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7/31/2006 1:13:09 AM Master Your Investments by Mastering Your Mind By Brooke Hall Atlantic City glows a deep, sinful red from across the bridge. And once you've made your way through the maze of the gray, musty parking garage, you begin your descent into the maze of the casino. Colored lights that make you dizzy flash and dance inside your eyes--- bells, whistles and random sirens tickle your ear. And the tacky, fluorescent carpet patterns put Andy Warhol to shame. The bling-bling of slot machines and the excited squeals of people who have finally been tossed a few quarters are inescapable. Beautiful, scantily-clad women handing out the free drinks smile and grin so long as you're putting chips on the table. A three-ring circus if you've ever seen one.... But there is always this overwhelming sensation in the air. As if the world will stop spinning for one second and you might walk out a richer man. Rich!! The ultimate motivation for this city, for this entire culture. The Black Jack table beckons with its felt, green cloth, reminding you to "give it a go." It's ominous and appealing all at once. You were once told that Black Jack has the best odds in the house. Just another (probably false) pre-conceived notion that you're convinced of. Preconceived notions, most are just wrong. Yet we live our life, make our stock picks, choose our travel destinations and weigh out our risks and benefits based on them. You spy from across the room this loud guy-he's trouble......and he's winning. And Winning Big!!! You sit down next to this rowdy character, but why? Well, if this guy's taking the house, you want to be in on it, right? Well, the stock market is no different. Depending on how you handle your wins (and your losses) will determine whether you walk back to that proverbial parking garage in the red or on top. Why Gambling in a Casino and Investing in the Market Teach the Same Lessons What is behind the investment sector of the market? What drives investors to act a certain way?? And how can you profit from knowing what other investors' behavioral patterns are? Is investing really "all in the mind?" Investor psychology has been treated like that dirty scam artist with cheap tricks up his sleeve from time to time. And although investor psychology hails from academia, in the free market it has been transformed into a method for profits, by profits--- so to speak. What began as a theory demanded research, which evolved into a debate. But the scholars can only take this one so far. Without actually practicing these methods, they were out of their element. Once the brokers and stock advisors got their hands on it, they attempted to break the code in order to benefit from the ways in which we can predict investor behavior. Welcome to the Wild World of Behavioral Finance Investors are ready to take it to the next level. Sure indexing and all the purely rational aspects of the stock market and real estate are enough to keep your brain ticking for a few months or so. But for the intellectual investor, the one that actually does end up banking it, it takes a little more to keep his interest piqued. Playing the stock market or real estate sector is a lot like gambling. And, like any wise guy from the 70's will tell you: there is a way to do things, and there is a way not to do things. They might also say that the house always wins. But when it comes to the stock market, somebody is winning and you don't want to get caught with the short end of the stick. Staying ahead of the curve is essential, even if that means getting into the minds of your competitors. Until the 80's the economic theory that investors built their little castles around was simple: Financial Markets are Efficient. So, in thinking that all relevant information was reflected in asset prices and that this was done in a rational manner, they thought they had the market clocked. But then the crash of '87 hit faster than that full metal jacket that plummeted into our office building a week ago. After this shot through the heart, EMH (Efficient Market Hypothesis) began to unravel like a shoddy hand made scarf. Soon after the crash, investors started eyeing up that scarf as if it could be used as a noose. And big surprise-- the EMH could not explain why the crash happened. It was not rational. It did not make sense. Some mysterious boogeyman was at work here. Like most useful inventions, Behavioral Finance was borne from this outright chaos....and grew strong in the nurturing hands of greed and fear. Investor Psychology aimed to nail down the specifics of why investors acted as they did. And then, tried to predict what they were about to do. It's like counting cards. If you know what cards are likely to come up next, you can place your bets accordingly. If you are any good at it, and you do end up with a stack of chips-you gotta know when to walk away. See, here's how the old model (EMH) worked: Let's talk bull and bear phases in asset markets (including residential real estate). EMH would explain this by saying that "when investors are confident asset prices rise and when investors are not confident, they fall." Yeah, this sounds nice and curt. Short and sweet. Logic over emotion. Well, it's sugar-coated bologna. Icing-frosted cow dung. What this method ignores, and almost stubbornly it seems, are the two biggest follies of our human condition. People are never perfectly rational. Crowds strongly influence the individual. It seems so simple, right? These lapses in logic when forming judgments, placing bets and processing information are the key to understanding (and predicting) what's going to happen in the market next. You're thinking, "Of course we're not perfectly rational." But the trick is understanding how we slip up and using that to your advantage. Many studies done by psychologists have identified that: Individuals over-emphasize brilliant, recent or personal experiences in assessing the probability of those events occurring again. Either way you look at it, this always results in emotional involvement with an investment strategy. For instance, let's say you invested a little nest egg into Apple (AAPL) this past week. All of a sudden your little nest egg is an ostrich egg. Studies say that more than likely, your first instinct will be to expect that gain to continue right on up towards bigger, better, and faster gains. So, once a bubble gets underway, the emotional commitment of the investors continues to rise, only to perpetuate the bubble. Individuals tend to ignore uncertainty and project the current state of the world onto the future-so if a share price has gains, chances are you'll assume that those gains will continue. Individuals tend to be overconfident regarding their own abilities. Individuals tend to be super conservative in adjusting their expectations to new. information-and that adjustment happens slowly over time (this is why bubbles and crashes usually unfold over long periods of time). Individuals require less information to predict a desirable event than an undesirable one. This points to our tendency of "wishful thinking." People want solid, scientific, irrefutable proof of global warming, the end of oil, etc. But you don't have to twist their arm to make them believe that "everything is perfectly fine." This may explain why asset price bubbles normally precede crashes rather than the other way around. Individuals tend to flat-out ignore information that conflicts with their prior decisions. Now. Crowd psychology is a whole other can o' worms. See, investment markets are a perfect arena to watch crowd psychology work its magic. When playing in the market, there are certain things to be aware of. Collective behavior is a beautiful thing, especially when you can see it for what it is and exploit it. For instance, collective behavior relies on several key elements: Mass communication or other means by which behavior can be "contagious." A structural strain-this could be the threat of losing (or missing out on) an opportunity for financial wealth. A general belief (correct or otherwise) that grows and spreads. (for example, that share prices are going up) Some event to take place to give the aforementioned general belief a foundation. (Like, say, a technological breakthrough or strong economic growth.) Perhaps you've noticed yourself responding to these things. And you are not alone. As humans, these elements of "the game" are our triggers. And like any gamble, you'll find yourself experiencing the emotional roller coaster. Investor emotion through a market cycle: The question isn't whether or not you can beat the market. That's easy. Can you beat yourself?? That's the real question. That is, can you master your emotions, think independently and not be swayed by the crowd? Decisions based purely on our natural instincts usually tend to be WRONG. And most of our preconceived notions are wrong too. Sure, you're comfortable buying when prices are high and rising. And no doubt you don't have any problem selling when they are declining. But can you, as an intellectual, as an investor, as a human develop an attitude that encourages you do to the opposite and still come out ahead? You can read books on market strategies ‘til your nose bleeds, but you will never master the market until you master your emotions. And this means mastering what happens when you lose, just as much as when you win. --Brooke Hall |
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