Subscribe now and watch my free trend following VIDEO.

Greenspan Wakes Up to Behavior

From The Wall Street Journal:

“I’ve always considered myself more of a mathematician than a psychologist,” says Mr. Greenspan. But after the Fed’s model failed to predict the financial crisis, he realized that there is more to forecasting than numbers. “It all fell apart, in the sense that not a single major forecaster of note or institution caught it,” he says. “The Federal Reserve has got the most elaborate econometric model, which incorporates all the newfangled models of how the world works—and it missed it completely.” He says JP Morgan had put out a forecast three days before the crisis saying the economy was on the rise. And as late as 2007, the International Monetary Fund also said that global risk was declining. “A few days [after the crisis hit], I run into an article, and it is titled, ‘Do we economists know anything?’ ” he says.

Mr. Greenspan set out to find his blind spot step by step. First he drew the conclusion that the nonfinancial sector of the economy had been healthy. The problem lay in finance, because of its vulnerability to spells of euphoria and irrational fear. Studying the results of herd behavior provided him with some surprises. “I was actually flabbergasted,” he says. “It upended my view of how the world works.”

He concluded that fear has at least three times the effect of euphoria in producing market gyrations. “I wouldn’t have dared write anything like that before,” he says.

Studying the minutiae of the events leading to the financial crisis brought to mind some lessons from his famous friendship, from the 1950s on, with the late Objectivist philosopher Ayn Rand. He says that Rand didn’t influence him politically—he was always a libertarian—but she did point out tensions in his philosophy about life. “She caught me in contradictions, which shook me, and I said, ‘My God, she is right,’ ” he says.

Mr. Greenspan then believed in analysis based mainly on hard science and empirical facts. Rand told him that unless he considered human nature and its irrational side, he would “miss a very large part of how human beings behaved.” At the time they weren’t discussing economics, but today he realizes the full impact of emotions and instincts on markets. He also has come to admire psychologist and Princeton University professor emeritus Daniel Kahneman’s work applying psychological insights to economic theory, for which he won a Nobel Prize in 2002.

Good for Greenspan. So late to the party.

Cold Truth About Emotional Investing

Consider an excerpt:

WSJ: What do you mean by emotional finance?

PROF. TUCKETT: What we try to do in emotional finance is start with the fact that the future is unknowable. The key thing about uncertainty is that it inevitably generates feelings. Because it matters to you, because your money’s on the line, so to speak, you’re bound to feel emotionally engaged.

WSJ: Some people think pros are more rational than individual investors.

PROF. TAFFLER: Although most of the fund managers we interviewed saw part of their particular competitive advantage as remaining, as they described it, unemotional or rational, in practice they were just as emotional as anyone else when they started to talk about the stocks they had invested in. There were lots of examples where they referred to them almost as if they were lovers.

If you’re entering into an emotional relationship with a stock, an asset or a company that can let you down, this leads to anxiety, which is often not consciously acknowledged. But it’s there, bubbling beneath the surface.

WSJ: The fund managers told stories about their investments. What was the role you found that storytelling played in their decision making?

PROF. TUCKETT: They have to feel conviction. With a narrative you can join up different facts with emotions, and that creates a sense of conviction, and that is absolutely essential for action. So we aren’t saying “Oh, they’re only storytellers.” We’re saying you need to tell a story.

PROF. TAFFLER: One of the fund managers talked about investing in a fast-food company, how he visited the restaurants and looked at what people were ordering. The story was about seeing something nobody else could see, and that feeling gave him the confidence to invest.

WSJ: Could you talk about what investors expect from fund managers and what effect that has on the fund managers?

PROF. TAFFLER: A very important insight in emotional finance is the concept of the fantastic object. It’s like Aladdin’s lamp, which you polish and can have anything you want. In unconscious terms this is ultimately what we are all looking for.

The whole environment is problematic, because fund managers are expected to outperform on a continuous basis, in competition with other equally able and well-resourced managers, and of course not everyone can do this. So actually the fund managers are required to be fantastic objects, to earn continuous superior returns at low risk. This is, of course, only possible in fantasy, not reality.

To be able to do this, fund managers have to be able to believe they can find fantastic objects themselves, stocks with which they can have special relationships and which are going to outperform with minimal risk.

WSJ: With individual investors, I suppose it’s about managing the uncertainty of putting their money into the markets—it helps if they’ve got this idea of the star manager who can handle it all for them.

PROF. TAFFLER: Yes. In emotional-finance terms an important part of the fund manager’s job is to defeat uncertainty. In a sense we’ve got an institutional structure which seeks to deny that ultimately we’re all working in an environment that is inherently unpredictable.

WSJ: What can individual investors learn from your research?

PROF. TAFFLER: I’ve done separate research on individual investors, and of course they have all these same feelings writ large. You need to recognize that cognition and emotion go together; you can’t have one without the other. If you were coldly unemotional, which is of course not possible, then you wouldn’t actually be able to generate the conviction necessary to take the risk of investing.

Sums up many reasons why trend following excels.

Learn to be a trend following trader.
Sign up free today.