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The Psychology of Price Signals

Aug 11, 2016


The definition of irony is when what you really mean is the opposite of what you say. So what do you call it when the effect caused by your actions is the opposite of what you intended. It's not irony. Is it a paradox? Hubris? Or plain old incompetence?

I'll come back to Mark Carney and the Bank of England in a moment. And be warned, I am trying to look on the lighter side of things today. When you want to cry or scream, sometimes laughter is the best medicine.

That's easier said than done when ten-year gilts are yielding under 0.60% and 30-year gilts fell to 1.39% yesterday. For pensioners and pensions funds, the total war being waged on fixed income is brutal. About the only consolation - if you own gold (which you should) - is the 45% in gold priced in British pounds over the last 12 months.

But back to the psychology of price signals. Why do so many investors read price signals incorrectly? Why do we buy high and sell low? Why do we sell winners and hold on to losers? What's going on in our big wet brains that causes us to consistently underperform the market?

That's a question I want to tackle today and for the rest of the week. I know the psychology of investment is not everyone's favourite cup of tea. But if you're serious about wanting to improve your investment results, knowing your own emotional and cognitive biases is crucial.

I've met someone who I think can help with "the knowledge problem". I'll introduce you to him today.

Why is the Bank of England failing?

Don't look now, but Mark Carney must be wondering what he's done wrong. His big shiny new stimulus package isn't even a week old and already it's breaking down. It's a bit technical, but yesterday the BoE failed to buy as many bonds as it hoped with its new programme. The reason?

Sellers aren't selling! It's a seller's strike. The Great Bond Hoarding has begun.

The BoE plans to add to the £435 billion worth of government bonds it already owns by buying £60 billion over the next six months. That seems fairly straightforward when you're a buyer with bottomless pockets (a printing press). But remember, a market has buyers and sellers.

Value isn't realised until there's a transaction. And there can't be a transaction if a seller won't sell. That's what happened yesterday. The BoE was unable to meet its target purchase quantity of 15-year government bonds. One cheeky seller even upped the price above market rates - and got it! But the rest refused to sell. Why?

Well, pension funds rely on the yield from government bonds to generate the income they need to pay current obligations. Longer-term government bonds are about the only place in the world where you can find sufficient yield. The BoE may want to buy those bonds. But the pension funds bought them for a reason.

This must drive central bankers crazy. First, negative rates have actually increased household savings rates in Sweden, Switzerland, Germany, and Denmark. Now, the BoE says it will buy bonds at any price and you have a new phenomenon: bond hoarding!

The explanation is simple, if the BoE bothers to reason it out. Negative interest rates are designed to send a price signal. That signal is simple in theory. When it's low or negative rates on savings deposits the signal is: spend!

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Spending is the rational choice if the return on your savings or on supposedly safe assets is low. You spend it before your purchasing power is gone. That's what you should do, according to central bankers.

The same thing should be true for bonds. If the central bank is buying at any price, yields are headed lower and prices are headed higher. Owners of bonds should trade the "safe" income/asset for a capital gain and then go out and buy something; like stocks, or a new pair of trainers.

Back to the irony/paradox question then. Why aren't British savers and investors behaving the way they are supposed to? Why are savers saving more and bondholders holding on to bonds which the central bank is prepared to buy?

The answer is obvious: negative rates create a fear and crisis of confidence. They don't send the signal the central bankers think they send.

The signal QE and negative rates send is this: we are out of control. We don't know what we're doing. We're going to distort markets and redefine the nature of money. Please cooperate.

Savers and investors aren't cooperating for a good reason. They know that negative rates signal something is deeply flawed in the financial system. The rational choice, when confronted with signs of a huge and impending risk, is to preserve what you already have, not part with it.

Even the most academic of financial authorities will realise this eventually. At that point, either interest rates will rise, or the financial authorities will double down on financial repression and impose a version of Financial Martial Law by coming after your cash and savings more directly.

But I promised I wouldn't bang on about that again today. So let's move on to other psychological matters. Let's assume we have a functioning market, free from distortions and manipulations. Even if you had such a market - which we don't - odds are most investors would still underperform the index. The answer why is below.

Do you have symptoms of "profit aversion"?

It's commonly thought that "loss aversion" is what drives investor behaviour. But that could be wrong. Understanding why (and correcting it) could improve your investment P/L.

According to "prospect theory" developed by Amos Tversky and Daniel Kahneman, human beings are hardwired with a preference. The preference is that avoiding losses is more desirable than pursuing gains.

I say "hardwired" to avoid losses. But it's more accurate to say it's a psychological preference. It's in your brain. But your brain, being a "plastic" and adaptable thing, can be changed for the better.

If you think about human history, "loss aversion" as a survival strategy makes total sense. When the margin of error in life is small - when you spend all day seeking just enough calories to say alive and not be eaten by a predator or killed by the elements - you'd probably exhibit a strong preference for not losing what you already have (your life).

Fast forward to today and your investments. Kahneman and Tversky showed that in psychological terms, losses are nearly twice as powerful as gains.

Can you see how "loss aversion" becomes "profit aversion"? If you do happen to make a good investment and it goes up, everything in your brain screams at you to sell it for a profit as soon as you can - to make that profit a real thing and not a theoretical gain. Psychologically, what's going on is that you fear loss more than you desire gain.

Unless you subdue this deeply embedded psychological preference for avoiding losses, you will limit your investment gains.

A colleague of mine, Dr Richard Smith, has agreed to sit down with Nick O'Connor and me next Monday night (15 August) to show you how his web-based software program helps you solve this psychological limitation. It's not psycho-babble or inspirational talk either.

It's practical. It's mathematic. And over 20,000 investors are already using it to manage their own portfolios, worth $13 billion in total.

Yes, I know that kind of service - a web-based portfolio management and risk management tool - is not the sort of thing you'd expect from a publisher of ideas. But that's exactly why I became so interested in it a few months ago. It's something we're not publishing that I believe could be of tremendous benefit to you and thousands of other British investors.

Dr Smith's presentation has been seen by hundreds of thousands of investors already. And as I mentioned in my invitation, over 20,000 investors are already using it to manage over $13 billion worth of portfolios.

Let me repeat that it's not a newsletter (although you can manage newsletter portfolios with it). It's a risk management software system that Dr Smith designed to solve a problem: the problem of why individual investors almost always underperform the market. It's true in bull markets. It's true in bear markets. Why?

The knowledge problem

I won't go into too much detail here. That's what next Monday's event is about. But from having worked with Dr Smith for over ten years - and seen his software first hand - I'd say the number one reason most investors fail to beat the market is that they simply don't know how much risk they're taking when they buy a stock or manage a portfolio of stocks.

Does that sound familiar? I don't mean the risk that a stock could go down, or that a company could fail to deliver earnings, or that an old industry could be challenged by a new technology, or that the market could crash. Those are all risks.

But they're all risks you're aware of, to one degree or another. The problem is that you can only be aware of them in a general way. You can't measure them. And if you can't measure them, it's harder to manage them.

What Dr Smith has done is take key aspects of risk - when to sell (profit/loss aversion), how much to buy (position sizing) and the best time to buy (market timing) - and quantified them for you. Not only that, he's made it easy for you to see that risk in visual terms, right in front of you on your computer screen (you'll see Monday night). And because you're measuring and seeing it, you have much more specific and useful information about how much risk you're actually taking.

The goal of it all, of course, is not simply to lessen your risk. It's to make more money on each individual investment and on your entire portfolio. But that's the whole point about knowledge right? The more accurately you know what's going on with the price action of a share, the better your chances of managing your risk. You let your winners ride and you cut your losers. And not only can you do this for each stock with Dr Smith's software, you can do it for your entire portfolio. Or multiple portfolios.

Now I hope you can see why I'm excited for Monday's event. I don't believe UK investors have ever been directly offered anything quite this powerful. And although Dr Smith's software takes no editorial positions and has no view on the goodness or badness of negative interest rates - it's a piece of software after all - it's a powerful complement to the views and analysis you get from the analysts at MoneyWeek Research.

Obviously if you're not an investor and don't actively manage money, Monday night's presentation will be less useful you. I was going to say "of no use". But I don't think learning is ever not useful. That's why I put together a short series of articles based on Dr Smith's work that I'm sending out to people who register for Monday's event.

Oh and one last thing. One reader wrote in asking what Dr Smith is a doctor of. Good question. He's a doctor of systems science. Don't feel bad if you don't know what that is. I didn't either. Dr Smith tells me it's an "interdisciplinary blend of mathematics, computing and complexity science".

Sounds a bit intimidating. But what I like about Richard is that he came at "the knowledge problem" - knowing when to sell, how much to buy, and when to buy in - as an investor first and a PhD second. He knows from his own experience how frustrating it can be to see yourself underperform the market. That's why he invented TradeStops ten years ago. He'll tell you the whole story Monday night

Please note: This article was first published in Capital & Conflict on August 10, 2016.

Dan Denning studied literature and history, moving to Agora Financial in Baltimore fresh out of college. Working alongside Bill Bonner and Addison Wiggin, he became managing editor of Strategic Investments. He then moved via Paris and London to Australia, publishing a book - The Bull Hunter - along the way, and opened Agora's successful office Down Under. He returned to London in 2015 and became the publisher of Fleet Street Publications' financial newsletters.

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1 Responses to "The Psychology of Price Signals"


Aug 12, 2016

"So what do you call it when the effect caused by your actions is the opposite of what you intended. Plain old incompetence?"

How correct is it to relate "consequences" of one's actions to "plain incompetence" ? Are you looking for one word answers to complex inter-related phenomenon?

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