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October 27, 2012
Resentment Investing: Fading Soros, Emotional Ruts, and Doubting the Bull
Breaking the Bank

When George Soros "broke the Bank of England," famously earning him $1.1 billion on a single trade, it was not only the Bank of England who was rocked by losses.  Some ambitious and formerly successful traders had bet against Soros - traders such as Bob.  


Some background:  In 1990 the Britain's Thatcher government decided to join the European Exchange Rate Mechanism (ERM).  The ERM was a system to reduce exchange-rate variability.  With U.K. inflation at three times the rate of Germany's and interest rates at 15 percent, the conditions for remaining the ERM were not favorable.   


Due to its inherent impossibility, as well as short-selling by an international group of currency speculators led by George Soros, the UK was forced to withdraw from the ERM on September 16, 1992 ("Black Wednesday").  Soros' trade was virtually guaranteed to be successful due to the large interest rate differentials between the U.K. and Germany.  Not all central bankers learned the lesson - Soros and others profited from similar trades put on before the Asian Currency Crisis of 1997. 

October 20, 2012
Psychopaths at Hedge Funds, Google, and the Persistence of Bad News
The School of Life


Street craps - played with two dice on a sidewalk - is little like its casino brother.  The odds are different, the pace is much faster, and your dealer is typically a hustler or worse, a psychopath.  As for me, I learned how to deal street craps in prison. 


As a psychiatrist I've evaluated competency and treated mental illness among prisoners, some of whom were hustlers or psychopaths.  Street hustlers in my experience are usually quite engaging and reflective, able to gain insights and do productive psychological work.  Psychopaths are cold and heartless - mimicking the emotions and social styles they have seen expressed by others.  Typically psychopaths don't see a psychiatrist voluntarily, and when they do, they spend a good deal of time looking for angles - how to game the system and get what they want from the doctor.


When a psychopath offered to teach me street craps in a prison, I knew from my clinical training that he was being friendly only because he wanted something from me - information, medications (some medications are used as currency in prisons), or to learn some therapeutic tricks he could use on others.  Nonetheless I was riveted as he explicitly taught me how to spin the dice to get the numbers I wanted and how to tap and blow on them to distract unsuspecting clients.  At the same time, I told myself, I was gaining valuable insight into the mind of a psychopath.   After the tutorial -- and alas too late to do anything about it -- I realized to my horror that my pen was missing.


He wasn't interested in passing time with some friendly banter or in gaining some psychological insights while he was teaching me how to roll the dice - the dice lesson was for distracting me while he swiped my pen.

August 15, 2012
Toxic Optimism: The Dutch-French Disease, Facebook Face-Plant, and How to Profit from Delusion
Optimism, Bind Optimism, and Balance

"The intelligent investor is a realist who sells to optimists and buys from pessimists."

~ Benjamin Graham, Jason Zweig in The Intelligent Investor, Rev. Ed.


As a psychiatrist I've born witness to many extremes of mood.  I've tried to steer manic venture capitalists away from spending their life savings on cocaine and sports cars.  And on the other extreme I've born witness to the deep pessimism and despair of suicidal clients, trying to help them choose life over oblivion.  My efforts are not always successful, and I've learned a lot about the limits of rationality when faced with extremes of mania and despair.  At both extremes many of the people I've worked with are highly intelligent and believe they are acting with perfect rationality.  Yet despite their innate intelligence, deeper emotions occasionally sweep away their anchor to reality.


In Ben Graham's quote above, one could be mistaken for thinking of the "intelligent investor" as a robot or algorithm.  Human investors feel the extreme optimism and pessimism of the markets.  And the effect of this optimism and pessimism is, almost universally, to bias their interpretations of real events.  While the best investors feel the moods of the market (that is, they are empathic), they also have the almost super-human ability to act contrary to their emotional biases.  Graham's vision of intelligence in the 1950s is what we today call emotional intelligence


Warren Buffett called Graham's book, The Intelligent Investor, "By far the best book on investing ever written."  I think it's worth looking for lessons in Graham's thoughts on optimism.


Today's letter will examine the nature of optimism in the financial markets:  How we experience it, how it distorts our investing, how it plays out in markets, and how we can succeed while being both optimistic AND realistic.  As we go through these themes, we will look at French and Dutch optimism in the Euro-zone, the delusional optimism at the launch of the Facebook IPO (see Dr. Murtha's hilarious Part 2 video), how portfolio managers can use optimism to their advantage, and visit some tools and techniques for making ourselves better investors.


But first, some housekeeping...

June 12, 2012
Greece, Spain, and the Psychology of Financial Collapse
Collapse of Dreams

"[T]he values to which people cling most stubbornly under inappropriate conditions are those values that were previously the source of their greatest triumphs."

- Jared Diamond, Collapse: How Societies Choose to Fail or Succeed

In Collapse: How Societies Choose to Fail or Succeed, Jared Diamond (UCLA professor of Geography) described the collapse of civilizations as a gradual environmental process, fueled by systematic behavioral weaknesses evident in inertia and short-term thinking, culminating in a rapid unwinding too rapid to stop.  As he describes it, as environmental stress increased in prior failing societies, social and economic disparities widened. Rather than looking to identify empirical causes and create functional solutions to save themselves, these societies fractured along political and class lines. As stress increased, the various factions hardened their tactics, ultimately physically attacking internal political enemies and igniting civil wars which destroyed the social and cultural mores that upheld institutions.

I was reminded of Diamond's thesis a few weeks ago in Canada, of all places. I was in Toronto's financial district when I was handed, with a direct and sincere look, a manifesto on the evils of capitalism. 

Now, when I lived in San Francisco and Austin (two cities I love), I often received such manifestos - usually followed by some unsolicited recommendations regarding marijuana cultivation or freeing Tibet. It was all fairly benign. But the Toronto pamphleteer was not unhinged, malodorous, or intoxicated - he was sincere, healthy, and appeared overtly rational. His apparent reasonableness shocked me more than the manifesto itself: A reasonable man pushing an overthrow of capitalism. That same night, student riots in Montreal over tuition increases led to the arrest of 122.

Democratic governments in the developed world have borrowed money to finance their promises.  Without displaying adequate performance.  As a result, voters are disappointed and angry, and now inclined to try extreme alternatives.

While I'll discuss social collapse in light of Greece this week, I think we should also take this opportunity to look at our own societies. The unraveling has already begun. What can we do to prevent a similar meltdown?

I consider myself optimistic, so it pains me to return to the topic of collapse. That said, I'm of the opinion that facing an ugly truth sooner allows us to have a happier life later. Sadly politicians have the incentive to avoid hard choices in the short term, and as a result the pain of collapse will be that much greater.  


New public policies that account for human (and elected official) psychological weaknesses are desperately needed.  Fortunately, such an effort has begun.  Read on to learn more.


But first, some housekeeping... 

April 10, 2012
Regret, When to Sell AAPL, and Timing Bubble Tops
Shorting Bubbles - Ouch!

I've made many unfortunate investments over the years, but one in particular still bothers me.  In 1998 it was very clear that the technology sector was in the midst of a historic bubble.  There were many overvalued stocks - with no earnings, high debt, too-good-to-be-true stories, and extremely high valuations.  I picked Amazon.com due to its high level of hype, and I sold short some shares.


A few months later I had lost 40% on that investment.  Then a few months after that 80%.  By the time I had lost 120%, I bought back my shares.  (And good thing I did, the stock continued much higher before it finally peaked).  I learned a lesson best-articulated by John Maynard Keynes:  "Markets can remain irrational a lot longer than you and I can remain solvent."


In the post-mortem analysis of that investment I looked back on my thought process.  My conviction had been high, I knew I was right.  Diagnosis:  Overconfidence.  And as a result of overconfidence, a weak risk-management plan.  This trade changed how I think about trading timing and risk management.  (It's ironic how improving risk management always becomes urgent AFTER a big loss). 


Steamrolled by the crowd, and my lesson learned, I turned to the study of timing bubbles.  I wondered, how could I time the expansion and ultimate collapse of market sentiment around hot tech stocks like Amazon.com?


I decided to start by looking inward - what were investors in Amazon thinking (or not thinking) when they bought in?  And what triggered the ultimate fall in the price?  In fact, my senior research project in medical school was on "The Social Psychology of Bubbles and Panics" (I was extremely privileged to work with a pre-eminent researcher on impulse-control - Ernest Barratt, Ph.D.).


It turned out that expectations are key to bubbles, and expectations are rooted in the brain's emotional circuitry.  That circuitry is easily activated by extraneous events.  In fact, researchers have found that completely unrelated positive events (movie clips, pictures of happy faces, pornography) prime us toward taking excessive financial risk (Read more in today's Researcher's Corner below).


We've had a similar sort of timing problem the past several newsletters.  And from our research, we know that a key success trait of investors is good timing - rapid execution on high conviction ideas.  Our monthly newsletter takes about 10 days from conception to publication, and during that 10 days our forecasts often become stale, rendering the monthly recommendations less profitable (e.g., the oil and copper short hints last month worked out a few days before publication - fortunately the decline in oil and copper prices continues). 


Before we jump into how to time bubbles, first some housekeeping.   
March 11, 2012
Middle Eastern Paranoia, Oil, and the Psychology of Playing Chicken
Shopping Carts and Playing Chicken

When I was a boy in Texas the neighborhood children enjoyed playing chicken, usually with speeding shopping carts.  Two children were pilots and two children were bombs.  The pilots dutifully ran their bombs up to full speed, released them, and ... CRASH.  Ideally your shopping cart remained standing after the collision, in which case you won.  Fortunately, two shopping carts crashing sounds much more painful than it actually was.  

But this newsletter isn't about bored suburban kids.


This month we look at a much more deadly game of chicken between Iran and Israel (and by proxy, the U.S.A.). Mirroring the escalating tensions, oil prices are up over 10% in the past five weeks.  Higher oil and gasoline prices are already impairing our economic recovery.


This newsletter will examine Behavioral Game Theory as it applies to Iran and Israel.  What is the best strategy to deter a foe who may be crazy, short of war?  We will then look at the current sentiment snapshot of news and social media as it relates to Oil, Iran and Israel, which reveals some surprises about global mood.  The psychology behind Oil's recent price rise reveals whether the rally is sustainable (hint:  fear is rarely sustainable).


In addition to our usual haunts of New York and Los Angeles, we will be speaking in San Antonio, western Pennsylvania, a CFA webinar, and San Francisco in March - we're look forward to catching up with our friends in those cities!