Successful traders psychology

Portfolio manager’s Letter July – August 2012

Successful traders psychology

The market may be efficient, but it is certainly not rational, and it is efficient only in the sense that it is very efficient at measuring Wall Street’s current mania. Whatever the market is measuring, it is undoubtedly not the intrinsic value of the stocks being traded. Then, this P.E. began to increase until, by 2000, it was 34 gradually. From its peak in and has a lot to do with successful traders psychology. In 1982, the P.E. of the S&P 500 was 9. 2000. It has decreased until today it is around 13.

During this entire period, Corporate Profits, ignoring the occasional recession, have increased at a reasonably constant rate of about 8% per year. An efficient market should reflect this steady growth in earnings, but the actual market does nothing of the kind, but a good deal of successful traders psychology. What we get instead is a steadily changing view of the value of corporate earnings.

Testosterone and risk

John Coates provides additional evidence of an irrational link between human behavior and the markets in his new book “The Hour between Dog and Wolf.” A successful trader first at Goldman Sachs then at Merrill Lynch and Deutsch Bank in the eighties and early nineties Coates returned to Cambridge to research neuroscience. His time on the trading floor got him interested in the effects of steroids on successful traders psychology. He now suspects there may be a chemical solution for the riddle of Mr. Market’s psychosis, and a biological basis for his behavioral problems. The laws of financial boom and bust, he maintains, have more than a little to do with male hormones and successful traders psychology.

In a series of experiments that he conducted on the trading floor of a large London firm, Dr. John Coates tested the testosterone level of traders in the morning as they showed up for work and found that traders with high testosterone made more profit during the day than those with low levels. Dr. John Coates identified a feedback loop between testosterone and success that dramatically lowers the fear of risk in men, especially younger men. This loop builds on success because successful trades feed successful traders psychology, generate higher testosterone, and acceptance of more significant trading risk.

The book moves on to a detailed look at nature human hormones and the effects of our chemistry on our behavior. Success fuels testosterone levels so that in a bull market successful traders psychology is fed encourages them to take on more and more risk, a process I suspect is intensified by the enormous bonuses paid to traders in large banks and brokerage companies. This process can continue to build over many years as bonuses get bigger and bigger, and eventually, the bull market turns into a mania.

We cannot blame testosterone for all of the collective insanity of the subprime mess. Still, it probably helped – the $40 million bonuses and salaries for traders and $100 million-plus compensation for CEOs affects successful traders psychology helps to build testosterone levels and tends to make humans think there are a lot smarter than they are.

Cortisol

Another Steroid that effects trader behavior is cortisol otherwise as known as the stress hormone or the anti-testosterone hormone. It has the opposite effect on trader’s behavior, lowering the appetite for risk across an entire spectrum of decisions and affecting successful traders psychology. Trading failure leads to a rise in levels of cortisol so that this hormone rules the bear market, and seems to have firm control of Mr. Market today. Cortisol can build if bad trades continue for an extended period to the point that the trader essentially becomes unable to initiate a new position.

The laws of financial boom and bust, it turns out, may have more than a little to do with male hormones and the effect they have on successful traders psychology, but hormones only part of the markets underlying irrationality. Coates set out to explain patterns of behavior that observed in his previous life on the trading floor, and his research offers valuable insights into the exploding new field — the biology of risk.

Traders (whether they are individuals, investment managers, or institutional investors) place their bets and live with the results. Coates finds biology tends to drive them to irrational exuberance and then an equally irrational pessimism. Risk concentrates the mind — and the body — like nothing else, altering our physiology in ways that have profound and lasting effects. What’s more, biology shifts investors’ risk preferences across the business cycle and can precipitate high volatility in successful traders psychology.

The Current Market

The good news is that Berkshire Hathaway is making new 52 week highs, so that is improving our investment results, but for the market as a whole, it is three days up and three days down and going no place. The best that can be said is that we are another month closer to the end of a long term bear market. Even though equity prices have made very little progress in the last twelve years, corporate earnings have been increasing at about 8% per year.

The P.E. ratio of S&P 500 stocks’ operating earnings has dropped from a very risky 28 in 2000 to moderately undervalued 11 based on 2013 estimates. One thing is clear: with prices going no place and earnings increasing year after year, there is a lot less risk in the market today than there was twelve years ago.

As Selby Davis once said, “you make all your money in a bear market, you just don’t know it till later.” The bear market is when you can buy good stocks cheap, and you should be able to establish the positions that will allow above-average investment performance for many years when the bull market returns.

The best measure of the market’s current irrationality can be found in short-dated government security markets. Currently, investors are eager to hand over money in exchange for sovereign debt yielding less than nothing. At the end of last week, two-year obligations of the governments of Austria, Denmark, Finland, Germany, the Netherlands, and Sweden all were yielding less than zero. Whereas, Berkshire Hathaway with less “real” long term risk than most Government credits (in my opinion) offers an earnings yield of 6.3%, if include look-through earnings. This willingness of investors to except a negative return lends to the market a strong flavor of panic and makes one wonder about the successful traders psychology.