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INVESTING and the IRRATIONAL MIND
Rethink Risk, Outwit Optimism, and Seize Opportunities Others Miss
By ROBERT KOPPEL
The McGraw-Hill Companies, Inc.Copyright © 2011Robert Koppel
All rights reserved.
A Concise History of Investor Psychology
In May 2008, in an interview with the New York Times, Kenneth C. Griffin, president and CEO of the $20 billion Citadel Investment Group, a leading global financial institution, offered some pretty harsh words about Wall Street. His gripe was with the Street's prevailing psychology of reckless and excessive risk taking. He called for an immediate overhaul of its mindset. No stranger to placing big bets, Griffin knew what he was talking about. While an undergraduate at Harvard, he had started two hedge funds from his dorm room, installing a satellite dish to channel real-time market data so that he could trade between classes. Founded in November 1990 with a little over $4 million, Citadel is now the world's eleventh largest hedge fund, earning Griffin a reported $900 million in 2009, after a double-digit drawdown in 2008.
Upset by the failure of Bear Stearns and the mistakes of big-name money managers and CEOs who assumed catastrophic risks that led to the evaporation of billions from their balance sheets and whose actions eventually led to the disappearance of Lehman Brothers and the near collapse of the financial system, he made an assessment that was blunt and to the point. "We, as an industry, dropped the ball," he said. "We have a responsibility to manage risk in a way that is prudent."
Was Wall Street once again guilty of hubris? According to Griffin, the problem was a market psychology that allowed for too much risk compounded by weak government oversight. "When you read that UBS did not even view parts of its mortgage portfolio as having risk," he said, "it becomes very obvious that a number of firms were not dotting the i's and crossing the t's when it comes to risk management."
He also cited the additional problem of youth and inexperience. "Walk across any of the trading floors—they are full of twenty-nine-year-old kids," he explained. "The capital markets of America are controlled by a bunch of right- out-of-business school young guys who haven't really seen that much. You have a real lack of wisdom."
Wall Street Journal reporter Scott Patterson's electrifying portrait, The Quants, describes how a group of brilliant, gutsy traders, composed of math geniuses and physicists, first earned their chops through gambling, then moved to take on Wall Street. Accentuating the quirky intrigue of this group, Patterson details the personalities and temperaments of its characters. Its principal figures included Citadel's Ken Griffin; chess master Boaz Weinstein of Deutsche Bank; Peter Muller, manager of Morgan Stanley's secretive hedge fund Process Driven Trading (PDT); Cliff Asness, the founder of the nearly $40 billion fund AQR Capital Management; and Ed Thorp, an MIT-trained mathematician and card shark, hedge fund manager, and author of Beat the Dealer, the first book to statistically prove that the house advantage in blackjack can be overcome by card counting.
This story opens not long ago in the Versailles Room, which is as posh as its name suggests, in Fifth Avenue's storied St. Regis Hotel. Beneath a gilded ceiling, antique floor-to-ceiling mirrors revealed the players, the quants, competing at Wall Street Poker Night. These yearly red-carpet events and tournaments, benefiting Math for America, brought together quants and professional poker players, surrounded by beautiful women, to play high-stakes, blue-chip poker. "The small group of wealthy and brilliant individuals ... had, through sheer brainpower and a healthy dose of daring, become the new tycoons of Wall Street," reports Patterson. "Few people outside the room had ever heard their names. And yet, behind the scenes, their decisions controlled the ebb and flow of billions of dollars coursing through the global financial system every day." This was not Gordon Gekko's 1980s game of liar's poker.
More than anything else in the world, the quants were searching for their truth. For the quants, it was revealed in the obscure patterns of the market, which could be discovered only through mathematics. These young masters of the universe devised an appropriate name for it: alpha. Alpha, Patterson explains, is defined as a "code word for an elusive skill certain individuals are endowed with that gives them the ability to consistently beat the market."
MARKET PSYCHOLOGY IN A NUTSHELL
The desire to beat the market is not a new idea, nor has it been limited to quants or to capital markets. When it comes to speculation, we are looking at a dramatic history of booms and busts. Our minds are irrationally fueled by the prospects of quick enrichment through such things as tulips in Holland, gold in Louisiana, real estate in Florida, art, Internet stocks, and mortgage-backed securities. We are driven by greed. We are panicked by fear.
Combining psychology, economics, and neuroscience, the recent field of neuroeconomics studies how people react in these emotionally exuberant situations. Looking at the role of the brain, researchers examine how we evaluate investments, categorize risks and rewards, and interact with one another in our economic transactions. However, the story of our attempt to comprehend the relationship between investing and the irrational mind begins much earlier.
Since the inception of modern markets, investors have sought to understand the factors that assured profit and prevented individuals from getting caught up in a psychological ricochet between euphoria and depression. One of the first attempts was made by Dickson G. Watts, president of the New York Cotton Exchange from 1878 to 1880, a great arena of economic activity in America. In Speculation as a Fine Art and Thoughts on Life, in his list of essential qualities of the speculator, Watts wrote, "Those who make for themselves an infallible plan delude themselves and others."
Watts identified five qualities that he believed were key for success: self- reliance, judgment, courage, prudence, and pliability. Summing up, he wrote, "The qualifications named are necessary to the makeup of a speculator, but they must be in well-balanced combination. A deficiency or an overplus of one quality will destroy the effectiveness of all. The possession of such faculties, in a proper adjustment is, of course, uncommon. In speculation, as in life, few succeed, many fail."
It was a good early attempt to understand a near chaotic speculative environment, one that relied heavily on nineteenth-century moralistic teachings and everyday common sense.
THE BOY PLUNGER
These observations won Watts the attention of young Jesse Livermore, who learned a lot about markets and himself from the slim volume, as revealed in Livermore's classic 1923 work on the art of speculation. Reminiscences of a Stock Operator, the fictionalized biography of the Boy Plunger, as he was known, charts the first-person experiences of Lawrence Livingston, a thinly disguised Livermore, through his progress in mastering Watts and the world of stock speculation to become one of Wall Street's most successful traders.
First appearing as a series of 12 articles in the Saturday Evening Post, Reminiscences of a Stock Operator was published under the name of its editor, journalist Edwin Lefèvre, a friendly newspaperman whom Livermore used as a source of information and as a plant to disseminate favorable news items. The book chronicles a trajectory of speculation that begins in the New England "bucket shops," brokerage firms, now illegal, that took the opposite side of customers' orders without having the orders actually executed on an exchange. The term itself derives from the fact that customers'
Excerpted from INVESTING and the IRRATIONAL MIND by ROBERT KOPPEL. Copyright © 2011 by Robert Koppel. Excerpted by permission of The McGraw-Hill Companies, Inc..
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