George Charles Selden believed that market prices were driven by the mental attitudes of investors. So in 1912, he wrote Psychology of the Stock Market based on his “years of study and experience” from watching and writing about the stock market.
Much of Selden wrote over 100 years ago is the same today. Investor behavior and market prices are still intertwined. Recognizing that fact is the first step to keeping an open mind — as Selden suggests we should — in order to limit mistakes and losses.
I pulled out some of the bigger issues investors face, as he described it:
On the market cycle and investor behavior.
As a convenient starting point it may be well to trace briefly the history of the typical speculative cycle, which runs its course over and over, year after year, with infinite slight variations but with substantial similarity, on every stock exchange and in every speculative market of the world—and presumably will continue to do so as long as prices are fixed by the competition of buyers and sellers, and as long as human beings seek a profit and fear a loss.
The fact will at once be recognized that the above description is, in essence, a story of human hopes and fears; of a mental attitude, on the part of those interested, resulting from their own position in the market, rather than from any deliberate judgment of conditions: of an unwarranted projection by the public imagination of a perceived present into an unknown though not wholly unknowable future.
Selden goes on to explain in detail the typical behavior at each stop along the market cycle. That behavior has a lot to do with how an investor’s situation fits or conflicts with the direction of the market. The cycle of behavior is as old as there are markets.
On the dangers of confirmation bias.
Probably no better general rule can be laid down than the brief one, “Stick to common sense.” Maintain a balanced, receptive mind and avoid abstruse deductions. A few further suggestions may, however, be offered:
If you already have a position in the market, do not attempt to bolster up your failing faith by resorting to intellectual subtleties in the interpretation of obvious facts. If you are long or short of the market, you are not an unprejudiced judge, and you will be greatly tempted to put such an interpretation upon current events as will coincide with your preconceived opinion. It is hardly too much to say that this is the greatest obstacle to success. The least you can do is to avoid inverted reasoning in support of your own position.
After a prolonged advance, do not call inverted reasoning to your aid in order to prove that prices are going still higher; likewise after a big break do not let your bearish deductions become too complicated. Be suspicious of bull news at high prices, and of bear news at low prices.
One of the principal difficulties of the expert is in preventing his active imagination from causing him to see what he is looking for just because he is looking for it.
Investors tend to look for information that confirms their theories and ignore information that opposes it. Charlie Munger would suggest investors are better off doing the opposite. Investors should seek out disconfirming information in order to destroy their worst ideas, so only their best theories are followed.
On relying too heavily on math and models.
The effort to reduce the science of speculation and investment to an impossible definiteness or an ideal simplicity is, I believe, responsible for many failures. A. S. Hardy, the diplomat, who was formerly a professor of mathematics and wrote books on quaternions, differential calculus, etc., once remarked that the study of mathematics is very poor mental discipline, because it does not cultivate the judgment. Given fixed and certain premises, your mathematician will follow them out to a correct conclusion; but in practical affairs the whole difficulty lies in selecting your premises.
So the market student of a mathematical turn of mind is always seeking a rule or a set of rules — a “sure thing” as traders put it. He would not seek such rules for succeeding in the grocery business or the lumber business; he would, on the contrary, analyze each situation as it arose and act accordingly. The stock market presents itself to my mind as a purely practical proposition. Scientific methods may be applied to any line of business, from stocks to chickens, but this is a very different thing from trying to reduce the fluctuations of the stock market to a basis of mathematical certainty.
Everyone wants a sure thing; a strategy that always works. Nobody likes uncertainty. But that’s what we got. No model or math formula is guaranteed to work all the time. The best you can hope for is a strategy that gives you the best chance of success.
On the dangers of recency bias
It is a sort of automatic assumption of the human mind that present conditions will continue, and our whole scheme of life is necessarily based to a great degree on this assumption. When the price of wheat is high farmers increase their acreage because wheat-growing pays better; when it is low they plant less. I remember talking with a potato-raiser who claimed that he had made a good deal of money by simply reversing the above custom. When potatoes were low he had planted liberally; when high he had cut down his acreage — because he reasoned that other farmers would do just the opposite.
Investors consistently extrapolate recent events indefinitely into the future. When things are going well, investors assume things will continue to only get better. When things are going poorly, they assume it can only get worse. At the extreme ends of a market cycle, doing the opposite has a higher chance of paying off.
On loss aversion, fear, and the cause of a market bottom.
It is sometimes assumed that the low prices in a panic are due to a sudden spasm of fear, which comes quickly and passes away quickly. This is not the case. In a way, the operation of the element of fear begins when prices are near the top. Some cautious investors begin to fear that the boom is being overdone and that a disastrous decline must follow the excessive speculation for the rise. They sell under the influence of this feeling.
During the ensuing decline, which may run for years, more and more people begin to feel uneasy over business or financial conditions, and they liquidate their holdings. This caution or fearfulness gradually spreads, increasing and decreasing in waves, but growing a little greater at each successive swell. The panic is not a sudden development, but is the result of causes long accumulated.
The actual bottom prices of the panic are more likely to result from necessity than from fear. Those investors who could be frightened out of their holdings are likely to give up before the bottom is reached. The lowest prices are usually made by sales for those whose immediate resources are exhausted.
The great cause of loss in times of panic is the failure of the investor to keep enough of his capital in liquid form. He becomes “tied up” in various undertakings so that he cannot realize quickly. He may have abundant property, but no ready money. This condition, in turn, results from trying to do too much—greed, haste, excessive ambition, an oversupply of easy confidence as to the future.
It is to a great extent because the last part of the decline in a panic has been caused not by public opinion, or even by public fear, but by necessity, arising from absolute exhaustion of available funds, that the first part of the ensuing recovery takes place without any apparent reason.
The effect of this fear or caution in a panic is not limited to the selling of stocks, but is even more important in preventing purchases. It takes far less uneasiness to cause the intending in vestor to delay purchases than to precipitate actual sales by holders.
The combination of selling out of fear and necessity is only partially to blame for market crashes. Since every share sold needs to be bought, a lack of buyers is also to blame. That fear of buying has the dual effect of causing bigger losses on the way down and missing out on gains after the market turns.
On the money illusion.
A psychological influence of a much wider scope also operates to help a bull market along to unreasonable heights. Such a market is usually accompanied by rising prices in all lines of business and these rising prices always create, in the minds of business men, the impression that their various enterprises are more profitable than is really the case.
The result is that…the high prices for stocks and the feverish activity of general trade are based, to an entirely unsuspected extent, on a sort of pyramid of mistaken impressions, most of which may be traced, directly or indirectly, to the fact that we measure everything in money and always think of this moneymeasure as fixed and unchangeable, while in reality our money fluctuates in value just like iron, potatoes, or “Fruit of the Loom.” We are accustomed to figuring the money-value of wheat, but we get a headache when we try to reckon the wheat-value of money.
Essentially, people recognize that they have more dollars. They feel wealthier because stock and other asset prices have risen. But they fail to realize that those dollars don’t always buy them more stuff. Their dollars don’t go further when inflation drives the cost of goods higher too.
On being aware of other’s biases or second level thinking.
We have seen that many, if not most, of the eccentricities of speculative markets, commonly charged to manipulation, are in fact due to the peculiar psychological conditions which surround such markets. Especially, and more than all else together, these erratic fluctuations are the result of the efforts of traders to operate, not on the basis of facts, nor on their own judgment as to the effect of facts on prices, but on what they believe will be the probable effect of facts or rumors on the minds of other traders. This mental attitude opens up a broad field of conjecture, which is not limited by any definite boundaries of fact or common sense.
Yet it would be foolish to assert that assuming a position in the market based on what others will do is a wrong attitude. It is confusing to the uninitiated, and first efforts to work on such a plan are almost certain to be disastrous; but for the experienced it becomes a successful, though of course never a certain, method. A child’s first efforts to use a sharp tool are likely to result in bloodshed, but the same tool may trace an exquisite carving in the hands of an expert.
This is what Howard Marks calls second level thinking. First level thinkers are drawn to things that seem obvious and simple. If something seems obvious, then there’s a good chance everyone else is thinking the same thing. So if everyone is thinking the obvious thing, then it’s already priced in.
It’s hard to make money when it’s already priced in.
But a second level thinker recognizes this. So rather than following the obvious and simple path, the second level thinker will go deeper. If you can recognize how other investors will react to a big news event or how they view a business, then you have an idea of what’s already priced in to the market, and avoid it.
On being aware of your own biases.
In this matter of allowing the judgment to be influenced by personal commitments, very little of a constructive or practically helpful nature can be written, except the one word “Don’t.” Yet when the investor or trader has come to realize that he is a prejudiced observer, he has made progress; for this knowledge keeps him from trusting too blindly to something which, at the moment, he calls judgment, but which may turn out to be simply an unusually strong impulse of greed.
It’s not enough to know what drives other peoples to make mistakes. Being an impartial judge of your own investments, requires an honest examination of yourself – your faults and limitations. This is most likely why some of the best investors are quick to admit mistakes and stay humble.
Psychology of the Stock Market – G.C. Selden