It is better to meet danger than to wait for it. He that is on a lee shore, and foresees a hurricane, stands out to sea and encounters a storm to avoid a shipwreck.
~ Charles Caleb Colton

My wife and I are vacationing on the North Carolina Outer Banks this week, and our vacation home was hit by Hurricane Arthur - a Category 2 hurricane. Before the storm we were forced to make a judgment call - should we evacuate voluntarily or stay through the storm?

As the week progressed, the storm was updated from a Tropical Storm to a Category 1 and then to a Category 2 hurricane, and its path was estimated to pass directly over us. An adjacent island (Hatteras) underwent evacuation.

Most vacationers around us chose to stay in their homes out of convenience, or perhaps inertia. "It should be all right" and "Likely just a few twigs blowing around" were two comments I heard from neighbors. Via internet and television we heard widely varying expectations of damage from "light" to "18 foot surge."

The ability to ascertain risk under ambiguity is an essential skill in life, as it is in investing.

The Toddler Trader

"I'm so proud of him, he's already a great trader."
~ A trader speaking of his two-and-a-half year old son.

Two-and-a-half years is 30 months old. Most boys of that age can speak 150 words and count to 3. Yet the 2-year-old's proud father explained to me:

"On the playground the other day I had forgotten to bring any sand toys for the sandbox. A big boy was playing with a dump truck under the slide. My son wanted that truck so bad. As I watched him, he asked for it and was denied. But he didn't get sad. He looked around and he found a discarded plastic shovel in one corner of the sandbox. Over the next five minutes he traded up. First the plastic shovel for some grapes, then the grapes for a small bulldozer, and then he showed everyone how much fun the bulldozer was - making lots of grumbling noise and pushing rocks, and a minute later he traded the bulldozer for the dump truck he had originally wanted."

Excellence in investing depends on both the ability to find an edge and trade up (the boy-trader), and the ability to accurately assess risks (as in the hurricane). Taken together these two abilities comprise strategic thinking.

Strategic thinking is more precisely called intuitive expected value assessment, and it is defined by the ability to rapidly and unconsciously evaluate the odds, risks, and potential benefits of a gamble. In today's newsletter we look at research into this cognitive ability among investors. The newsletter later demonstrates how this individual trait improves our understanding of the current low volatility market environment, and we examine a model that predicts sudden spikes of volatility in the S&P 500. Finally, we offer a series of exercises to help you sharpen your strategic thinking skills.

Investors Who Play Games

There is anecdotal evidence that excellent strategic game players have an edge in investing. It is well known that Warren Buffett is an avid bridge player and that many hedge fund portfolio managers play poker. Bridge and poker are games in which a knowledge of odds and an assessment of fellow players are necessary. Yet you don't see many chess grandmasters in hedge funds - strategic thinking is not a deliberate mental process, as in solving mathematical problems or understanding visuospatial relationships, but rather it is a subtle intuitive process that blends pattern recognition, emotional intelligence, adaptability, and stress management.

How Investors Think

As part of our research efforts to understand the performance traits of top investors, MarketPsych has been offering a variety of free online financial tests since 2004. Over 25,000 people have taken one of our tests.

Paul Squires, a psychometrician, recently analyzed our test results. He cleaned the data extensively and studied results isolated from professional traders and investors.

Dr. Squires found that among professional investors there are few - if any - personality traits that comprise a "success profile." For example, whether one is extroverted or introverted is not material to one's success in the markets. On the other hand, cognitive traits - thinking style - do appear significant. In particular, the MarketPsych Gambling Task, in which players are forced to make rapid and intuitive expected value calculations, correlates strongly with Investor and Trader returns.

A graphic of one of Dr. Squires' findings for this test is below. A high score on the MarketPsych Gambling Task is more likely among Investors who report higher returns. Investors with lower scores are more likely to report losses or lower returns in their investing.

This result was the most significant from among our various tests. We decided to look more deeply at the origin of skill on this test, and as it turns out, the origins may be partially biological.

The Warrior Gene

While genetic science is still primitive, there are fascinating preliminary findings relevant to finance. For example, the presence of the gene (MAOA-L) in an individual correlates with superior financial risk taking.

The MAOA gene produces an enzyme involved in catabolism (breakdown) of dopamine, norepinephrine, and serotonin. The abnormal variant MAOA-L is more active. This enzyme is inhibited by some antidepressants, which raises mood as well as serotonin, norepineprine, and dopamine levels.

Behavioral traits associated with the MAOA-L gene variant include impulsive risk -taking and aggression. Those with this gene take more risks, but with higher expected value, thus the nickname “The Warrior Gene.” In a study on the genetics of financial risk taking biases, Frydman et al. note, “Our computational choice model, rooted in established decision theory, showed that MAOA-L carriers exhibited such behavior because they are able to make better financial decisions under risk, and not because they are more impulsive.” In summary, carriers of this gene perform better strategic financial decision making.

So it appears that some investors are better risk evaluators based on their genetic endowment.

Forecasting Volatility

"How did you go bankrupt?"
"Two ways. . . . Gradually and then suddenly."
~ Ernest Hemingway, The Sun Also Rises

Academic research demonstrates that periods of high and low volatility are persistent. Persistence means that volatility, once low, tends to stay low longer than would be expected by random chance. Transitions from low to high volatility happen at first gradually and then rapidly, similar to going broke.

Note that when times are good, they tend to remain good until either a sudden shock or a gradual breakdown occurs. Investors waiting for a potential shock - even when they have evidence that the shock is coming - will experience inertia just as vacationers do when facing a hurricane. Investors who act quickly can beat the herd in predicting volatility.

We don't make that claim lightly - we developed metrics that allow us to see what markets are thinking. MarketPsych's text analytics software quantifies business indicators, sentiments, and expectations in millions of financial articles, messages, tweets, and postings every day. If you've been reading our newsletter for a while, then you've seen our Fear, Optimism, and SocialUnrest indexes.

We custom-built one index to measure speculative activity. We call this the MarketRisk index (a.k.a. the Bubbleometer). Speculation is a combination of upwards projections of an asset's price and positive emotion. Rational analysis focuses on business fundamentals and is usually associated with pessimism. The net difference between the total positive speculation about an asset versus rational analysis of it constitutes the MarketRisk index.

Our MarketRisk index has an uncanny ability to forecast the trend of the S&P 500. The image shows a candlestick chart of the S&P 500 (SPY). A MACD of the 30 day average of MarketRisk is superimposed on the 500 day average of MarketRisk. When the short term average of MarketRisk is higher than the longer term average, the distance between the two lines is shaded green. When the short term average is lower than the longer term average, the distance between the two lines is shaded pink.

You can see that following this strategy would have had you out of the S&P 500 before the 2011 meltdown, and in the market for most of the rally. In backtesting, this particular MACD also shows value in predicting both price and volatility (VIX futures) back to the beginning of our data in 1998.

Steps to Unleash Your Warrior

Reading a note handwritten to himself:
"Dear Homer,
I. O. U. one emergency donut.
Signed, Homer."
Bastard! He's always one step ahead!
~ Homer Simpson

Imagine you're on a diet. It just so happens that you pass a doughnut store on your way to work everyday. Let's say you love doughnuts, and despite your diet, you find yourself frequently stopping there to pick one up. You know it's not good for you, but nonetheless you buy a doughnut or two and eat them on the spot.

Excellent strategic thinkers see this behavior, understand it is a bad habit, and make a realistic appraisal of their own self-control. Rather than fighting the temptation every day, they are flexible and willing to take a different route to work (one that doesn't pass the doughnut store). Excellent strategic thinkers understand that flexibility and self-control are keys to success, and they take advantage of short-cuts rather than fighting losing battles.

To apply intuitive expected value calculation to your investing, consider these exercises to expand your perspective:
1. Dedicate time to contemplating the big picture. Schedule time in your calendar daily or weekly to step back and think. If we can't see the big picture, then we can't see the longer-term risks and opportunities.
2. Ask yourself, "What do I need to do to thrive in this environment? Am I doing it? If not, why not?"
3. Ask yourself, "Can I conceive of a sea-change in how this business works? How could I better prepare for one?"
4. Ask yourself, "When conditions begin to shift, am I prepared to act quickly?"

Closing

Times of great calamity and confusion have been productive for the greatest minds. The purest ore is produced from the hottest furnace. The brightest thunder-bolt is elicited from the darkest storm.
~ Charles Caleb Colton

As we were contemplating the inbound hurricane during our North Carolina vacation this week, we elected to evacuate before it hit. There was no question that the risk of damage outweighed the inconvenience of getting out of its way. We followed a sound process in making that decision. And fortunately the storm caused relatively little damage for those who stayed behind.

In the next two newsletters we will examine two investing success traits that work alongside strategic thinking:
1. The mental flexibility to abandon (or even reverse) a failed position when new information dictates, and
2. The emotional strength needed to stick with a good idea through the ups and downs (managing stress).

We are speaking at many events globally over the next few months. Please contact Derek Sweeney to book us for a talk or training: 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 economics! Please 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

Frydman, Cary, Colin Camerer, Peter Bossaerts, and Antonio Rangel. 2010. “MAOA-L Carriers Are Better at Making Optimal Financial Decisions under Risk.” Proceedings of the Royal Society B. 278: (1714), 2053-2059.

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