CHAPTER 1

A Concise History of Investor Psychology

In May 2008, in an interview with the New York Times, Kenneth C.Griffin, president and CEO of the $20 billion Citadel Investment Group, aleading global financial institution, offered some pretty harsh words about WallStreet. His gripe was with the Street's prevailing psychology of reckless andexcessive risk taking. He called for an immediate overhaul of its mindset. Nostranger to placing big bets, Griffin knew what he was talking about. While anundergraduate at Harvard, he had started two hedge funds from his dorm room,installing a satellite dish to channel real-time market data so that he couldtrade between classes. Founded in November 1990 with a little over $4 million,Citadel is now the world's eleventh largest hedge fund, earning Griffin areported $900 million in 2009, after a double-digit drawdown in 2008.

Upset by the failure of Bear Stearns and the mistakes of big-name money managersand CEOs who assumed catastrophic risks that led to the evaporation of billionsfrom their balance sheets and whose actions eventually led to the disappearanceof Lehman Brothers and the near collapse of the financial system, he made anassessment that was blunt and to the point. "We, as an industry, dropped theball," he said. "We have a responsibility to manage risk in a way that isprudent."

Was Wall Street once again guilty of hubris? According to Griffin, the problemwas a market psychology that allowed for too much risk compounded by weakgovernment oversight. "When you read that UBS did not even view parts of itsmortgage portfolio as having risk," he said, "it becomes very obvious that anumber of firms were not dotting the i's and crossing the t's when it comes torisk management."

He also cited the additional problem of youth and inexperience. "Walk across anyof the trading floors—they are full of twenty-nine-year-old kids," heexplained. "The capital markets of America are controlled by a bunch of right-out-of-business school young guys who haven't really seen that much. You have areal lack of wisdom."

THE QUANTS

Wall Street Journal reporter Scott Patterson's electrifying portrait,The Quants, describes how a group of brilliant, gutsy traders, composedof math geniuses and physicists, first earned their chops through gambling, thenmoved to take on Wall Street. Accentuating the quirky intrigue of this group,Patterson details the personalities and temperaments of its characters. Itsprincipal figures included Citadel's Ken Griffin; chess master Boaz Weinstein ofDeutsche Bank; Peter Muller, manager of Morgan Stanley's secretive hedge fundProcess Driven Trading (PDT); Cliff Asness, the founder of the nearly $40billion fund AQR Capital Management; and Ed Thorp, an MIT-trained mathematicianand card shark, hedge fund manager, and author of Beat the Dealer, thefirst book to statistically prove that the house advantage in blackjack can beovercome by card counting.

This story opens not long ago in the Versailles Room, which is as posh as itsname suggests, in Fifth Avenue's storied St. Regis Hotel. Beneath a gildedceiling, antique floor-to-ceiling mirrors revealed the players, the quants,competing at Wall Street Poker Night. These yearly red-carpet events andtournaments, benefiting Math for America, brought together quants andprofessional poker players, surrounded by beautiful women, to play high-stakes,blue-chip poker. "The small group of wealthy and brilliant individuals ... had,through sheer brainpower and a healthy dose of daring, become the new tycoons ofWall Street," reports Patterson. "Few people outside the room had ever heardtheir names. And yet, behind the scenes, their decisions controlled the ebb andflow of billions of dollars coursing through the global financial system everyday." This was not Gordon Gekko's 1980s game of liar's poker.

More than anything else in the world, the quants were searching for their truth.For the quants, it was revealed in the obscure patterns of the market, whichcould be discovered only through mathematics. These young masters of theuniverse devised an appropriate name for it: alpha. Alpha, Patterson explains,is defined as a "code word for an elusive skill certain individuals are endowedwith that gives them the ability to consistently beat the market."

MARKET PSYCHOLOGY IN A NUTSHELL

The desire to beat the market is not a new idea, nor has it been limited toquants or to capital markets. When it comes to speculation, we are looking at adramatic history of booms and busts. Our minds are irrationally fueled by theprospects of quick enrichment through such things as tulips in Holland, gold inLouisiana, real estate in Florida, art, Internet stocks, and mortgage-backedsecurities. We are driven by greed. We are panicked by fear.

Combining psychology, economics, and neuroscience, the recent field ofneuroeconomics studies how people react in these emotionally exuberantsituations. Looking at the role of the brain, researchers examine how weevaluate investments, categorize risks and rewards, and interact with oneanother in our economic transactions. However, the story of our attempt tocomprehend the relationship between investing and the irrational mind beginsmuch earlier.

Since the inception of modern markets, investors have sought to understand thefactors that assured profit and prevented individuals from getting caught up ina psychological ricochet between euphoria and depression. One of the firstattempts was made by Dickson G. Watts, president of the New York Cotton Exchangefrom 1878 to 1880, a great arena of economic activity in America. InSpeculation as a Fine Art and Thoughts on Life, in his list of essentialqualities of the speculator, Watts wrote, "Those who make for themselves aninfallible plan delude themselves and others."

Watts identified five qualities that he believed were key for success: self-reliance, judgment, courage, prudence, and pliability. Summing up, he wrote,"The qualifications named are necessary to the makeup of a speculator, but theymust be in well-balanced combination. A deficiency or an overplus of one qualitywill destroy the effectiveness of all. The possession of such faculties, in aproper adjustment is, of course, uncommon. In speculation, as in life, fewsucceed, many fail."

It was a good early attempt to understand a near chaotic speculativeenvironment, one that relied heavily on nineteenth-century moralistic teachingsand everyday common sense.

THE BOY PLUNGER

These observations won Watts the attention of young Jesse Livermore, who learneda lot about markets and himself from the slim volume, as revealed in Livermore'sclassic 1923 work on the art of speculation. Reminiscences of a StockOperator, the fictionalized biography of the Boy Plunger, as he was known,charts the first-person experiences of Lawrence Livingston, a thinly disguisedLivermore, through his progress in mastering Watts and the world of stockspeculation to become one of Wall Street's most successful traders.

First appearing as a series of 12 articles in the Saturday Evening Post,Reminiscences of a Stock Operator was published under the name of itseditor, journalist Edwin Lefèvre, a friendly newspaperman whom Livermore used asa source of information and as a plant to disseminate favorable news items. Thebook chronicles a trajectory of speculation that begins in the New England"bucket shops," brokerage firms, now illegal, that took the opposite side ofcustomers' orders without having the orders actually executed on an exchange.The term itself derives from the fact that customers' orders went "in thebucket," having never been executed by the pseudo brokerages.

Starting off as a quotation boy, Livermore developed a "feel" for the market andbegan to trade for himself. After considerable trial and error, he arrived atcrucial insights about the market that allowed him to build a million-dollarfortune while he was still in his twenties. Unfortunately, he lost that fortuneand several more. But with each mistake, he extracted a lesson that he sharedwith his readers, often explaining that his lack of adherence to his own ruleswas the source of his most devastating losses.

"It never was my thinking that made the big money for me. It always was mysitting. Got that? My sitting tight! It is no trick at all to be right on themarket," Livermore says. "You always find lots of early bulls in bull marketsand early bears in bear markets. I've known many men who were right at exactlythe right time, and began buying or selling stocks when prices were at the verylevel which should show the greatest profit. And their experience invariablymatched mine—that is, they made no real money out of it. Men who can bothbe right and sit tight are uncommon."

It is the very psychological nature of Livermore's insights combined with greatstorytelling that make his ideas so compelling, as in this other example: "Thereis profit in studying the human factors—the ease with which human beingsbelieve what it pleases them to believe; and how they allowthemselves—indeed urge themselves—to be influenced by their cupidityor by the dollar-cost of the average man's carelessness. Fear and hope remainthe same; therefore the study of the psychology of speculators is as valuable asit ever was."

This advice is as useful today as it was when it was written nearly 90 yearsago, perhaps even more so in the wake of the meltdown of Bear Stearns and LehmanBrothers and a global economy that is still struggling to apprehendirrationality's meaning. Livermore was particularly wary of tips and theirruinous effects, another unfortunate lesson that many are now learning at thecost of their jobs and their homes. "Tips! How people want tips! They crave notonly to get them but to give them. There is greed involved, and vanity."

Livermore made $3 million after the panic of 1907 and $100 million in the 1929stock market crash, an astonishing sum for the time, and subsequently lost bothfortunes. His greatest legacy appears to be the dissemination of a practicalinvestment philosophy and a cautionary tale that a life in the market is not allbeer and skittles. His battle-tempered perceptions about maximizing profits andreducing losses provide evergreen market advice. In the bestselling classicMarket Wizards: Interviews with Top Traders, which delves into the mindsof some of the world's most successful traders, Reminiscences of a StockOperator was cited as the major investment primer for the traders thatauthor Jack Schwager interviewed.

In March 1940, Livermore published, under his own name, How to Trade inStocks, an attempt to codify all that he had learned in his long life ofspeculation. He wrote, "All through time, people have basically acted andreacted the same way in the market as a result of: greed, fear, ignorance, andhope. That is why the numerical formations and patterns recur on a constantbasis." The book did not sell well; the prospects of war were high, and interestin the stock market was low.

Largely dismissed by the market gurus of the era, Livermore's effort tosystematize his methods was viewed as being outside of Wall Street's orthodoxy.It is ironic that as late as 2009, when two MIT neuroeconomists, Andrew W. Loand Jasmina Hasanhodzic, published their book on Wall Street's leading technicalanalysts, including John Murphy, Stan Weinstein, Bob Farrell, Paul Desmond, andRalph Alcampora, their title was The Heretics of Finance, indicating thelevel of esteem still accorded to these market professionals.

On November 28, 1940, Jesse Livermore fatally shot himself in the cloakroom ofthe Sherry-Netherland Hotel in New York. In a leather-bound notebook found inhis pocket was a letter addressed to his fourth wife. It read, "My dear Nina:Can't help it. Things have been bad with me. I am tired of fighting. Can't carryon any longer. This is the only way out. I am unworthy of your love. I am afailure. I am truly sorry, but this is the only way out for me."

Seven years earlier, Livermore had married 38-year-old Harriet Metz Noble inGeneva, Illinois. It was his third marriage and her fifth. Despite Livermore'sbattle-tested risk acumen, he hadn't hesitated in his choice of Harriet, whoseprevious four husbands had committed suicide. Trusts and cash assets atLivermore's death totaled more than $5 million.

Although Livermore ultimately did not follow his own advice, and often actederratically, his psychological insights have provided fertile ground forgenerations of investors.

THE LONE WOLF OF WALL STREET

A friend and colleague of Livermore's, who had also earned a fortune by shortselling in the 1929 market crash, was stock trader Bernard Baruch, later afinancier and statesman who advised presidents Woodrow Wilson and Franklin D.Roosevelt on economic matters. Baruch's keen observations demonstrate thevolatile nature of the market and the mindset required to master it. Today hisname decorates a branch of the City University of New York. Like Livermore, hehad read Scottish journalist Charles Mackay's 1841 book, ExtraordinaryPopular Delusions and the Madness of Crowds, which examined its subject inthree parts: "National Delusions," "Peculiar Follies," and "PhilosophicalDelusions."

Among the financial manias that Mackay described were the South Sea Companybubble of 1711 to 1720, the Mississippi Company bubble of 1719 to 1720, and theDutch tulip mania of the early seventeenth century. According to Mackay, duringthis bubble, speculators bought and sold tulip bulbs with abandon, eveninvesting in futures contracts on them. Some varieties briefly became the mostexpensive luxuries in the world. Both Livermore and Baruch learned vital lessonsfrom Mackay that they would bring with them to Wall Street.

Known as the Lone Wolf of Wall Street, Baruch earned a fortune before the age of30. Famous for his razor-sharp observations, he is remembered today for pithystatements like his answer to the question of what was the key to his success inthe market, "Selling too soon!" or "I'm not smart, but I like to observe.Millions saw the apple fall, but Newton was the one who asked why."

One of my favorites is Baruch's statement about self-reflection: "Only as you doknow yourself can your brain serve you as a sharp and efficient tool. Know yourown failings, passions, and prejudices so you can separate them from what yousee." The full importance of this insight in light of recent developments inbehavioral finance and neuroeconomics will soon become apparent.

Baruch provided his rules for successful investment:

* Don't speculate unless you do it full time.

* Resist so-called information or tips.

* Before purchasing a security, know everything you can about the company: itsearnings and its capacity for growth.

* Never attempt to buy at a bottom or sell at a top of a market: this is a featachieved only by liars.

* Take your losses swiftly and clearly. The first loss is your easiest loss.

* Don't buy too many securities. Focus on a few investments that can bemonitored carefully.

* Periodically reappraise all your investments to make sure that they areappropriate for your particular strategy.

* Know when you can sell to your greatest advantage (of course, this alsoapplies to buying).

* Never invest all your funds. Keep some liquid.

* Don't try to be a "jack of all investments." Stick to the field you know best.

A lifelong skeptic of both giving and taking advice, Baruch qualified his marketrules with a caveat: "Being so skeptical about the usefulness of advice, I havebeen reluctant to lay down any rules or guidelines on how to invest or speculatewisely. Still, there are a number of things I have learned from my ownexperience that might be worth listening for those who are able to muster thenecessary self-discipline."

MR. MARKET

The first serious attempt to distinguish between speculation and investment andto address the investor's natural inclination toward irrational investing wasmade by economist and professional investor Benjamin Graham, born BenjaminGrossbaum. "An investment operation is one which, upon thorough analysis,promises safety of principal and an adequate return," he wrote. "Operations notmeeting these requirements are speculative."

Advocating what he called "value investing," Graham taught this approach atColumbia Business School and refined it over many editions of his famous bookwith David Dodd, Security Analysis, first published in 1934 and eversince considered to be a bible for serious investors. The idea behind valueinvesting was to purchase stocks whose price was lower than their true value andthen to hold them until the price returned to that value, earning a gain on theinvestment.

Graham's disciples make up a pantheon of professional investors, includingWarren Buffett, Irving Kahn, William J. Ruane, and Walter Schloss. Buffettcredited Graham with giving him the basis for his investment framework,describing him as the most influential person in his life after his own father.Irving Kahn and Buffett both named sons after him. Buffett describes TheIntelligent Investor, published in 1949, as "the best book about investingever written." In it, Graham states that the investor should regard equityshares as offering part ownership of a business, making the stockholders focuson the long term, and cautioning against a short-term perspective that gets onebogged down in the erratic fluctuations of stock prices.

Graham's favorite allegory is that of Mr. Market, a fellow who turns up everyday at the shareholder's door offering to buy or sell stocks at a differentprice. Often, the price quoted by Mr. Market seems plausible, but sometimes itis ridiculous, either way too low or way too high. The investor is free to tradeat the quoted price or to ignore Mr. Market completely. But Mr. Market isagnostic, returning the following day to quote another price.

The point of this anecdote, then and now, is that the investor need not regardthe arbitrariness of Mr. Market as the determining factor in the value of one'sshares. The investor is advised to focus on the performance of his businessesand receiving dividends, rather than to concentrate on moody Mr. Market'sfluctuations and irrational behavior.

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