Introduction
"Perceiving a situation seems, at first glimpse, like a remarkably simple operation. You just look and see what's around. But the operation that seems most simple is actually the most complex, it's just that most of the action takes place below the level of awareness. Looking at and perceiving the world is an active process of meaning-making that shapes and biases the rest of the decision making chain."--David Brooks, "The Behavioral Revolution"
Shortly after the events of September 11, I left New York and returned to Chicago. I thought that I was done writing about the psychology of money forever. As the author of more than half a dozen critically acclaimed books on investing and money issues, what more did I have to say? Yet, with the global financial meltdown brought on by a new breed of traders fueled by greed, testosterone, and genius-level IQs, I once more felt the urge to enter the fray. A few years ago, who could have imagined the near demise of the financial world at the hands of traders trained as mathematicians and theoretical physicists?
It is only a recent phenomenon that the threat of "black swans" disguised as mortgage-backed securities or "quants gone wild," discussed in the news, could have been considered anything but a remote possibility. The problem was neither the disastrous effects of quantum physics and differential calculus, nor a global think tank run amok by a handful of whiz kids from Harvard, MIT, and Princeton.
What is to blame for the recent economic upheaval is our basic understanding of finance and market psychology, and those mysterious and unconscious forces-human emotions, social norms, and delusional expectations-that guide our investment decisions. In retrospect, we should have heeded Warren Buffett's warning to "beware of geeks bearing formulas" and taken into account the systematic and predictable irrationality of our brains when confronted with financial decision making.
FUNDAMENTALLY IRRATIONAL
Born out of the desire of economists going back to the eighteenth century to have their field regarded as a natural science, explanations of financial activity have traditionally been understood as fundamentally rational. In finance, people widely subscribed to the "efficient market hypothesis," first expressed by French mathematician Louis Bachelier, which holds that markets are "informationally efficient," with the prices of invested assets reflecting all publicly available information. Yet this rational model is coming increasingly under fire as eye-opening revelations provoke a deeper examination of us as market participants. The real question is whether we act in our own portfolio's best interests.
Benefiting from the latest insights in the fields of behavioral finance and neuroeconomics, today's market psychology has come a long way since the days of hard-and-fast investment axioms and reliance on pop psychology hawked by trading gurus and coaches. Today, it seems that almost anyone who has a large grant and Ivy League cred is demonstrating just how fundamentally irrational we really are-in love, in our business relationships, but especially when it comes to our pocketbooks, as this book will investigate. Studies released regularly from institutions such as Harvard, Caltech, Duke, and Berkeley note our ever-inventive expressions of herd behavior when it comes to spending our hard-earned cash and making financial decisions. For any doubters, everything from brain imagery to "theory of mind"- both of which we will discuss later-proves the point. A recent study from the University of Illinois has even shown that our brains know the market not as an orderly algebra class, but as the wild jungle.
In Predictably Irrational: The Hidden Forces That Shape Our Decisions, MIT professor Dan Ariely explored how our choices in everything from occupational preferences to sex partners are derived from deep-seated emotions, misunderstood beliefs, and cultural norms that, as his title suggests, are not senseless or random, but are to be expected: inevitable and irrational. His work builds on the insights of behavioral economists and psychologists, among them several Nobel laureates: Daniel Kahneman and Amos Tversky, Herbert Simon, Richard Thaler, Robert Shiller, and Andrew Lo.
In this book, which focuses on how to overcome our irrationality when managing our trading and our investment portfolios, I will explore at length this group's contributions to the field of behavioral finance and what we can learn from them, and ourselves, to become better investors.
MY EXPERIENCE
The German philosopher Arthur Schopenhauer, his hair in two white tufts on either side of his elastic mind, once wrote, "Every truth passes through three stages before it is recognized. In the first it is ridiculed, in the second it is opposed, in the third it is regarded self-evident." When it comes to behavioral finance, after a long period of buffoonish laughter and academic criticism, we have now arrived at stage three. In truth, understanding the financial arena in psychological terms has been how I have always viewed markets from my earliest days trading foreign currency, interest rate, and equity futures on the floor of the Chicago Mercantile Exchange.
Since my start in the trading pits, there always seemed to be something undeniably irrational about the markets, my fellow traders, and myself. Although I came to the exchange with little practical financial training, beyond degrees in economics, philosophy, and group behavior from Columbia University, my greatest asset was a burning need to discover what made this place thrive. What unseen forces controlled whether or not we survived in the financial jungle? My quest for competitive intelligence was often not shared by my rivals. I was more anxious to learn than they were to teach.
Today, I have the perspective of being a market veteran who has spent more than 30 years trading equities and futures, long and short term, utilizing technical and fundamental analysis, and a range of financial instruments. I have been an exchange member trading my own account, as well as a principal in a CME Group clearing firm, where I hired and managed a team of proprietary traders who were market makers in every pit of the Chicago Mercantile Exchange and the Chicago Board of Trade, which today make up the CME Group, the world's largest futures exchange. I have also run, along with my business partner, Rand Financial Services' Innergame Division, which is recognized as one of the premier firms in the industry, executing trades and clearing for institutional clients with $50 million to several billion dollars under management. In New York, I was a principal in a $300 million hedge fund, where I supervised and created risk parameters for our team of proprietary traders. In addition, I have enjoyed friendships and conversations and conducted hundreds of in-depth interviews with top traders, hedge fund managers, and financial experts that were developed into my books, including The Inner Game of Trading, The Intuitive Trader, and Money Talks. I continue to work with traders to develop models and trading programs, and I advise others on trading strategy and risk management. In addition to all this, I've had my own ups and downs in the market.
Over time, I have learned that the stock market is a Rorschach test. The more I look, the more I see myself. The market is a mirror of complexity, inconsistency, irony, and paradox. Now, as validated by behavioral economics and neuroscience, investing is recognized as having less to do with the science of computation and more to do with the art of managing one's outlook, emotions, and consciousness. It involves invention, imagination, and know-how, and the courage to exploit the hard edge of a price chart-the action on the right-hand side that reveals the stock market's next unexpected move.
MAKE PROFITS, REDUCE LOSSES, AND GROW CAPITAL
Investing is a microcosm of life. Within it, we experience joy, uncertainty, frustration, and struggle. It requires courage, optimism, humility, and the desire to succeed. It would also be wise to refer to our army field manual on jungle survival, as at times there are predators as fierce as biting ants, spiders, and snakes. Our challenge is made all the more difficult because our decisions are under assault from our brains. As economist Richard Thaler, best known as a theorist in behavioral finance, has pointed out, we are bounded by rationality, willpower, and self-interest. We fluctuate irrationally between an aversion to losing and our own delusional optimism.
In this context, irrationality means poor decisions, systematic errors, market inefficiencies, herd behavior, and the hasty, often detrimental collective decisions of "groupthink," a mode of thinking in which the members of a group strive for unanimity by overriding their motivation to appraise alternative courses of action realistically, with the resulting loss of individual creativity, uniqueness, and independent thinking. This leads us, like lemmings, to inevitable bubbles and crashes. Our brain's hardwiring predisposes us to misconceptions of reasoning, aggravated by emotional triggers and deviations in judgment: biases, fallacies, illusions, and paradoxes. Why? Because we ache for certainty, control, and the validation that we are right.
Our minds are messy, confusing, and ambiguous, mirroring the market, which is messy, confusing, and ambiguous. Behind this paradox is our deep-seated fear of losing. Losing draws down our account and, worse, provokes thoughts of insolvency and failure. Within our repertoire of responses are denial, inaction, confusion, and anger. Loss burns into our psyches. We feel its effects in tightened muscles, sweaty palms, and shallow breaths. It makes us anxious and on edge. We can see, hear, and even taste past mistakes and visions of doom. It makes us think less of ourselves, leading us to confuse our investment decisions with our self-worth. Obviously, this is not the desired end result of investing.
Beginning with a subjective, concise history of investor psychology, I will draw on behavioral finance to explore, and then demonstrate how to apply, state-of-the-art concepts. By the end of this book, you will know how to overcome debilitating emotions, irrational biases, and investment fallacies and arrive at an understanding of overall market risk through an approach that identifies, assesses, and controls losses. It is only through the development and implementation of focused, disciplined, patient, and confident market behavior-important internal skills that have been recognized as essential for nearly as long as there have been markets-that investors from small-share traders to billiondollar hedge fund managers can make profits, reduce losses, and preserve and grow capital.
Insights from top traders, behavioral economists, risk managers, and neuroscientists further serve to illustrate the latest thinking, such as the work of Joseph Stiglitz, winner of the Nobel Prize in economics, whom the New York Times's Paul Krugman calls "an insanely great economist, in ways you can't really appreciate unless you're deep into the field." Building on such brilliant analysis, I will ask some of the basic and provocative questions needed to arrive at an understanding of the source of market failure, relating it to the individual investor and emphasizing the persistent need for scrutiny, regulation, and oversight of our own decisions. Financial meltdown and flawed response is not a phenomenon that occurs only on the macro level.
Just as life doesn't come with instructions that, once followed, will enable you to sink baskets like Kobe Bryant or sing like Bono, in my experience knowing and working with many of the world's top traders and investors, I have come to realize there is no winning algorithm, no blueprint to explain peak performance. Unfortunately, knowing all the rules or mastering an objective system is about as far removed from the experience of optimum investing as painting by numbers is from producing a Picasso.
While it would be grievously incorrect to deny or underestimate the importance of reason or logic, as we will see, successful investing involves far more than specific analytical and strategic skills. It requires the development, cultivation, and conditioning of habits, thought patterns, and creative attitudes that influence the way we think and act in the market.
It is my goal in Investing and the Irrational Mind to answer the most fundamental question about financial decision making: how does the investor overcome habit-driven behaviors and ordinary reasoning, and move forward to achieve the psychological freedom to invest? In other words, I will reveal how we can master our irrational minds to gain the skills necessary to control our financial decisions.