Improving Your Market Odds

Despite what many economists and financial theorists assume, people are not good intuitive statisticians, particularly under difficult conditions. They do not calculate odds properly when making investment decisions, which causes consistent errors. First, we must leam why such mistakes occur so frequendy. Once their nature is understood, we can develop a set of mles to help monitor our decisions and to provide a shield against serious mishap. We will then see how the contrarian strategies presented above are anchored upon these intuitive statistical limitations. We can then apply the same principles to other investment opportunities outside of financial markets, and be in a position to profit from crisis and panic in the marketplace itself.

In Simplification We Believe

Lets quickly review the limitations of mans information-processing capabilities, a sort of black hole that is constantly exerting great force on his decisions. We briefly looked at the problem in chapter 6. According to Nobel laureate Herbert Simon, people are swamped with information and react consciously to only a small part of it. Simon also stated that when overwhelmed with facts, we select a small part of them and usually reach a different conclusion from what the entire data set would suggest.

Researchers have found that people react to this avalanche of data by adopting shortcuts or mles of thumb rather than formally calculating the actual odds of a given outcome. Known to psychologists as judgmental heuristics in technical jargon, these shortcuts are leaming and simplifying strategies we use for managing large amounts of information. Backed by the experience of a lifetime, most of these judgmental shortcuts work exceptionally well, and allow us to cope with data that would otherwise overwhelm us.

predictable manner, not only in the marlcetplace, but in virtually every aspect of our lives. The bottom line is that these powerful forces lead most people to make the same mistakes time and again. Understanding them is your best protection against stampeding with the crowd, and perhaps profiting from their mistakes instead. But as you read on youll see its much easier said than done.

It Aint Necessarily So

Let us first look at one of the most common of the cognitive biases that Daniel Kahneman of Princeton and the late Amos Tversky of Stanford (whom we met earlier) call "representativeness." The two professors show its a natural human tendency to draw analogies and see identical situations where none exist.

In the market, this means labeling two companies, or two market environments, as the same when the actual resemblance is superficial. Give people a littie information and, click!, they pull out a picture theyre familiar with, though it may only remotely represent the current situation.

An example: the aftermath of the 1987 crash. In five trading days the Dow fell 742 points, culminating with the 508 point decline on Black Monday, October 19. This wiped out almost $1 tiillion of value. "Is this

Driving a car down a superhighway, for example, you concentrate only on operating the vehicle, on other traffic, and on traffic signs, screening out thousands of other distracting and disruptive bits of information. The rule of thumb is to focus solely on what directly affects our driving, and the rule is obviously a good one.

We also use selective processes in dealing with probabilities: in many of our decisions and judgments, we tend to be intuitive statisticians. We apply mental shortcuts that work well most of the time. We think our odds of survival are better when driving at 55 miles an hour than at 90 miles an hour, although few of us have ever bothered to check the actual numbers. A professional basketball team is likely to beat an amateur one, if the "amateurs" are not "The Dream Team"; a discount computer store will probably sell personal computers more cheaply than Macys or Bloomingdales. And we might expect to get to a city 300 miles away faster by air than by ground (if it is not a United Express flight to a Colorado ski resort). There are dozens of examples that such procedures are valuable and immensely timesaving.

But being an intuitive statistician has limitations as well as blessings. The very simplifying processes that are normally efficient time-savers lead to systematic mistakes in investment decisions. They can make you believe the odds are dramatically different from what they actually are. As a result, they consistentiy shortchange the investor.

The distortions produced by the subjectively calculated probabilities are large, systematic, and difficult to eliminate, even after people have been made fully aware of them, as well see next.

1929?" asked the media in bold headlines. Many investors taking this heuristical shortcut cowered in cash. They were caught up in the false parallel between 1987 and 1929.

Why? At the time, the situations seemed eerily similar. We had not had a stock market crash for 58 years. Generations grew up believing that because a Depression followed the 1929 Crash it would always happen this way. A large part of Wall Streets experts, the media, and the investing public agreed.

Overlooked was that the two crashes had only the remotest similarity. In the first place, 1929 was a special case. The nation has had numerous panics and crashes in the nineteenth and early twentieth centuries without a depression. Crashes or no, the thriving American economy always bounced back in short order.

In recounting how often they occurred, Victor Niederhoffer, in his insightful book. The Education of a Speculator, notes that Henry Clews wrote after the panic of 1837 that "Prices dropped to zero." The same observer casually stated a few pages later, "The panic of 1857 was much more severe." Clews doesnt say whether in the latter panic sellers actually had to pay buyers to cart away their stocks or bonds. In neither case was there a depression. So crash and depression were not synonymous.

More important, it was apparent even then that the economic and investment cUmate was entirely different. My Forbes column of May 2, 1988, noted some of the differences clearly visible at the time. The column stated that although market savants and publications were presenting charts showing the breathtaking similarity between the market post-crash in 1988 with that of 1929, there was far less to it than met the eye. Back then the market rallied smartly after the debacle before beginning a free-fall in the spring of 1930, and many experts believed history would repeat itself 58 years later.

The similarities were obvious. The major averages had moved up 20% from the Oct. 19, 1987, bottom and then skidded lower, again in a manner similar to early 1930. But as I warned readers: a chart, unlike a picture, is not always worth a thousand words; sometimes it is just downright misleading.

The economic and investment fundamentals of 1988 were worlds apart from those of 1930. At that time economic and financial conditions were beginning to blow apart, as the worst depression in the nations history rapidly approached.

It was hard for even the most fervent gloom-and-doomer to argue that a parallel situation existed after the 1987 crash. The economy was rolling along at a rate above most estimates pre-crash and 8 1 above