The first time our canoe capsized in the Congo river, I immediately called out for my traveling companion. He was a poor swimmer, and we were in the milky brown rapids just above Kisangani (formerly Stanleyville).

The day before we hadn't prepared well for the canoe trip. We had needed to escape town in a hurry as the police shakedowns - common in Africa at that time, 1996 - were intensifying. My buddy elected to buy our dugout canoe himself while I changed money. We might have been OK through the rapids had my companion 1) had canoeing experience (I should have asked), 2) not been stoned when he bought the canoe (sadly he was always stoned, so I'm not sure if it would have made a difference), and 3) bought a larger canoe.

The morning of our launch we tried to escape police detection by arising early and fleeing our hotel at 4am. We loaded our petite canoe on the bank of the Congo at 5am, and set out into the Congo River above the town.

Kisangani is built just below the famous rapids that block further navigation of large boats from Kinshasa. As we watched the lights of the still-sleeping city come into view around a bend, the roaring sound that I thought was insects in the night continued to grow louder. I recalled with dread a few lines from Heart of Darkness: "There were rapids in the river here, and the sound of rushing water drowned out everything else." We tried to turn towards shore, but it was too late. We floated into the rapids, ascended up the crest of a massive surge of whitewater, and slid down into a minor whirlpool, swamping the canoe.

We were lucky after capsizing. I'm a good swimmer, and my buddy managed to haul himself onto our sack of money. (Due to hyperinflation, Zaire's largest bill was worth about $0.20, so we had piles of money stored in a waterproofed bag that floated high and dry. That bag was also a favorite target of the police).

Some events in life make you swear to never repeat them. For me, crossing Zaire in 1996 was one. After surviving that trip, I tried to understand what I could have done differently. I started learning more about political risk, I gained a greater understanding of failed economies, and I looked to better manage the risk of those who make decisions around me. In hindsight, we should have prepared better. And at its core it was a learning experience, which is what all worthy goals are, as we'll discuss later in the newsletter.

Navigating the financial markets is like canoeing across a river. Markets experience periods of calm. Investing in calm markets requires little skill or practice or even awareness of what you're doing. Markets also experience periods of crisis just as there are rapids in rivers. We cannot control the river, and so we must prepare. Within our control is how we learn about and train for contingencies, how we maintain mental flexibility, and how we adapt to unforeseen circumstances. But the chaos of the water itself is completely out of our control.

In 2013 the average hedge fund returned just over 8% according to Hedge Fund Research, while the U.S. equity market (S&P 500) returned over 26% and the Nasdaq over 38%. The stated expected return of most hedge funds is 10 to 20% annually, so with returns of 8% in an extremely positive year for equities, they are sorely lagging expectations. Why?

Every year at this time professional investors set goals and prepare for the new year, and every year they tend to make the same two mistakes. Their recent experiences color their risk forecasts, and they do not prepare appropriate goals. This month's newsletter examines how to set proper goals for 2014, looks at last year's U.S. equities rally, China, and lays out a vision for the year ahead. As you'll see (and hopefully experience) in the next sections, setting effective investment goals involves maintaining a big picture perspective, relying on internal goals, staying mentally flexible, and most importantly, creating a vision.

MENTAL BAGGAGE

Too often we bring too much mental baggage to our investing, like excessive heavy gear on a canoeing expedition. And just as a canoe can be weighted down by baggage and become more susceptible to swamping, too often our investing is made vulnerable by weighty preconceived notions about how the markets should work and what to expect. Such heavy baggage diminishes maneuverability and renders us more vulnerable.

The first common mistake arises because investors prepare for a future based onhow they feel right now. If they are coming into the new year in a bunker mentality, having emerged from a crisis, then they are bringing in lessons from the crisis. They've learned that what works is protecting themselves, and they keep their heads down for the next year. Yet when equity market out-performance resumes as it did in 2013, they tend to first rationalize why the market is wrong, and then - often too late - join the party. This stubborn reliance on old patterns is the first cause of hedge fund under-performance in 2013.

The second mistake, and likely the most important, is that fund managers don't structure their goals properly. Most managers think of financial goals as if they are athletes working hard toward an external end point. While external goal-directed thinking is good for short-term motivation and performance, it often leads to sub-par results in the long-term. Fixed external goals are more likely to provoke emotional reactions when managers perceive themselves moving away from their expectations - either positive or negative. Using external (numerical) goals is the second cause of hedge fund under-performance in 2013.

IT&39;S A MARATHON, NOT A SPRINT

Winning isn't everything, but wanting to win is.
Vince Lombardi

The first key to successful investment goal-setting is to always keep the long game in mind.

Financial losses stimulate the release stress hormones such as cortisol and peptides such as epinephrine (adrenaline) which have the unfortunate cognitive effect of focusing attention on the short-term. Attention is pulled in close, and investors unknowingly and gradually abandon their longer term process and the discipline that surrounds it. Stressed investors with 3-year holding periods start thinking 6 months ahead, and stressed traders move from hourly to minutely holding periods.

Reappraisal refers to expanding one's perspective. Researchers find that cognitive “reappraisal” reduces the impact of loss aversion on decision-making (Thinking Like a Trader, PNAS, 2009). In their trading experiment, the researchers randomly asked subjects to think of their individual investments under the following conditions: (1) as part of a portfolio, (2) as one of many in a series, (3) as part of a routine job, (4) as expecting that losses are going to happen (“you win some and you lose some,”), and (5) as not having direct consequences to their lives. In aggregate these cognitive reappraisals reduce both physiological reactions to losses (measured via galvanic skin response) and subsequent loss-averse behavior. According to the authors, “‘perspective-taking,’ uniquely reduced both behavioral loss aversion and arousal to losses relative to gains, largely by influencing arousal to losses.” As a result, it's likely that such reappraisals lead to higher long term returns.

When you find yourself emotionally reacting to short-term losses, take a step back and re-orient on the big picture by reminding yourself of the realities of (1) to (5) above:

(1) Your loss is only one part or your overall portfolio,
(2) You've experienced many losses before, and you've always worked your way back,
(3) Loss are a routine part of investing - part of the fabric of the work,
(4) Remind yourself that losses are going to happen (“you win some and you lose some,”), and
(5) Remember that the loss has no (or little) consequence to your overall life.

SETTING INTERNAL GOALS

Q: "What do you call an economist with a forecast?"
A: "Wrong."
~ Adapted from WSJ

While many investors imagine themselves to be elite athletes of the markets, few realize that setting athletic-type external goals guarantees self-sabotage. It makes sense to model elite athletes' drive, determination, and achievement in oneself. And some of the psychological tools athletes use are appropriate to investing. Yet in investing input does not necessarily equal output, while in athletics the relationship is more direct. Investing is not a game in which hard work or late nights in the office guarantee higher returns. The key to succeeding in investing is to refine one's process, know oneself, and match the process to who you are. Your inputs must be smart - efficient, time-maximizing, and directed towards an internal vision, not towards a discrete outcome.

Carol Dweck (a professor at Stanford University) has gathered evidence suggesting that pursuing fixed external goals (good grades, material outcomes, high investment returns) leads to lower overall performance than pursuing internal goals (learning or process goals). Dweck notes that optimal motivation relies not on intellectual intelligence or a level of ability, but rather on a mindset of curiosity and belief in the ability to learn. Her book Mindset describes her research. (Personally, I found her academic studies easier reading than her slow-paced book).

Internal goals are controllable, process-oriented goals. What can you control about investing? Risk management, testing, process framework, researching, and learning from history are all controllable. Focusing on external goals that are beyond your immediate control such as profits, accuracy, and other market-dependent feedback sets one up for emotional self-sabotage.

STAYING MENTALLY FLEXIBLE

It is not enough to take steps which may some day lead to a goal; each step must be itself a goal and a step likewise.
Johann Wolfgang von Goethe

Markets change, and your approach should adapt. To remain adaptable, we must cultivate mental flexibility, reviewing and revising our plans throughout the process. Mental flexibility is founded in work-life balance. It's important to strive for overall balance in sleep habits, exercise, diet, social life, and recreation. If you get off track on these basics, prioritize getting back on. Without a stable foundation, the rest of your efforts will be fragile.

LEARNING FROM 2013

As you review your 2013 gone past, consider how you can learn from your experience. For example, ask yourself with curiosity:

What did I miss in 2013, and how/what can I learn to avoid repeating this?
1) Were you stuck in fears of another financial crisis and missed the regime-change that underlay the 2013 rally? Such stuckness, should prompt a goal of learning about the catalysts that underpinned the rally of 2013 so they can be identifIed in the future.
2) Were you so in love with emerging markets due to high past returns that you missed the re-emergence of economic and political growing pains in Brazil, Turkey, China, and India? Such a mistake should prompt a goal of learning about the cycle of development, and how to understand the political and economic underpinnings of a durable equity market rally.
3) Did you miss the rise of Bitcoin? If so, a worthy goal involves learning to identify the factors that fuel the rise of major trends (and when they reverse).

Then ask yourself, how can I apply the lessons of 2013 to improving my process in 2014?

Now set some learning and development goals. Don't set fixed numerical goals that aren't attached to a feeling - you can't ultimately control what the markets do, yet you can manage your process as you learn to better navigate them over your career.

CREATE A VISION

“Formulate and stamp indelibly on your mind a mental picture of yourself as succeeding. Hold this picture tenaciously and never permit it to fade. Your mind will seek to develop this picture!”
Dr. Norman Vincent Peale

It's not quite as easy as Dr. Peale suggests above, but it's not terribly difficult either. Ask yourself, how would you like to see yourself at the end of the year? Create a vision and feel how you are living at the end of this year when the goal is accomplished. Your vision must be believable. Feel the vision as if it is happening now, and imagine yourself in that state of mind, who you're speaking with, where you are in your home and professional life.

In this paper, Keith Chen at Yale notes that the construction of a language's grammar is correlated with savings rates and other long-term economic behavior of it's native speakers. Languages with explicit future tenses have populations who generally save less. For example, the construction "I will save money from my next paycheck" leads to a separation between your present-self and your future-self. And we're more likely to see that future self as apart from us, and are thus less attentive to his/her needs. In German or Chinese the same statement would be uttered, "I save money from my next paycheck," which represents continuity with one's present self and correlates with a higher savings rate.

Keith Chen's study indicates that if we want to better prepare for the future, we should imagine ourselves already in the desired state. Interestingly, Abundance, Law of Attraction, and New Age self-help teachings encourage goal-setters to experience their goals as already-achieved. This wisdom parallels Keith Chen's findings.

Ask yourself, how am I living my intention for 2014? How about for the next 5 years? 20 years?

In the next newsletter we'll look at the optimal way to handle setbacks and slumps if your goals start slipping away during the year.

TRADING CORNER

Life can be pulled by goals just as surely as it can be pushed by drives.
Viktor Frank

At the beginning of January 2013 I attended a Chinese economic forecasting meeting on Wall Street. Many in the crowd were bullish on Chinese equities. The Chinese equities indexes seemed to have bottomed after the central government moved in to provide a base of support. And the economy was cruising along nicely. The only worrying sign was the uniformity of the bullishness, which a friend of mine adroitly pointed out to me (as I gushed on the potential of China for 2013).

Our recent Thomson Reuters MarketPsych Indices (TRMI) research has focused on identifying what factors drive asset prices. We've found that various ideas - macroeconomic topics, general sentiments, and price discussions - when prevalent in the news and social media flow, lead shifts in asset prices.

Using the TRMI I noticed the surge of Joy in the economic commentary about China in late 2012 and early 2013. This isn't necessarily a bad thing. It's when Joy fades that the stock market is vulnerable. Interestingly, the Joy appears to be fading again in December 2013 (after many ups and downs this year). Note in the chart below that there have been several spikes in Joy about Chinese equities over the past 3 years:

In looking at the broader macroeconomic drivers of U.S. stocks since 2008, we've found that the macroeconomic variable CreditEasyVsTight is significantly predictive of broad shifts in U.S. stock prices over that period.

The following image depicts a Classification Tree for our United States variables and how they predict the S&P 500. Classification Trees are a statistical technique similar to decision trees. The trees identify which variables are most highly predictive of a dependent variable in a hierarchical fashion. In this case the S&P 500 monthly return is the dependent variable, and the prior month's TRMI index values are the dependent variables. Classification trees identify the most important factors predicting prices over a period of time, but they aren't necessarily predictive of the future.

The tree below shows that over the past 72 months (6 years), if the variable CreditEasyVsTight was high (if business credit is reported to be easy in the news), which is true of 53% if the sample, then the S&P 500 rises the following month 84% of the time, and if they are NOT grousing about the U.S.. government being corrupt (GVTCORR = GovernmentCorruption, a mark of disenfranchisement), then the S&P 500 rises all but one of the following months, 97% of the time. If business credit is reported to be relatively tight (47% of the months in the sample), then the S&P 500 tends to fall 62% of the following months, and if social media discussions are emphasizing high interest rates at the same time, then the odds of decline over that period rise to 81% of the following months.

This combination (tightening credit and high interest rates) may lead to U.S. equity market declines going forward as the Fed slowly tapers bond-buying. And I wish it were that simple to diagnose a falling market based on recent Fed action and interest rates, but it's not. Only subscribers may read on for our prognostications on 2014.

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HOUSEKEEPING AND CLOSING

“Imagination is more important than knowledge. For while knowledge defines all we currently know and understand, imagination points to all we might yet discover and create.”
Albert Einstein

Remember to engage your imagination as you set your goals for 2014. If you can feel it, live it, and believe it, then you will set your mind and body in motion towards achieving it.

Please contact us if you'd like to see into the mind of the market using our Thomson Reuters MarketPsych Indices to monitor market psychology and macroeconomic trends for 30 currencies, 50 commodities, 120 countries, 40 equity sectors and industries, and 5,000 individual equities extracted in real-time from millions of social and news media articles every day.

We love to chat with our readers about their experience with psychology in the markets and with behavioral economics! Please also send us feedback on what you'd like to hear more about in this area.

Happy Investing!
Richard L. Peterson, M.D. and the MarketPsych Team

REFERENCES

Sokol-Hessner, Peter, Ming Hsu, Nina G Curleya, Mauricio R. Delgado, Colin F. Camerer, and Elizabeth F. Phelps. 2009. “Thinking Like a Trader Selectively Reduces Individuals’ Loss Aversion.” Proceedings of the National Academy of Sciences 106: (13):, 5035–5040.

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