Improving Your Perspective On Markets

We all want:

1. To become better investors.
2. To improve our ability to probabilistically forecast future market outcomes.
3. To reduce daily investment stress.
4. To sleep better at night.

If any of the points above apply to our current investment circumstances, it is highly unlikely these issues will be addressed unless we are willing to take an honest inventory of our current approach to the financial markets.

Topic Is Timely

Stocks have been holding up relatively well in recent weeks. However, an inflation report released Wednesday could bring the markets closer to the bearish vigilante scenario outlined on May 7, which highlights the relevance of today's interrelated topics of ego, bias, and the all-important concept of investment flexibility. From USA Today:

Wholesale prices rose sharply last month, driven up partly by higher prices for meat and other foods. The producer price index, which measures changes in the prices of goods and services that companies buy, increased 0.6% in April, the Labor Department said Wednesday. Although inflation remains low, wholesale prices last month were up 2.1% on an annual basis. That's the biggest 12-month increase in more than two years and close to the Federal Reserve's 2% annual inflation rate target.

Standard Issue Ego Is An Investor's Enemy

Investing successfully is one of the most challenging tasks on the planet. The financial markets are a difficult nut to crack; one that has frustrated even the most gifted doctors, lawyers, economists, and money managers for all of investment history. A major step in the journey to producing more favorable investment results comes when we are able to step outside ourselves and understand how our ego fits into the investment puzzle. From Eclectic Energies:

We don't feel particularly safe with ourselves, though it may not always be that obvious. We often are protecting ourselves, in one way or another, from some kind of hurt. Psychology calls this self-protection "defense." We perceive threatening events or feelings as "attacks" that we need to "defend" from. It is the ego's primary activity. It seems more noticeable by others than by us that this self-protection can be more important than the truth.

The Truth, Investment Success, And Our Egos

When we talk about ego in an investment context, we are talking about the intense human desire for our opinions and stance to be confirmed by the markets and other human beings. In short, we all want to be right. If we are to become more relaxed and better investors, we need to have a healthy and sound understanding of what "being right" means. Experienced investors who got tired of common investment missteps started a process of ongoing improvement by seriously contemplating this question:

What is more important to me: (a) protecting and growing my capital, or (b) protecting my ego?

This passage from Eclectic Energies is the root of many investment missteps:

Self protection can be more important than the truth.

Once we decide that protecting and growing our capital is more important than protecting our ego, it becomes much easier to say to ourselves:

I have been humbled time and time again by the markets. It is time to take a step back and figure out what is really important in terms of improving my odds of investment success.

What Determines The Value Of Our Investments?

If we want to be more successful in the markets, it is logical that we need to understand how markets work. More specifically, if we want to improve our odds of investing in things that "go up", then it makes sense to understand why some investments go up and some go down. Understanding how asset prices are set is key to understanding the "truth" in the financial markets. If you are a regular reader and are comfortable with how asset prices are set, you may want to skip down to the section titled Stress Reducing Realization or even down to Bias Can Still Be An Issue. For readers new to the fold, the sections that follow are integral to the master topic two-faced investing.

Markets Are The Truth, Not Our Opinions

Before we can talk about personal bias and the value of becoming a two-faced investor, it is important to understand the significance of personal opinions. Some simple math and a few charts can help establish a reference point for our personal views. Technical analysis is the study of charts, but it is more accurate to say:

"Technical analysis is the study of the market's pricing mechanism."

If we want our investments to increase in value, it is important to understand how that will be determined in the real world, which has very little to do with our personal opinions or ego. Technical analysis (TA) often gets lumped together with voodoo and palm reading. The power of charts, and why they are used by the vast majority of pension and hedge funds, is they allow us to monitor the mechanism that sets asset prices. If you understand how assets prices are set, then the value of monitoring charts is easy to understand.

A Different Way To Approach Investing

An asset pricing example will quickly put our personal opinions in the proper perspective, which will immediately take pressure off our ego's desire to be right all the time. Let's assume we run a controlled market experiment where:

1. We give 1,000 investors an annual report to read for company XYZ.
2. All 1,000 are asked to read the report and then value the stock.
3. Stock XYZ can only be traded or owned by these 1,000 investors.

The Market Does Not Care What You Think

If I am one of the 1,000 investors in the experiment, how relevant is my personal opinion in terms of how the price of stock XYZ is set in the marketplace? In simplified terms, my personal take on the value of XYZ impacts the price by roughly 0.10% (1/1000). Stated in a politically correct manner, 99.9% of the factors impacting the price of XYZ have nothing to do with my personal analysis, forecast, or opinion about XYZ. Said in a more direct manner, the market does not care what "I think" about where XYZ is headed or what I think it is worth. It sounds harsh, but that is the way markets work. Does that mean fundamental opinions don't matter? Absolutely positively not; the concept simply defines how fundamentals impact asset prices.

If we expand the XYZ analogy to the real world, it gets even more humbling. Facebook (FB) trades 70,500,000 shares on a typical day. It closed Tuesday at $59.83. If we assume the average FB trade is for $10,000 worth of stock, that means the average number of shares traded per individual transaction is 167 (10,000/59.83). A back of the napkin estimate of the number of people that trade Facebook every day comes to 422,155 (70.5M shares per day / 167 shares per individual transaction). Therefore, if I am trading Facebook, the impact of my personal opinion/research/forecast on the price of the stock is 1 divided by 422,155 or 0.00023%. The admittedly crude analysis tells us 99.99977% of Facebook's value is impacted by external factors that are in no way impacted by what "I think" or "what I think will happen next".

Stress Reducing Realization

If roughly 99.9% of a liquid stock's value is determined by factors that have nothing to do with our personal opinion, intelligence, or fundamental knowledge, then it is fair to ask ourselves the following questions:

1. Why am I constantly trying to figure out what is going to happen next?
2. Shouldn't I be more concerned with what the market "thinks" is going to happen next since the market determines the value of my investments?
3. If my opinion matters very little in the real world of asset pricing, then why I am so concerned about being right all the time?
4. If the market doesn't care what I think, then maybe I shouldn't care what I think, right?
5. If my opinion has little-to-no impact on the value of my investments, then whose opinion does matter?

What Really Matters?

If we can answer question 5 above, then we are in a much better position to be successful going forward. Going back to the controlled experiment with 1,000 investors, if my opinion impacts the price of stock XYZ by only 1/1000, then whose opinion matters most? Answer: the aggregate opinion of all 1,000 investors in the experiment. If they are net-bullish about the future of company XYZ's stock, then when controlled trading starts, XYZ will most likely go up. Conversely, if the aggregate or net opinion is bearish, then when controlled trading starts, XYZ will most likely go down. So instead of sitting down and reading the annual report to form our own opinion on XYZ before controlled trading starts, we would be better off walking around the conference room and polling the other 999 participants in the experiment. Well that sounds logical, but how are we supposed to do that in the real world when we estimated that roughly 422,155 people per day trade Facebook? We can't phone 422,155 people and have them answer a poll question. That is true, but we can look at a chart of Facebook.

Using Charts As A Polling Mechanism

If the aggregate investor opinion on Facebook determines the price of the stock, then how can we reasonably and efficiently monitor the aggregate opinion? Monitor a chart of Facebook. Prices are determined by the law of supply and demand. Thus, if we think in terms of aggregate demand, it can help from a clarity perspective. When the aggregate demand for Facebook is net bullish, the stock trends in a bullish manner (see chart below).

When the demand from Facebook optimists is equal to the demand from Facebook pessimists, the stock consolidates or moves sideways. The chart below shows a low-conviction market when neither the bulls nor the bears have a clear advantage. Note the chart below is from the present day, which tells us something about the current state of bullish conviction vs. bearish conviction.

When the aggregate demand for Facebook is net bearish, the stock shifts into a downtrend (see below).

In over simplified terms, we can improve our odds of investment success by owning investments that are in bullish trends and avoiding investments that are in established downtrends. Trends monitor aggregate investor opinions. Aggregate investor opinions, not personal opinions, set asset prices.

Bias Can Still Be An Issue

Assume we have made a decision to add charts to our investment tool kit. Everything will be fine now, right? It is not that easy. Why? Charts, and any new information concerning the markets, are only helpful if we can interpret them with as little personal bias as possible, which brings us to the two-faced investor theme.

One-Sided Forecasting Brings Ego Into Play

If I tell you the stock market will go up 10% in the next six months, then I will consciously or subconsciously review new fundamental and technical information through a "stocks will go up 10% in the next six months" lens. Conversely, if I tell you the stock market will fall 10% in the next six months, then I will consciously or subconsciously review new fundamental and technical information through a "stocks are going to drop 10% lens". Annual reports, economic data, and charts are of little value when we review them through a biased lens. Remember, it is the market's aggregate interpretation of the annual reports, economic data, Fed policy, etc. that determines asset prices. Our personal interpretation means next-to-nothing.

Two-Faced Investors Are More Flexible

We all bring bias to the markets. We will never completely eliminate personal bias. However, we can do things to limit the negative impact of our market biases. One method to reduce personal bias is to always respect and understand BOTH the bullish and bearish case for the general market, economy, and any investment we hold or are considering. It is much easier to review new information and charts of the S&P 500 Index if we understand and respect the rationale for both bullish and bearish outcomes. It is easy for all of us to come up with bearish bullet points for equities. For example:

Economic growth is tepid and appears to be slowing.

Geopolitical risks are increasing.

The Fed has created unsustainable bubbles (again).

Housing, a key part of the economy, is not carrying its weight.

It is easy to come up with bullish bullet points for equities. For example:

Bear markets typically occur alongside recessions.

A recession does not appear to be imminent.

Markets often look past geopolitical tensions.

Interest rates are low.

Perceptions concerning systemic risk have improved.

Balanced View Keeps Ego In Check

The inspiration for covering this topic came from Twitter, where one-sided forecasting in a public forum brings egos into play, which in turn magnifies personal bias. Just a simple back of envelope exercise of jotting down a few positives and negatives helps us respect both the possibility of both bullish and bearish outcomes. Therefore, before you boldly tweet your one-sided market forecast or tell your coworkers where the market is headed, think about how it may impact your ego, biases, and most importantly, your ability to make the best investment decisions possible. To stay aligned with the market's pricing mechanism, we must maintain maximum flexibility; something that is nearly impossible when we publish one-sided forecasts that bring our ego into the decision making process. Another simple method to keep our egos in check is to think in terms of probabilities, a topic covered in detail back in October 2013.

Investment Implications: The Present Day Aggregate Opinion

Using the concepts outlined above, what is the aggregate investor opinion telling us about the market's current risk-reward profile? The answer is not much different from the read of the low-conviction 2014 chart of Facebook reviewed earlier in this article. Common sense tells us when investors are very confident about the economy and earnings growth, demand for growth-oriented stocks will clearly be greater than the demand for more-defensive oriented bonds. How confident have investors been since early November 2013? Answer: Not very confident; in fact, downright indecisive according to the chart of stocks (SPY) relative to bonds (TLT) below. If we made a friendly bet on November 4, 2013 and I picked SPY and you picked TLT, we would be tied as of May 14, 2014. The chart below tells us the desire to own SPY has been roughly equal to the desire to own TLT, which is symptomatic of waning economic confidence. Waning does not mean bearish, given the weight of the evidence in hand.

If the market is not willing to make a big bet on stocks relative to bonds, nor is it willing to make a big bet on bonds relative to stocks, then it is prudent to have a diversified portfolio of stocks (SPY), bonds (TLT), and cash, which is what we have at the present time. From Bloomberg:

"The indices are hitting all-time highs, but underneath that there's a big divergence happening with individual stocks," Patrick Spencer, London-based head of equity sales at Robert W. Baird & Co., which oversees more than $100 billion, said in an interview. "There are concerns about the market having rallied so far, the underlying weakness in some of the momentum stocks, and there is also some underlying worry about earnings and economic data."

While it may be a bit extreme for an investment application, author Andrew Samuels captures the highly influential nature of our egos and why it is difficult to remain a flexible and unbiased investor:

"People's need to protect their own egos knows no bounds."

Are Charts More Important Than Fundamentals?

Critics of technical analysis often mistakenly believe that using charts discounts the importance of fundamental data, such as earnings, employment, and economic growth. Charts allow investors to monitor the aggregate investor interpretation of all the fundamental data, including Fed policy. Said another way, charts are efficient tools used to monitor vast amounts of fundamental data, which is important since fundamentals ultimately determine which asset classes will perform best. When the economy is healthy, stocks tend to beat bonds. When economic fear dominates, bonds tend to beat stocks. Therefore, fundamentals are important since they drive asset prices. Charts are simply a tool to help us monitor the aggregate interpretation of the fundamentals, which ultimately determines the value of our investments.