Money Is a Drug

The following is an excerpt (actually, it's Chapter 1) from Snap Judgment: When to Trust Your Instincts, When to Ignore Them, and How to Avoid Making Big Mistakes with Your Money, published FT Press.

In the summer of 2008, Rob Arnott’s research indicated there were problems ahead in the commodities boom. Arnott, founder of Research Associates, Inc., the giant Newport Beach-based money manager, is a quantitative investor as well as a contrarian who goes against the herd. His entire career has been built on finding ways to counter human emotions, including his own. His research but not his gut instincts told him that prices in commodities, including oil, had gone too far, and the future held more downside than upside.

This was not the conventional wisdom: Oil prices had surged by 300% between 2003 and 2007, and their climb upward seemed to only be accelerating. In 2008, prices crossed the once unthinkable $100 a barrel threshold, then $110, and finally brushed past $140 a barrel. Mainstream thinking held that the price increase was the result of changed fundamentals in the world economy. The newly awakened Chinese and Indian economies, with their nearly unquenchable thirst for raw materials, could only send the price of oil to higher and higher levels. Analysts who questioned if oil was in fact in the midst of an unsustainable price bubble were dismissed as bubble headed.

Arnott questioned his quantitative-based commodity. After all, the smart money, led by sophisticated institutional investors such as Harvard’s endowment, continued to pour money into oil. The continuing rise in price seemed to reinforce the wisdom of their decision. As Arnott admits, “I looked for ways to tweak the models, to fix them because the models were missing the huge bull market in commodities. That is what my intuition told me.” Arnott’s intuition, which was in conflict with the models, was wrong. The models had been right.

The price of oil soon crashed, but not before Arnott had sold his position. As an investor, he has trained himself to listen to his intuition—only to then do the opposite. “I use intuition, but in a warped fashion,” he says. If he feels comfortable about the direction his models are pointing him in, if they are in sync with his intuition, he immediately begins to worry.

He explains why so much of investing is nonintuitive: “The natural instinct is to follow others. As we were evolving on the plains of Africa, if everyone in the tribe starting running, you better start running. But in investing, if you act after everyone has starting running, you are catching the late end run of an asset and your timing will be atrocious.” For most investors, doing what comes naturally means chasing trends, doing what everyone else is doing. But although this makes sense in other areas of life, it is not a wise strategy for investing.

The easiest way for an investor to overcome this vulnerability is simply to build a natural skepticism to natural instincts. You don’t have to become a dogmatic contrarian—you just have to question your first impulse. Take, for example, a typical scene at a cocktail party. Someone brags about their fantastic investment. The natural reaction is to ask yourself if you are missing out on a great opportunity. The more skeptical and informed reaction should be to ask if the great past performance will continue into the future. Have you missed your window? Is it still attractive at current prices?

Arnott has trained himself to ask these counterintuitive questions when thinking about a new investment opportunity, and he feels everyone else can do the same. But he is merely one investor among many. And, the fact is, during the bubble years few investors showed this sort of skepticism—or any sort of skepticism. The entire world seemed intoxicated with money. It did seem like one big cocktail party, at least for people benefiting from the boom. With markets, as well as bankers’ bonuses soaring, why worry?

The cocktail party analogy holds a deeper truth about why investors may have suffered from impaired decision making and poor self control during these years before the crash. This was more than a simple case of minor intuitive errors in reasoning. Instead, according to MIT finance professor Andrew Lo, the real problem is traders literally were drunk on money. As Lo testified before Congress about the origins of the credit crisis:

“While this boom/bust pattern is familiar to macroeconomists, who have developed complex models for generating business cycles, there may be a simpler explanation based on human behavior. There is mounting evidence from cognitive neuroscientists that financial gain affects the same pleasure centers of the brain that are activated by certain narcotics. This suggests that prolonged periods of economic growth and prosperity can induce a collective sense of euphoria and complacency among investors that is not unlike the drug induced stupor of a cocaine addict....”

Lo, who is CEO of a hedge fund in addition to his work as an academic, has an interest in neuroscience. He has wired foreign exchange traders with biofeedback devices during the course of their work. When the market showed significant changes, so did the physiological response of all traders, but inexperienced traders were a lot more emotional when trading. For instance, they exhibited rising heart rates compared to the pros. For Lo, this indicates some emotion is necessary for decision making, but too much is problematic. (Neuroscience, though it has a different focus from evolutionary psychology, is consistent with and often supports the idea discussed throughout this book that humans have two decision systems—an intuitive one and an analytical one. Different responses exhibit different patterns of brain activation.)

I met with Lo at his office at MIT overlooking the Charles River. He was wearing sneakers, which made him look like either a trendy hedge fund manager or a down-to-earth academic. (Of course, he is both.) Lo explained to me how the way our brains are wired could lead to an economic crisis: “The situation had been building for 10 years. Everyone was making money all the time. Traders became confused because money was so cheap and risks were so hidden. Bond traders became caught up in a feedback loop.” It is Lo’s contention that the traders’ brains were affected by this loop. Financial success triggered the same neural circuits as by cocaine. Said Lo: “The same neural circuitry that responds to cocaine, food, and sex has been shown to be activated by monetary gain as well.”

As a result of their financial success, traders became inured to risk. In fact, they began to take on extreme financial risks—the financial equivalent of someone who is hallucinating stepping out of a 30-story building because they are certain they can fly. And to make matters worse, banks encouraged this risky behavior. Traders who refused to jump, were in effect pushed—or fired by their employers. Risk managers at large investment banks, in the months leading up to the crash, were sidelined or terminated if they warned the banks were taking on too much risk.

What this all suggests to Lo is the need for an external solution: a government intervention. If there is something hardwired in our cognitive processes that pushes us to excess, someone has got to stop us. Not everyone has the discipline to be a hyper-controlled investor and resist temptations that turn out to be damaging. Nor did financial institutions see any rationale to puncture the growing bubble. That leaves regulation as the mechanism society uses to prevent itself from indulging in self-destructive behavior.

Fire code regulation is a great example. Creating buildings with well-built emergency stairways, sprinkler systems, and clearly labeled exit signs is costly. This building infrastructure isn’t free. Why not leave it up to the market to choose which buildings are fireproof and which ones are not? Those worried about fires will pay more; those less worried will choose the second type of building.

Lo explained why, as a society, we haven’t left it up to the market to sort out this choice for us: “Left to our own devices, no would pay for the expensive infrastructure because when we walk into a building, our assessment of the likelihood of fire is zero,” said Lo. It is a cognitive bias. Intuitively, we underestimate the probabilities of this sort of catastrophe. But as a society, we have learned the hard way that people don’t worry about fires until after the fact. As a result, we put in regulation to ensure that buildings offer adequate fire safety.

The metaphor to financial markets and the crisis is clear. Here, we didn’t put in regulations to prevent banks from doing what they felt comfortable with in terms of risks. There was an inadequate “financial infrastructure” in terms of strong bank regulation and adequate bank reserves in place to protect the financial system in case of a catastrophe. Banks, left to their own devices, discounted this likelihood. They pursued aggressive trading strategies that seemed safe at the time, only to create conditions that led to a collapse in prices and an eventual fire sale of assets.

Errors in judgment, therefore, aren’t just ruinous to individuals: They can be damaging to society on the whole. A containable problem can quickly grow into something much worse—either a fire or a financial meltdown—if society chooses to ignore or discount people’s all too predictable biases.

Lo ended our interview on a poetic note, telling me that as a society, we need to look to Odysseus for guidance: “Just as Odysseus asked his shipmates to tie him to the mast and plug his ears with wax as they sailed past the Sirens of Circe’s island, we must use regulation as a tool to protect ourselves from our most self-destructive tendencies.”

-----------------------------------

My conversations with Rob Arnott and Andrew Lo were really about the same problem: investor irrationality. Arnott’s strategy is squarely focused on improving returns, asking what is best for the investor. Lo’s arguments are more macroeconomic, asking how these biased individual decisions add up collectively.

Later, I will turn to the macro issue of the role intuition played in creating the conditions that led to the financial crisis. I then explore how to build a stronger financial system, given the way humans really think and behave, including the need for better regulation. More immediately, I now turn to specific investments and how in a time of panic, rather than engaging in an irrational flight to quality, there may be more profitable ways to invest. These behaviorally based investing strategies are literally “counterintuitive.” They require overcoming your own initial instincts and taking advantage of others’ rush to snap judgment about investment decisions.

Comments

[Eugene Krabs]

That's a really good article on behavior investing. Irrational exuberance always seems to follow right up to the point of the bubble bursting. And then every herd follower *cough* I mean er momentum investor gets slaughtered.

And to qualify my statement, there is nothing wrong with momentum investing, but you have to know when to get out. And clearly, Arnott's model showed him that he needed to get out at that time.

This was a particularly interesting point last year, during the height of the oil bubble.

The psychological influences in trading and investing may never be erased, but what separates the men from the boys is in having a strategy that copes with it. This is why Warren Buffett jokes about trying to get as far away from Wall Street as possible.

[Old Limey]

From 1992 until late in 2007 I traded mutual funds very successfully. I was a Momentum investor. In other words I could care less why a sector is trending up nicely, all that mattered to me was that it was trending upwards in a very nice, low volatility uptrend. One particular sector in recent years that proved to be a very consistent, and very low risk, sector for me was the Junk Bond sector. I wrote my own software that calculated the best parameters to use for timing a mutual fund using a filtered, exponential moving average. This technique works the very best for sectors that have low volatility such as junk bonds.
I then selected a few of the best no-load junk bond funds from the 111 that are in the junk bond family in the database that I use. I then calculated the parameters for each fund that performed the best over a time period of about 5 years. The timing method got me in soon after a nice uptrend started and got me out soon after the uptrend ended, it was like having a machine that printed dollar bills.

I gave up trading because I wanted to lead a more stress free life, be able to go on foreign vacations with my wife several times/year without worrying about the market, and also because making more and more money wouldn't benefit us, it would just make our estate larger when I'm gone and increase the inheritance taxes for the government.

On 3/9/09 the average of 111 junk bond funds hit bottom. Since 3/9/09 it has gone up 31.87% (an annual rate of return of 89.47%) and during those 5 months the worst possible drawdown was only -1.61%. It is still trending up but who knows when it will end, you have to watch it every day and rely on your software to tell you when to get out.

That's how momentum investing works. Some of the mutual funds have instituted short term redemption fees of late to discourage short term trading, but my experience was that with junk bond funds there were usually no more than 3 or 4 trades/year required.

There is no way, in my opinion, that you can be a Buy and Hold investor. A Buy and Hold investor in the last two years would have undergone a lot of stress in junk bonds. He would have lost in 2008 about the same as he has made in 2009 for a net gain of about 1.8% (including all dividends), and he would be just hoping that the current trend continues - that's not the way you make money year in and year out. I have had one losing year since 1992.

[Concojones]

Interesting chapter. Too bad that we're not getting a flavor of the actual investing advice promised for the next chapters. If some of the book reviews I saw are right, it's an interesting book but with noo practical investing advice whatsoever.

(And it would also be interesting to hear Arnott's arguments for a commodity bubble, excluding oil which seemed obvious to me.)

[Apex]

@Old Limey

Care to share your software or your methodology?

[Old Limey]

Apex:
My software consists of 85 separate programs, each operated from a main menu so that it appears to the user as if it is a single program. I worked solidly for 2 years, 7 days/week, 16 hours/day constructing it. It was written in Microsoft's QBASIC language that runs on the MS-DOS operating system which is extemely limited in the amount of memory available, regardless of how much memory your computer has. It uses a proprietary database of mutual funds, ETFs, and market indexes that has been around since 1987. The database came with charting software, also written in QBASIC. The database and its charting software is called Investor's FastTrack. I took my software, one of FastTrack's 3rd. party products, off the market in July 2008 since the growth of the database in terms of numbers of funds and numbers of market days had grown to the point where many of my modules required more DOS memory than was available. The task of converting my software to the Windows operating system was one that I was unwilling to undertake since it would have required me to become proficient in that system and would have required giving up at least one whole year of my life to complete the project. Investor's FastTrack's software was converted to Windows and now incorporates a lot of my techniques. I ended up giving all of my source code to the owner of Investor's FastTrack, free of charge, and the last I heard was that he had a programmer in India working on the conversion. Since I am no longer a trader and hold only CDs and municipal bonds to maturity, I have dropped out of the picture and am enjoying a very relaxed retirement doing many other more pleasurable things than watching the market being manipulated by the big boys on Wall St. 5/days per week.

[Apex]

@Old Limey,

I understand that you have achieved financial nirvana, however it seems like if you software served you as well as it did, it had value that could have been exploited. It does sound quite complex however.

[Old Limey]

Apex:
In the early stages of development I gave my software away because I needed beta testers so that I could get valuable feedback and suggestions from investors more experienced than myself as to how I could make it better. During that period I received lots of nice non-monetary gifts in the mail. After about a year of non-stop hard work my wife was tired of playing second fiddle to my computer for most of my waking hours every single day so she said, "You need to either sell it or quit working on it", so I decided to finish it, have nice manuals printed and to start selling it. I knew from other developers that it was just a matter of time before the database would outgrow its memory capability and that a Windows version was the only solution, however I figured, at the time, nobody would pay good money for a Windows version that didn't do anything more than the DOS version they had already purchased, other than it would look more modern. It was a simple decision to decide that sacrificing one whole year of our retirement for hardly any reward would not be a smart decision. My customers had great use of it throughout the great decade of the nineties and up through the dot.com bubble and made lots of money so they aren't complaining. In general a software product has a life of only about 10 years, and mine far exceeded that.