Believe Your Eyes, Not Your Brains. Ask Yourself What, Not Why.

Seventeen thousand money managers around the globe pay to use BlackRock’s Aladdin risk assessment platform to manage $15 Trillion.  Therefore, nearly 7% of the world’s $225 Trillion in financial assets are being managed by people who all ponder the markets using the same tools.  As a result, 30,000 of the world’s most significant investment portfolios are kept track of by Aladdin.  And so, by default, any flaws in the system matter to every investor, not just to Aladdin subscribers.

It is my belief that there is no professional out there who truly understands the truckloads of reports and analysis that Aladdin regularly produces.  Certainly there is no way for individual investors to do their own legwork and come up with the equivalent of Aladdin’s risk models, but I submit to you that this should never be our focus.  Instead, let your eyeballs do the work.  What matters most is not why these 17,000 money managers vote with their dollars in a particular manner.  What matters most is that we see where they are deploying their assets and what they are voting for.  Believe your eyes and not your brains.  It’s their gigantic footprints that they leave all over our charts that really matter.

Source:
Gatis Roze -  Believe Your Eyes, Not Your Brains Ask Yourself What, Not Why

James Montier's Seven Immutable Laws of Investing

1. Always insist on a margin of safety

2. This time is never different

3. Be patient and wait for the fat pitch

4. Be contrarian

5. Risk is the permanent loss of capital, never a number

6. Be leery of leverage

7. Never invest in something you don't understand

Source: GMO

Cicada-Like Synchronized Traders Have Fewer Losses

"Traders who align their transactions much like cicadas synchronize their chirping make a profit more of the time, according to a study of market behaviors.

The more often traders acted within the same one-second window, the more money they made at the end of the day, according to a study in the Proceedings of the National Academy of Sciences. Traders make a profit 60 percent of the time when they're in sync, more than the overall average of 55 percent profitable trades, said study author Brian Uzzi, who is the co-director of the Northwestern Institute in Complex Systems at Northwestern University in Evanston.

Synchronized behavior benefits individuals and groups in a variety of animals, Uzzi said. Cicadas who chirp at the same time are less likely to be spotted by a predator, according to previous research. The cicada chorus, works like the trading patterns, arising spontaneously through local interactions, without a central leadership.

"If you go to animal behavior, synchronicity usually occurs when animals are faced by complex information problems, and any individual in a school of fish or flock of birds is overwhelmed," Uzzi, who also teaches at the Kellogg School of Management, said today in a telephone interview. "So it gave me the hunch that where humans are likely to be overwhelmed by the pace or volume of information, we might be able to find synchronicity."

Not 'Groupthink'

Unlike groupthink, synchronicity arises from multiple people solving the same problem separately. Groupthink, which is comparable to herding in animals, happens when traders see others trading and join. Syncing doesn't always lead to herding, and when it does, it usually takes place before the herd behavior, Uzzi said.

Uzzi's study followed 66 traders over a year and a half. The traders are talking to a few people at once, ignoring what's going on in the larger market, he said. Multiple traders are looking at different parts of the market and when they begin to process masses of information, such as IMs, RSS feeds, and news from various sources, they begin to act in concert. Trade after the sync, and the "solution" will be priced into the stock, Uzzi said.

The trades and the cicada chirps are examples of how complex systems emerge out of simple interactions. Although neither the cicadas nor the traders are centrally organized, their behavior isn't random. Trading houses may wish to design software that notices moments of sync, enabling traders to wager more money during that time, Uzzi said."

This article reminds me of the website motto: "So, what about the stock market? The universe of numbers that represents the global economy. Millions of hands at work, billions of minds. A vast network, screaming with life. An organism. A natural organism."

Source: Cicada-Like Synchronized Traders Have Fewer Losses, Study Shows

Paul Desmond's Market Musings

"On a fundamental basis, the fundamental factors are always different in every bull market or every bear market. But the technical factors are based upon something much simpler. They are based on human psychology. Investors tend to go from periods of extreme depression at market bottoms, to extreme elation at market tops. And there are always a different set of circumstances that help boost that change in psychology. But the range of human psychology remains pretty much the same. And we simply move from panic at market bottoms, fear at market bottoms, and finally we move to greed at market tops. And that is the limit of what technical analysis is really doing — measuring the psychology of investors regardless of events that may have inspired their bullishness or bearishness."

"You cannot time the market off of fundamental information, because the stock market operates off of expectations as to what is going to happen six months or nine months down the road. In other words, investors don't buy stocks because of what they know today. They buy because of what they think they are going to know six months or nine months from now. So the market is always ahead of the economy. And as a result, if you are trying to look at fundamental information, you are always too late."

"..if we were in the fall foliage season prior to winter, what we would tend to see in the trees up north, we'd start to see leaves dropping off the tree one at a time. And the stock market is very, very similar, that as you get into the latter stages of a bull market, individual stocks tend to peak out and begin to drop into their own individual bear markets, while there are still a lot of stocks continuing to advance. As the bull market becomes more and more mature, a greater number of individual stocks tend to fall off the trees, so to speak, and drift to the ground, whereas the investment community is not watching the leaves, they are watching the indexes."

"You have to be willing to buy in the face of bad news. By the same token, at market tops, the news is dominated by good news, and that is the time to watch out because if the news can't get any better then all it can do is get worse."

"..the important things for investors to realize is that market declines start out with complacency as being the most dominant emotion at that time. And the means that most people are half asleep, and they are just not paying attention. They don't think the markets can go down, so they don't think there is any need be watchful, but that is exactly when an investor needs to be particularly alert. The last stages of a decline, the very last couple of months of a market decline are the most intense, because that is when the panic sets in, and that is when it is absolutely essential that you are already out of the market. You surely don't want to go through that final stage."

Source: Q&A: Paul Desmond of Lowry's Reports

The Zurich Axioms

On Risk:
- Worry is not a sickness but a sign of health – if you are not worried, you are not risking enough.
- Always play for meaningful stakes – if an amount is so small that its loss won’t make any significant difference, then it isn’t likely to bring any significant gains either.
- Resist the allure of diversification.

On Greed:
- Always take your profit too soon.
- Decide in advance what gain you want from a venture, and when you get it, get out.

On Hope:
- When the ship starts sinking, don’t pray. Jump.
- Accept small losses cheerfully as a fact of life. Expect to experience several while awaiting a large gain.

On Forecasts:
- Human behaviour cannot be predicted. Distrust anyone who claims to know the future, however dimly.

On Patterns:
- Chaos is not dangerous until it starts to look orderly.
- Beware the historian’s trap – it is based on the age-old but entirely unwarranted belief that the orderly repetition of history allows for accurate forecasting in certain situations.
- Beware the chartist’s illusion – it is characteristic of human minds to perceive links of cause and effect where none exist.
- Beware the gambler’s fallacy – there’s no such thing as “Today’s my lucky day” or “I’m hot tonight”.

On Mobility:
- Avoid putting down roots. They impede motion.
- Do not become trapped in a souring venture because of sentiments like loyalty and nostalgia.
- Never hesitate to abandon a venture if something more attractive comes into view.

On Intuition:
- A hunch can be trusted if it can be explained.
- Never confuse a hunch with a hope.

On the Occult:
- If astrology worked, all astrologers would be rich.
- A superstition need not be exorcised. It can be enjoyed, provided it is kept in its place.

On Optimism & Pessimism:
- Optimism means expecting the best, but confidence mean knowing how you will handle the worst. Never make a move if you are merely optimistic.

On Consensus:
- Disregard the majority opinion. It is probably wrong.
- Never follow speculative fads. Often, the best time to buy something is when nobody else wants it.

On Stubbornness:
- If it doesn’t pay off the first time, forget it.
- Never try to save a bad investment by “averaging down”.

On Planning:
- Long-range plans engender the dangerous belief that the future is under control. It is important never to take your own long-range plans or other people’s seriously. In essence these axioms point to the benefit of having an investment strategy and sticking to it, regardless of what other investors say or do. If you don’t have an investment strategy, you could do worse than adopt these principles. However, don’t be afraid to add or subtract ones according to what works for you.

Source: Max Gunther's Zurich Axioms via TBP

Secret of Film Success

The Cocktail Party Market Indicator

“If the professional economists can’t predict economies and professional forecasters can’t predict markets, then what chance does the amateur investor have? You know the answer already, which brings me to my own ‘cocktail party’ theory of market forecasting, developed over the years of standing in the middle of living rooms, near punch bowls, listing to what the nearest ten people said about stocks.

In the first stage of an upward market – one that has been down awhile and that nobody expects to rise again – people aren’t talking about stocks. In fact, if they lumber up to ask me what I do for a living, and I answer, ‘I manage an equity mutual fund,’ they nod politely and wander away. If they don’t wander away, then they quickly change the subject to the Celtics game, the upcoming elections, or the weather. Soon they are talking to a nearby dentist about plaque. When ten people would rather talk to a dentist about plaque than to the manager of an equity mutual fund about stocks, it’s likely the market is about to turn up.

In stage two, after I’ve confessed what I do for a living, the new acquaintances linger a bit longer – perhaps long enough to tell me how risky the stock market is – before they move over to talk to the dentist. The cocktail party talk is still more about plaque than about stocks. The market is up 15 percent from stage one, but few are paying attention.

In stage three, with the market up 30 percent from stage one, a crowd of interested parties ignores the dentist and circles around me all evening. A succession of enthusiastic individuals takes me aside to ask what stocks they should buy. Even the dentist is asking me what stocks he should buy. Everybody at the party has put money into one issue or another, and they’re all discussing what’s happened.

In stage four, once again they’re crowded around me – but this time it’s to tell me what stocks I should buy. Even the dentist has three or four tips, and in the next few days I look up his recommendations in the newspaper and they’ve all gone up. When the neighbors tell me what to buy, and then I wish I had taken their advice, it’s a sure sign that the market has reached a top and is due for a tumble.”

-Peter Lynch, One Up On Wall Street

Source: The Big Picture

The Seven Sins of Fund Management

“This collection of notes aims to explore some of the more obvious behavioral weaknesses inherent in the ‘average’ investment process. Seven sins (common mistakes) were identified:

1. The first was placing forecasting at the very heart of the investment process. An enormous amount of evidence suggests that investors are generally hopeless at forecasting. So using forecasts as an integral part of the investment process is like tying one hand behind your back before you start.

2. Secondly, investors seem to be obsessed with information. Instead of focusing on a few important factors (such as valuations and earnings quality), many investors spend countless hours trying to become experts about almost everything. The evidence suggests that in general more information just makes us increasingly over-confident rather than better at making decisions.

3. Thirdly, the insistence of spending hours meeting company managements strikes us as bizarre from a psychological standpoint. We aren’t good at looking for information that will prove us to be wrong. So most of the time, these meetings are likely to be mutual love-ins. Our ability to spot deception is also very poor, so we won’t even spot who is lying.

4. Fourthly, many investors spend their time trying to ‘beat the gun’ as Keynes put it. Effectively, everyone thinks they can get in at the bottom and out at the top. However, this seems to be remarkably hubristic.

5. Fifthly, many investors seem to end up trying to perform on very short time horizons and overtrade as a consequence. The average holding period for a stock on the NYSE is 11 months [in 2005, nowadays is less, according to the same author]! This has nothing to do with investment; it is speculation, pure and simple.

6. Penultimately, we all appear to be hardwired to accept stories. However, stories can be very misleading. Investors would be better served by looking at the facts, rather than getting sucked into a great (but often hollow) tale.

7. And finally, many of the decisions taken by investors are the result of group interaction. Unfortunately groups are far more a behavioral panacea. In general, they amplify rather than alleviate the problems of decision making.

Each of these sins seems to be a largely self imposed handicap when it comes to trying to outperform. Identifying the psychological flaws in the ‘average’ investment process is an important first step in trying to design a superior version that might just be more robust to behavioral biases.”



Source:

James Montier – Seven Sins of Fund Management

Why we love predictions

"Behavioral scientists have discovered that at the core of the dislike human beings have for randomness, is an overwhelming desire to believe we are in control. "Knowing" that the S&P 500 will close at 1,450 next year gives investors that feeling of control, even though it gets us into the stock market after it has doubled."

Below you have some healthy advice about the "The Folly of Forecasting":

"Whenever you find yourself reading (or watching) someone who tells you where a stock or the markets are going, consider these factors:

- No one truly knows what tomorrow will bring. Nobody. Any and all forecasts are, at best, educated guesses.

- All prognostications are instantly stale, subject to further revision. Conditions change, new data are released, events unfold. Yesterday's prediction can be undone by tomorrow's press release.

- In order to "become right," some investors will stand by their predictions despite a stock or the market going the opposite way, hoping to be proven correct. Ned Davis called this the curse of "being right rather than making money."

Sources:

Allan Roth - 5 Financial Predictions for 2011

Barry Ritholtz - The Folly of Forecasting

On Conventional Wisdom

“… it is the long-term investor … who will in practice come in for most criticism wherever investment funds are managed by committees or boards or banks. For it is the essence of his behavior that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

Source: John Maynard Keynes via Investment Postcards

Behavioral Vulnerabilities

Source: Butler/Philbrick

Behavioral Investment Tips

Top tips for better decision making

This applies to me, you and everyone else.

You know less than you think you do.

Be less certain in your views, aim for timid forecast and bold choices.

Don’t get hung up on one technique tool, approach or view – flexibility and pragmatism are the order of the day.

Listen to those who don’t agree with you.

Top tips for better decisions

You didn’t know it all along, you just think you did. Forget relative valuation, forget market prices, work out what the stock is worth (use reverse DCFs).

Don’t take information at face value, think carefully about how it was presented to you.

Don’t confuse good firms with good investments, or good earnings growth with good returns.

Vivid, easy to recall events are less likely than you think they are, subtle causes are underestimated.

Try to focus on facts, not stories.

Sell your losers and ride your winners.

Beating the biases

Being aware of the biases is not enough. It is just an important first step.

Need to create a framework that incorporates mental best practice. Easier said than done. Mental bad habits are persistent.

The good news, we continue to create new brain cells throughout our lives.

Source:

James Montier - Behavioural Finance: Insights into Irrational Minds and Markets

Bob Farrell’s 10 Market Rules to Remember

Wall Street “gurus” come and go, but in the case of Bob Farrell legendary status was achieved. He spent several decades as chief stock market analyst at Merrill Lynch & Co. and had a front-row seat at the go-go markets of the late 1960s, mid-1980s and late 1990s, the brutal bear market of 1973-74, and October 1987 crash.

Farrell retired in 1992, but his famous “10 Market Rules to Remember” have lived on and are summarized below. The words of wisdom are timeless and are especially appropriate as investors grapple with the difficult juncture at which stock markets find themselves at this stage.

1. Markets tend to return to the mean over time

When stocks go too far in one direction, they come back. Euphoria and pessimism can cloud people’s heads. It’s easy to get caught up in the heat of the moment and lose perspective.

2. Excesses in one direction will lead to an excess in the opposite direction

Think of the market baseline as attached to a rubber string. Any action too far in one direction not only brings you back to the baseline, but leads to an overshoot in the opposite direction.

3. There are no new eras – excesses are never permanent

Whatever the latest hot sector is, it eventually overheats, mean reverts, and then overshoots. Look at how far the emerging markets and BRIC nations ran over the past six years, only to get cut in half. As the fever builds, a chorus of “this time it’s different” will be heard, even if those exact words are never used. And of course, it – human nature – is never different.

4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways

Regardless of how hot a sector is, don’t expect a plateau to work off the excesses. Profits are locked in by selling, and that invariably leads to a significant correction eventually.

5. The public buys the most at the top and the least at the bottom

That’s why contrarian-minded investors can make good money if they follow the sentiment indicators and have good timing. Watch Investors Intelligence (measuring the mood of more than 100 investment newsletter writers) and the American Association of Individual Investors Survey.

6. Fear and greed are stronger than long-term resolve

Investors can be their own worst enemy, particularly when emotions take hold. Gains “make us exuberant; they enhance well-being and promote optimism”, says Santa Clara University finance professor Meir Statman. His studies of investor behavior show that “Losses bring sadness, disgust, fear, regret. Fear increases the sense of risk and some react by shunning stocks.”

7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names

This is why breadth and volume are so important. Think of it as strength in numbers. Broad momentum is hard to stop, Farrell observes. Watch for when momentum channels into a small number of stocks.

8. Bear markets have three stages – sharp down, reflexive rebound and a drawn-out fundamental downtrend

I would suggest that as of August 2008, we are on our third reflexive rebound – the January rate cuts, the Bear Stearns low in March, and now the Fannie/Freddie rescue lows of July.
We have yet to see the long-drawn-out fundamental portion of the bear market.

9. When all the experts and forecasts agree – something else is going to happen

As Stovall, the S&P investment strategist, puts it: “If everybody’s optimistic, who is left to buy? If everybody’s pessimistic, who’s left to sell?” Going against the herd as Farrell repeatedly suggests can be very profitable, especially for patient buyers who raise cash from frothy markets and reinvest it when sentiment is darkest.

10. Bull markets are more fun than bear markets

Especially if you are long only or mandated to be fully invested. Those with more flexible charters might squeak out a smile or two here and there.

Source: Investment Postcards

Fibonacci, Fractals and Financial Markets

The Illusory World of Economic Forecasting

"William Sherden did research on the accuracy of leading forecasters over a few decades, and his findings were summarized in his book "The Fortune Sellers: The Big Business of Buying and Selling Predictions." And his conclusions are still accurate:
"They are timeless. The political influence on predictions is basic human nature. I see no way that economic forecasting can improve since it is trying to do the impossible."

Here are Sherden's top 10 findings in The Fortune Sellers:

1. The forecasting skill of economists is on average about as good as guessing. In fact, predictions by the politically driven Council of Economic Advisors, Federal Reserve Board and Congressional Budget Office were often worse than guessing.
2. Economists cannot predict the turning points in the economy. Of 48 predictions made by economists, 46 missed the turning points.
3. Economic forecasting accuracy declines with longer lead times.
4. No economic forecasters consistently lead the pack in accuracy.
5. No economic ideology consistently produces superior forecasts.
6. No economic forecaster has consistently higher forecasting skills predicting any particular economic statistic.
7. Consensus forecasts do not improve accuracy (although the press loves them).
8. Psychological bias affects forecasters and their forecasts. Some economists are naturally optimistic and bullish, others are consistently pessimistic bears.
9. Increased sophistication provides no improvement in forecasting accuracy. Remember the Long-Term Capital Management hedge fund? Two brilliant Nobel Economists backed by Wall Street's elite nearly sabotaged the world economy.
10. Finally, Sherden says there's no evidence that economic forecasting has improved in recent decades. In fact, forecasting appears to be deteriorating as partisan politics, Wall Street gaming and unpredictable global events invent new illusions."

Therefore..always bet against the forecasters!:)

Source:

The Illusory World of Economic Forecasting

The Big Picture