Emotions in the Marketplace
No one can escape the transforming power of the stock market. Investing, once practiced on the periphery of society by a small group of like-minded professionals, has become a cultural phenomenon. More than 50 percent of all households now own stocks in one form or another, double what it was in 1987. Baby-boomers depend on the stock market to put children through college and to retire; financial websites and stock message boards have become the most popular destinations in cyberspace; and the number of household trading online tripled to 6.3 million from 1998 to mid-1999. People browsing the newspaper now turn to the business section before the sports section or comics, and the Federal Reserve's interest-rate decisions are now headline news anxiously awaited by the masses.
Our connections to the stock market have become part of everyday life. Investors now play out in real time and with real money the realities of winning and losing that used to be limited to the fantasies of Monday-morning quarterbacking. Between January 1998 and October 2002, investors made and then lost more money than they ever imagined was possible. While some cashed out with millions, more than $7 trillion was lost in the wake of the technology bubble that closed out the twentieth century. Is it any wonder that investing has triggered such a powerful quest to learn how to win what Charles Ellis once referred to as the "loser's game"?
WE ARE ALL SUBJECTIVE INVESTORS
One of the most important lessons I have learned in my years of consulting with investors is that winning the loser's game requires that we appreciate the highly subjective and personal nature of the investing process. Each minute of the day the stock market generates a vast array of data: market performance numbers, economic statistics, company information, and geopolitical happenings. Thanks to the Internet, all of this data is now at our fingertips. But thanks to human nature, we each react to this market information in our own personal, unique way.
What shapes our perceptions of the market goes far beyond the "real" data we uncover on the Internet, in the newspapers, or on CBS Marketwatch, Yahoo!, MSN, CNN, Fox, or CNBC. We take each bit of information we receive and then interpret it through lenses that organize the data into some personally meaningful interpretation that can be translated into action or the deferral of action. These lenses are formed by our idiosyncratic personalities and emotional makeup. As a result, we all react differently to each piece of new information we glean, garner, or abstract from the marketplace.
One of the enduring findings to emerge from psychological research in the past thirty years is that a primary motivation of all people is the need to make sense of the world around us, to create organization and meaning in our lives. During our formative years, we all unconsciously create principles that help us to organize automatically our many disparate experiences in the world. Our emotions and experiences not only color how we make meaning of the world, they shape the personal, emotional lenses through which we interpret all events, information, and encounters throughout our lives.
Constance Hunting, the poet and critic, perhaps said it best: "Emotion dictates vision. Vision is therefore selective--the eye falls on what fits into the emotional scheme. In grief, for instance, everything reminds of the lost beloved. So the lost beloved becomes the world, and the world is arranged by the griever into a composite portrait of the one who has vanished." This is equally true in the investing world.
Consider, for example, the everyday occurrence of stock picks in the newspaper. An investor scans the Market section of The Wall Street Journal and reads that a well-known analyst has issued a buy recommendation on Pepsico. If you read the financial pages or check out Internet sites on the stock market, you will probably encounter many stock recommendations every day. How you interpret that information has much more to do with you than with the market.
After reading the analyst's enthusiastic recommendation for Pepsico in the Journal, our first investor, Ruth, reacts to the story by immediately calling her broker and buying Pepsi stock, even if it means selling her stock in some other company to do so. If we asked Ruth why she had made this decision, she would tell us it seemed like the natural thing to do or that it was the rational, smart thing to do. Ruth may agree with the analyst's theories about the beverage industry and the future demand for Pepsi and Pepsico's other products. Or she may simply assume lots of other investors will read the article and then buy Pepsico, and she might be trying to capitalize on the heightened demand for the stock.
Our second investor, Frederick, reacts very differently, deliberately choosing not to buy the stock. Frederick probably assumes that, because this recommendation appeared in the Journal, a paper read by millions of people every day, it is already too late to gain any advantage by buying the stock. According to Frederick, by the time he gets around to reading the Journal, Pepsico's stock has already felt any bump in the price, and it is simply too late for him to cash in on the rising tide.
Like Frederick, our third and final investor, Susannah, also reacts by not buying the stock, but for different reasons. Susannah is a bit of a cynic, a lesson she learned the hard way after following the recommendations of some star Internet analysts and watching her dot-com portfolio implode. She thinks that the analyst may not be telling the whole truth, that some huge investment bank, perhaps the analyst's employer, is stuck with a huge long position in Pepsico. The demand stimulated by the buy recommendation and ensuing price rise will help the brokerage firm reduce its holdings at the expense of the market. Or Susannah may just be the sort of investor who likes to make decisions based on her own assessment of the facts, not someone else's recommendation. She'll wait until Pepsico's interim results confirm or dispel the analyst's interpretation. Newspaper stock recommendations are almost always irrelevant to Susannah's investment decision-making.
I could give many more examples of how investors react to something as simple as a recommendation in the Journal, Barron's, or Investor's Business Daily, but that is not the key point. There is no right or wrong reaction to a recommendation beyond digesting the information to improve our understanding of the companies in which we invest. What is also important and perhaps even more valuable is for investors to figure out their standard behavior pattern in reacting to this sort of information. What separates Ruth, Frederick, and Susannah is their emotional reaction to reading the Journal article. How do they choose their way of interpreting and organizing the data?
My research suggests that each person will automatically organize the information he reads in the Journal according to the barely conscious and highly idiosyncratic organizing principles or lenses that he uses to structure his experiences. These principles are really "emotional convictions" that have evolved and acquired their uniqueness through a lifetime of interactions with others. As investors, it is our personal experiences in and out of the market that shape these very subjective but stable windows "that lend form and meaning" to our perceptions.
Ruth's lens is likely to be tinted with experiences in which trusting relationships with admired people provided her with information that proved reliable. Those experiences predispose her to believe she can trust and act on any statement from a well-known, respected analyst. Frederick's lens may be colored with a psychological feeling that he is usually behind the times or likely to miss the boat for new trends. Based on experience, he might believe other people with better connections or positions are likely to acquire and capitalize on information more quickly than he can.
Susannah seems to operate from an emotional conviction that she should never depend on anyone other than herself to make decisions. Her lens may be colored by historical incidents that give her good reasons to mistrust others. If so, the idea that a recommendation in the media could in any way benefit individual investors would now seem naive to her. Perhaps her cynicism took root when friends and contacts gave her information that turned out to help them but hurt her. Susannah concluded that, when it comes to research and facts, it's best for her to rely on herself and not on tips from others. She may therefore have an ingrained belief that any information in a newspaper stock-picking column is unreliable when compared to information gleaned from her own analysis of financial reports.
When we function according to our emotional convictions or organizing beliefs, we often do so unconsciously. We assume that the action of the stock market, rather than our emotional experience, is responsible for investment success or failure. However, long-term success and failure have little to do with the market. Both are related more specifically to the unique, individual way we interpret the information the market throws at us. Market theories, Internet message-board comments, pundit predictions, and individual investment decisions are typically based on these unexplored semiconscious emotional convictions--on feelings, not on facts.
Most of these emotional convictions remain unexplored in the investing community because there is a general resistance to examining our unconscious lest an inward glance distract us from the more reality-oriented task at hand--picking stocks. As Erik Erikson once stated, an individual who focuses on a specific external task "prefers enlightenment away from himself, which is why the best minds have often been least aware of themselves." Although the well-known economist Merton Miller probably never studied the psychoanalyst Erikson, he confirmed this observation with his statement that behavioral finance is "too interesting and thereby distracts us from the pervasive market forces that should be our principal concern." Individual investors comprise some of these best minds. Well educated, creative, and task-oriented, most investors are not trained or disposed to believe that our inner, unrecognized emotional convictions are capable of dramatically impacting what our thought processes analyze and create. In fact, consistent with Miller's observation, most investment theories suggest that the more we keep emotions at bay during the investing process, the more successful we will be.
This resistance to developing an in-depth understanding of investor psychology is in part responsible for economists' unwillingness to acknowledge that investing is a highly emotional, subjective process. Instead for decades economists have based their decision-making systems on some rarefied models of rationality akin to Star Trek's Mr. Spock, for whom decisions should be based on pure logic, unencumbered by emotions or the ambiguities of human relationships, and capable of some predetermined standard of perfection.
This philosophical view underlies the efficient market hypothesis (EMH), which maintains that since stock prices necessarily reflect all available information, it is nearly impossible for one individual to know more than the market knows at any give time. The ramifications of EMH contributed to the development of modern portfolio theory. Taken to its logical conclusion, it follows from EMH that it is useless to analyze stocks. If you accept this idea of a perfect market, as the business schools began teaching, a monkey throwing darts at the stock tables would have just as much success picking stocks as a well-trained security analyst.
While the Internet bubble and its subsequent collapse made monkeys of many investors, money managers, and security analysts, this hardly confirms EMH or its progeny. In fact, these events suggest quite the opposite. As David Dreman has observed,
The explanation for this phenomenon is relatively simple. Investment theory does not consider that psychology plays any role in investor decision-making, while in fact, in periods of mania and panic, the psychological influences play the leading role. Cognitive, social, and group psychology all provide numerous experiments that illustrate how psychological factors can divert investors from the purely rational decision-making of investment theory.
Presumably even Mr. Spock would agree. Hopefully the awarding of the 2002 Nobel Prize in Economics to Daniel Kahneman, one of the founding fathers of behavioral finance, will help to put a final nail in the EMH coffin.
But just as we do not always make rational decisions--especially under conditions of risk--neither do we always make irrational decisions. Contrary to economic assumptions, human emotions are not by definition irrational. The idea that psychological factors can divert investors from purely rational decision-making implies that we should do our best to eliminate these psychological factors (our emotions) when making investment judgments.
I strongly disagree. My clinical research indicates that no matter how much we try to eliminate emotions from the investing process, we will ultimately fail. Why? Because our unconscious emotional convictions (the emotionally tinted lenses through which we see the world) continue to operate and influence our decision-making, no matter how hard we try to deny them. As the Pepsico scenarios indicate, emotional patterns led Ruth, Frederick, and Susannah to make three different, well-thought-out decisions from available data. If asked, all three investors would believe their decisions were "rational" and "logical," no matter how much you challenged them. While Mr. Spock would disagree, it doesn't follow that any of these investors made decisions that were wrong for them.From the Hardcover edition.
Excerpted from Investor Therapy by Richard Geist. Copyright © 2003 by Dr. Richard Geist. Excerpted by permission of Crown Business, a division of Random House LLC. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.