Most of us have experienced "Aha!" moments, when ideas and feelings click, and our minds work productively and rapidly. Some people experience such episodes again and again, associated with intense joy, elevated self-confidence, little appreciation of risk, rapid thinking, and decreased need for sleep. For some, this is a biological state called hypomania, a lesser version of clinically significant mania.

As a psychiatrist I had friends who had worked on staff at a mental hospital where a renowned comedian was occasionally hospitalized with mania. My friends said that one of the most enjoyable times at their work was when his friend, another celebrity comedian, visited the psychiatric unit. Those two would rapidly take on characters and engage from their perspectives, pretending to be a stodgy old English woman berating a young German boy for stepping on her flowers, or a cowboy asking a deaf, toothless cook to prepare his breakfast. The staff told me their dialogue was funnier than anything those comedians had produced for the mass media (which was itself award-winning).

I once saw a manic engineer from a large high-tech company. The interaction proceeded like this:

Me: "Hello Mr, X, what brings you into the psychiatric emergency room today?"
Him: "7 719 2 619 4639 3 911."
Me: "Um...I don't understand."
Him: "7 263 7621 199 3 7639."
Me: "Hmmm..."
<Five minutes later, I'm still baffled>
Me: "Are you speaking in prime numbers?"
Him: "YES!"
Me: "OK, let's try English now."

He had decomposed every word in the English language into a prime number. (Later, to further demonstrate how perfect his brain state was, he recited the decimals of pi until, after 30 seconds, I asked him to stop).

Mania is a biochemical phenomenon with predictable psychological and behavioral consequences. Manic people feel a wonderful energy - the senses are alive, fear is entirely extinguished, they have little need to sleep, and their self-confidence is supreme. But it is not only individuals who may take on these characteristics, we also see mild manic (and depressive) behavior among herds of investors.

Leftward Skew of Returns

Investing legend Benjamin Graham described Mr. Market as having Manic-Depressive (bipolar) characteristics. Per Graham, investors ought to wait to buy from Mr. Market when he was feeling depressive (as he was likely to be discounting prices excessively), and to sell to him when he was feeling manic (in which case he was over-paying for assets).

Academic researchers have found that asset price returns are distributed with a leftward skew in returns, meaning that large declines (especially), but also large gains, happen more frequently than would be expected from a normal probability distribution. Here is what the distribution looks like. Such large gains and declines are nonlinear events, and they are presumed to be over-reactions of the manic-depressive investing herd.

Today's newsletter looks at the value of hypomanic thinking, how market prices are subject to nonlinear changes, and discusses how we can change our own mindsets in order to perform better in our nonlinear market reality.

Mania in High-Achievers

Imagination is more important than knowledge.
~ Albert Einstein

There is a connection between the biochemical changes of mania and productivity. It is rumored that a higher percentage of CEOs of Fortune 500 companies have bipolar disorder than among the general population. According to a website on the subject, bipolar disorder has been a driving force behind some of the most colorful and ambitious business professionals of our times. Among them are media mogul Ted Turner, Vancouver stock promoter Murray Pezim and former real estate magnate Robert Campeau. Similarly, some of the most accomplished people in history were - in hindsight - manic depressive, including Abraham Lincoln, Winston Churchill, Leo Tolstoy and Vincent van Gogh. From the same source:

According to Dr. Sam Ozersky, a senior consultant at Toronto Hospital's Mood Disorders Clinic, if you are manic depressive, there are times "you can work with hardly any sleep," says Ozersky. "You can plan any business deal, seduce any man or woman or spend any amount of money." If it were possible to bottle its positive aspects in a safe, controlled compound, manic depression wouldn't be a sickness, he says, it would be a wonder drug."

But there is no such wonder drug. Hypomania increases productivity, but outright mania occasionally leads - by definition - to excessive risk taking. Mania both enlivens (and shortens) one's career and even one's life.

People who have experienced a manic illness know that one's sense of reality can shift rapidly. And back in the markets, manic surges in attention or trading activity have their own signature that we are learning to identify.

The Character of Information

We cannot solve our problems with the same thinking we used when we created them.
~Albert Einstein

Despite hundreds of years of evidence to the contrary, assuming a normal linear distribution is considered a useful shortcut for many quantitative analysts. As a data vendor I speak to quantitative analysts about the sentiment and macroeconomic data MarketPsych produces, and I'm frequently startled by the linear modeling techniques used by some analysts. Linear models assume normal distributions of prices and information and are the basis for factor models based on multiple regressions. These modeling techniques smooth over extreme movements in price, information, or data. As we now know from unfortunate experience, when quantitative analysts use linear models, they often miss important outlier events - such as the fact that credit can freeze or mortgage-holders can default in high numbers.

Information and price movements are not linear. As attention shifts across assets, we see the manic energy of the herd move with it. For example, as the Turkish Lira declined in January of this year, we saw an enormous spike in daily chatter about the currency. See this chart of Buzz around the Turkish Lira.

When news and social media focused on the currency's decline, it was at a manic-depressive climax, as you can see by the subsequent price bounce.

In our data we also see how unusual fundamentals can fuel manic price movements.

During the series of polar vortices across the Eastern and Northern United States this winter, concerns emerged about a shortage of Natural Gas for heating homes. Natural Gas prices predictably rose in response to those fears. See the below chart of the event:

When the shortage concerns abated after adequate inventory was reported, prices plunged dramatically. In our data we've seen many similar patterns of fundamental triggers driving large price trends.

Hypomanic individuals experience enhanced productivity but their changes in perception are nonlinear. Most of us have difficulty comprehending a nonlinear reality, and thus we exclude nonlinear events from our mental models of the world.

Human Learning

Human learning is widely hypothesized to be a linear updating process. Humans integrate new information, and they weigh it more heavily in their learning depending on its relevance, impact, and recency.

After we receive new information, we incorporate it into our behavioral strategies. Humans tend to have 3 to 4 behavioral strategies available during their approach to a dilemma. This limited number of strategies supplies a narrow decision space, and the selected strategies are often habitual. The financial cost of these safe habits is apparent in an innovative risk taking study called the Soochow Gambling Task.

Soochow Gambling Task

Look deep into nature, and then you will understand everything better.
~ Albert Einstein

Most people take financial risk following a series of gains, even if they know that a large loss looms.

In the Soochow Gambling Task (SGT) experimental subjects are told to make as much money as possible by selecting cards from one of four decks. The decks are labeled A, B, C, and D. Each card displays a monetary gain or loss. Decks A and B have expected values, for each five card flips, of -$250. Decks C and D have expected values of +$250 for each five cards. For each deck, the cards have very different payoffs. Deck A has four $200 wins for each $1,050 loss. Deck B has four $100 wins for each $650 loss. Deck C has four $200 losses for each $1,050 gain, and deck D has four $100 losses for each $650 gain.

Amazingly, most experimental participants prefer cards from the money-losing decks. Over 200 trials, more than 60 percent of the cards flipped were from decks A and B. Subjects had a financial incentive to make money in this game, but they consistently acted against their best interest.

As a result of the subjects' consistently poor performance, researchers Ching-Hung Lin and Yao-Chu Chiu alerted them, after 100 card flips, to the actual payoffs and odds of each deck. Yet even after they learned the payoffs and odds per deck, the subjects continued to select almost half their cards from decks A and B. According to researcher Ching-Hung Lin, “Almost everybody lost money in our experiment. We couldn't figure out how to help them ....”

Training Yourself to Think Outside the Box

When you find yourself in a hole, the first thing to do is stop digging.
~ Will Rogers

While hypomania enhances creativity, we don't need to be hypomanic to think nonlinearly.

Usually we benefit from thinking nonlinearly when we are trying to find a solution to a dilemma. But the dilemma is stressful, and stress provokes the release of neurochemicals which, at high levels, increase linear thinking (causing us to dig our hole deeper). For example, stress causes investors to continue using a non-performing strategy even when there is substantial evidence that it no longer works.

A classic puzzle used to test one's capacity to "think outside the box" is the 9-dots puzzle. But trying to solve such puzzles isn't enough to prompt one to think differently. To break habits and think outside the box we need courage - courage because it is difficult to leave what we know and to launch into a different way of thinking.

In order to boost out-of-the-box thinking it is helpful to:
1. Get into a relaxed and playful state of mine (if we do feel under threat, then we need to engage in relaxing activities until we can feel relaxed)
2. To entirely stop what we are doing. To make a clean break.
3. To play with the challenge - to stop trying to think of answers and instead to turn it upside down, roll it around, smash it up a little with a spirit of playfulness and intellectual curiosity.
4. To take a walk
5. Sleep well. Sleep aids the creative process, specifically in the REM stage.
6. Avoid excessive alcohol intake. REM sleep is diminished by more than 1-2 drinks of evening alcohol use.

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Closing

Creativity is intelligence having fun.
~Albert Einstein

We are presenting at many events, public and private over the next few months. Please contact Derek Sweeney to book us for a talk or training at one of your events: Derek@thesweeneyagency.com, +1-866-727-7555. We're in London monthly, and we are speaking at this conference there in late June: “4th Annual Conference: Behavioural Models & Sentiment Analysis Applied to Finance” 18 – 19 June, 2014.

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 5,000 individual 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 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

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