Trading Psychology

Trading Psychology – Group Intelligence

Group Intelligence is a type of synergistic IQ where the collective IQ of the group (assuming that the participants have little emotional connection) becomes greater that any of the individuals on their own.

Group Intelligence as a part of trading psychology is the basis of the ‘Efficient Market Hypothesis’. It assumes that at any given time, security prices fully reflect all available information making it impossible to beat the market except through luck.^[1] Many studies have been conducted that clearly demonstrate the power of Group Intelligence.

Do you remember the TV show ‘Who Wants to Be a Millionaire?’ By answering correctly 15 multi-choice questions that got successively harder, contestants had the opportunity to go home with up to 1 Million dollars.

Unintentionally every week ‘Who Wants to Be a Millionaire?’ pitted group intelligence against individual intelligence and nearly every week, group intelligence won. When people got stuck they could call a pre-selected person to help answer the question, another option was to poll the studio audience who would cast their votes by computer instantly.

Logic would suggest that the pre-selected ‘smart’ friend who no doubt had access to the internet would be most likely to have the correct answer. As it turned out the ‘smart’ friend was right 65% of the time which is not bad. However the collective answer of the random people in the studio audience who had nothing better to do with their time, was right 91% of the time.^[2]

One of the first recorded examples of this phenomenon is from 1906 when Sir Francis Galton analyzed the entries of an ox-weighing contest at a county fair. In the hope of winning a prize nearly 800 participants paid a six penny fee to enter. Galton discovered the average guess to be 1,197 pounds which was almost identical to the ox’s actual weight of 1,198 pounds.^[3]

The price of the stock market is determined in the same way just on a larger scale: people place their guess on what they think stocks are worth and the average of those guesses determines the clearing price, the point where a willing buyer meets a willing seller.

While the process of a group pricing a stock or identifying the weight of an ox is the same, the influnces on the individuals of the group are very different and so are the results. Guessing the weight of an ox is not an emotionally demanding decision and there is no influence on the decision by the other participants. Guessing the price of a stock however can be a very emotional decision and one that is easily influenced by other members of the group. This is why the ‘Efficient Market Hypothesis’ fails; it does not allow for the distortion caused by emotion. Returning to our definition of the stock market:

The stock market represents the collective human emotional interpretation of all that is known and its subsequent effect on the supply and demand of shares in publicly traded companies.

Collective human emotion causes Herd Mentality which leads to irrational behavior and subsequent inefficient pricing. Yet the collective knowledge, ‘all that is known’ in the absence of emotions (Fear, Greed etc) causes Group Intelligence; synergistic IQ where the pricing of an asset will be extremely close to its true value.

Hypothetical True Value

Above you can see a chart of the Dow Jones Industrial Average going back to the 1930s on a log scale. This example is purely for illustrative purposes but assuming the black line represented the markets true value, the gyrations either side show where fear and greed have caused irrational pricing. By averaging out the performance of the market over time, the extremes of emotion become more obvious.

Most of the time stocks are subject to irrational and excessive price fluctuations in both directions as the consequence of the ingrained tendency of most people to speculate or gamble … to give way to hope, fear and greed. – Benjamin Graham

These deviations from fair value are what professional investors and traders are able to exploit because of their ability to remain emotionally neutral in their reasoning. Unfortunately their profits come at the expense of the majority of market participants who follow the crowd and are driven by emotion.

Eventually the market will always correct back to the true value of its underlying companies as a whole. The true returns from a mature market over the long term will never be more than a few percent a year and this is the return that can be expected by the buy and hold investor.

Where have you seen Group Intelligence in action? Do you think that the markets are efficient? Leave your thoughts in the comments section below.

Part 1 – Trading Psychology

Part 2 – Herd Mentality

^ Efficient Capital Markets: A Review of Theory and Empirical Work by Eugene F. Fama, The Journal of Finance, Vol. 25, No. 2, May, 1970, Pages 383-417.
^ Group Intelligence – The Wisdom of Crowds, 2004 by James Surowiecki.
^ Vox Populi by Sir Francis Galton, Scientific Journal – Nature, March 7, 1907 Pages 450-451.

Trading Psychology – Herd Mentality

Herd Mentality results in the dilution of I.Q. by the members of a group. This dilution increases exponentially with the size of the group and the level of emotion common amongst members. Herd Mentality is the reason why a group of people can abandon reason and descend into madness in a way that any individual of the group would not, it is also a major cause of Contagion. For this reason it is essential to maintain your individuality when investing. In doing so you can objectively observe the herd’s behavior and profit from its stupidity.

Herd mentality is not reserved for the stock market; have you ever watched a riot on TV and seen regular people committing terrible acts of violence with a complete disregard for others? This is a reaction to peer pressure which makes individuals act in order to avoid feeling ‘left out’ from the group.

Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one! – Charles Mackay

French sociologist Gustave Le Bon developed a theory called Contagion (different from Financial Contagion). It assumes that crowds exert a hypnotic influence over their members. People find themselves in a situation where they are anonymous and can abandon personal responsibility. They get sucked up in the contagious emotions of the crowd and can be driven toward irrational, often violent action that most isolated individuals would not attempt.^[1] The main flaw in this theory is that crowd behavior is not necessarily irrational.

The crowd is always intellectually inferior to the isolated individual, but that, from the point of view of feelings and of the acts these feelings provoke, the crowd may, according to circumstances, be better or worse than the individual. All depends on the nature of the suggestion to which the crowd is exposed – Gustave Le Bon

Another theory to explain Herd Mentality is called Convergence. It suggests that crowd behavior is a product of the convergence of like-minded individuals; that people who wish to act in a certain way come together to form crowds.^[2] Floyd Allport, a man considered the founder of social psychology said “The individual in the crowd behaves exactly as he would behave alone, only more so.” Convergence theory better explains why not all groups of people behave irrationally but does not explain why some people do things in a crowd that they would not have the courage to do alone.

I agree with both theories in part. My research suggests that it is the underlying emotions of the crowd that hold the key to understanding its behavior. If the emotions are negative such as anger, hate, fear, greed etc. then the resulting behavior is best explained by Contagion Theory. As the negativity and the intensity of the emotions increases the resulting behavior is progressively more animalistic and irrational.

Examples:

The Netherlands Tulip mania 1636–37
New York Draft Riots 1863
The Roaring Twenties and the crash of 1929
The Black Monday market crash October 1987
June 2001 riot by Los Angeles Lakers fans after the Lakers victory over Philadelphia in the NBA Finals
Run on the Bank of England September 2007

Stock market bubbles and crashes are great examples of Herd Mentality and Contagion Theory. They tend to begin and end with extremes of emotion; frenzied buying (Greed) to cause a bubble and then selling in a panic (Fear) to trigger a crash. Otherwise sensible people act against their better judgment.^[3] Individuals don’t want to be ‘left out’ and rush with the crowd into or out of the market.

The crimes of Nazism are not the crimes of one nation. Cruelty a taste for violence, the religion of force, ferocious racialism, are not the prerogative of a period or of a people. They are of all ages and of all countries. They have biological and psychological bases which it is by no means certain that we shall escape again. The human being is a dangerous wild animal. In normal periods his evil instincts remain in the background, held in check by the conventions, laws and criteria of civilization, but let a regime come that not only liberates these terrible impulses but makes a virtue of them, then from the depths of time the snout of the beast reappears, tears aside the slender disguise imposed by civilisation and howls the death-cries of forgotten ages – Jacques Delarue (The History of the Gestapo)

However if the underlying emotions are positive such as love, peace, serenity, unity, understanding etc. then the resulting Herd Mentality is better explained by Convergence Theory.

Examples:

The majority of weekly Religious Gatherings
The majority of sporting events
The majority of music concerts
Peaceful Protests

The most significant example of Herd Mentality as explained by Convergence Theory was seen during the Salt Satyagraha. It was a campaign of non-violent protest against the British salt tax in India lead by Mahatma Gandhi. There are reports of over 100,000 people at times marching in a spirit of peace, unity and harmony.^[4] These people were suffering racial and financial injustice and had every reason to be angry yet they remained non-violent.

So what has this got to do with making money in the stock market? Well, it’s the emotions of fear and greed that cause the Wall Street herd to behave irrationally. In contrast; Gandhi, through maintaining positive emotions and resisting anger and fear, induced 200 million people to maintain their composure and act with a clear mind. The result was to bring Britain, a world super power to its knees without any violence or financial backing.

To stay separate from the herd we must remain emotionally neutral, resisting both fear and greed. This is only possible when you know that probability is in your favor. Then you don’t need to care about the outcome of a particular trade, you can remain detached from the outcome and let the law of averages run it course.

If you cannot control your emotions you cannot control your money – Warren Buffett

A fascinating aspect of Trading Psychology is that when the emotional influence on members of a group is low, Herd Mentality evolves into Group Intelligence.

Even the intelligent investor is likely to need considerable willpower to keep from following the crowd. – Benjamin Graham

What tactics do you use to remove emotions from your investing decisions? Have you ever been caught following the crowd?

Part 1 – Trading Psychology

Part 3 – Group Intelligence

^ The Crowd: A Study of the Popular Mind, 1896 by Gustave Le Bon.
^ Sociology, 2007 by John J. Macionis.
^ Herd mentality rules in financial crisis by Maggie Fox, Reuters September 30, 2008.
^ Gandhi and Salt Satyagraha, 1981 by S. R Bakshi.

animalistic

Trading Psychology – Imperative Foundation For Success

An understanding of Trading Psychology is the imperative foundation for all the other skills required for success in the financial arena.

The inability of the masses to endure the psychological effects imposed by the market is the main reason why Wall St eats them alive and why there is so much money to be made by the emotionally intelligent minority. If you are aware of how psychology drives the market you can stand witness to it and maintain clarity of mind in the face of both jubilation and crisis.

Psychology is probably the most important factor in the market – and one that is least understood. – David Dreman (Author of “The Psychology of Stock Market Success”)

Studying Trading Psychology completely altered my definition of what the stock market is. (Before this realization I nearly whipped out my entire trading account). How you define the market defines how you approach it and the turning point for me came when I began to see the market through the following paradigm:

The stock market represents the collective human emotional interpretation of all that is known and its subsequent effect on the supply and demand of shares in publicly traded companies.

If it were not for human emotion then all investments would be perfectly priced, the markets would be efficient and it would be impossible to beat the average return. In reality the market is driven by the twin emotions of Fear and Greed. When prices are rising, greed is the dominant emotion. When prices are falling, fear is the dominant emotion. Notice that logic is not a factor in the equation.

I’d be a bum on the street with a tin cup if the markets were always efficient. – Warren Buffett

The market consists of two main groups; the Smart Money and the general public. The general public ride on emotion and profit only by luck, while the Smart Money ensure they make decisions based on logic. As a result the Smart Money consistently profit over the long term.

When logic and emotion come into conflict, emotion always wins. If logic was the more powerful of the two then there would be no fat people. Instead the logic of eating adequate portions of food selected on the basis of health and a long life is not as powerful as the feelings/emotions experienced by eating gluttonous amounts of food selected on the basis of taste and convenience.

Valuable insight into Trading Psychology can be gained by studying the market during booms and busts because these are the times when it’s effects are most obvious. Huge groups of people will ignore their better judgment and seemingly go insane. Do you remember the height of the Dot Com boom; Oct 1999 – Feb 2000?

This is from the prospectus of VA Linux’s IPO – November, 1999: (now SourceForge, Inc. LNUX)

We incurred losses of $14.5 million in fiscal 1999 primarily due to expansion of our operations, and we had an accumulated deficit of $29.9 million as of October 29, 1999. We expect to continue to incur significant … expenses… We do not expect to generate sufficient revenues to achieve profitability and, therefore, we expect to continue to incur net losses for at least the foreseeable future. If we do achieve profitability, we may not be able to sustain it.^[1]

Based on this information how would logic suggest the IPO went?

Shares in VA Linux Systems soared eightfold today, setting a new record for the largest first-day gain of any initial public offering. – CNET News^[2]

A first-day price gain of about 700% and a closing price of $239.25^[3] gave Linux a market cap of roughly $9 billion.^[4] It went on to lose $728 million over the next 5 years before turning its first profit of $3.9 million in 2006.^[5] On November 25, 2008 it closed at an all time low of $0.58

Can the market get any crazier than this? You bet… Is was revealed by a Purdue University study that during the Dot Com boom companies could get a 89% jump in their stock price simply by switching to a Dot Com name.^[6]

The price of NEI Webworld, rose almost 1,170% in a day simply because it made news for its involvement in an Internet scam… NEI had no assets and was already in bankruptcy liquidation!!^[7]

In this kind of environment many people lose all self control, get swept up in their emotions and forgo the most basic due diligence into a companies fundamentals. Like in 1999 when AppNet Systems, Inc. filed for an IPO under the symbol APPN, at the time there was a company called Appian Technology, Inc. trading on the NASDAQ OTC Bulletin Board under the same APPN symbol. In a feeding frenzy people started buying shares of Appian technology thinking they were getting AppNet Systems before its IPO. Appian Technology shares went up 142,757% in the two days following the filing. Over 7.3 million shares were traded compared to just 200 shares the day before.^[8]

I can calculate the movement of the stars, but not the madness of men. – Sir Isaac Newton, lost a fortune in the South Sea Bubble

Perhaps the most hilarious examples of the utter madness that humans are capable of when driven by greed were seen during the South Sea Bubble. Capital was raised through stock offerings for, among other things; “a wheel for perpetual motion”^[9] and “The trading of hair”.^[10] But my personal favourite is a prospectus by one audacious con-man entitled:

“A company for carrying on an undertaking of great advantage,
but nobody to knows what it is.”

The man (who nobody has been able to identify) simply stated that the required capital was half a million. Just 5 hours after opening the doors for the IPO he had raised £2000. Then, that evening, displaying infinitely more intelligence than the people he had just robbed, he set sail for the new world (America) and was never heard from again.^[11] He knew enough about the psychology of trading to see the bubble and prey on those blind with greed.

Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities – that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future – will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.^[12] – Warren Buffett

This irrational behavior by people riding on emotion opens the door of profit to those that understand trading psychology. Crooks use it as an opening for their underhand tactics but the lasting profits are to be enjoyed by emotionally intelligent traders and investors.

It is important to distinguish between the Psychology of the individual and that of the crowd. It is not possible for large numbers of individuals to reach such extremes of irrational behavior simultaneously. This only occurs when individualism is lost and ‘Herd Mentality‘ takes over.

What examples of madness have you witnessed in the the market? Have you ever missed opportunities or made regrettable investments under the influence of emotion? Share your experiences in the comments section below.

Part 2 – Herd Mentality

Part 3 – Group Intelligence

^ VA Linux Systems, Inc. IPO filed with the SEC November 17, 1999. Page 7; Risk Factors, Paragraph 2; We have a history of losses and expect to continue to incur net losses for the foreseeable future.
^ VA Linux storms Wall Street with 698 percent gain by Dawn Kawamoto and Stephen Shankland, CNET News December 9, 1999.
^ VA Linux storms Wall Street with 698 percent gain by Dawn Kawamoto and Stephen Shankland, CNET News December 9, 1999.
^ Meeting of the Federal Open Market Committee December 21, 1999. Page 12, Paragraph 2.
^ SourceForge Inc: Financial Statement, Income Statement – 10 Year Summary (in Millions).
^ A Rose.com by Any Other Name by: Cooper, Michael J; Dimitrov, Orlin; Rau, P. Raghavendra. The Journal of Finance, Volume 56, Number 6, Page 2379, Paragraph 1, December 2001. Department of Finance, Krannert School of Management, Purdue University.
^ In the wild world of Internet postings, sometimes bad news is good news by Rebecca Buckman, The Wall Street Journal, December 17, 1999.
^ Mistaken ID takes stock for a ride Briefly shared symbol caused AppNet mix-up by Terzah Ewing, The Wall Street Journal, May 9, 1999.
^ Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, Volume I, 1852 by Charles Mackay, LL.D. Chapter 2 The South-Sea Bubble, List of Bubbles, Page 58, #36.
^ Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, Volume I, 1852 by Charles Mackay, LL.D. Chapter 2 The South-Sea Bubble, List of Bubbles, Page 57, #14.
^ Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, Volume I, 1852 by Charles Mackay, LL.D. Chapter 2 The South-Sea Bubble, List of Bubbles, Page 53, Paragraph 2.
^ Chairman’s Letter 2000, Berkshire Hathaway, Page 14, Paragraph 2.