Know thyself to decode markets

D. Murali
source: The Hindubusinessline  

Investing and the irrational mind

 

October 15, 2011:  

Investing has less to do with the science of computation and more to do with the art of managing one's outlook, emotions, and consciousness, writes Robert Koppel in ‘Investing and the Irrational Mind: Rethink risk, outwit optimism, and seize opportunities others miss' It involves invention, imagination, and know-how, and the mettle to exploit the hard right edge of the price chart, which reveals the stock market's next unexpected move, he adds.

“Investing is a microcosm of life. Within it, we experience joy, uncertainty, frustration, and struggle. It requires courage, optimism, humility, and the desire to succeed.”

The author instructs that the key to understanding investment risk is recognising that it goes far beyond math and strategy, deep into the recesses of human psychology and emotion. “For most of us, our emotions are too involved in our choices to allow us to strictly adhere to a trading system or mathematical model… Behavioural finance has clearly shown that rational decision-making is the exception, and judgment by emotion and imperfect reasoning the norm.”

Biases to watch out for

In a section on ‘heuristics and biases,' the book cites the work of psychologists Daniel Kahneman and Amos Tversky, who performed a series of gambling experiments to study how we evaluate probabilities. Chief among the biases they identified were the following: Availability heuristic (whereby events that are more easily brought to mind are judged as being more likely than events that are less so); anchoring (leading individuals to start with one piece of known information and then adjust it to create an estimate of an unknown risk); asymmetry between gains and losses (that is, investors are risk-averse with respect to gains but risk-seeking when dealing with losses); and threshold effect (according to which individuals prefer to make choices based on perceived degrees of certainty). Interestingly, “Kahneman and Tversky also found that investment experts were not necessarily any better at estimating probabilities than the ordinary person. Experts often expressed overconfidence in their estimates and relied too heavily on small data samples.”

Emotional intelligence

In the concluding chapter, the author observes that what is most appreciated by the professional investor is not the monetary rewards.

The real appeal, he says, is that if you really commit yourself, there is the potential of reaching the maximum level of your abilities. When the market heats up and the crowd positions itself to rush in a particular direction, the best traders profit handsomely from their capacity to perceive and capitalise on emotions, notes Koppel.

He calls this ability ‘emotional intelligence,' the ability to detect and decipher emotions in the faces, voices, and actions of others, as well as an ability to identify their own emotions. Suggested reading for investors looking for clues within.