Investor, know thyself

A manic-depressive market
Say your stocks are sliding. Say your mutuals are being maimed. You try to blame the market, but have a nagging suspicion that you, personally, have had a share in the disaster. Should you have dumped those stocks sooner, or held onto the mutuals longer, in an attempt to outlast the downturn.
To economists, these questions are answered by cold-hearted analysis of numbers. But to those who study the mind, they're answered by a look inward.
Economists assume that the almighty buck is the great leveling tool. In other words, the dollar of dividend you earn from an investment in The Why Files, Inc., is worth the same as the buck you could earn delivering the paper-only version of the Files. This is despite the fact that you would have to brave sleet and snow to deliver the paper, but you can sit back and watch the dividends deposit themselves in your cash account.
If economists were paid lower wages, they'd have realized that somebody scratching up $500 for a rent payment would not treat it the same way as Michael Milken, the convicted Wall Street trader, treated the half-billion he reputedly earned at his peak. But the irrationality of the market extends far beyond that. Investors buy dumb stocks. They dump promising stocks. They hold onto losers long past the point of disaster. And they don't recognize a challenger that's going to rebound from the ropes and knock out the titleholder.
With issues like these, The Why Files decided it was time for psychoanalysis. We called John Schott, a clinical instructor in psychiatry at Tufts and Harvard Medical Schools who also manages money at Steinberg Global Asset Management, Ltd.

How do people study the psychology of investment?

For 2,000 years, there's been an informal study. The more formal study began in 1852, with the publication of book by Charles MacKay (see "Memoirs of Extraordinary Popular Delusions" in the bibliography). But in the past decade, the whole field has exploded. To look at the psychology behind the psychology, it's been caused by this phenomenal bull market.
There are two basic approaches. I look at the particular behavior of individuals. If a person has a neurotic personality, will that affect their investing? (The answer is yes, but proving it is the big problem.) The people who study behavioral finance look at understanding value investing (defined) and why the market has inefficiencies (defined).

What is the foundation of your investing approach?

Ben Graham [a legendary investment advisor], essentially said that the market acts like a manic-depressive. He put it in mathematical terms, but the metaphor was this: You have a business worth $5 million, and you have an equal partner called Mr. Market, who's affected by mood swings. One day, Mr. Market's feeling gloomy, he's sick of the business, and he offers to sell you his share for $500,000. Another day, it's the first day of spring, he thinks the business is super and he offers to buy your half for $10 million.
There are times when the whole market is manic like that -- now is one good example. There are times when individual stocks are like that. And they can be manic for no reason, or for a good reason. But these mood swings give opportunities to buy stocks at extremely low prices.

How can an investor keep track of over- and under-valued stocks?

The most common system is to use the price-earnings multiple -- the P/E ratio (defined). Currently, the S&P 500 P/E is 19.05, but historically, it runs in the 13 to 14 range. So the market is currently overvalued, even with the recent correction. Each market sector has its own historical P/E range. It's higher for growth stocks, and lower for cyclical (defined) stocks. A P/E below 10 catches the eye of value investors. A P/E over 30 is a red flag.

What's caught your eye recently?

Right now, ADM [Archer Daniels Midland, the food processor] is selling at very low price-earnings multiples. It has unassailable control over its market, it has good management, but nobody's interested in the stock. A smart money manager will recognize that as a buying opportunity. You want to buy a dollar bill for 25 cents.

How can psychology drive up individual stocks?

In today's manic atmosphere, if you create the illusion that something is rare, you can incite greed. You can legitimize that when "experts" start investing. And as prices go up, you can incite more greed. There's a feeling of being left out, say if your neighbor bought Microsoft and you didn't. A stock can develop the illusion of unlimited growth -- people think the computer industry is going to continue to grow, and that Microsoft will continue to dominate it. But if Microsoft keeps growing at the rate of the past decade, it will be about as large as the U.S. economy in 2025. That won't happen.

What kind of investor's personality has the surest hand during a downturn?

It's people who are able to not panic -- Warren Buffet [manager of Berkshire Hathaway mutual fund] is a good example. They have a sense of value, they approach the market not as a gamble, but as a business phenomenon. If the market fluctuates, they are not disturbed because they are operating on their own valuation. If they are buying an undervalued stock and the market collapses, they are happy because it gives them an opportunity to buy more when the price is even lower. The ability to independently assess a stock and stick with it is probably the most important thing.

In today's world, our perceptions of money are a changin'.

nothing There are 1 2 3 4 5 6 7 documents.
Glossary | Bibliography | Credits | Search

			How do people study the psychology of investment?
			For 2,000 years, there's been an informal study. The more formal study began in 1852, with the publication of book by Charles MacKay (see "Memoirs of Extraordinary Popular Delusions" in the bibliography). But in the past decade, the whole field has exploded. To look at the psychology behind the psychology, it's been caused by this phenomenal bull market. There are two basic approaches. I look at the particular behavior of individuals. If a person has a neurotic personality, will that affect their investing? (The answer is yes, but proving it is the big problem.) The people who study behavioral finance look at understanding value investing (defined) and why the market has inefficiencies (defined).
			What is the foundation of your investing approach?
			Ben Graham [a legendary investment advisor], essentially said that the market acts like a manic-depressive. He put it in mathematical terms, but the metaphor was this: You have a business worth $5 million, and you have an equal partner called Mr. Market, who's affected by mood swings. One day, Mr. Market's feeling gloomy, he's sick of the business, and he offers to sell you his share for $500,000. Another day, it's the first day of spring, he thinks the business is super and he offers to buy your half for $10 million. There are times when the whole market is manic like that -- now is one good example. There are times when individual stocks are like that. And they can be manic for no reason, or for a good reason. But these mood swings give opportunities to buy stocks at extremely low prices.
			How can an investor keep track of over- and under-valued stocks?
			The most common system is to use the price-earnings multiple -- the P/E ratio (defined). Currently, the S&P 500 P/E is 19.05, but historically, it runs in the 13 to 14 range. So the market is currently overvalued, even with the recent correction. Each market sector has its own historical P/E range. It's higher for growth stocks, and lower for cyclical (defined) stocks. A P/E below 10 catches the eye of value investors. A P/E over 30 is a red flag.
			What's caught your eye recently?
			Right now, ADM [Archer Daniels Midland, the food processor] is selling at very low price-earnings multiples. It has unassailable control over its market, it has good management, but nobody's interested in the stock. A smart money manager will recognize that as a buying opportunity. You want to buy a dollar bill for 25 cents.
			How can psychology drive up individual stocks?
			In today's manic atmosphere, if you create the illusion that something is rare, you can incite greed. You can legitimize that when "experts" start investing. And as prices go up, you can incite more greed. There's a feeling of being left out, say if your neighbor bought Microsoft and you didn't. A stock can develop the illusion of unlimited growth -- people think the computer industry is going to continue to grow, and that Microsoft will continue to dominate it. But if Microsoft keeps growing at the rate of the past decade, it will be about as large as the U.S. economy in 2025. That won't happen.
			What kind of investor's personality has the surest hand during a downturn?
			It's people who are able to not panic -- Warren Buffet [manager of Berkshire Hathaway mutual fund] is a good example. They have a sense of value, they approach the market not as a gamble, but as a business phenomenon. If the market fluctuates, they are not disturbed because they are operating on their own valuation. If they are buying an undervalued stock and the market collapses, they are happy because it gives them an opportunity to buy more when the price is even lower. The ability to independently assess a stock and stick with it is probably the most important thing.
			In today's world, our perceptions of money are a changin'.