Archive for the ‘Triangular Psychology’ category

The Big Decision

The latest HBR carries an article written by Daniel Kahneman on decision making. The article gives a checklist approach to handling decision making at an institutional level to avoid biases. According to the article, the potential for distortions are so high that knowing biases was not enough to eliminate them. The authors illustrate the reflective and intuitive thinking process. In intuitive thinking we don’t focus on doing things, we just do them. Intuitive is good at making contextual stories. This is when cognitive failures happen because there is no way of knowing when they are happening.

According to the authors talking doesn’t eliminate biases. A more methodical approach is needed. A study observed that eliminating biases achieved returns 7% point higher.

Kahneman and team suggest that eliminating biases can improve decision making profitably. So if the method works for businesses, the approach should also work for investors and markets and…

This article was written for Business Standard

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Time Triads, Time Fractals, Time Arbitrage, Performance Cycles are terms coined by Orpheus Research. Time Triads is our weekly market letter. The report covers various aspects on TIME patterns, TIME forecast, alternative research, emerging markets, behavioral finance, market fractals, econohistory, econostatistics, time cyclicality, investment psychology, socioeconomics, pop cultural trends, macro economics, interest rates, derivatives, money management, Intermarket trends etc.

 


The Greedy Cluster


Emotions are as mathematicaly ordered as stars in the galaxy.

Are emotions subjective or objective? Why investors are known to buy high and sell low? Why do we overreact? Why do we exaggerate? Why are we greedy? Why does the society panic? Why majority of us move with the trend? Can we define happiness as a mathematical function?

If we could do this, we could change our understanding of the society. We could understand how the society thinks and how it acts. Businesses could understand consumption patterns, target audiences. It could open up new ways of marketing and advertising.

The recent Economist article illustrated the correlation between money and happiness. If money and happiness were studied on an arithmetic scale, money it seemed could not buy happiness, the correlation was poor. But when similar GDP data was plotted along with life satisfaction on a logarithmic scale, the relationship between income and happiness looked more robust. The author does not make an attempt to explain why this happened. Logarithmic scale compares proportions. Somehow the pattern of increasing income was similar to increasing happiness. This lead to a more robust correlation compared to the initial belief that money and happiness correlations weaken beyond a GDP per capita of $ 15,000.

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Time Triads, Time Fractals, Time Arbitrage, Performance Cycles are terms coined by Orpheus Research. Time Triads is our weekly market letter. The report covers various aspects on TIME patterns, TIME forecast, alternative research, emerging markets, behavioral finance, market fractals, econohistory, econostatistics, time cyclicality, investment psychology, socioeconomics, pop cultural trends, macro economics, interest rates, derivatives, money management, Intermarket trends etc.


Top underperformer Spain wins

Time Triads, Time Fractals, Time Arbitrage, Performance Cycles are terms coined by Orpheus Research. Time Triads is our weekly market letter. The report covers various aspects on TIME patterns, TIME forecast, alternative research, emerging markets, behavioral finance, market fractals, econohistory, econostatistics, time cyclicality, investment psychology, socioeconomics, pop cultural trends, macro economics, interest rates, derivatives, money management, Intermarket trends etc.


The momentum psychology

Momentum investing done by the majority of investors and fund managers today is a feel good factor that does more damage than benefit to a portfolio.

According to behavioral finance Momentum investing is at the heart of investor mistakes. But do you know whether you are a momentum investor? Putting simply, if your stock picking is news based, volume based and price based you are a momentum investor. Your belief in market movers and stories ties you to momentum. What’s good about momentum investing? The majority is with you. So there is comfort in numbers. Momentum periods can be extended and large. Not being a momentum investor could be painful as you could miss substantial price movements. Momentum investing is also more about investing in growth, winners, successful companies, stocks that are already identified as performers. The technique is about doing what the majority is doing. Be it technical oscillators which continue to suggest that the trend is running or fundamental indicators which tell that earnings continue to be good, momentum is about our need to speculate with safety that we are not alone. The technique is also about good stocks and bad stocks. Behavioral finance has written about investor’s ability to ascribe more value to the company that the market considers good and reject the ones the market thinks are bad.

Majority of the investors today are momentum investors irrespective of the technical, fundamental or quantitative approach they use in stock or sector selection. Investors don’t change their investment style because they believe in market efficiency or inefficiency. Actually the majority of investors doesn’t care or even know about the debate. The momentum psychology rules them. Even analysts and experts suffer from the momentum psychology. After the hard lessons from 2000, the street has started paying more attention to analyst’s calls against market momentum. The calls are still few. Being against market momentum is a hard skill owing to the fact that market timing tools are at a nascent stage and few attempt to do it. Being few in numbers, market timers are generally judged harshly. A prey standing alone is more prone to attack from the hunter, in numbers, probability of being killed seems low.

Life would have been easy if an investor get’s on the bus to the zoo with a group of friends and come back on his own or goes somewhere else from the zoo leaving his friends behind. Such individual behavior may leave us with few friends in real life, but unfortunately how we are in real life is how we are in markets. Very few can dissociate their economic life from their social life. We will invest together in real estates and lose together in real estate. Momentum investing is genetic, you were born with it and to comprehend, question and change it is a monumental obstacle. Once in a while you might say “Wow!! I was smarter as I exited earlier”, but till the time you break the momentum psychology and social thinking you are and will be a momentum investor whose luck may not protect him every time.

Some investors may now say, we relate to this and this is why we look for smart money managers. Looking for performance in money management is an extension of momentum investing. History of market literature has proved that your fund manager did not beat the benchmark over the long term. So what are you left with? In the end market is the best performing benchmark and all your effort is a waste of time, if all that internet and news and research gets your portfolio returns marginally higher or lower than the market why not just buy the benchmark.

I am trying to convince you that if the investment approach where you are the fund manager (or you chose one) does not beat the benchmark, you need to restrategise and rethink the value of your time. It’s not easy for a money manager to tell this to his clients (that he screwed up), but this is the hard truth. Not very many managers will tell you this, what they will show you is how the comparable benchmark has done or how risky was the portfolio. We don’t judge our money managers harshly because we are in love with them and this is why there is no real alpha just beta. If you think the idea is going too fast in challenging your mindset, you should read Robert Arnott’s, Fundamental Indexing. Arnott runs Research Affiliates and has challenged the benchmark creation itself. According to him the way we construct our benchmarks is itself flawed and even the case for indexing is weak. Benjamin Graham (father of security analysis) proposed the case of indexing as superior stock selections get tougher. If the gods of fundamental investing dissuade you from stock selection and push you to passive index investing, you as a reader have to judge where you and your fund manager are on the learning curve.

Actually my aim is not to convert or dissuade you against riding the trend, be a momentum investor because without what the majority does with momentum psychology there would be no market. Very few market literatures really acknowledge this economic role. Momentum investing creates the economic cycle. Who is not a momentum investor? A person who does not bet on trends, news, and price movement but on sentiment extremes, low risk entry points and value. This is how growth and value cycles are created. Momentum investor pursues growth takes it to unsustainable extremes when the cycle turns and brings on value purchasers who give prices support.

According to a paper on growth and cycle written by Arnott, the market did a good job in differentiating between growth and value, but that the market discounted the value companies too deeply and paid about 50% more premium for growth companies, relative to the value companies. Although growth stocks (those trading at high multiples) do historically exhibit superior future growth, the premium carried in their market price is too high to be justified by reality. Arnott talks of distinct pattern in time i.e. periods that begin with low valuation (growth stocks prices at a small premium to value) followed by fast rising valuation (major rally for growth stocks). For spans of 20 years or more years, the market never failed to overpay for the long term realized successes of the growth companies. Value has outperformed growth in most years, in most markets around the world for decades. Have we learned from this experience? Investors have always paid more for premium stocks than value stocks? Arnott’s fundamental indexing has an overlap with Behavioral finance, which also talks about buying the winners and selling the losers. Are both of them not talking about performance cycles? And how without understanding the Cycle (Time) investing is incomplete and just momentum driven?

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THE PATTERN OF BELIEF

The first week of Jun I transformed myself into a movie buff. I saw eight films at Transilvania International annual Film festival in Cluj. Pa-ra-da, Marco Pontecorvo’s moving feature film about homeless children in post-Ceausescu Romania. This according to New York time was Europe’s answer to the Indian rags-to-riches blockbuster “Slumdog Millionaire.” Then it was Dominique Blanc, French award winning actress in L’autre. She played the role of a jealous obsessive woman after opting out of a relationship. Award winning Filmephobia, Kiko Goifman (Brazil) made a documentary about fear in contemporary society. The crew of this film-within-a-film documentary explores the limits of the psyche by exposing phobics to their greatest irrational fears. ‘Valentino the last emperor’ is a feature-length film on the legendary designer Valentino Garavani in the wake of his exit in 2008 from the company he founded in Rome more than 45 years ago. The film won the Chicago film festival. ‘Hollywood I am sleeping over tonight’, directed by Antoine de Maximy, a French comedian is a film about the director’s journey from East coast to West coast. The travelling cameraman takes to the road, on foot, hitchhiking, by taxi, by bus, by bicycle and even in a hearse. The film paints a picture of the United States that is both touching and surprising. Then was ‘Man on Wire’ an Academy Award-winning 2008 documentary film directed by James Marsh. The film chronicles Philippe Petit’s 1974 high-wire walk between the Twin Towers of New York’s World Trade Center. It is based on Philippe Petit’s book, ‘To Reach the Clouds’. The last film was ‘Gabhricha Paus’, The Damned rain, by Prashant Pethe. This was the lone Indian film to figure in the list of 31 projects selected for the prestigious funding from the Rotterdam International Film Festival.

The last film completed a cycle for me, as it connected me back to an article ‘who is killing the cotton farmers?’ I wrote here on 05 Feb 2007. This connected me back to psychology, prediction, philosophy and time. All that we call art or cinema has individuality about it. We celebrate individualism, we make films and paintings about them, we blog, we sing, we express. On the other side of individualism is the generalism, the groupism, the masses, the social mood, which has inertia and is different than individualism. It’s like a continuum of shades, only clearly different in colors at extreme but without really a clear line of separation. We can never grasp it totally like one single film at one single Cannes film festival. We can never see the big picture, it’s too big for all of us to even visualize. Some pictures we relate to, some we don’t, and some we don’t want to. This is why we will have many festivals and thousand of films animating that subtle mood, that human emotion, the infinitesimal part of the universal ever-changing mood. Actually the stories we see in films is what we write about in markets. It’s just that we call it differently.

The reality of rain for a farmer is harsh, but it can just be a mood spoiler for the city man. Human mood is shocking and beautiful at the same moment. Despite this diversity and contrast, does this mood have a form? Is belief patterned? Does emotion have self similarity? Water is the similar aspect but has different meanings or different interpretations as settings change. How different are interpretations anyway? Let us say a farmer and a trader. There is a human anticipation (for rain or for news), there is debt (farm land or house mortgage), there is prediction (regarding rains or markets), there is unrelentless speculation and hope (things would be different this time), there is a risk and return (correct or incorrect) in both cases and there is an inertia to hold on to the status-quo. The farmer can’t stop farming and so can’t the trader resist the lure of a trade. We are tied to our vocations, different occupations, interpretations but with a similar emotional frame.

Interpretations are the color, the illusion, the chaos as one might put it. Was it really the rain that killed the farmer? There is a more than a decade long secular negativity on cotton. There was no mention about the cotton prices in the film. Why? Because the reference frames to explore the emotion was different. So whom do we blame for a life lost, it was definitely not the cotton price also, if it was not the rain. It was the emotional drift. Human inability to detach, to stop, to pause, not to trade, to take a vacation, to not go to work one day (you should see the film). It’s not that we are mechanical. It’s that we drift.

Behavioral finance also refers to a similar psychological tendency as drift. In his survey of the literature on post earnings announcement drift, Bernard (1993) discuss evidence concerning market prices underreact to analysts forecasts. He explains that the post announcement stock prices for firms that have reported “good news” tend to drift up, whereas the prices for firms that have reported “bad news” tend to drift down. It pays to hold stocks that have experienced recent large positive earnings surprises, because the market does not fully adjust to the good news. Instead, the market adjusts over the three quarters that follow an announcement. This same underreaction or overreaction of prices is later ascribed to analyst behavior. Behavioral finance does not make an attempt to differentiate underreaction or overreaction in prices from that witnessed in analyst behavior. The subject also talks about two types of investment approach viz. momentum and reversal (contrarian) approach. Momentum approach is nothing but herding approach, more common and comfortable owing to the sentiment drift.

We at Orpheus will not be surprised, if the following question was raised for the first time ever to the behavioral school of thought. What overreacts, prices or people or both?  Inability to book a loss or procrastination can be associated with the drifting sentiment. The other behavioral ideas like extrapolation bias, psychological herding all is an extension of this drift. When people get together, group thinking takes over and the group is assumed to think right, this is why herding (drifting) becomes natural. Technical analysts have also unknowingly handled the idea of drift. Why do bear markets have two stages of fall? Why do markets extend? Is this not because the sentiment has inertia, it cannot just stop after a deep crash, it needs time to reflect, make up its mind. This is why the group sentiment shifts. Even if top formations are sharper and faster, there are many cases of historical tops being retested, sentiment does not let go easy of status-quo. This is the way we as a group are and this is why we feel comfortable, drifting. Where did the frog in the well come from? It came from our need for the status-quo. We love the proverbial well.

Why is dramatism the most touted approach to bringing real change, because dramatism is the only way a drifting society can be caused to change its approach. Moving out of the comfort of groupism needs overcoming fear of being alone and changing status-quo. Groupism to individualism or vice versa is also about movement, change. Hence any questions regarding dynamic sentiment or drifting sentiment can be put to rest if one associates drift with pulse or life. If mood is such an important driver for economic trend then it got to be moving and not static.

Now if we have come to terms that sentiment moves. How can we start quantifying it? Sentiment surveys are trashed by behavioral finance, but not even one behaviorologist talks about the cyclicality in sentiment surveys. The bullish percent readings move from one extreme to the other in a banded (0 - 100%) fashion. Now one may ask what has belief, fear, greed, panic got to do with sentiment readings? Well the readings are only expressing the degree of belief or greed in market on the positive extreme and degree of fear and panic or the lower extreme. The cyclicality of sentiment can be observed across time frames, 1 min to multi years, people (traders) will move from euphoria to complacency (passiveness) on all time degrees. So now if cycles are not mathematical, how can mood be mathematical? What if cycles were mathematical, then mood becomes mathematical too? Time translation we explained prior not only connects the bell curve (efficient school) with the Pareto curve (inefficient school) but also is the underlying force that drives and defines mood.

The human mood drifts because of time. The larger the time behind a mood, the larger the impact. It’s the degrees of mood which cause war when they are at an extreme low, the same degrees of mood which are in positive time cause euphoria and invariably bubbles. There is a theory about mood drift causing market movement, there is a theory about markets causing changes in mood, there is a theory of what credit leverage can do with social mood. There is no theory about what time does to mood? Whether mood like everything takes the pattern of time? Whether mood also fractals like everything else in nature and price? It is easy to demonstrate that social mood is a pattern, not just a cycle. Fear and greed has a pattern, just like belief. They all assume the pattern of time, the pattern of time triads, triangle in a triangle.

Behavioral Finance became a school of thought because there was an observed pattern, a pattern of behavioral flaws. It is just that behaviorologists saw emotions like films, many films, many emotions, and many flaws. No attempt was made to group them. Robert Prechter’s Socionomics was the first subject which ever attempted to classify mood. In 2002, Prechter said that he expected it to take another ten years to construct a full theory of the components, aspects, processes and structure of social mood. This article attempts to extend Prechter’ s work, even if not in the direction Prechter might have imagined 20 years back.

Socionomics demonstrates the social mood trend, which we are labeling as drift. Prechter accepted that component work was more of observational summaries and not a hypothesis. Time translation and its impact on mood is a hypothesis for us. It was seventy years back R N Elliott said that human emotions are rhythmical and their waves governed “all human activities, whether it’s business, politics or the pursuit of pleasure”. Elliott said “Human emotions” is not a precise term. For us at Orpheus human emotions are measurable and mathematical just like price, it’s just that quantifying mood for 1 min time frames is a cumbersome process, as the trader is busy trading rather than filling sentiment surveys regarding how he feels at that moment.

Socionomics suggests that there appears to be a social polarity that underlies all social interaction. Prechter refers to these opposites as “positive” and “negative”, which according to us are the polarity of time reflecting in the mood. He illustrates two poles of social mood viz. confidence/fear, constructiveness/destructiveness, happiness/unhappiness etc. In his book ‘The Wave principle of Human social behavior’, Prechter details a thorough classification of changing moods causing changing prices or changing trends. However, the seminal work does not delve much into the linkage of mood with time. The guru admits that his observations could be used to probabilistic predict social mood, but he does not suggest that mood could itself be a self similar fractal and measurable as a Pareto power law curve. Prechter has demonstrated smaller aggregations to suggest mood expressing a fractal form, but he still admits that his classification of moods is roughly representative, not precise or conclusive. Understanding time fractals simplifies many challenges linked with quantifying mood.

A human mood doesn’t need a language to communicate. I remember cooking with my chef for a complete week in Mysore (South India), we both spoke two different languages in the same country. The society mood is interwoven in time and time translates and moves giving a pulse to social mood like it pulses everything else. Even if we communicate or miscommunicate, the polarity of mood is a universal mathematical truth owing to the underlying time.

The best traders I have met question their own emotions. It just like Philippe Petit the man on the wire told himself, “it cannot be done”. It was only when the dream of tightrope walking the twin towers was improbable that the hurdle could be overcome. This is how celebrated individualism comprehends the pattern of belief.

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Irrational Exuberance

irrationalexuberance

Irrational exuberance - At the recent meeting, a client said that it is time for new valuation theories as old theories are dead. This coming from someone who made it to the Top 300 rich list of Romanians indicated what smart money was thinking. It also illustrated how much time it took for a mainstream thought to be challenged.

Shiller’s theory

It was about 30 years ago, Robert Shiller - the award winning economist, author of Irrational Exuberance, a bestseller that challenged the Efficient Market Hypothesis (EMH) in an article published in the American Economic Review in 1981. 30 years, yes that is what it took. This is how outdated we are in our thought.

This was my second reading of the book. I read the first edition in 2000. Unlike Beyond Greed and Fear by Hersh Shefrin, Irrational Exuberance was more focused and had more objective criticism of conventional research thought. Despite the incredible timing of the book which shuts up comments like “who knew it?” The author calls himself plain “lucky” and makes no claim of having a forecasting ability. He also talks about the role of opinion leaders to stabilize markets even if in a minor way.

In a follow-up discussion paper titled From Efficient Market Theory to Behavioral Finance, Shiller explains how in the 1970’s it would have been wishful thinking that models which describe the world around us could be true.

Anomalies in the EMH were discovered in 1970’s and it was the excess volatility of the stock markets which was too large an aberration to remain unexplained. In simple terms, changes in prices occur for no fundamental reason and are primarily driven by mass psychology. He does mention other drivers like “sun spots”, albeit casually.

On to behavioral finance

To validate his case he takes present value (PV) of dividends paid on S&P composite stock price index discounted by a constant real discount rate for the period (1871-2002). He demonstrates that PV behaves remarkably like a stable trend. In contrast, stock price index gyrates, wildly up and down around this trend. This proved that there is excess volatility in the aggregate stock market relative to the PV implied by the EMH.

You cannot defend the EMH. Markets are crazy, even if not totally. There has been no effective study linking fluctuations with fundamentals till date. This is where Shiller moves to another explanation, behavioral finance feedback model which is the academic form of a feedback theory first written by Charles Mackay in 1841 in his book Memoirs of Extraordinary Popular Delusions. The book described the famous tulip mania of 1630’s, a speculative bubble in tulip flower bulbs, with words that suggest feedback and the ultimate results of the feedback.

A price to price feedback theory causes word-of-mouth enthusiasm giving birth to new era theories and popular models that justify price increases. The feedback that propelled the bubble carries the seeds of its own destruction. Smith, Suchanek and Williams (1988) were able to create experimental feedback trading.

All in feedback loops?

Shiller is unequivocal regarding the feedback loops as the explanation for excessive volatility or bubbles. He supports his case by research in cognitive psychology, which shows that people try to predict by seeking the closest match to past patterns leading to feedback dynamics. Such human interactions, he says, are the essential cause of speculative bubbles (positive and negative), which appear to recur across centuries and across countries. Recurring ponzi schemes is an example.

We have some questions and observations on Shiller’s case. Is the model Shiller working on for 30 years an all-encompassing one? What he mentions as appearing to recur not cyclicality in time? Is he not just replacing cognitive psychology patterns with another pattern which seems consistent with some combination of feedback effects driving the stock markets? Why even after 30 years of challenging and a Nobel Prize for behavioral finance are fundamental stories so engraved in human psyche? Is behavioral finance a capable alternative to conventional research? Is psychology really driving the markets? Or are something like “sun spots” more significant than what Shiller thinks.

Role of proportion

What about proportion? Everything is ruled by proportion, why is psychology so special? Why there is repetitive mention of 30 years, 10 years in Shiller’s work? Why does he not mention about all the work done on time cyclicality which is as old as the dividend data he charts? Is it too much for him to admit that the basic tenet of behavioral finance “what goes up comes down and what goes down comes up”, is nothing but a cycle? Why does he never mention Edward R Dewey, chief economist of President Hoover who said depression was a cyclical reality? Why in his now famous comparison of dividend PV and stock prices he does not observe the 30 year cycle? From a time perspective, all the talk about excessive volatility may have disproved the EMH, but it does not prove that feedback loop is the final explanation. Bubbles are a cyclical phenomenon caused in time and both amplification and time are mathematical aspects.

The question of “when” which 83 per cent of Shiller survey respondents including Shiller himself admit being an illusion and an opportunity too good to be true might be a thought 30 years behind its time.

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The Triangular Harmony

triangular_harmony

A simple triangle can integrate all market theories. Can we spot it?

While writing ‘Theory of Moral Sentiments’ in 1776, Adam Smith would never have thought that after 2 centuries people will find it oxymoronic to see morals and sentiment in the same phrase. Now, sentiment creates the popular news, lack of morals are ascribed to capitalists and what’s left of the father’s work are fragmented theories.

Today markets and prices are believed to be efficient, inefficient, random and/or ordered. All efficiency experts won’t subscribe to the mathematical order and some believers of inefficiency will call randomness preposterous. If this was not enough, we even have a few thinkers defining a new model of finance different from economics.

Unlike the coherent attempt to find a universal scientific string theory, there is no attempt to look for an integrated market model. A few behaviorologists are trashing efficiency theorists, who in turn call behavioral finance as nothing more than ‘anomalies dredging’. Meanwhile the other two viz. random and order experts tune their trumpets. It’s a cacophony out there, exacerbating the confusion as the historical crisis unfolds.

There is one thing common in all these market specializations. Implicitly or explicitly they all look at patterns. Behaviorologists are trying to model human emotion. Fundamentalists attempt to model market information. Random experts wait for the recurring odd event. And order driven experts call the market model a pattern or fractal.

Behaviorologists raise some questions like, “Can the human mind count?” There are of course limitations to the human minds computing ability, the very reason we cannot be called pure rational beings. This is the same reason why even if there was complete order till infinity, we would find it muddled with randomness. What if the whole debate regarding market type is because even specialists, like rest of us all suffer from biases? What if markets were efficient, inefficient, ordered and random on the same scale but on a different time? What if order or chaos was a factor of time?

If we assume this to be true, we start answering most of the discrepancies between the various theories. Behaviorologists say humans suffer from an extrapolation bias, suggesting that we can’t see the future and we judge the past and present to estimate the future. This is why when we are on the efficient side of the market mountain, we just see efficiency. Simply putting it, we just see positivity when we are on a rising trend. When markets are inefficient or say falling, we just look down and are unable to see the bottom or impending order. This extrapolation bias also explains why humans underreact or overreact. When we cannot see the top of the market mountain, we cannot judge how far the high is, this is why we underreact. And when we are on the declining face, we just can’t seem to place the low and we tend to overreact.
Behaviorologists call it momentum and reversal dichotomy as they don’t see the market mountain. We can explain every other behavioral human error of loss aversion, disposition, ambiguity, validity, representativeness, winner’s curse, gambler’s fallacy, heuristics, framing, risk return distortion, over and under confidence, hope and anxiety, optimism and pessimism, if we continue to look at the market as a two dimensional triangular pattern, a face up and down, a low- high - low, a cycle. One can see how the errors start getting polarized along the positive and negative slope, order being the positive and flip side of the negative uncertain chaos.

The triangle also explains why behaviorologists see the fundamentalist’s conservatism in earning predictions as the reason positive surprises tend to be followed by further positive surprises. The unanticipated surprise is the hallmark of overconfidence, a positive slope characteristic of the cycle. The three phased glitter and stock selections linked to excess volume, recent news and extreme price reaction is another up cycle character. The unending debate of the Fama and French three factor model, one side talking about efficiency and other side challenging it are also on different slopes of the same triangular cycle. Psychologists say fundamentalists select stocks like bonds, “good stocks are stocks of good companies”. The reason they follow thumb rules and extrapolation is because the ongoing polarity of the up cycles, makes them comfortable and complacent. This is why high degree of sentiment interest is followed by subsequent low returns. The turn down catches a majority by surprise. This is why psychologists compare option traders to farmers, taking more risk with cash crops after planting sustenance crops and hedging the downside. It’s our way to take more risk, inefficient risk when we feel hedged. This is the reason we always misprice options.

The same triangle can explain why buybacks happen more at market lows and cause under reaction compared to overreaction, meaning though buy backs end up performing better, they get less attention from investors, investors underreact. Possession and dispossession of dividend also leads to over reaction and under reaction. When investors feel they own a dividend, they tend to over react and take more risk and vice versa. The behavioral criticism that humans are naive trend watchers is because humans don’t understand cyclicality. It is this same lack of understanding of cyclicality why past performance fails.

The holistic pattern can also explain why prices will always keep oscillating between efficiency and inefficiency? Why riskless pair trading done on price will never be riskless? Why long-short funds playing on price are not hedged like LTCM thought and can fail? Why there will always be psychologists writing ‘trading is hazardous to your health’? Why existence of markets is linked with our inability to see the triangle? Why flipping coins can explain randomness, order, efficiency and inefficiency? Why there will always be a conflict and challenge to earn profits in economics? Why capitalism will always be driven by crisis? Why correlations are cyclical like performance? Why behavioral strategies have more tests to pass? Why saving for tomorrow is a hindsight bias? Why we save when we should invest, and why we invest when we should save? Why Mandelbort and Taleb work together, though one is the father of mathematical order and the other claims to be the philosopher of randomness? Why ordered fractals are very close to chaotic randomness? Why the Nobel Prize winning prospect theory is about ownership and disposition that blinds humans against cyclicality? Why Prechter-Parker’s Financial-Economic dichotomy in social behavior dynamics is not the new model of finance, but the other face of the mountain? Why demand sensitivity to price can rise and fall? Why we can make money in markets through physics, mathematics, history, psychology and so on? Why access to information and belief in it is triangular?

The two faced cycle links everything. We are not trying to simplify 200 years of market knowledge. It was always like this, simple. Psychologists are as biased as everybody else, even if they claim to be otherwise. Time contrarianism is not for everyone, as the preordained harmony kills all the beautiful stories.

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Finding Peter Lynch

Both Jonathan Clements and Hersh Shefrin say it’s tough looking for the next Lynch. Clement said it in 1990 in an article in Wall Street Journal, while Hersh says it loud in his book on behavioral finance. Actually they are both true, finding a 13 year stellar growth record with the underlying fund growing from $ 20 million to $ 13 billion is a text book case study, rare.


Though they both say the same thing Clement is pointing to a high skill, but Shefrin on the other hand says it was also luck and not the simple investing approach which Lynch followed. There is another aspect that they disagree on, past performance. The ex Wall Street Journal columnist does not discredit past performance as an indicator to future performance but the behavior guru says past performance is difficult to evaluate.

The subject of past is widely debated between people who live ”there” and believe in it to drive the future, and people who say past is meaningnless, future is always different. The non believers forget that life is ruled by law and not by accident and action and reaction is part of life’s mystery or misery. If the past is such an important driver for the evolution of a society, how can past lag behind. Future builds on the past and so does performance, positive or negative. The famous quote of Jean Baptiste Alphonse Karr “The more things change, the more things remain the same” summarizes how we cannot break away the two ends of time. So if we keep revisiting the past, how can the future we so different from the past and how can past stellar performance not be delivered again. If randomness was the future, why do option traders keep waiting for the black swan from 1987?

Cyclicality is another thing which behaviorologists miss. Teaching masses how emotionally flawed they are is one thing and telling them how economic cycles change and force us to adapt is another thing. We as a group of humans can learn how error prone we are but we still need to understand how changing asset cycles force us to change our thinking. Emotional maturity is just a step in the right direction.

There is a host of literature written about understanding and identifying a professional. The process becomes tricky when prices are falling and belief levels are less in institutions and professionals who run them. Just like individuals, majority of professionals tend to be overconfident about their skills. The institutionalization of the professionals intensifies the incompetency further. Hersh illustrates the ‘games’ institutions play to mask failure. Merging loss making funds can have multiple aims like showing the winners, masking the risk and failure.

Benchmarking an industry wide practice is more of a performance masking than performance illustrating technique. Michael Jensen (1968) who studied performance over 1945-1964 found that past year winners don’t repeat. He said that a fund could only be expected to return more than the market if it held a portfolio that featured more systematic risk than the market. What Jensen did was to take the raw return to a fund and subtract out a portion that reflected the compensation for taking risk. He called this residual “alpha” and it is called as “Jensen’s alpha”. In effect, Jensen found that all mutual fund alphas were indistinguishable from zero. This is one reason, why the skyline has very few positive return histograms standing if you compare funds locally or globally. Majority of them fall and rise together. Grinblatt, Titman and Rauss Wermers (1995) find that about 77 percent of mutual fund use momentum strategies, meaning that they purchase stocks that have recently gone up. There is a clear herding behavior with respect to stocks that have recently gone up. They move in to buy past winners at the same time but don’t herd when it comes to selling past losers.

Past performance indicator for future success is not the fair coin flip catch up, but fading rationality as overconfidence enters. It’s tough to stand alone with a performance less than the benchmark. It’s tough to resist a big city glitter for a small city bland shine. It’s tough to be conservative when risk taking is the norm. It’s tough to stand against the peer group pressure. We have lived with peer group pressure from the day we were born, competing with siblings, competing at school. It’s is this which makes us herd and not stand alone as a fund manager or investor happy with single digit portfolio returns in a double digit market or be a fund manager more focused on risk control than on return increase. The time ahead will change this, as new genre of individuals emerges, new professionals creating new institutions.

It is this individuality that is first step to finding Peter Lynch out there or inside us. In a recent sentiment survey that Orpheus conducts with Prognosis, the individuals preferred sector of investment was “None”, while the professionals were looking at “Utilities”. Even if late, the fact that the professionals are looking at taking risk when risk aversion has reached an extreme, places the professionals higher in skill above individuals. We as a society are scared at the wrong time, more after an 80% collapse and less before that. Fool’s Gold continues to hold below historical highs suggesting a global reduction in panic levels rather than an increase. Even if we see a fall in Q2 2009, the current price levels remain a relatively attractive time to invest for the next 15-18 months. It is late to close the exchange, go back to the village and look for a job out of capital markets. The damage is already done. It’s rebuilding time now. A 10% spot allocation on metals, energy, health care and FMCG now, increasing it to 25% by the end of Q1 is how we would allocate. Broad markets may still be failing, but FMCG pushed up. BSE health care has made clear five wave structures down, suggesting we might be hitting a base there too. Recession times and late economic cycle is the Pharma outperformance time, as market takes a toll on a healthy society.

The human mind may be full of biases, but it has an amazing will power and determination to stand alone, sometimes foolishly. Daniel Kahneman’s famous words regarding the great mystery of finance ” Why do people believe they can do the impossible? And why do other people believe them?” is more about how we are constructed to dream the impossible, dreaming to become Peter Lynch and not just finding him.

We don’t think the Lynch record is unassailable, human brightness is limitless, a double edged sword, determination to succeed versus spending time hiding evidence and failure. This reminds me of a Bill Naughton short story I read in school titled ‚seventeen oranges’. Clem Jones’s (the delivery boy at docks) love for oranges puts him in trouble when Pongo the policeman decides to punish him. There was no escape, locked in the hut and with the oranges on the table, Clem had to think of a fast solution before Pongo brought a witness. The inner voice ’Oh, my god! What can i do? Eat the oranges. Eat the evidence. No time to eat, you have to swallow the pips too.’


The uncertainty bias

The Oct low we talked about held against all odds. A strange time cycle held against all conventional knowledge, which failed. And now that 2008 comes to end, we can sum up a few gaps in generational thinking which concerns us as a society and as economic beings. On one hand the experience is overwhelming because the ideas overlap most areas of study viz. economics, finance, history, psychology, mathematics, sciences, time cycles and art. But on the other it’s no short of revolution in research to be able to comprehend, interpret and derive applied predictive tools from such a vast scale of research areas. It may take another generation for us to look for convergence in ideas. And there are things we may never understand. But then it’s the quest that leads to solutions and differentiates one society from the other.

Though Adam Smith’s Capitalistic model stands challenged, we have had no alternate system that has stood so long. Even some long standing socialistic systems have taken elements of capitalism and witnessed enhanced prosperity. Karl Marx’s idea of capitalism as a system prone to cyclical crisis was true. But still the system has survived and lived, more than any mortal soul today. We are sure, human race will move beyond this model, but this is too farsighted a thought for us as a myopic society.

Charles Dow started modern finance discovering a fractal, without knowing it was one. Elliott an accountant by profession rediscovered that markets were fractalled. He redefined the Dow Theory with his principle. But even Elliott despite his fractal observation only later started connecting it with Fibonacci mathematics. Both Charles Dow and Elliott mentioned about social behavior aspects along with their theories but did not quantify behavioral finance like Daniel Kahneman did with the prospect theory.

Father of fractal geometry Mandelbrot may have coined the term fractal, and proved them mathematically, but he only extended the work of Dow, Elliott and Gaston Julia. And if all these connections seem strange coincidences, the fact that Eugene Fama, the father of Efficient Market Hypothesis was a doctoral student under Mandelbrot should surprise fractal practitioners and fundamentalists who might consider themselves from different school of thoughts.

But this is where the gap lies. Mandelbrot’s M set has become popular outside mathematics both for its aesthetic appeal and for being a complicated structure arising from a simple definition, but this has not really pushed Elliott structures forward to a similar popularity. It’s this lack of convergence of market fractals with the M set that has also pushed the fractal work done by Thomas Malthus and Verhulst as peripheral despite being part of the same extended thought.

This is not the only disconnect. Fractals are growth, decay structures, whether we take the M set, Elliott’s Fractals or Verhulst’s ‘S’ curve, they all convey the natural process of growth and decay, which is cyclical. Not many attempts have been made to connect cycles with fractals. Tony Plummer, cyclist, makes an attempt of explaining Elliott fractals through cycles. But this is such a nascent area that even experienced cyclists admit they have never thought about Elliott being a footnote in the larger subject of cycles. In crux market fractals being a subset of market cyclicality.

The discontinuity extends, when you read the work of physicists like Eugene Stanley from Boston, who has written many papers on power law in markets extending the thought of Kingsley Zipf, the linguist who first proved the power law relationship in popular words spoken in the language, 150 years back. Though we have proofs of power law governing us in nature and markets, we never as academicians, practitioners and scientists thought of power law in cycles. Plummer despite his comprehensive attempt on Cycles fails to talk about it. We at Orpheus link Cycles with Fractals with Mathematics suggesting Cycles as the finality above fractals. Cycles also reinforce the thought we mentioned regarding history being modelable as a science.

Robert Prechter might disagree with the fact that we place cycles over fractals. Prechter also calls Elliott a science and not art. We disagree, as cycles are about two things periodicities and patterns. Watching an understanding a pattern will always be an art and not a science. This is where we come to the other aspect of mathematics.

George Cantor theorem implies the existence of an infinity of infinities. Cantor’s theory of transinfinite numbers was regarded as so counterintuitive - even shocking that it encountered resistance from mathematical contemporaries such as Henri Poincare. A few saw Cantor’s work as a challenge to the uniqueness of absolute infinity in the nature of God. Poincare referred to cantor’s ideas as a grave disease infecting the discipline of mathematics. Some even went ahead and called him a “Scientific Charlatan”, “renegade” and “corruptor of youth” , “utter nonsense”, “laughable and wrong”. The debate cantor opened is also a cyclicality linked with the subject of Mathematics, which illustrates order and chaos. We humans are scared of the uncertain and it’s only when we overcome the fear that we understand how little we know.

This is where behavioral finance comes in. The subject illustrates the errors in our thinking. We mentioned about aversion to ambiguity (uncertainty aversion), which describes an attitude or preference for known risk over unknown risks. It is demonstrated in the Ellsberg paradox i.e. people prefer to bet on a box with 50 red and 50 blue balls than one with 100 total balls but where the number of red or blue balls is unknown. The probability of winning on a bet remains unchanged in both cases. But still we prefer betting on familiar scenarios over unfamiliar territory.

Behavioral finance researchers have also found that we as humans process uncertainty of risk and time similarly. This means that we don’t think rationally when future is uncertain and when time aspects (return to certainty) are unclear. This bias has proven to be expensive in markets both in terms of actual losses and opportunity loss. The aversion to uncertainty also explains why we as masses need more information. More information is generally considered as removing future uncertainty or ambiguity as it creates familiar ground. But still this does not change the underlying risk and return. The news efficiency also has been challenged. It has been proven statistically that more information is necessarily not efficient.

Behavioral finance has junked 200 year of economic thought just because the psychologist were not scared of challenging economists at an unfamiliar territory. And still this does not mean that Behavioral gurus will not be challenged. Hersh Shefrin mentions about predictability being an illusion. He also talks about the limitation of behavioral finance to predict and forecast and time markets. This is not true. Fractal watching can give unprecedented accuracy. This is why Behavioral finance is incomplete without connecting fractals with the subject. Stand alone sentiment surveys also have predictive elements. Comprehending and connecting the idea of patterns and psychology might be unfamiliar to the current generation of behavior finance experts.

Challenging a thought is not easy. We will always challenge the new, as we love certainty. But there is never a certainty, it’s a bias. The research revolution is ongoing and it will keep changing the way we think. Prechter’s thoughts about Economics being different from Finance might just be a research paper now, but this is the economics our children will read. Conventional research may not die, but it will become marginal, as the thought process of the society will migrate ahead. Predictability is much ahead of stories, even if we like stories. And even predictability is not fool proof, as we will always have a chaos, which will tell us that we know nothing about the world we live in.


Heuristic Bias and the Forex Markets

The first question asked to me as a forecaster by a foreign investor few years back was not on Gold or Oil or India, but on Euro Dollar Forex rate. Such is the engagement with Forex that internationally Forex is the top traded asset. And after the equity preoccupation has reduced with the equity slowdown, this engagement with Forex has only increased. We see online trading platforms for Forex spurting out each day, enticing investors to put a few 100 dollars and allowing them to trade with a leverage of 100. A 500 dollar put in by a small investor can play up to 50,000 dollars of exposure. The preoccupation or excessive speculation in the Forex market is not just owing to these daring day traders. But also because of the normal investor on the street, who is using a different kind of leverage, the credit leverage. The idea that lending Euros is easier as it comes with a 3-5% interest rate compared to say the Romanian Lei, with a double digit rate, invariably pushes the investor to borrow in Euro.

This heuristic bias, or thumb rules are also extended to the fact that Euro is inherently considered stronger than many emerging market currencies, so a loan in Euro is perceived better than that on a local emerging currency. Be it the real estate owners, tenants, builders, or simple personal finance purchasers, the Euro bias is a part of the large global credit character. Moreover, even if one is not a trader, there is a monthly car installment or mortgage to pay, less or more is the preoccupation that increases and decreases as the rate fluctuates. A local currency exposure is less adventurous and exciting when you have something international or global to speculate on.

Similar cases have happened in other economies around the world like Indonesia and Thailand before the South East Asian crisis when two-thirds of the region companies had 40% of their debt in foreign currencies. The text book case of interest rate arbitrage traps a majority of the Forex users who fail to see beyond the interest rate differential. What happened after the South East Asian crisis was an 80% collapses in currency values in Asia and the collapse of the Turkish Lira in 2001, old stories from econohistory. The excessive speculation in Forex happens both in normal and extraordinary times.

A search on the Turkish crisis in 2001 will take you all over the information loop regarding the political crisis, the deficit, inflation etc. And it’s a rare research blog or institution that will illustrate the steps that led to the currency crisis. What happened in Turkey too was also the classic case of Turkish Banks performing interest rate arbitrage. This positioned the local bank’s profitability in the foreign hard currency. The arbitrage activity could have continued as long as the exchange rate at the end of the period did not change radically against the banks. A severe devaluation, which was not expected happened and forced the lira 36% down in two days.

These cases have a limitation when we look at the Indian subcontinent owing to “convertibility issues” or to the very fact that we still have not got used to trading currency as masses. This has its advantages. But that’s changing, as India learns to speculate on the Rupee Futures. We also have a large corporate trading based on forwards. Forward bias is another illusion. Ideally and conventional wisdom might suggest that a forward premium in the Forex market would be indicative of direction the currency might take in the coming trading days. But research has proved that forward rates are a poor predictor of future rates. No wonder surveys have shown traders betting against the forward rate. Even futures premiums and discounts on equity side perform dismally as predictive tools. Hersh Shefrin in his book ‘ Beyond Greed and Fear’ raises the question about profiting from betting against the forward rate. He proves that the prediction of error tends to move in cycles. When the error is positive, it tends to stay positive for a while before turning negative. Once negative, it stays negative for a while. Forex traders overreact, bet on trends and are overconfident making Forex market as inefficient as any other asset class.

According to Shefrin, it’s not greed and fear, but hope and fear. We all commit forecasting or investing errors because a majority of us rely on rules of thumb (heuristics). Conventional research is primarily extrapolation. We don’t live in a rational environment i.e. the world we live in is not error free. This is why the most exciting of riskless arbitrages have brought economies and companies like LTCM (Long Term Capital Management) crashing. This is why conventional Long and Short funds have failed, despite being market neutral. In a research paper published in the July 1985 issue of the Journal of Finance, De Bondt and Richard Thaler, argue that investors overreact to both bad news and good news. Therefore, overreaction leads to past losers becoming underpriced and past winners becoming overpriced. Heuristic biases are ubiquitous, germane and very expensive.

Shefrin classifies the Heuristic biases in his book. Availability bias is like the first recall, what comes in mind first seems right. Representativeness, suggests investors become unduly pessimistic about prospects of past losers, which turn out to give exceptional returns. Regression to mean is a bias too, as historical average return on equity does not mean much for equity performance in the near future. Historical averages or regression to mean is a bias with little predictive ability. Overconfidence and accuracy generally does not go hand in hand. When people are overconfident, they set overly narrow confidence bands and end up being “humbled” and surprised. Aversion to ambiguity bias explains why people prefer the familiar to the unfamiliar. Bailouts don’t happen to save the world from the crisis, but more because people are scared of fathoming the depth of the unfamiliar ground. Emotion and cognition…first we did not expect the markets in India to crash, now that they have crashed a majority of the investors might spend years worrying about it that it may happen again.

Heuristic biases are also the reasons why conventional research gets surprised. Past performance is the best indicator of future performance is a heuristic error, generally imperfect. The best way to analyze extrapolation and accountability of conventional research is to look at inflexion points. Look at Yen Dollar rate and press releases issued by the Bank of Japan and the top researchers in JAN 2007 when the pair was ruling at 122 and this is what news the search might get…“In Tokyo, the yen dropped following the BOJ’s rate decision to leave interest rates unchanged” This as we know was followed by the historic strengthening of the yen against the dollar. And now change YEN with INR and look at 15 Nov 2007 Rupee levels at 39 and hit search and you might get a Reuters Poll on the same date. Axis, Bank of America, Bank of Baroda, Bank of Nova Scotia, BNP Paribas, Calyon, Citigroup, DBS, Deutsche Bank, HDFC Bank, ING Vysya Bank, JP Morgan, Kotak Mahindra, Lehman, NCDEX, Royal bank of Scotland, Standard Chartered Bank, State Bank of India and Syndicate Bank participated in poll. All of them were forecasting INR for DEC 2008. They were nearly in consensus of where the rupee should go after a year. The Median was 37.63 (highest 41 – lowest 36.6). What happened was 50.58. We at Orpheus are not free from heuristic errors and bias. But we are trying.


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