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Behavioral Reasons For You Being Merely An Average Investor

Summary Most of us are held back by our behavioral barriers. Knowing them helps you to understand why markets behave as they do. Anchoring and the bandwagon effect are one of the most important. If you are not happy with your investing returns, then you can basically find fault in two areas: Your knowledge of investing, or your behavioral barriers. This article will go through the most common behavioral barriers that you need to understand before you can climb over them towards greater wealth. I have long believed that investment success requires far more than intelligence, good analytical abilities, proprietary sources of information, and so forth. The ability to overcome the natural human tendencies to be extremely irrational when it comes to money is equally important. Warren Buffett agrees, commenting that, “Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ… Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.” The following text is taken and modified from my master’s thesis that focused on value investing and behavioral finance. If you want to read more on the subject, two excellent books to read are Thinking, Fast and Slow and Beyond Greed and Fear . For even deeper knowledge on the matter, you can look for articles written by people named in the following text. Behavioral financial experts basically do not have much faith in the rationality of investors and therefore are against the idea that markets are efficient. If it was, then value premium would be easily explained by the relationship between risk and return. Lakonishok, Shleifer and Vishny write that, due to irrational behavior, the market prices value stocks lower and growth stocks higher. Naive investors typically overreact to the stock market related news and forecast the same growth far into the future. Because of this type of actions, they enhance the effect that might have already been taking place. In simple cases, purchase happens because stock price has gone up, and selling happens because price had gone down. But, as a simple example, this can be due to one large investor selling or buying a large amount at the same time, resulting in a price change. Some investors might take this as a sign of change and hop on or off the train. This type of investor behavior can also be explained, at least partly, by agency issues. Many professional investors might be under pressure from their bosses, clients, or due to peer competition they are forced to deliver quick results. Therefore, they are being forced to favor short-term profits over better quality investments that require longer holding periods. This type of investment pattern is often seen among institutional investors and even CEOs. Also for any professional investor, it is greatly easier to recommend the purchase of well-doing growth stocks that have a good track-record, than value stocks with a long period of negative returns. Representativeness A financial example to explain representativeness is the winner-loser effect that was proven by De Bondt and Thaler. They find that stocks that have been biggest winners during the past three years do much worse than the stocks that were the biggest losers during that same timeframe. De Bondt proves that as analysts make long-term earnings forecasts, their views tend to be biased to the direction of recent success of the firm. Meaning that analysts are overly optimistic about recent winners and feel pessimistic about recent losers. Also, De Bondt finds that market predictions are overly optimistic (pessimistic) after three-year bull market (bear market). Therefore, it becomes quite clear that analysts’ recommendations are not particularly useful when they can be linked to representativeness. One reason for this behavior is that people underweigh evidence that disconfirms their prior views and overweigh confirming evidence (Shefrin). Overconfidence In simple terms overconfident people overestimate their skills to complete a difficult task and therefore are surprised more often than they anticipated. Clarke and Statman proved that people are overconfident. They showed this by simple questions such as: How long is the Nile? Give your answer with minimum and maximum so that you are 90 percent confident that the actual length is inside your low and high guess. They asked this type of questions in survey form and found that most people are not well aware of such things but are overconfident as their high guesses were often very low compared to the actual numbers. So when people are overly confident they set too narrow confidence bands in such questions and just like financial analysts, are surprised by the results. One way to understand this is to think of a stock you were following and should have sold much earlier than you did, but you didn’t because you kept believing it can’t go lower. Anchoring and Failure to Adjust Mendenhall and Abarbanell and Bernard find evidence that analysts underreact to earnings information. Even when they get to adjust their forecasts based on new information (such as a profit warning), they are still underreacting to actual results. Their work shows that analysts fail to appropriately tweak their forecasts. What happens is that, as analysts anchor their expectations to previous information, then surprises that happen are even larger in the end. This failure to adjust expectations can then lead to value stocks and large price jumps. Psychology and limits to arbitrage Arbitrage refers to a situation where investors are able to gain a riskless profit due to the market mispricing an asset. By buying an undervalued asset and cashing the profit when prices have returned to normal. In reality the risk is that the market can continue to misprice the asset even further. This is called as the “Noise trader risk”, introduced by Long, Shleifer, Summer and Waldman. Noise trader risk happens when irrational investors keep moving the price of an already mispriced asset to the same direction, despite the actions of one or more rational investors. Also transaction costs add more risk to the equation therefore limiting arbitrage behavior. Mental accounting A typical investor does not see every euro that he possesses as being identical. Mental accounting theory helps to explain why it is quite typical for investors to divide their money to “safe” money invested in low-risk assets, while investing their “risk capital” very differently. Once money has been placed in one mental account, it no longer is a direct substitute for money in another mental account. Mental accounting theory tries to understand this psychology of decision making. Mental accounting has three components, according to Thaler. First, outcomes are apprehended and experienced. Based on this, decisions are made and later evaluated. Second, activities and sources are categorized. For example to invest or to save and also the use of these funds for spending such as housing and food. Lastly, these accounting activities are rebalanced daily, weekly, monthly or so depending of that person’s personal preferences. Gross claims that in cases where a client’s investment is at a loss a stockbroker can keep its customers by using words “Transfer your assets”, instead of referring to selling and buying. Selling would lead investors to acknowledge their losses, but now they merely transfer their money from one mental account to another. Myopic loss aversion People have stronger reaction to losses in their wealth, than they do to increases even if gains are bigger than losses. Psychologically losses are taken approximately twice as heavily compared to gains. A myopic investor is defined as a person who tends to make short-term decisions over long-term ones, and often evaluates his/her losses and gains. An example of this would be to follow a myopic and a non-myopic investor. Myopic investors would likely avoid stocks and invest in assets such as safe and stable government bonds. If he had stocks, he would constantly check the market and, in case of a loss, feel it emotionally as very painful. Therefore, myopic loss-aversion leads investors to choose portfolios that are overly conservative. While a non-myopic investor would not check the market as often and would be comfortably unaware if his wealth happens to take an occasional downhill. Therefore, he prefers long-term investments with better returns over safer government bonds. (Thaler, Kahneman, Tversky and Schwarz) Framing As defined by Tversky and Kahneman, the term “decision frame” means the acts, outcomes and contingencies that a decision maker associates with a certain choice. This one frame depends on personal characteristics, norms, habits and also on how the problem is presented. As problems can be presented in many different ways, that can also change the outcome of framing. According to Tversky and Kahneman, “Individuals, who face a decision problem and have a definite preference, might have a different preference in a different framing of the same problem, and are normally unaware of alternative frames of their potential effects on the relative attractiveness of options.” Prospect Theory Developed by Tversky and Kahneman, it is an alternative theory to analyze decision making in situations that contain risk. Prospect Theory (PT) focuses on gains and losses instead of wealth. Also, instead of using probabilities and risk aversion, PT uses decision weights and loss aversion. An outcome is called a prospect, and a prospect includes a decision with some level of risk. Decisions are made in two levels: The editing and evaluation levels. In the editing level, possible outcomes are put in order, according to some heuristic. This can be explained by people looking at the outcomes and they make a mental note of an approximate and possible average outcome. By using that average as their reference point, they’ll then categorize lower outcomes as losses and higher ones as gains. So Tversky and Kahneman state that humans prefer focusing on gains and losses instead of their final wealth. The Bandwagon Effect This is a form of group thinking. With stocks, it refers to a situation when more and more people start to buy a certain stock, the more will follow, therefore increasing the demand more and more. They might do this despite their individual beliefs and opinions, simply because other people are doing it. As more and more people join, those that are still out are under group pressure to “join the fun”. The expression, “hop on the bandwagon” is typically used when this kind of a group effect is happening. Bandwagon effect has two sides to it, according to Shefrin. First, it is believed that a crowd must know something. Second, losers don’t want to be alone. In the case of negative returns, the pain of regret is eased by the knowledge that many others made the same mistake. This theory helps us to understand why growth and value stocks perform as they do. As more and more people abandon the stock, it becomes a value stock when enough people have “left the bandwagon”. Growth stocks are the opposite until they reach their peak when the first people start jumping off. The most rational investors should be the first ones to jump on and off the stock. Conclusion The world is full of information to learn. The hard part is learning to control yourself. When you understand and remember these behavioral barriers, you are above the average investor and closer to greater wealth. The bandwagon effect is one of the most basic ones, but also the most important one, in my opinion. It explains the market behavior during the most critical times, during a bubble and a crash. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

1 Unique Method To Successfully Play A Volatile Market

Summary One way to make money no matter what the stock market is doing. Choosing the right sector is the key – in my case is was specific commodities. Knowing consistent price movements over time will determine the trading spread to work within. There is no doubt we’re in a stock market environment ruled by fear, as confirmed by the extreme volatility in the movement of the various indices. Much of this was triggered by the crash of the Chinese stock market, but even before then there was a growing concern about the dizzying heights the market had shot up to without a correction. The U.S. has went through a mini correction, but many believe we need a deeper and more prolonged one to bring share prices back in line with actual values of companies Other factors given as reason for volatility are low interest rates, which have tempted companies to be more reckless in their spending; uncertainty concerning whether or not the Federal Reserve will raise interest rates; slowing Chinese economy; commodity deflation; and signs manufacturing in America is slowing. I could add many more to the list. Together what it says is investors no longer have some clarity on the future, and that has been the impetus behind the extreme volatility in the market. When visibility is down and parts of the global economy collapsing, it generates an environment of fear. And that’s where we are today. One thing we must do as investors is to ignore the endless financial news headlines about the last big plunge in the stock market, and the soon-to-follow “rebound.” That’s stock price movement that historically precedes a major correction. The day-to-day movements are irrelevant. What’s relevant is if after all the movements the direction remains level or continues on down. Trading in times of fear With future uncertainty can come investing paralysis and fear, as investors move their money to the sidelines to wait to see where things go. That’s a good strategy, but there are many others that still want to find ways to grow their capital in these volatile times. I’m going to share one strategy I’ve used to capture profits in situations similar to this. As a matter of fact, it doesn’t matter whether the stock market is going up or down with this type of trade, as it has volatility built into it either way. I’m talking about silver, although I’m simply using it as a proxy for other commodities or markets that are volatile in nature. I’m going to say that again: I’m only using silver as a proxy for a number of opportunities to make money using this method. I’ve used this with silver in the past, but know of some colleagues that are using it with other commodities right now, and in your specific expertise, there could be many other sectors or segments to do the same thing. Silver trade The first thing to do is identify a highly volatile commodity that moves in predictable patterns. The one I know the best is silver, and it’s one I made a lot of money with several years ago. I decided to go with stocks and not silver options or futures. At the time I was trading was when gold and silver were still soaring, and among the top-performing and predictable silver companies at the time was Silver Wheaton (NYSE: SLW ). It was highly volatile, but it still have a primary upward share price movement, which made up for the occasional timing mistake I made, which forced me to hold it a little longer than usual. Remember, it doesn’t matter whether a commodity is going up or down in price, as long as it’s operating within a trending pattern. That’s where a lot of the risk is mitigated. The other thing is there has to be discipline in not trying to get every penny out of the trade. I always sold when the share price moved within the parameters I had put in place. Once it rose within those guidelines, I didn’t get cute, I immediately pulled the trigger and sold. Did I miss some upside? All the time. But I never regretted it. I made money on trade after trade as long as I stayed within my pre-set parameters. How was the trading performance during this time? At the best I had fourteen straight trades I made money on. Under normal conditions I would make five or six trades, and then lose on one. Keep in mind I was trading with a similar amount of money, so it was like taking 5 steps forward and one step back. It could have been even better, but within my parameters I had a holding restriction, meaning if the stock didn’t perform as expected within a specific time frame, I would sell it. That protected me from losing more than what I would make on one trade. What needs to be known In my silver trading I needed to identify the overall trend direction of silver and the daily share price movement of Silver Wheaton within that trend. Everything else I ignored. When I say everything else I ignored, I mean with the exception of something that would point to a reversal in overall trend. For example, when Silver Wheaton surpassed the $40 mark, I knew it was either going to explode in growth or move up a little more, and then start to pull back. That is how it did move, with it topping off between $46 and $47 a share. I don’t believe it ever closed at that level (during the time I was trading it), but it did reach that in intra-day trading. This isn’t rocket science. Volatile markets like silver, still have patterns within them that can be observably known, and it only takes a little research on the level of the price movements of a stock within that pattern. The only tricky part in my experience was when it not only dropped per its normal volatility, but then dropped a little more than usual for some temporary reason. If I hadn’t committed to a trading time frame, I I would have simply held a little longer and waited for it to rebound, which during the trend, it literally always did. That’s how I could hit it so many times in a row. Again, it’s understanding the flow of the pattern, which can be easily identified with any day-to-day chart. What about making money on the downside? After getting some confidence with Silver Wheaton because of my success, I started thinking about a way I could make money when the price dropped. Keeping within my preferred method of stocks or an instrument that would trade like a stock, I decided to go with ProShares UltraShort Silver (NYSEARCA: ZSL ). What ProShares UltraShort Silver does at its basic level is short silver via different financial instruments. My only problem there was I only allowed myself a certain amount of money to use with this type of trading, so I had to break up the amount I spent on Silver Wheaton if I wanted to take advantage of the downward price movement of silver. It wasn’t really a problem, but it limited my upside because of my refusal to break my discipline. That’s the key to success in this type of trading: you have to stay disciplined within your predetermined parameters. Stray outside of them and you’re likely to get hammered, even if you occasionally get lucky. What has to be watched if playing silver for upside and downside, is one of them aren’t on trend, and if it suddenly moves off trend, you could be hit hard. This is another reason I always sold when it reached the level I was looking for; whether the price of silver was going up or down. This protects you from starting to believe you know what you’re doing in regard to price movements. We can know the trends and daily movements, and within a tight trading discipline, do very well. I can’t emphasize that enough. Don’t start to think you have an inside handle on a volatile segment of the market. That’s why there has to be a system in place that is religiously followed, no matter much more that could have made on a trade. Take the gains and run. Then do it over and over again. To give an idea of how one could lose on a trade if you’re not careful and disciplined, check ZSL when it was trading at just under $5,600 a share. That happened because it was going against trend because the price of silver was moving up. On December 1, 2008, it closed at $5,598. On December 15, 2008, it closed at $3,928. You can trade against trend, but that is far riskier. I had no trouble with it, but I kept a constant eye on it throughout the day. Also understand, these were trades I would usually make within an hour or two. Rarely would I hold on longer than that. This isn’t investing, where I was analyzing the company, it’s trading, where I only analyzed price movements and the trend. I was doing this to play both volatile movements. If silver was going down in price, one could play only ZSL and drop Silver Wheaton. Conclusion Unless you have a nice chunk of extra money lying around for high-risk trading, I would stay with one trend direction and first get a grasp of its consistent daily price movements. I say that because you won’t make as much playing two different trends unless you have significant capital to put into play. You’ll have to wait for your trade to clear, which could take several business days before you have access to your capital again. And if you do that on both ends of the trade, the daily price movement could be up, which if that’s the way you’re playing it, you may have to wait a day or two before it rebounds. That means if you sell on a Thursday, you may have to wait until Tuesday before you have access to your money, and then maybe an extra day or two for the price to be positioned correctly for an entry point. If you haven’t done this type of trading before, that may seem like it’s not a big deal. But when you’re used to moving in and out of the market based upon price movements, it can seem like an eternity, and you may be tempted to get in just to be in the game. Once you decide on a commodity, or possibly a volatile stock, be sure you know the macro-economic situation, the general trend of the sector, and then the consistent price movement intervals of the commodity or company. After you have a handle on that, then develop a simple system to work within, with the most important being the price spread you will buy or sell within. You could make more money without the parameters, but you could lose more too. Under this type of discipline I’ve used it to generate significant earnings time and time again. Keep in mind I’m not suggesting to trade in Silver Wheaton here. It’s only a proxy I used because I made a lot of money using this technique with silver and Silver Wheaton in the past, and it represents the type of predictable volatility needed to make money. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Sell UVXY: It’s Still A Busted ETF Heading Lower

UVXY is a widow-maker of an ETF, down more than 99.9% over the past five years. A recent trebling in its share price is irrelevant to longer-term investors. UVXY is still a terrible product, sell it or short it. It’s going to drop further. Volatility ETFs are one of the worst inventions to hit retail investors in the past decade. These products that are literally designed to go to zero if you read the fine print in the prospectus. And yet thousands of small-time investors and speculators get sucked into them, thinking this is a good way to bet on, or even prudently hedge against volatile markets. The iPath S&P 500 VIX Short-Term Futures ETF (NYSEARCA: VXX ) is still the gold standard for the space. And it’s a very lousy product. Short it or avoid it. However, with the dark magic that is a leveraged fund, you can take the inherent terribleness of VXX and cube it. Enter the ProShares Ultra Vix Short-Term Futures (NYSEARCA: UVXY ). The Velocity Shares Daily VIX 2x (NASDAQ: TVIX ) is basically the same functional product as UVXY in a slightly different wrapper and with less trading volume, but the same analysis applies. VXX, UVXY, TVIX and other such long volatility instruments are designed to benefit when the VIX rises. However, since VIX – somewhat inaccurately known as the “fear gauge” — is a mathematical construct rather than an actual investable instrument, no ETF tracks VIX properly. What you’re investing in when you buy VXX or UVXY isn’t the VIX you see scrolling across the CNBC ticker but rather a blended combination of futures contracts (derivatives) that aim to predict where VIX will be at a later date. There’s usually a large disconnect because VIX today and VIX in the future, leading to the returns on VXX and UVXY not coming close to what you’d expect just looking at spot VIX changes on the day. The general case against VXX and UVXY is rather simple. Volatility in the future is generally projected to be higher than volatility today. Since traders fear unknown future events more than the present knowable situation in most cases, traders will pay up more for protection farther into the future. Traders are usually more fearful of a crash farther along the horizon than in the short-term. Since VXX, UVXY and others own a mix of current month VIX futures and next month VIX futures, they tend to lose value when they have to rollover contracts. Say spot VIX as quoted on CNBC is 14, VIX futures for September are 16, and VIX for October is 18. Every day, VXX and UVXY have to sell some of their September contracts at 16 and buy Octobers at 18. They lose more than 10% of their net asset value (NAV) every month rolling over. Once October comes, October futures will be down to 16, Novembers at 18, and they’ll lose another 10% rolling again. VXX tends to lose about 70% of its value every year, and it’s largely driven by this effect. The long term impact of this effect, named contango, is most difficult. It’s why these funds always go down over the longer term, and why they make for poor investments. VXX is down from a peak of 7,000 (split-adjusted various times) in 2009 to 29 today. A drop of 99.6% since inception. UVXY’s done even worse, given the 2x leverage, falling from almost 500,000/share (yes, you read that right) to 64 just since 2011! (click to enlarge) Ouch! These are very-poor performing investments that most folks should steer clear of. However, now that the market is dropped and UVXY has tripled off the lows, everyone’s all excited about volatility products again. Now the talk of the town is that volatility is in “backwardation” meaning the usual value-destroying albatross that hits these investments is no longer in play. Backwardation, explained simply, is that now this month’s futures are worth more than next. If you can sell Septembers at 18 and buy Octobers at 16, your (NAV) rises 10% a month. If that state is maintained for awhile, particularly with UVXY’s leverage, you get some fat upside. And yes, that’s all true. But no, it doesn’t generally play out like that. Look at the long-term log chart of UVXY posted above. There were two periods of relatively long-lasting backwardation, during both the 2011 and 2012 market sell-offs. And UVXY and TVIX did indeed benefit from rising volatility and backwardation… however, the increases were very small compared to the larger downward trend. These instruments are so poorly constructed that brief periods of backwardation don’t move the needle. Backwardation almost never persists for a lengthy period of time because the market is almost always more fearful for the future than the present. Unless you’re actively seeing markets go through the floorboards right now, like during the recent Monday’s flash crash festivities, volatility expectations are almost always higher at a later date than what you see at present. While UVXY got to 90 during the current panic, it sold back off to 60 in just two days on a rather modest market recovery. And Tuesday, it dumped 19% again in a single day. Any instrument where you lose 33% of your money in two days or 19% overnight during a fairly routine market recovery is best avoided by most market participants. When you’re long UVXY, you are playing with fire. September VIX futures are currently at 26. Around 15 has been normal during this bull market. So just a reversion to normal wipes out more than a third of VXX’s value, and UVXY will suffer losses greater than that due to the leverage. The lottery ticket type upside in a crash scenario just isn’t worth the near certainty of an 50-75% loss in UVXY in coming weeks as the market and volatility stabilize. Even if you manage to time a sell-off correctly, you’re almost undoubtedly better off just buying puts on the market, through an ETF such as SPY. UVXY may go up 6x-8x if you hit a sell-off just right. Getting that, or a whole lot more, from SPY puts is no more difficult. In a perverse sort of way, it’s nice that these ETFs’ lives have dragged on as long as they have, as they are among the best short sales in the market. It will be a sad day when these sources of easy alpha are taken away from the short-selling arsenal. Disclosure: I am/we are short UVXY, VXX. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.