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Nothing to Fear

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By rclosch
February 17, 2009

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At a time when the financial media has become convinced that the sky is falling, it is perhaps a good time to stop and consider the impact of market psychology on our investment decisions.

James Montier has written a book on Behavioral Finance runs short side of a hedge fund; and writes a news letter for Societe Generale. He is one of my favorite financial commentators. In a recent Letter he discussed behavioral patterns that lead the typical investor to emotional errors of judgment in bear markets

Our problems stem from the fact that within the human brain emotion tends to override the rational function. "Our brains consist of two different (although interconnected) systems. One is a fast and dirty decision maker (the X-system), the other is more logical but slower (the C-system)."

While this emotional override response served a useful purpose for our ancestors confronted with a woolly mammoth. It not nearly as constructive for today's investor confronted with a market that is rapidly eating his net worth "Effectively from an evolutionary standpoint a rapid response to fear carried a very low cost to a false positive, relative to the potentially fatal cost of a false negative."

Fear and bear markets

So whereas fear of a negative outcome may have helped our ancestor's survival, it is not nearly as useful when dealing with contemporary financial markets. As an example of this negative impact Montier sites a 2005 study by Shiv, Loewenstein, Bechara, Damasio and Damasio (2005) Investment Behavior and the negative side of emotion,

"They asked players to participate in the following game. At the start of the game you are given $20 and told the following the game will last 20 rounds. At the start of each round you will be asked if you would like to invest. If you say yes then the cost will be $1. A fair coin will then be flipped. If it comes up heads you will receive $2.50 back, if it comes up tails then you will lose your $1."

Obviously it is optimal to invest in all rounds due to the larger return if you win (expected value is $1.25, giving a total expected value to the game of $25). In fact there is only a 13% chance that you end up with total earnings of less than $20 (the return you achieve if you don't invest at all and just keep the initial endowment). The second thing we know about this game is that the outcome in a prior round shouldn't impact your decision to invest in the next round after all the coin has no memory.

There were three groups of participants in the experiment. The first came from a very unusual group, they have a very specific form of brain damage; effectively these individuals can no longer feel fear. The second group (normals) are people like you and I. The third group (control patients) are those with brain damage in other parts of the brain not related to the processing of emotion (and fear).

When the experiment tested these three groups on the percentage of time that they chose to invest after a round in which they had invested and lost. "The first group of players those who can't feel fear behave pretty optimally, investing around 85% of the time after they have suffered a loss. However... the other two groups. Display seriously sub-optimal behavior. In fact, so bad is the pain/fear of losing even $1 that these groups invested less than 40% of the time after a round in which they had suffered a loss!"

Even more interesting is the fact the study indicated a complete lack of leaning on the part of the normal group and the control group. Logic would say that participants would performance would improve the longer the game went on, an effect that would be demonstrated by increasing rates of investments as the game when forward, but in fact the opposite was true and the longer the game went on, and more negative outcomes experienced, the less that was invested by the last two groups.

From this Montier reaches the following conclusion. "The parallels with bear markets are (I hope) obvious. The evidence above suggests that it is outright fear that drives people to ignore bargains when they are available in the market, if they have previously suffered a loss. The longer they find themselves in this position the worse their decision-making appears to become. ..The fact that time seems to drain the ability to think rationally fits with a lot of the work done looking at the psychology of self-control.

Bear Market Fatigue

"Baumeister (2003)3 argues that self-control (effectively our ability to hold our emotions in check) is like a muscle - too much use leads to exhaustion. He concludes his survey of the field by highlighting the key findings of his research: When self-esteem is threatened, people become upset and lose their capacity to regulate themselves when self-regulation fails people may become increasingly self-defeating in various ways,"

Unfortunately, many of the biases we face seem to stem from the X-system (the automatic part of our brain's processing capabilities). As such they are outside of our conscious awareness and therefore can sometimes (indeed one could say, often) go unchecked by the more logical C-system.

Montier has run a separate study of his own on a sample of 700 professional investment managers and found that about 60% of this sample were prone to this tendency for X-system (emotion) to override the C-system (intellect).

It is up to the individual investor to decide for himself the extent that his X-system is in control, but as a hint for those of us that consider ourselves to be value investors we can look to our leader. We will not have the figures for the fourth quarter until the annual report is released but from the news we have of fourth quarter transactions, and if you subtract the $10 billion Buffett has said he will hold for catastrophe insurance it is likely the annual report will reveal that Buffett is pretty well all in. Then if we consider ourselves to be Value investors and are not fully invested then you have to ask yourself if you really think you know something that Buffett does not, or if your X system is in control and we our reluctance place a good bet is primarily the result of previous negative results.

Of course none of this means that market will not go lower from here, but to get your C-system in control it is time focus only on value, and individual stocks. Ignoring the noise is easy to talk about, but hard to do and the longer the bear market lasts the harder it gets; but it is the only way you have any chance of overcoming the power of your emotions. My personnel therapy suggestions to block my pesky X-system, turn off CNBC, cut back on reading news papers, and spend more time writing posts. For me there is something about writing that elevates the C-system.