We go out of our course to make ourselves uncomfortable; the cup of life is not bitter enough to our palate, and we distill superfluous poison to put into it, or conjure up hideous things to frighten ourselves at, which would never exist if we did not make them.
~ Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds, 1841

The first time I ate chimpanzee was in 1996 in Zaire (now Congo). At the time I was traveling across central Africa by road, but the road became impassable. After a failed attempt to canoe the Congo river (as described in the opening of this prior newsletter), with two other travelers we assembled a raft to proceed downriver Joseph Conrad-style.

While traveling down the river on our raft, we ran out of food. We had left Kisangani in a hurry and had lost some provisions to the river rapids. In order to eat we bought bush meat from local hunters. Unfortunately, we soon ran out of coal for our cooking stove. In order to replenish our cooking coal and food supplies, we decided to make a pit-stop in Bumba on the northern bank of the Congo river. We were floating near the southern bank, but visually the northern bank of the river looked only about a mile away on the morning we decided to cross. But that was an island. In fact it was seven miles across, and after an exhausting and hungry paddle, we arrived at the tail end of the city at sunset.

We tied up our raft near an open-air market, and the first food stall I encountered was surrounded by a boisterous group of men around a metal vat full of bubbling stew. One man placed a bowl of meat stew in my hands and encouraged me to eat up. I was half-starving, they were friendly, and the stew smelled delicious.

It was a wonderful dish - smooth with lightly textured meat and spiced exquisitely. The men were asking me questions in broken, heavily-accented French, and it took me a few minutes to understand - as I scraped the last bits from my bowl - that they were asking me if I'd eaten chimpanzee before.

Chimpanzee is a delicacy in central Africa, said to increase strength and virility. Unfortunately I was also aware that the body fluids of infected chimpanzees were the vector that caused the 1995 outbreak of Ebola virus in Zaire, in that same region.

I put down my empty bowl with a grim expression, concern gripping my mind. I interrogated the men in urgency - "Where did you get this chimpanzee?!" "Was the chimpanzee found dead in the forest or killed while alive!?" "Haven't you heard of Ebola fever?!" The men were baffled why I cared about the pre-morbid state of my dinner, and I was unable to get a satisfactory response.

I developed a fever a few days later, and I was seriously worried that I had contracted Ebola. Perhaps, I thought, my death was imminent.

Having feared I would die from Ebola, I know how easy it is to overreact to the danger of an infectious disease. In fact, as humans we're genetically programmed to overreact.

Such overreactions frequently occur in markets. Our hedge fund strategies used to profit from such outbreaks, as you will see below in the Swine Flu example. Today's newsletter focuses on investors' propensity to overreact to danger, the patterns this phenomenon creates in markets, and how self-controlled investors take advantage of such panics. We also have a section on trading strategies and recent events in Hong Kong, and a section on Apple and the psychology of the iPhone 6 release. This newsletter is the fourth in our series on the success traits of top investors, and this month we focus on the management of fear.

The Fear In Your Genes

In investing there is a premium on the ability to stay cool under pressure. Such investors are less likely to panic after hearing of one person diagnosed with Ebola in their city. In fact, they do thorough research and ascertain that Ebola is much less contagious in the developed world than fear would lead one to believe. They are able to think about the optimal timing for shorting pharmaceutical stocks that have spiked on Ebola fears (e.g., when the Ebola scare starts to recede from the news, as it is now doing). We want to think that such teflon-traders are made, not born, but recent research on genetics is overturning our cherished notions of free will.

Our ability to trade against fear is in large part genetic.

Several traits influence how we take investment risk including personal background, life experiences, age, and gender. Gene-environment interactions are also important. But primary among these influences is our personal genetic endowment.

Consider a polymorphism of the serotonin transporter gene: 5-HTTLPR. Individuals carrying the short polymorphism of this gene are more likely to develop depression in response to negative events and are more likely to experience a long-term emotional impact from financial losses. In some studies, people carrying this polymorphism experience more financial anxiety than others.

Kuhnen and Chiao (2009) had previously reported that this polymorphism biased investment preferences among a sample of university students. Students who are homozygous for the short form of the transporter - the s/s allele - took 28% less investment risk in their study.

Building on this work, Gregory Samanez-Larkin, Camelia Kuhnen, and Brian Knutson examined the investing habits, genetics, and beliefs of a group of 60 retail investors in this excellent study. They showed that all factors have some explanatory power over investment risk-taking, but that genes appear to be the strongest contributor. Our genes - an element out of control - determine the majority of our financial risk taking (the contribution of the personality trait neuroticism to risk taking is accounted for by the 5-HTTLPR variant).

This is a dramatic conclusion, and it's important to qualify that it hasn't been replicated on other genes. It's disturbing to discount the valuable notion of free will. But it's only when we recognize that much of what we THINK is in our control actually is not, that we can we then accurately forecast and plan for our errant investing behaviors.

Meanwhile, the vast herd of investors is reading news and reacting in a knee-jerk biological manner. And the saavy (and self-controlled) investor can take advantage of the surges of market fear and relief.

To Catch the Falling Knife

All through time, people have basically acted and reacted the same way in the market as a result of: greed, fear, ignorance, and hope. That is why the numerical formations and patterns recur on a constant basis.
~ Jesse Livermore, How To Trade In Stocks

We experienced a textbook fear-based sell-off this week in the U.S. equity market on Ebola fears. In our research we've found that many types of negative news cause investors - and market prices - to overreact, from news that strikes fear to news that inspires investor anger.

After a rally in healthcare stocks on Ebola fear, the prices are likely to reverse and fall back to their original levels, creating a what-goes-up-must-come-down event - that is overreaction. Overreaction also describes when stocks fall in panic - as airlines did this week on the Ebola scare - and then rally back once the fear begins to abate. In both cases, investors are mispricing an asset due to biased risk perceptions, and the mispricing will shortly correct.

When panic abates, there is typically a pause before the price bounces. Fear has a refractory period in which - after the danger has passed - the sufferer takes some time to catch their breath.

When we ran our hedge fund based on text-analytics several years ago, we were lucky enough to be managing it during the Swine Flu scare. There have been several such scares - bird flu, mad cow, SARS, etc... - they seem to happen every 2 years or so.

We executed the below trade in American Airlines stock (AMR) during the Swine Flu anxiety. Our quantitative signalling systems indicated that investors were overreacting to Swine Flu by inappropriately selling off airlines and other leisure stocks in a panic. We stepped in to buy once the panic appeared to be abating.

We see that this pattern of overreaction happens not only during infectious pandemics. And it is not only due to Fear. In fact, Anger is a more consistent predictor of equity prices than Fear.

On average investors are overreacting in anger every week or so, across sectors and industries. The below equity curve shows the profits to be had from taking a group of 15 of the top long-only U.S.-listed ETFs, ranking them by Anger on one week, and then buying the most Angry 20% of ETFs on the open the following week and shorting the 20% of least Angry ETFs at the open. Hold them for one week and then repeat the process. This creates a market-neutral portfolio that performs emotional arbitrage of Angry overreaction.

Both fear and anger are markers of overreaction to negative news or information, and anger is more consistent than fear. Fear occurs in bursts, while the equity curve for anger arbitrage is quite smooth.

Emotionally stable investors can "wade into the fray" even when it looks like all is lost. They know that such periods are the best times for outperformance.

Trading Global Overreaction

I was in the wonderful city of Hong Kong last week, enjoying the hospitality of Macquarie Securities and meeting lots of wonderful people. The protests had not yet begun (or at least I didn't encounter them), and I spent most of my free time marveling at the amazing infrastructure and the groups of mainlanders reselling piles of iPhone 6's outside of the Hong Kong Apple store (more on Apple below).

From the perspective of overreaction, Hong Kong investors may be the most susceptible to overreaction. I'm not saying that the political conflict is not important, rather I'm referring to results of quantitative analytics of our Hong Kong stock sentiment data.

Using a basket of the largest Hong Kong-listed stocks, our Head of Research CJ Liu created the following equity curves. He took a group of the most buzzed-about Hang Seng stocks in the news over the past week. He then ranked them by the Sentiment (Positive to Negative) expressed in the news about that stock. On the following Monday morning at the open, he went short the most positive stock(s) and long the most negative stock(s). This was repeated week after week and the returns tallied into the below equity curve. This strategy goes against the prevailing sentiment, betting on a weekly reversal in stock price against the common sentiment.

As you can see in the various equity curves, the results are staggering (excluding transaction costs). The most impressive is an 80-fold return from buying the single most negative of the top 5 Buzz stocks and shorting the single most positive stock in that group.

CJ performed several other sensitivity analyses and found this to be a robust effect. Again, we see that it is useful to buy on negativity/fear on a weekly basis (and to sell on exuberance).

So what does this pattern say about the current Hong Kong protests?

Hong Kong Protests

Hong Kong's Hang Seng equity index is down more than 8.7% over the past month. An image of global SocialUnrest in Hong Kong from a few days ago is below. Hong Kong being part of China, you can see that Hong Kong's protests have not only precipitated a fall in the Hang Seng index, but they have been dominating the English news about China generally.

Given what we know about negative overreaction, share prices in Hong Kong are likely to rally over the net week or two. Adding fuel to the rally - there is considerable enthusiasm about the Shanghai-Hong Kong Connect, and prices are likely to experience positive pressure into the date of that event (pushed from October into November).

It's not only emotional reaction to the downside that we need to manage, it's also exuberance to the upside, as we discussed in last month's newsletter. The release of the iPhone 6 is a recent example of that phenomenon.

Excitement for the iPhone 6

We find that whole communities suddenly fix their minds upon one object, and go mad in its pursuit; that millions of people become simultaneously impressed with one delusion, and run after it, till their attention is caught by some new folly more captivating than the first.
~ Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds, 1841

Over the years we have found that Apple is one of the most psychology-driven stocks in the market. The emotional overreactions to the products themselves often drive the stock price, as you can see in the below 2002 Wall Street Journal mention of the price pattern:

The Cupertino, Calif., company's stock increasingly has been caught in a strange cycle: In recent years, the shares have run up strongly in advance of product debuts -- and declined thereafter. In a December study from Morgan Stanley, analyst Gillian Munson found that in three of five cases after Apple launched a new computer since 1997, its shares slipped. Of those three occasions, the stock fell an average 19% in the ensuing six months, she noted.
~ Pui-Wing Tam. January 3, 2002. "Apple’s stock may tumble after new products debut." The Wall Street Journal.

I first wrote a paper about positive overreaction that mentioned the pattern in Apple in 2002. We have followed Apple over the years, and a presentation slide on the positive overreaction to last year's iPhone 5 release is below:

We found the same emotional pattern before the iPhone 6 release. Despite massive sales and high levels of enthusiasm, the stock price of AAPL did not stay up after the launch, as our MarketRisk (a.k.a. Bubbleometer) metric forecast. The red shading indicates the negative price pressure on AAPL due to the over-exuberance:

How Not to Panic When you think you have Ebola

A key challenge of investing is the proper balance between rational and irrational fear. This month's newsletter focuses on fear-based overreaction, and in this section we explore a few techniques for managing such contagious fear.

Chronic fear creates stress and impairs one's fluidity of thinking. Stress creates biases in our style of thinking including catastrophization (believing the worst case is more likely than it actually is), black-and-white thinking (all-or-none, global epidemic vs no big deal), and over-generalization (believing that all related issues are similar, such as all healthcare stocks are worth buying in case of an Ebola spread). Stress also impairs judgment and even health: see cautionary tales of stress among investors in this Newsweek article.

The key to managing fear and stress lies in prevention first, then stress-reducing lifestyle habits, and then management of acute stress (e.g., panic). A MarketPsych write-up on stress management is here.

Staying grounded in the midst of chaos is a lifelong effort of the mind. Investing greats such as Bill Gross, Ray Dalio, and others utilize meditations that improve stress management and boost insight. At MarketPsych we prepared a simple acronym to remind you of the importance of staying G-R-O-U-N-Ded.

There is no simple solution to stress management. Rather, optimizing your mind is a lifelong pursuit that integrates an understanding of your personality strengths and vulnerabilities, genetic propensities, personal history, moral values, and life passions. With such an understanding, we can engage the best practices to place ourselves on the most positive trajectory.

Closing

The fever I came down with after eating chimpanzee in Bumba abated quickly, and it was probably a benign tropical virus. Upon returning to the United States I read that the particular strain of the Ebola virus I had feared was then called the "Bumba strain," sharing a name with the city where I had eaten the vector. Fortunately, I am here to tell the tale.

Overreaction is an enormous influence over financial markets. It dominates asset price movement around most events that are saturated with expectation. Learning to identify and trade against overreaction is a key talent of successful investors.

Next month's newsletter is our last letter in the series on top performers in investing, and it focuses on taking advantage of longer-term patterns generated by negativity.

Please contact Derek Sweeney to book us for a talk or training at one of your events: Derek@thesweeneyagency.com, +1-866-727-7555.

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, 130 countries, 50 equity sectors and indexes, and 8,000 global equities extracted in real-time from millions of social and news media articles daily.

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

Remember: Fear Can Be Your Friend.
Richard L. Peterson, M.D. and the MarketPsych Team

LinkedIn Twitter