Wall Street WARZONE

Warning, “The More You Trade, The Less You Earn:” Stick to These 8 Winning Rules for America’s 95 Million “Predictably Irrational” Investors, Direct from Princeton’s Daniel Kahneman, Nobel Economist & Behavioral Scientist

by Paul B Farrell, JD, PhD
| Print | 1/20/2011

The Buttonwood Agreement was signed in 1792 near Wall Street, creating what is now the New York Stock Exchange. For two centuries after that, the industry lived with a “rational man” theory. Recent research by behavioral economists and neuroscientists proves conclusively that investors are actually quite “irrational and woefully uninformed, especially when they're betting against Wall Street. Wall Street's theory of the “rational investor” was actually pure propaganda, purposely intended to mislead investors. Today, the new theory of the “irrational investor” has set the “law of unintended consequences” into motion"instead of helping Main Street investors get a grip on their irrational behavior, it has opened new opportunities for Wall Street to exploit and turn the research, tools and technology of behavioral finance against investors, putting Main Street investors at an even bigger disadvantage than they were before, because Wall Street's arsenal is growing stronger, while Main Street is last in denial.

The English playwright Harold Pinter, well-known for his long mysterious “pregnant pauses,” won the Nobel Prize in Literature a few years ago. A rarity, only the third playwright in a century. Equally rare, a few years earlier Princeton psychologist Daniel Kahneman won the Nobel Prize in economics. What do the two have in common?

Just this: Both are students of human nature, both know that most of the time most of us don't have a clue what's going on. We have so little factual information. And what facts we do have are colored by preconceived beliefs. On top of that, our emotions constantly override the few facts we do have. The truth is, we don't really know what's going on in the world “out there.” And we know even less about what's going on in our own heads. So we fake it! Yes, you heard me, investors are masters at of the fine art of faking it, “acting as if” we know. We are masters of disguise. Telling others we're “certain.” And worse yet, we actually believe what we say. We convince ourselves that we really do know what's going on"in the world, the economy, the market, and even in our heads.

All the world's a stage - and you're an actor

Technically we're not lying, we actually believe we “know” what going on. But the truth is"we're faking it. (Admit it, just this once!) I'm not just saying you and me and the rest of America's Main Street investors don't have a clue, I'm talking about everyone"amateur and professional"who makes an entrance or exit onto the Wall Street stage"the Morningstar 5-star stage, sound-bites on the CNBC stage, talking heads on the Fox News stage, interviews with Kiplinger's, quotes in The Journal. We're all faking it. All clueless. But nobody will admit it's just a stage play, a big act.

So we all just keep acting like we know something, while smiling and pretending. That's what I get from these two Nobel prizewinners. Both have the same message about human behavior. Kahneman knows he cannot beat the market: “The idea that I can see what no one else can see is an illusion.”¬† Pinter is equally blunt: “People fall back on anything they can lay their hands on verbally to keep away from the danger of knowing, and of being known.” Writing in the New York Times, Charles Isherwood says Pinter's characters “attempt to mask feeling or motive, to avoid communication or connection. And often the characters are themselves blind to the impulses that move them.” Sound familiar? You bet! They accurately describe the behavior of investors on Main Street and professionals on Wall Street - blind, clueless, and faking it.

Broadway and Hollywood - or Wall Street: “That’s Entertainment!”

When I was working on Wall Street at Morgan Stanley, I soon discovered that Wall Street was just one endless staged drama. So I went in search of the real thing: Five years writing scripts at night, acting lessons at the Strasberg Theater, Off-off-Broadway auditions, Soho dance classes. Directed a film in a Television Academy workshop. Won a gold medal at an international film festival. Came close to producing a couple Pinter plays on Broadway.

Pinter was one of the big reasons I left Wall Street for Hollywood. Today, Kahneman is the reason I stick around. Why? Because Kahneman's brilliant mind articulates some amazingly simple psychological lessons for all investors. His eight lessons were discussed in a Money magazine interview with Jason Zweig before Kahneman was awarded the Nobel Prize in Economic Sciences. Here's a suggestion: Between reading each of these eight lessons, please stop for a minute and think about the lesson. Take a long "pregnant pause' and sit silently and ask yourself: What can you do differently to improve your awareness as an investor. And if it helps, imagine you're in a seminar with Pinter and Kahneman co-hosting. Imagine how you'd explain to them why you agree (or disagree) with each of Kahneman's eight simple lessons on how to become a successful investor:

One. Distrust all data!
Here's a fast-moving scenario: The Journal quotes a Morgan analyst. Bill Gross is on CNBC. Bloomberg tests Bernanke's inflation strategy. Your stock-picking software signals a “buy!” Your brain sees a pattern, a trend, an opening. Time to act, before the “window of opportunity closes. Warning: Big mistake! Why? Kahneman doesn't mean there's something wrong with the hard data, although there probably is. He means don't trust what your brain's doing with the data you have in your head! Brains love seeing things that aren't there, inventing epic dramas based on minimal facts. They like feeling in control, especially when they feel out-of-control, when feelings are dominating facts.

Two. Cool it, big shot!
Chasing fads and hot investments makes Wall Street's drama queens feel important, like they're “in the action!” But even stupid ideas like no-earnings dotcoms win in bull markets. Psychologists warn that overconfidence is our brain's biggest saboteur. You win some, think you're a genius, take bigger risks, wind up a loser, deny it, try harder, guess again, double down. It's just a market cycle. You believe you have the secret. But you really don't have a clue what's coming next. Relax and take a deep breath, you're not really as smart as you think you are.

Three. Distrust all gurus!
All gurus, all the time, all over. In print, cable, online. They're hustlers selling you something. See every talking head, naked on stage, wearing a big “used-car salesman” nametag. Warning: Their “recommendations,” their “advice,” just self-serving sales pitches. Period. Now notice how your brain still wants to believe in them. Conflicted, your brain insists you're an independent thinker, yet is still dependent on outside gurus, trapped in a double bind. Why? Pause.

Four. Stop the obsessive counting.
Behavioral psychologists note that investors who check their accounts often are more anxious and, ironically, bigger losers. Kahneman's blunt on this phenomenon: Looking at your stocks and funds every day is not only dumb, it's “the worst possible thing you can do” he says. Why so obsessed, so fearful

Five. It's the portfolio, stupid.
Kahneman calls it “global framing,” focus on the big picture, your whole basket of assets rather than worrying about gains and losses in individual assets. Create a well-balanced portfolio diversified enough so that the losses in one sector are balanced across the returns of the rest of the portfolio. Stop for a minute, a day, stop listening to the anchors, gurus, breaking news, say a prayer.

Six. Autopilot investing.
Sorry folks but your investing brain really is a very bad computer; irrational, clueless, and extremely vulnerable to making mistakes. Junk it! Get an upgrade, what Kahneman calls a “permanent auto-pilot portfolio.” Also, set up your savings so new money is automatically transferred from your paycheck into your portfolio. Get your error-prone brain out of the loop. Pause again.

Seven. Limits on casino betting.
Think about CNBC's frantic Mad Money program. It works if you're an investor with a hyperactive teenager's brain. Next time you have a sane moment, lock up 90% or more of your portfolio. Can't touch it. And if you insist, give your self-sabotaging gambler's brain limited access to the other 10%. When that's gone, you stop, walk off the stage, and enjoy a very long “Pinter pause,” doing nothing with your portfolio. Protect yourself against the gambler. Set limits.

Eight. Trust yourself!
Well, do you? Most don’t, but pretend. They can't make the big, tough decisions, don't trust their inner voice, so they rationalize with all kinds of excuses for being dependent on some gurus"so-called experts who are also driven by primal emotions, greed, fear, survival and self-interest.

Whatever your emotions are, they are yours, listen closely, trust them. Besides, in the end, as Jack Schwager put it in The New Market Wizards, “Whether you win or lose, you are responsible for your own results. Even if you lost on your broker's tip, an advisory service recommendation, or a bad signal from the system you bought, you are responsible, because you made the decision to listen and act - do your own thinking.” No matter what, you're stuck, lose or win. Trust yourself.

When the curtain falls, when the applause dies down, when the lights dim in that little theater inside your head, when you are stuck alone with the box office receipts, will you walk out into the night with your head high, proud of that you gave it your best, no matter what results, win or lose? What would you say to Pinter and Kahneman about your performance"good show!?

FirstPubDate: Nov’05

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