Thursday, April 14, 2005

Market Psychology Quotes

"Scared money never wins." Old Wall Street Maxim

“[I]ntuition comes from experience.” Charles Faulkner

“Few people have absorbed the hard neuroscience research that reasons arrive afterwards.”
Charles Faulkner

“[G]iven the choice between a simple, easy to understand, explanation that works and a difficult one that doesn’t, people tend to pick the latter...Confusing hindsight with foresight, and complexity with insight....”
Charles Faulkner

“’I am competent to be confident. I know what’s going on in these markets. If I don’t know, I get out.’”
Charles Faulkner

“No matter what kind of math you use, you wind up measuring volatility with your gut.”
Ed Sekoya

“Playing it safe is dangerous.”
Charles Sanford

“The smarter you are (or think you are), the more you’ll think, and the less money you’ll make.” Jake Bernstein

“Traders who can act quickly, evaluating information and reacting to it on a gut level, are often traders who succeed.”
Jake Bernstein

“The job of traders is to follow, not forecast.” Jake Bernstein

“Being aggressive at the wrong time can be very costly.”

Jake Bernstein

“Fear narrows attention.”
Mark Douglas

“Accept a loss without guilt, anger, shame or self punishment.” Mark Douglas

“The more I trusted myself the more I could focus my attention on subtle relationships in the market’s behavior to learn new things about the market helping me become a better trader....the less I cared about whether or not I was wrong, the clearer things became, making it much easier to move in and out of positions, cutting my losses short to make myself mentally available to take the next opportunity.” Mark Douglas

“Entering a trade will involve all your beliefs about opportunity in relation to risk, missing out, needing a sure thing, and not being wrong. Exiting a trade will involve all your beliefs about loss, greed, failure, and control. Considering the unlimited potential for profits, entering the market [will be] much easier...because exiting will require you to confront your beliefs about greed, loss, and failure in relationship to the constant temptation of the possibility for unlimited profits.” Mark Douglas

“[G]reed [is] fear founded in a belief that there will never be enough.” Mark Douglas

"Bulls win, bears win, hogs [or pigs] get slaughtered." Old Wall Street Maxim

“In effect, his fear of losing causes him to exit the trade early for a small profit regardless of whatever the profit potential was in that trade. Once he is out he will agonize over the profits he left on the table and wonder why he just couldn’t hang in there a little longer not realizing that his fear of losing actually caused him to lose those additional profits.” Mark Douglas, on how fear of loss leads to loss, just as fear of dogs may lead to an increased risk of attack from dogs

“The problem with the poor is they submit; with the rich is they don’t know what they are loved for.” Charles Bukowski



Interestingly, and perhaps revolutionarily, the most successful traders in the world—although not as well known as Soros or Buffet—have long term (over ten years) rates of capital appreciation of almost twice as much as these luminaries. Such rates, of up to 60% a year, would never be predicted if markets were completely random; indeed, the chances of such rates of return have been compared to the spontaneous production of aircraft in windswept junkyards: there is simply no way the rates of return of Soros and Buffet are random, let alone those who double their long-term returns. Among those who do are Ed Sekoya, formerly of MIT and the first to write computer programs to trade stocks, and John Henry, the manager of a hedge fund (and owner of the World Championship Boston Red Sox). Successful trend followers are distinct from other market players in their refusal to predict prices. Rather, they identify trends, using mathematical and chart-based techniques. Once a trend is identified, the trend follower bets that the trend will continue. Since he or she doesn’t know when the trend will stop, the trend follower uses a stop loss order below the market (if long or having bought stock, commodities, or other instruments) or above the market if short (if having sold borrowed stock, commodities, or other instruments). The stop is kept outside normal volatility fluctuations which, if exceeded, might indicate a change of trend. By cutting losses quickly, but staying in trends until they end, trend followers do not try to outsmart, but rather stay in trending markets. Some report that while their intellectual analysis persuades them of a change of trend, they defer to their objective mathematical measures that a trend is still in progress. In retrospect, certain simple but effective systems—such as buying stocks that have doubled in price from their 52 week lows to reach all time new highs when they have relative strength of 80 or over (relative strength, which measures a stock’s price performance relative to the market as a whole, can be found in Investor’s Business Daily, and at in the Sectors section)—and selling them when their relative strength reaches 75 or lower—can be recognized as trend-following systems. Another example is the system of Stan Weinstein, originally a commodities trader. Weinstein exhaustively studied charts and read works of technical analysis looking for systems. His system, explained in How to Profit in Bull and Bear Markets, is a trend following one that buys stocks that move through their 30 week moving average to the upside, and sells stocks that move down this average to the downside. He then does not try to predict, but rather uses stops to get out of successful positions. Many of Livermore’s precepts, such as “trailing along” stocks that have normal reactions can also be recognized, in retrospect, as trend following methods and systems. The most successful trend followers follow several trends at once, both uptrends and downtrends, in markets around the world. Some trends can last for decades. For example from the early 1980s to 2001 stocks trended strongly higher while commodities decreased in value; in the two decades before that, however, commodities rose in price while stocks stagnated or decreased in value.

In summary, the most effective means of making money in the markets appear to be by trend following, a system which works best when mathematically automated to recognize and ride trends within normal levels of volatility.



Technical analysis. Technical analysis is predicated on the belief that price and volume patterns can predict future price movement. The first known forms of technical analysis include 13th century Japanese rice farmers, who devised a technique known as “candle stick” analysis to predict movements in the price of this important commodity. Later visual and mathematical techniques were developed by western traders to predict movement in the stock and commodity markets. One difficulty with technical analysis is that, since market participants are themselves included among the factors that determine prices, and may themselves learn to predict prices on the basis of technical analysis (if valid), then predictive patterns may lose their efficiency as they become broadcast to and acted upon by sufficient numbers of market participants. It is thus appreciated by believers of technical analysis that important segments of the market advisory community (e.g., The Motley Fool website) decry technical analysis as superstitious tea leaf reading. In fact, however, in the short term especially, markets probably can be predicted because the actors in markets tend to be emotional. For example, if a stock hits a new high, no one who has ever bought it will have (yet) lost money on it, and so the general feelings associated with the stock are positive; if, on the other hand, the stock has traded for years at higher prices, then many people who own the stock will have lost money on it, and have a negative feeling associated with such loss. If this second stock rises to levels where many people bought it previously (technically known as “resistance” ), they will be more likely to sell in order “to get even” or “to get out without a loss” than those in the new-high stock. Because technical analysis can identify such factors probabilistically associated with emotions such as hope, fear, greed, desperation, and panic—and because these human emotions, magnified by crowd behavior—are not likely to disappear any time soon, then it seems likely that at least some of the patterns recognized by technical analysis as predictive will continue to be valid. Nonetheless, these emotional verities that can be found in price patterns on charts probably only exist when stocks are strongly trending, which is estimated to be the case only about 30% of the time. Moreover, the patterns that reveal such trending or reversal at emotional climaxes may be relatively simple to identify—in contrast to some of the very complex systems and methods sold under the rubric of technical analysis. Finally, although computers can be programmed to match past price patterns perfectly, past exactitude does not correlate with future accuracy. Trading on the basis of trends, which does not try to predict future price so much as recognize current direction, is closer to technical analysis than to the academic theories above and the fundamental analysis below, but is so important it will be treated in another section.

Fundamental analysis. This is the determination of the “real” value of stocks based on factors such as managment quality, price to sales ratios, yield (if the stock pays a dividend), price to earnings ratios (if there are earnings), and so forth. The most successful fundamental analyst practitioner is probably Warren Buffet, the “sage of Omaha” who has used his never-split stock Berkshire Hathaway to buy undervalued companies and hold them, sometimes forever. Buffet’s method advocates buying a stock with a margin of safety (i.e., on sale) and holding it indefinitely; if the stock declines in value by 50%, twice as much stock is purchased. Although this technique is diametrically opposed to the “buy high, sell higher” method of technical analysis, it shares with it a studied reluctance to indulge in the emotions of the crowd. Some traders, such as hedge fund manager George Soros, combine technical and fundamental analysis—although this is not recommended for most people, as the two techniques, as stated, can lead to confusingly different standpoints.



Extensive analysis reveals three main sorts of understanding about how markets work, and thus how money can come to be taken out of the market on anything like a regular basis.

Academic theory. Efficient market theory, a favorite of academics, suggests that all prices reflect all available information. According to this theory, future price direction is unpredictable, since all information is already priced in to price, which will immediately change as information changes. Another academic theory, called “random walk” theory, argues that price change is completely random within certain parameters. Such randomness actually contradicts efficiency, as a truly efficient market would be determined by information, and thus probably not random. In any case, both sorts of academic theories assume that market participants are rational actors. The reality of stock market, real estate, commodity booms and busts belies this assumption. In fact, prices can become extremely extended and extremely oversold as people, trying to make money based not on rational decisions but on fear and greed, follow prices to their point of inflection. Rather than rational, market participants would describe market behavior as manic depressive.

Jesse Livermore: Articulate Intuitive Market Genius

Although he lost all his money at least twice, once going into debt for over a million dollars—and although he eventually killed himself (graphically showing that money can’t buy happiness)—Jesse Livermore was a brilliant self-taught stock trader who made millions of dollars during the Crash of 1929. Arguably the greatest trader who ever lived, Livermore’s hard-won insights about the behavior of prices in a publically traded environment such as Wall Street are priceless insights not only into making money, but also into human emotions and the way they interfere with the behaviors needed to make money. Livermore was born in South Acton, Massachusetts. His great work, Reminiscences of a Stock Market Operator, is remarkable not only for the quality of its insights but the clarity of its prose.

“When I am bearish and I sell a stock, each sale must be at a lower level than the previous sale. When I am buying, the reverse is true. I must buy on a rising scale. I don’t buy long stock on a scale down, I buy on a scale up.”

This behavior is exactly the opposite of most retail investors. People tend to buy stocks like they buy groceries or clothes, more when the commodity or service is cheaper. But since stocks vary in prices, and the speculator profits off of price differentials, prices that are moving in the wrong direction can be extremely deleterious, and “sales” can go to zero. Unlike most purchased items, stocks are purchased only for their resale value (unless a big investor buys the whole company).

“Remember that stocks are never too high for you to begin buying or too low to begin selling. But after your initial transaction, don’t make a second unless the first shows you a profit. Wait and watch. Suppose a man’s line is five hundred shares of stock...suppose he buys his first 500 and that promptly shows him a loss. Why should he go to work and get more stock? He ought to see at once that he is wrong; at least temporarily.”

Livermore here is essentially revealing that he is following trends. If the movement of the stock is in the direction he determines (with some uncertainty) that he thought it was going, he adds to his position. The continued movement suggests that he was right in identifying the trend. On the other hand, if he was wrong, then he was wrong (at least for the moment) about the direction of the trend. The method can actually be considered a combination of trend following and an evolutionary algorithm (or rather, the evolutionary algorithm): get rid of what doesn't work. Most people have difficulty admitting they're wrong but, in fact, this is key not only to the stock market but to learning in general. "An expert," as physicist Philip Morrison, former book reviewer of Scientific American, has said, "is someone who makes all possible mistakes."

Wednesday, April 13, 2005

Welcome to the Sciencewriters Money Page

This site is devoted to a sober, scientific look at market knowledge with an eye to making money as well as understanding its nature. Jesse Livermore, the solar basis of the global economy, psychology, motivation, and trends are among the topics covered. Unlike the great morass of sites out there, this site is opposed to hucksterism and boosterism. We take a literary, and even philosophical approach to the markets. Oscar Wilde said, "A cynic is a man who knows the price of everything and the value of nothing." This site attempts to disentangle the huge overload of purported wisdom pertaining to the markets, separating the wheat from the chaff, the counterfeit from the real. Interested in the business of making money in the markets, we have collected, among other things, epigrams from market participants whose success defies statistical fluctuation. The results are interesting and occasionally surprising.