BEHAVIORAL INVESTINGDEMYSTIFYING THE PSYCHOLOGICAL DRIVERS OF GLOBAL MARKETS

November 27, 2013

Richard L. PetersonMarketPsych, LLC

Digital OctoberKnowledge ExchangeMoscow

WHAT FACTORS PREDICTABLY DRIVE MARKET PRICES?

PRIMARILY ECONOMIC FUNDAMENTALS?

PRIMARILY PRICE PATTERNS?

PRIMARILY INVESTOR PSYCHOLOGY?

BEHAVIOR

BRAIN

INFORMATION

COMPLEX INTERACTION?

ABOUTMARKETPSYCH

MARKETPSYCH HAS DEVELOPED APPLIED BEHAVIORAL FINANCE TOOLS SINCE 2001.

Research group includes experts in quant finance, natural language processing, affective neuroscience, psychometrics, cloud computing and behavioral economics.

Published research in academic journals, textbooks, and two award-winning books.

Frequent appearances in financial media including BBC, WSJ, FT and Bloomberg.

BEHAVIORAL/FINANCE

“All through time, people have basically acted and reacted the same way in the market as a result of: greed, fear, ignorance, and hope. That is why the numerical formations and patterns recur on a constant basis.”~ Jesse Livermore, How To Trade In Stocks, 1927

Behavioral Economics

Individual investors make predictable decisions when experiencing Stress, Uncertainty, Optimism, Trust, Fear, and other states.

Market Sentiment

Sentiment has long been anecdotally associated with asset price fluctuations driven by crowds.

Thomson Reuters MarketPsych Indices

MarketPsych partnered with Thomson Reuters to produce the most comprehensive quantitative data source for testing the predictive power of market sentiment.

YOUR MARKET BRAIN

EXPERIMENT (Winkielman et al, 2007)

People shown fearful or angry faces took less risk in an investment task, earning less money.

Happy face increased risk-taking 30% versus negative expressions.

Afterwards subjects denied that the faces had affected their judgment.

How does emotional priming affect investors’ decision making?

EMOTIONAL/PRIMING

The brain’s structure may explain some individual economic behaviors.

Frontal Cortex Executive function Judgment

Subcortex: Limbic system Emotions Drives Desires

“X-ray” view through the brain

EMOTION/OVERVIEW

EMOTION/REWARD SYSTEM

Knutson and Kuhnen, 2005

Excited motivation Confidence Desire Dopamine

Threat perception Memories of loss Serotonin Fear

EMOTION/LOSS AVOIDANCE

EMOTION/LOSS AVOIDANCE

YOUR MARKET PERSONALITY

BRAIN/PERSONALITY

• Investor’s Personality Test free online since 2004 at tests.marketpsych.com.

• 4,000+ respondents (20,000+ over all tests) from 89 countries.

• Measuring the “Big Five” personality traits.

• Collect largest drawdown, returns, experience, and demographic information.

• The common reported mistakes are the same worldwide.

WHICH PERSONALITY TRAITS ARE KEY TO INVESTING SUCCESSFULLY?

Emotionality

Extraversion

Openness

Agreeableness

Conscientiousness

Emotionality

Extraversion

Openness

Agreeableness

Conscientiousness

Emotional Stability

Introversion

Traditionalism

Self-Interest

Spontaneity

Emotional Stability

Introversion

Traditionalism

Self-Interest

Spontaneity

MANAGING YOUR MARKET REACTIONS

19

“If you want a positive outlook, you’re going to have to turn your chair around, Walter.”

TOOL/GO TO G-R-O-U-N-D

• Step 1: Managing Emotion• Ground in the present• Reappraise the situation• Observe your thoughts• Understand the emotion• ------------------------• Step 2: Thought and Action• Noodle on it: Analyze• Do Something: Take Action

GET GROUNDED:BE PRESENT IN YOUR CURRENT EXPERIENCE

REAPPRAISE THE SITUATION: HOW TRULY SIGNIFICANT IN TERMS OF TIME, URGENCY, AND IMPACT?

IS THIS AN EXPECTED PART OF YOUR JOB AS A RISK TAKER? (PROBABLY YES)

OBSERVE YOUR THOUGHTS:OBSERVING WITH CURIOSITY, WITHOUT JUDGMENT, LET GO OF SELF

JUDGMENTS AND CRITICISMS.

UNDERSTAND WHAT USUALLY HAPPENS WHEN YOU FEEL LIKE THIS.

SINCERE EMPATHY ELIMINATES ITSINCERE EMPATHY ELIMINATES IT

NOODLE ON IT: RE-ENGAGE ANALYTICAL THOUGHT

DO SOMETHING: MOVE FROM REASON TO ACTION

UNGROUNDED

• The Cardinal Sin:

• Attempting STEP 2 (action) before addressing STEP 1 (managing emotion).

STEP 1: MARKETPSYCH PEARLS

You can’t reason yourself out of a position you didn’t reason yourself into.

All emotions linger until they are actively grounded (good) or discharged (bad).

To (re)build discipline, take baby steps: commit and deliver.

INFORMATION, CROWD EMOTION, AND PRICE BEHAVIOR

THOMSON REUTERS MARKETPSYCH INDICES (TRMI)

• Complex statistical language processing.

• 3,000 topics and sentiments scored.

• 40,000 specific companies, currencies, commodities, and countries tracked.

• 2 million articles daily• 1998 to the present.• Social media and news

media data feeds.

A selection of TRMI sentiments and macroeconomic indexes.

Covering 35 commodities, 120 countries, 4000 equities, and 30 currencies.

A summary of MarketPsych text analytics.

WHAT IS THE ANGRIEST MONTH FOR INVESTORS?

September

WHAT IS THE MOST OPTIMISTIC MONTH?

December

MARKETS/PSYCHOLOGICAL CYCLES

MARKETS

Egypt country data derived from textual analysis of global social media.

INVESTORSUSING SENTIMENT

1. Timing Turning Points2. Relative Value Screens3. Identify Price Drivers4. Gauge The Consensus

Before Events5. Forecast Economic

Activity

TIMING TURNING POINTSMOVING AVERAGES

“We look to buy from pessimists and sell to optimists.”~ Benjamin Graham

RELATIVE VALUEU.S. ETF’S

Sector and industry sentiments such as Anger and PriceForecast (inverse) correlate with future weekly ETF returns.

Below are equity curves derived from going long the top four and shorting the bottom four of sector and industry ETFs weekly.

MARKETS/COUNTRIES

SENTIMENT

OPTIMISM

FEAR

JOY

TRUST

VIOLENCE

URGENCY

UNCERTAINTY

MARKET RISK

BUDGET DEFICIT

CREDIT DEFAULTS

ECONOMIC GROWTH

ELECTION SENTIMENT

INFLATION

GOVERNMENT INSTABILITY

AND 19 MORE...

Government Instability, 2012

Question: What sentiment and macroeconomic factors drive international equity returns?

RELATIVE VALUEGLOBAL EQUITIES

“Buy to the sound of cannons, sell to the sound of trumpets”~ Baron Nathan Rothschild, 1812

See the Equity curves of simulated strategies below. Using a rolling window of the 20 countries most frequently mentioned in the news: • These strategies go short the top 20% of countries high in Joy

(MP_JOY) and go long the 20% low in Joy. • For GovernmentInstability (MP_GVTINST), they go long the most

unstable 20% of countries and short the most stable 20%.

Government Instability, 2012

Country sentiments such as Joy and Government Instability inversely correlate with future country stock index returns. White paper available.

MARKETS/EXTREMES

Question: How can we test the robustness of a rotational strategy?

SENSITIVITY ANALYSIS

Returns are robust and increasing with rank.

GLOBAL INVESTING/EQUITY CURVE

MONTHLY ROTATIONAL MODEL

Long on Government Instability, Low Joy, and Loose Fiscal Policy among others.

MARKETS/IDEAS

1-YEAR LONGS: Russia and Indonesia1-YEAR SHORTS: Australia and JapanQuestion: What is the forecast

of the final rotational one-year model in November 2013?

ONE YEAR MODEL

Long on Government Instability, Disasters, and Low Joy.

ECONOMIC FORECASTINGPREDICTING PMI

Econometric models fit to country PMI values since 2008. Updated daily using the latest news about a country’s economic activity and sentiment. Models predict Flash PMI releases.

1. Investors can’t reason themselves out of an investment they didn’t reason themselves into.

2. G-R-O-U-N-D yourself when feeling emotional to reduce decision mistakes.

3. In addition to fundamentals and technicals, consider market emotion.

4. Social media and news content exacerbate emotion-based biases.

5. Saavy funds trade against high investor emotion and consensus in news and social media flow.

SUMMARY/YOUR INVESTING BRAIN

SUMMARY

Check out our sentiment tools, sign up for our free newsletter, and take a free Investor Personality Test at: www.marketpsych.com

Sentiment Data Has Predictive ValueSentiment IndicatorsRelative Value ScreensPrice DriversAnticipated EventsEconomic Forecasting