Regular readers of this blog know that Behavioral Economics and Investor Psychology are two themes I frequently come back to. We know that Humans are far from the rational participants that many Economic theorists assume them to be; We also know that these same Humans, when gathered together in a herd, engage in very specific behaviors that they wouldn’t otherwise when acting alone.
Those observers who figure this out stand to benefit from this knowledge.
"Unfortunately, investors are still asleep: Most investors don’t realize they’re in denial. They still assume they’re making rational investment decisions. Worse yet, most investors are not only clueless about being irrational, they’re clueless about being clueless.
There are three reasons for this ongoing psychology of denial. First, many investors hate being irrational. Their weak egos need the myth of rationality. Second, Wall Street loves having investors trapped in the myth. A clueless investor is easy to manipulate when it comes to fees and commissions. The third reason is that most behavioral-finance books are dull, boring texts filled with jargon and cryptic formulas."
A bit harsh, but true. Farrell presents a 10-question behavioral-finance quiz that will determine if you aware, in denial, irrationa, or simply a patron of the casino. He calls the quiz "10 facts Wall Street would rather you continue denying."
See how many of the 10 you can accept:
1. Regardless of the facts, you cannot admit failure
"The greatest consistent damage to businesses and their owners is the result not of poor management but of the failure, sometimes willful, to confront reality." Same with investors and governments.
2. The market loves making fools of everybody
Ask yourself: Does 2006 look good because the first quarter closed with the best gain since 1999, or is it a sucker’s rally? History’s more important than quarterly reports. Looking back six years the market’s a loser: the DJIA, Nasdaq and S&P 500 are still below 2000′s record highs. In "Stocks for the Long Run" Jeremy Siegel studied history, the biggest up and down days from 1801 to 2000. His conclusion: Markets are random. There’s no rationale for 75% of the moves that trigger most long-term gains or losses. Investing is unpredictable.
3. Optimism is the investor’s worst nightmare
P/E ratios reflect optimism, your worst nightmare. Long-term, P/Es are still high. They’ve been under 15 most of the last century and peaked at 44.3 in 2000. They spiked over 15 twice before, once in the 1920s before the Great Depression. Again in the 1960s bull, before an 18-year sideways market. Today P/Es are 21.4, below the peak but still deceptively high. Are you overly optimistic?
4. America is like an addict who can’t stop
Our savings rate is below zero so we borrow $67 billion a month to feed our addictive consumerism. We’re insatiable, only crashing will stop us. If you’re not saving 10%, you’re spending too much.
5. Kids will rebel against their out-of-control elders
In "The Coming Generational Storm," economists Larry Klotnikoff and Scott Burns warn us about the massive debt we’re piling on our kids: Social Security, Medicare, government deficits, trade debt, corporate pensions, mortgages, credit cards. Our kids will rebel against the $70 trillion legacy created by today’s reckless out-of-control spenders.
6. We’re selling our power to Asia and the world
Back in his 1997 "Megatrends Asia," John Naisbitt predicted: "the 21st Century belongs to Asia." Our egos still can’t accept that we’re giving away our power, mortgaging our future, selling key assets, self-sabotaging.
7. Failure to plan for crises guarantees failure
Failed societies are the ones whose leaders "focus only on issues likely to blow up in a crisis within the next 90 days." Sounds like Wall Street’s fixation with quarterly earnings or Washington rebuilding Category 3 hurricane-resistant levees.
8. ‘Greed is still very good" … for Wall Street
The problem is obvious: Despite all the scandals, Wall Street is sinking deeper into a culture of greed, where investors come second. And unfortunately, Washington and Corporate America back Wall Street, not you.
9. God, oil and skyrocketing debt don’t mix
Rome, Britain and others lost power following a convergence of three trends: diminishing resources, ballooning debt and militant religions. The mix creates a blind obsession for world domination, which ultimately self-destructs. Are we in denial, or is he?
10. You can’t trust ‘them,’ they’re lying to you
Begin with this assumption: You cannot trust anyone out there, not Wall Street, not Washington, not cable, not ads, nobody. "They" are all trying to control your mind, spinning and lying all day. Skepticism wins.
Farrel claims that "Anything less than eight and you’re definitely clueless, trapped in denial, clueless about being clueless … and easily manipulated by Wall Street."
His advice? "If you do see what’s going on, then you can choose to either get out of denial and use the new concepts of behavioral finance to your advantage or continue letting Wall Street spin your cluelessness against you."
Are you a ‘clueless’ investor? Tell us how you ‘see’ these 10 facts
Behavioral finance: a psychology of denial?
Paul B. Farrell
MarketWatch, 7:00 PM ET Apr 10, 2006