for stock trading grew,and a price bubble formed among the traded shares. When the sometimesfraudulent promotions of new joint-stock companies became apparent tolegislators, a law was passed by the British parliament in June 1720 (the“Bubble Act”) to prevent non-royal-endorsed joint stock companies fromissuing shares to the public. Even after the “Bubble Act” was passed, com-panies continued selling shares for absurd enterprises. One such offeringadvertised its business as follows: “For carrying on an undertaking of greatadvantage; but nobody to know what it is.”3
In the midsummer of 1720, Newton foretold a coming stock marketcrash, and he sold his shares of the South Seas Company for a proﬁt of7,000 pounds. Subsequently, however, Newton watched the Company’sstock price continue to rise, and he decided to reinvest at a higher price.Newton then remained invested as prices started a precipitous decline.Soon panic ensued, and the bubble collapsed. After the dust had settledfrom the stock market crash of August 1720, Newton had lost over 20,000pounds of his fortune. As a result of these losses, he famously stated,“I can calculate the motions of heavenly bodies, but not the madness ofpeople.” Newton’s fear of missing out on further gains drove him to buyshares as the price soared higher. His inertia during the panic led to theloss of most of his assets.
MARK TWAIN AND THE “SILVER FEVER”
The celebrated author and humorist Samuel Clemens (pen name MarkTwain) was the most widely recognized American in the last decade ofthe nineteenth century, both nationally and internationally.4 Clemens’s
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documentation of his experiences in the Nevada mining stock bubble areone of the earliest (and certainly the most humorous) ﬁrsthand accountsof involvement in a speculative mania.
After a brief stint as a Confederate militiaman during the beginningof the U.S. Civil War, Clemens purchased stagecoach passage west, toNevada, where his brother had been appointed Secretary of the Territory.In Nevada, Clemens began working as a reporter in Virginia City, in oneof Nevada’s most productive silver- and gold-mining regions. He enviouslywatched prospecting parties departing into the wilderness, and he quicklybecame “smitten with the silver fever.”5
Clemens and two friends soon went out in search of silver veins inthe mountains. As Clemens tells it, they rapidly discovered and laid claimto a rich vein of silver called the “Wide West” mine. The night after theyestablished their ownership, they were restless and unable to sleep, visitedby fantasies of extravagant wealth: “No one can be so thoughtless as tosuppose that we slept, that night. Higbie and I went to bed at midnight, butit was only to lie broad awake and think, dream, scheme.”6
Clemens reported that in the excitement and confusion of the days fol-lowing their discovery, he and his two partners failed to begin mining theirclaim. Under Nevada state law, a claim could be usurped if not workedwithin 10 days. Clemens lost his claim to the mine due to inattention, andhis dreams of sudden wealth were momentarily set back.
But Clemens had a keen ear for rumors and new opportunities. Someprospectors who found rich ore veins were selling stock in New YorkCity to raise capital for mining operations. In 1863, Clemens accumulatedstocks in several such silver mines, sometimes as payment for working asa journalist. In order to lock in his anticipated gains from the stocks, hemade a plan to sell his silver shares either when they reached $100,000 intotal value or when Nevada voters approved a state constitution (which hethought would erode their long-term value).
In 1863, funded by his substantial (paper) stock wealth, Clemens re-tired from journalism. He traveled west to San Francisco to live the highlife. He watched his silver mine stock price quotes in the newspaper, andhe felt rich: “I lived at the best hotel, exhibited my clothes in the most con-spicuous places, infested the opera. . . . I had longed to be a butterﬂy, and Iwas one at last.”7
Yet after Nevada became a state, Clemens continued to hold on to hisstocks, contrary to his plan. Suddenly, the gambling mania on silver stocksended, and without warning, Clemens found himself virtually broke.
I, the cheerful idiot that had been squandering money like water, andthought myself beyond the reach of misfortune, had not now as muchas ﬁfty dollars when I gathered together my various debts and paidthem.8
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Clemens was forced to return to journalism to pay his expenses. Helived on meager pay over the next several years. Even after his great literaryand lecture-circuit success in the late nineteenth century, he continued tohave difﬁculty investing wisely. In later life he had very public and largedebts, and he was forced to work, often much harder than he wanted, tomake ends meet for his family.
Clemens had made a plan to sell his silver stock shares when Nevadabecame a state. His rapid and large gains stoked a sense of invincibility.Soon he deviated from his stock sales plan, stopped paying attention to themarket fundamentals, and found himself virtually broke.
Clemens was by no means the ﬁrst or last American to succumb tomining stock excitement. The World’s Work, an investment periodical pub-lished decades later, in the early 1900s, was beset by letters from investorsasking for advice on mining stocks. The magazine’s response to these let-ters was straightforward:
Emotion plays too large a part in the business of mining stocks. En-thusiasm, lust for gain, gullibility are the real bases of this trading.The sober common sense of the intelligent businessman has no partin such investment. [1907a, pp. 8383–8384]9
While the focus of market manias changes, the psychology of specula-
tors remains remarkably similar over the centuries.
Mathematical brilliance and Nobel Prizes (in the case of LTCM),scientiﬁc genius (in the case of Newton), and creativity (in the case ofClemens) do not insulate against investment failure. As we’ll see in thisbook, accolades and success can actually impede investing success. In allthree cases, as warning signs became apparent, the investors remained inan overconﬁdent worldview, dismissing risks and turning their attentionaway from prudent money management. Then, as their wealth evaporated,they remained passive in the face of losses.
Regardless of their professional standing, the vast majority of investorsunderperform the markets, often for the same reasons as the three casesabove. Emotions easily overwhelmed reasoning when money is at stake.When times are good, investors take them for granted and do not preparefor risks. When markets turn sour, they are not paying attention, often hold-ing on to their positions too long while hoping for a comeback or denyingthat there is a problem.
WHAT’S THE USE OF NEUROFINANCE?
In neuroscience laboratories, revolutionary new tools are available forinvestigating investor behavior. These technologies enable researchers
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to watch changes in brain function in real time, allowing the precisecharacterization of the decision-making process. As researchers havecome to better understand the brain, some fascinating and importantﬁndings have come to light regarding how people make good, and bad,decisions with money.
“Neuroﬁnance” is the name for the interdisciplinary study and ap-plication of neuroscience to investment activity. Finance, psychology,economics, and neuroscience collaborators are exploring common ques-tions, such as why and how people make nonoptimal ﬁnancial decisions.Furthermore, with the contributions of clinical psychologists, psychia-trists, and neurologists to recent research, it has become apparent thatsome “neural” biases can be corrected by implementing therapeutictechniques.
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Foundations
The Intersection of Mind
and Money
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C H A P T E R 1
Markets onthe MindThe Challenge of Findingan Edge
“I’d be a bum on the street with a tin cup if themarkets were always efﬁcient.”
—Warren Buffett
E ven though trillions of dollars change hands in the ﬁnancial mar-
kets every day, most active investors cannot ﬁnd an edge overtheir competition. They are vulnerable to psychological biases thatimpair their investment decisions, and their proﬁtability is eroded. Con-sider the fate of Internet-era day traders.
Day traders typically aim to earn money from small intraday pricemovements and trends. Most are not ﬁnancial professionals by training orexperience. Often, they enter day trading from other occupations, encour-aged by the independence and high expected ﬁnancial returns of trading.
A 1998 study sponsored by the North American Securities Administra-tors Association (NASAA) analyzed 26 randomly selected day-trading ac-counts. The year 1998 should have been an excellent year for day trading,with the S&P 500 up over 26 percent that year. However, the report’s con-clusions were pessimistic. “Eighteen (18) of the twenty-six accounts (70percent) lost money. More importantly, all 18 accounts were traded in amanner that realized a Risk of Ruin of 100 percent.” The “risk of ruin” isthe statistical likelihood, based on swings in value, that the account willgo bankrupt over the next year. The report noted that “Only three (3) oftwenty-six (26) accounts (11.5 percent of the sample) evidenced the abilityto conduct proﬁtable short-term trading.”1 The report observed that mosttraders were limiting their proﬁts and letting their losses ride, and “that’s asureﬁre way of going broke.”2
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It wasn’t only American day traders who lost money in the late 1990s.In an analysis of Taiwanese day traders on the Taipei Stock Exchange,most traders’ proﬁts were not sufﬁcient to cover their transaction costs.“In the typical six month period, more than eight out of ten day traderslose money.”
Short-term currency traders lose with similar consistency to daytraders. One of the largest retail foreign exchange dealers in the UnitedStates is Foreign Exchange Capital Markets (FXCM). In 2005, Drew Niv,chief executive of FXCM, remarked to the Wall Street Journal “If 15 per-cent of [currency] day traders are proﬁtable, I’d be surprised.”3
While short-term trading looks like a losing proposition on average, inboth the United States and Taiwan a small percentage of day traders wereconsistently proﬁtable. Among the Taiwanese, “Traders with strong pastperformance continue to earn strong returns. The stocks they buy outper-form those they sell by 62 basis points [0.62 percent] per day.”4 Most daytraders aspire to be as successful as this small minority, but they ﬁnd them-selves held back by poor decision making.
What are the underlying reasons for the poor performance of most daytraders? Researchers analyzed the daily trading records and monthly posi-tions of investors at a large discount brokerage. They examined 10 yearsof trading records for 66,465 households, including over two million com-mon stock trades. They divided the accounts into ﬁve groups based on thelevel of turnover in the stock portfolios. The 20 percent of investors whotraded most actively earned an average net annual return 7.7 percent lowerthan the average household.5 Based on this study, it appears that exces-sive stock turnover and the attendant transaction costs contribute to poorperformance.
It is not simply overtrading, but choosing the wrong stocks to buy andsell, that reduces proﬁtability. Individual investors underperform becausepsychological biases interfere with their investment decision making. Ina different study, researchers analyzed the trading records of 10,000 bro-kerage accounts over six years, including 162,000 common stock trades.6,7They compared the performance of losing stocks held to that of the win-ning stocks sold. One year after the sale, the losing stocks investorsclung to had underperformed the winners they sold by an average of3.2 percent.8 Most investors sold winning stocks too early and held losingstocks too long.
In a broad study of mutual fund returns, Vanguard founder John Boglecalculated that while the stock market rose 13 percent annually from1983 through 2003, the average mutual fund returned 10 percent and thefund investor gained only 6.3 percent.9 Other re-average mutualsearchers have found that the average mutual fund investor underperformsinﬂation.10
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11
Mutual fund managers’ decisions are impaired by psychological biases.In a study of mutual fund performance from 1975 to 1994, on a net-returnlevel, the studied funds underperformed broad market indexes by one per-cent per year.11 Mutual fund underperformance is due, in part, to fund man-ager overtrading.12 Furthermore, the higher a mutual fund’s managementfee, the lower its performance. Mutual funds look like a lose-lose propo-sition. Even if you can control your own overtrading, your mutual fundmanager may not be able to manage himself.
While the vast majority of mutual funds underperform their bench-marks over time, about 3 to 4 percent earn consistently high returns, yearafter year.13 The persistent success of these star funds suggests that a smallminority of portfolio managers have “the right stuff.” Chapter 12 discussesthe psychological characteristics of such star performers.
On average, both mutual fund managers and individual investors sig-niﬁcantly underperform the markets due to psychological biases. Overtrad-ing and its high associated transaction costs are one cause of poor perfor-mance. Other mistakes, such as holding losers too long and failing to stickto a prearranged risk management plan, are behind the “celebrity” mishapsof LTCM, Newton, and Clemens described in the introduction. Yet biasesare not fated for most investors. With experience, bias severity declines (orthe nonbiased preferentially survive) and as a result, returns increase.14Furthermore, biases are less prevalent if nothing of value is at stake inthe decision. Some of the best-performing ﬁnancial professionals are thosewho don’t have to make actual trading decisions: stock analysts.
ANALYSTS AND DART BOARDS
While most mutual fund managers and individual investors struggle to keepup with the market, stock analysts’ buy and sell recommendations are gen-erally quite accurate. In 1967, Nobel Prize winning economist Paul Samuel-son declared to a U.S. Senate committee: “A typical mutual fund is provid-ing nothing for the mutual fund owner that they could not get by throwinga dart at a dartboard.” Samuelson’s assertion prompted a series of compe-titions between stocks selected randomly by throwing darts at the stocktables of a newspaper and stocks selected by professional stock analysts.Several major business news publications featured these contests, includ-ing a Swedish newspaper that trained a chimpanzee to throw the darts. Themost highly regarded contest was that of the Wall Street Journal (WSJ),which ran from 1982 to 2002.
In the WSJ results from 142 six-month contests, professionals cameout signiﬁcantly ahead of the darts with a six-month average return of
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10.2 percent. The darts averaged a 3.5 percent semiannual return, whilethe Dow Jones average climbed 5.6 percent.15,16 It appeared that stockanalysts’ recommendations contained a great deal of value to investors.However, the pros’ recommendations could not be acted on by individualinvestors to beat the markets. The stocks recommended by the analystsopened up an average of 4 percent from the prior day’s close.17 The advan-tage of analysts’ expertise was eliminated by dissemination.
In general, professional stock analysts’ strong buy recommenda-tions outperform their strong sell recommendations by almost 9 percentannually.18 However, because of frequent turnover and high transactioncosts when investing based on analysts’ advice, the excess return of sucha strategy is not signiﬁcantly above the market return. Analysts’ forecastsare quickly priced into stocks, and the transaction costs accrued by follow-ing their frequent changes in opinion prevent excess returns for the generalpublic.
Many funds employ analysts in-house so they can have instant accessto their insights, and some hedge funds pay high trading commissions,which entitle them to “ﬁrst-mover” insights from the best analysts at ma-jor brokerages. Due to much higher compensation, many excellent ana-lysts work at hedge funds where their opinions are kept a closely guardedsecret.
What does this mean for the individual investor? In the end, if you wantan advantage, you’ve got to learn to be your own stock analyst. The ﬁrststep toward that goal is to learn how analysts think.
DEVELOPING BETTER EXPECTATIONS
Analysts have better forecasts than others because they have superior ex-pectations of likely stock price moves. Russ Fuller is a portfolio managerfor the mutual fund group Fuller and Thaler Asset Management, based inSan Mateo, California. Fuller has written that “having better expectationsthan the market is the mother of all alphas.”19 Alpha is the amount by whicha portfolio manager outperforms his benchmark. The benchmark is usuallya stock index of similar size, growth, or value characteristics to the stocksthe fund is buying.
So how can investors develop better expectations to increase their al-pha? According to Fuller, they can develop one of three advantages. First,they can have superior private information about company fundamentalsor markets. Superior private information is often obtained through a betterresearch process, such as through an in-depth examination of a company’sgrowth prospects, earnings quality, product viability, or management team.
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The second method for generating superior expectations, according toFuller, is by processing information better. It is possible to ﬁnd mathemat-ically predictive relationships within fundamental and ﬁnancial data basedon quantitative, computerized information processing. Additionally, someexpert human analysts can perceive predictive relationships in corporatedata.
The third technique for developing better expectations is to under-stand investors’ behavioral biases. Behavioral biases are caused both by(1) investors who are not wealth maximizing and (2) investors who makesystematic mental mistakes.20 Finding the impact of behavioral biases onstock prices requires psychological savvy, but it can be quite proﬁtable.Fuller and Thaler’s portfolios have returned average alphas of almost 4 per-cent since their inception,21 a track record that has prompted the creationof many copycat “behavioral ﬁnance” funds.
This book will address each technique for developing superior expec-tations. In particular, it will help readers to identify and eliminate errorsin analysis and modeling. The discussion of corporate management bi-ases, particularly overconﬁdence in Chapter 8, should be useful for read-ers who are fundamental analysts. The description of data-interpretationerrors (self-deception) in Chapter 20 is helpful for quantitative and techni-cal analysts. The majority of the book is devoted to behavioral biases. Touse behavioral biases in investment strategy, one should ﬁnd where suchbiases affect the majority of investors and show up in characteristic marketprice patterns.
“THE WISDOM OF THE COLLECTIVE”
“Markets can still be rational when investorsare individually irrational. Sufﬁcient diversityis the essential feature in efﬁcient price forma-tion. Provided the decision rules of investors arediverse—even if they are suboptimal—errors tendto cancel out and markets arrive at appropriateprices.”
—Michael Mauboussin, More Than You Know22
Michael Mauboussin is chief investment strategist at Legg-Mason Cap-ital Management and a professor of ﬁnance at the Columbia BusinessSchool. He is also a polymath who has integrated elements of com-plex adaptive systems theory and behavioral ﬁnance into his investmentphilosophy. One aspect of his philosophy he calls “The Wisdom of the
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Collective.” Mauboussin has found abundant literature indicating that in-dividuals (even experts) can estimate “correct” stock valuations no betterthan the consensus market price.
When people are asked to guess answers to problems as diverse as thenumber of jelly beans in a jar, the precise weight of an ox, or the location ofa bomb, individual guesses (even guesses by experts) are relatively poor.Averaging the participants’ guesses often produces a consensus averageestimate that is the most reliable and accurate solution to the problem. Inmany ways, the stock market is a collective estimation about the future ofthe economy.
Mauboussin explains that humans are not rational agents in the mar-kets, there is no steady-state market price equilibrium, and price changesare not normally distributed, thus the markets are a complex adaptive sys-tem. Using the assumption of complexity, one can account for real-worldconsiderations