How To Avoid Wall Streetís "Monkey Trap"

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
April 10, 2007

IN THIS ISSUE:

1.  Weapons Of Mass Manipulation

2.  Counting On Irrational Behavior

3.  The Science Of Behavioral Finance

4.  Wall Street’s Hypocrisy

5.  Farrell’s Solution Is No Solution

6.  Don’t Run With The Herd

Introduction

As my long-time readers know, I spend a lot of my time reviewing reports, studies and articles regarding economic, financial and investment topics.  In addition, several members of my staff also do extensive reading and research, and frequently forward me articles and information they run across that might be of interest to clients and our E-Letter audience.

Being the serious readers we are, we frequently come across articles in which the authors chose particularly titillating or inflammatory titles meant to have a “shock value.” We’ve long since learned not to read too much into such titles, but a recent posting on a financial news website surprised even me.  The title was “Just Surrender to Wall Street’s Weapons of Mass Manipulation.”  This title was bold enough to entice us to read the entire article.

This particular article, which I will discuss in detail this week, is disturbing on several levels.  The article was written by Paul B. Farrell, author of several books on investing, including The Millionaire Code and The Lazy Person’s Guide To Investing.  As we have often found, however, being a book author does not necessarily make one an expert, as we will see.

To his credit, Farrell’s first assertion is his belief that Wall Street is using “manipulation” techniques to sell investments.  He painted a clear picture of how some major Wall Street firms are using behavioral analysis to stack the deck in their favor.  We’ve actually done a good bit of research on this topic ourselves, and I can tell you that it’s quite alarming what some well-known investment firms are doing to get you to invest with them.

Where we strongly differ with Mr. Farrell is his main point in the article, that investors should just surrender and let Wall Street have its way.  Basically, Farrell recommends you invest all your money in “index funds” and never (or only rarely) tinker with them, and that you should avoid altogether professionally managed accounts, hedge funds and alternative investments that are designed to enhance returns and reduce risk.  I couldn’t disagree more! 

In this week’s E-Letter, I’m going to discuss what is being discovered in the area of “behavioral finance” and how it is being used to market products in the investment industry.  I’ll also tell you exactly what I think of the practice, and how its use could lead to very unhappy results.

Counting On Irrational Behavior

Nothing goes against my grain more than the feeling that something is being forced upon me.  Even worse is when the one doing the forcing is trying to manipulate my thoughts and/or feelings to make me think what’s happening is good for me.  I guess that’s why I reacted so strongly to the article’s shocking title.

When it comes to investing, I would dare to say that most people are like me, preferring a customized approach to their investments rather than running with the herd and investing only in index funds.  Wall Street, however, is learning that even though investors want to act rationally, they frequently do just the oppositeMany investors are “hard-wired” for irrationality. 

Unfortunately, this tendency to have hard-wired responses override our rational response is highly predictable, according to the studies and articles I have read.  Wall Street is increasingly counting on this irrational investor behavior, as we will see below.

Perhaps a good example of the detriment of hard-wired behavior is the infamous “monkey trap.”  We read that in the third-world, monkeys are caught by drilling a small hole in a gourd or coconut (or other object), placing a bit of fruit in it, and then securing it with a rope or chain.  The hole is large enough to allow a monkey’s open hand to get in, but not large enough to accommodate a fist holding the piece of fruit to get out.  Thus, when the monkey reaches in and grabs the piece of food, it cannot withdraw its hand from the hole.

When the hunters approach, the monkeys predictably attempt to flee.  However, the monkeys’ “hard wiring” won’t let them release their fisted grip on the fruit, making it easy for the hunters to simply walk up and capture them. 

Of course, humans have the ability to reason, so they would never act this way, right?  Wrong! 

In fact, if you do a Google search for “monkey trap,” you’ll get over 28,000 hits, many of which are related to websites that use the monkey trap as an analogy for a variety of (mostly) self-destructive human behaviors.  That being the case, why should we expect human approaches to investments to be any less irrational?

The science of behavioral finance is uncovering a number of “hard-wired” tendencies that we as humans exhibit in relation to our investments, and Wall Street is busy trying to exploit them.  Read on to see how they want to try to get into your head.

The Science of Behavioral Finance

Actually, the science of behavioral finance is not new.  Economists have been wrestling with human behavior as it relates to economic decisions since Adam Smith’s 18th Century observations.  However, the practice of applying psychological principles to investors is a relatively recent innovation.

One of the earliest modern studies of behavioral finance came in 1979 with the concept of “Prospect Theory.”  Amos Tversky and Daniel Kahneman found that individuals are more distressed by prospective losses than they are happy about an equal level of prospective gains.  In other words, the loss of a dollar is more painful to the average individual than the happiness derived from the gain of a dollar.  Obviously, this is just a generalization and not applicable to everyone, but the basic principle is consistent with many investors fearing loss more than they appreciate gains. 

Here’s an example of Prospect Theory:  Kahneman and Tversky presented groups of subjects with a number of problems. One group of subjects was presented with this problem:

1. In addition to whatever you own, you have been given $1,000. You are now asked to choose between:
            A. A sure gain of $500
            B. A 50% chance to gain $1,000 and a 50% chance to gain nothing.

Another group of subjects was presented with another problem:

2. In addition to whatever you own, you have been given $2,000. You are now asked to choose between:
            A. A sure loss of $500
            B. A 50% chance to lose $1,000 and a 50% chance to lose nothing.

In the first group, 84% chose A.  In the second group, 69% chose B.  The two problems are identical in terms of net cash to the subject, however the phrasing of the question causes the problems to be interpreted differently.  (Source: Daniel Kahneman and Amos Tversky, "Prospect Theory: An Analysis of Decision Making Under Risk," Econometrica, 1979.)

I have commented in previous E-Letters on how some investment sponsors use fear and greed to promote their products.  However, continued research in the field of behavioral finance has uncovered many other irrational behaviors exhibited by investors.  Here are some other interesting findings in the field of behavioral finance uncovered by Tversky, Kahneman and others in the field:

*          Professor Meir Statman says that the “fear of regret” affects an investor’s decision to sell or keep a losing stock.  One theory is that investors avoid selling losing stocks to avoid the pain and regret of having made a bad investment decision.

*          Some researchers take Statman’s idea even further and theorize that some investors follow the crowd when investing to avoid the possibility of feeling regret if their hand-picked investments perform worse than their peers.  I guess these investors adhere to the old saying that goes, “misery loves company.”  These investors will stick with the well-known, mainstream stocks and funds just to avoid the potential for having bad performance when everyone else is doing well.

*          Perhaps most disturbing is that some economists believe that even professional money managers tend to also favor well-known and popular stocks and funds as a sort of self-preservation strategy.  In the world of relative returns, money managers are more likely to keep their jobs if their performance follows that of the major market indexes.  Thus, they are less likely to stray too far away from big name, popular stocks that make up many of the major stock indexes.  I have written in the past about mutual funds that have been called “closet indexers” for this very reason, but investors who buy these types of funds thinking they are getting the benefit of active management are in for a rude awakening.

*          People in general tend to give too much weight to recent experience and extend recent trends out into the future, even if they are not in line with established long-term averages and trends.  Back in the 1990s, this was called the “it’s different this time syndrome.”  It wasn’t different back then, and likely won’t be different when you hear this phrase used in the future to justify outlandish stock prices that defy fundamental logic.

*          The tendency for people to give recent experience too much weight also contributes to extremes of optimism and pessimism.  I’m sure you’ve probably heard that one of the signs of a bear marketing nearing an end is when most everyone is pessimistic and out of the markets.  Likewise, the likely sign of the end of a bull market is when most everyone is optimistic and fully invested, despite the lack of good fundamentals.  Plus, with today’s 24-hour financial news coverage, an overly optimistic or pessimistic view can be achieved much faster than in the past.

*          People often interpret accidental success to be the result of skill.  In money manager terms, it is theoretically possible to produce a winning streak over a limited period of time by just flipping a coin.  However, in the long run, the law of averages will catch up with this manager.  We always seek to determine whether a money manager under review was lucky or smart.  Sometimes it’s hard to tell, which is why my company spends so much time and effort in the due diligence process.

*          People are often overconfident in their own abilities, especially in areas where they have some knowledge.  This can be true for individual investors as well as professional money managers.  Studies have found that money managers are consistently confident about being able to outperform the market, though most fail to do so.  (This behavior is why we say it’s important to hire a “gatekeeper” Advisor like Halbert Wealth Management, since an overconfident money manager will never recommend that you take your money elsewhere, even if its performance is horrible.)

*          Some researchers think that the tendency to gamble is a basic human trait, and some apply this characteristic to their investments.  I think this tendency is easy to spot if you just take every piece of investment promotional material that talks about “beating the market” with replace that phrase with the words “beat the house.”  Some investors have an insatiable need to perform better than the overall market, just as if they were in a casino. Unfortunately, trying to “beat the market” may involve more risk than these investors need to take on to meet their individual investment goals. 

*          Some people have the “touchy-feely syndrome,” where they become overly attached to something they have touched or personally selected.  In one experiment, subjects were either given a card automatically, or allowed to select a card on their own.  Those that selected their own card required four times the price to buy back the card than someone who was simply handed a card.  Putting this into an investment context, those who pick their own stocks or funds may hold onto them longer than they should in light of poor performance.

The above points illustrate just a few of the many behavioral finance findings and theories.  While I certainly can’t verify all of them, I can say that we see evidence of many of these as we have discussions with current and prospective clients.  The bottom line is that, while we all want to think of ourselves as acting in a rational manner (especially in regard to investing), just the opposite is often true.

The “Quants” Are Out To Get You

Getting back to Farrell’s article, the most disturbing part was not that behavioral finance is discovering irrational behaviors.  Instead, it was the implication that Wall Street knows that investors behave irrationally, and actually seeks to take advantage of it.  In the article, Farrell states:

“Moreover, they [Wall Street firms] actually prefer a market filled with irrational investors.  That way, they can manipulate you easily without you ever really knowing it…Wall Street has added this powerful new ‘weapon of mass manipulation’ [behavioral finance] to its arsenal.  And with it Wall Street has refined ‘mind control’ to a high art, making absolutely certain you do not stand a chance trading.”

Such an accusation requires that we look deeper into Farrell’s article to seek to determine the methods allegedly being employed by Wall Street to take advantage of unsuspecting investors.  The difference between the behavioral finance practiced over the last few decades, and what is supposed to be going on now, is that psychologists are being replaced by mathematicians. 

In a nutshell, Farrell fears that the practice of quantitative mathematics will lead to the undoing of the average investor.  As behavioral finance identifies more and more irrational behaviors, practitioners of quantitative mathematics - “quants,” for short - reduce these behaviors into mathematical relationships, and then seek to use this information to manage money.

Here’s how it might work – through computerized analysis of tons of historical stock market data, strategic models can be developed that have the potential to predict future market activity by counting on irrational investor behavior.  The models then anticipate where money should be invested to take advantage of the herd mentality of the masses.

Farrell cites the leader of the quants as University of Chicago finance professor Richard Thaler.  Thaler’s book, entitled “Advances in Behavioral Finance,” consists of over 700 pages of mind-numbing mathematics that seek to explain investors’ irrational behavior, and how it might be taken advantage of.  Thus, Farrell comes to the conclusion that investors are better off just giving up, since Wall Street now has math on its side.  (More about this later on.)

Wall Street Hypocrisy

As I have noted above, one of the basic tenets of Wall Street’s new quant mindset is the fact that investors can’t help but act irrationally.  Perhaps I wouldn’t have so much of a problem with this idea if Wall Street was not so busy trying to convince investors otherwise.

For example, Wall Street has pulled out all of the stops to publish studies that support the “efficient market theory.”  In a nutshell, this theory says that all players in the investment game have all knowledge and act rationally.  Thus, there cannot be inefficiencies in the market that can be exploited.

As I noted above, psychologists have discovered a number of irrational behaviors exhibited by investors, which effectively debunk this theory, in my opinion.  If you want more evidence, just look back to the tech bubble of the late 1990s.  Investors were paying exorbitant prices for stocks of companies that had no experienced management, few assets, no profits, and were really little more than just a business plan.  So, tell me how the market can efficiently factor in details about a business when the information doesn’t even exist. 

If that’s not enough proof, a 2002 article from CNNMoney.com provides additional verification.  It states that the science of behavioral finance has shown that the market is not efficient because investors are irrational.  What’s more, the market’s “random walk theory” isn’t quite as random as once thought.  The quants of behavioral finance believe that careful analysis of past trends and behaviors can at least partially predict future stock price movements.  Pretty heady stuff, huh?

So how do you get in on the quant revolution?  If you’re an average client at a big Wall Street firm, you don’t.  Farrell concludes that while these firms are busy rolling out products for the “irrational” average investor, they are using quant strategies to provide alternative investment opportunities to their institutional and high-net-worth clients.

If Farrell’s article is correct, the bottom line is that big Wall Street firms may argue that the market is efficient and investors are rational, but all the while they are developing investment programs that rely on the irrational investor behavior they know to exist, and marketing them to their institutional and high-roller clients.  To me, this is downright hypocrisy.

Farrell’s Solution Is No Solution

So far, we have discussed how Farrell’s article has correctly stated that behavioral finance shows investors to be irrational, and that Wall Street firms are capitalizing on this tendency and marketing it to their fat-cat clients.  So what is Farrell’s advice to you, the average investor? 

First, a little background:  When the “efficient market” theory was king, Wall Street’s standard investment advice was to buy and hold index-fund investments, diversify widely, and seek to control costs through low-cost mutual funds.  The idea was that the market was so efficient, you couldn’t possibly get an edge without insider information, so you were best served to just settle into an asset allocation strategy (largely index funds) that would flow along with the ups and downs of the markets.

Now that behavioral finance has sought to blow a hole in the efficient market theory, what advice does Wall Street give to the average investor?  Farrell’s article states it clearly: “buy and hold, use index funds, diversify and seek to control costs.”  Notice a pattern here?

That’s right, whether or not the market is efficient, Wall Street and the financial press want you to put your money in their low-cost index funds and ride the market’s roller coaster on the way to your financial goals.  Never mind that such an investment strategy can lay waste to your nest egg during major market corrections or bear markets.  As I have noted many times before, the S&P 500 Index fell over 44% during the 2000-2002 bear market, and the Nasdaq Composite Index fell over 70%.

Let me level with you: I think Farrell’s solution sounds like the most irrational behavior of all.  Why?  Because by investing in the indexes, you actually put yourself at the mercy of all of the irrational investors out there.  Thus, while Wall Street’s well-heeled clients are benefiting from alternative strategies that might include hedging, moving to cash or even “shorting” the market, average investors are left at the mercy of the up and down waves of the market.

Don’t Run With The Herd

Farrell’s conclusion shows me that he is just parroting Wall Street’s conventional wisdom.  Whether it’s sold under the name of asset allocation, index investing or Modern Portfolio Theory, the result of this type of strategy is that you buy and hold a diversified portfolio that cannot help but be subject to the ebbs and flows of the market.  Though your portfolio may rise high during irrational optimism (such as in the late 1990s), you will also be subject to the subsequent irrational pessimism that creates bear markets like we saw from 2000 through 2002.

Yet Farrell’s article does bring one important point to light, and that is Wall Street’s use of quantum mathematics to put the irrationality of the average investor to good use on behalf of its institutional and high-net-worth clients.  This shows, at least to me, that sophisticated investors know that the markets are inefficient, and that there are strategies that can take advantage of anticipated market trends.

Fortunately, you don’t have to be rich or a large institution to take advantage of these sophisticated investment strategies.  I have written on many occasions about the advantages of my company’s AdvisorLink® and Absolute Return Portfolios (“ARP”) investment programs.  One of the primary advantages of these programs is that they utilize many alternative investment strategies either at the fund level or through professional Investment Advisors.

Within the AdvisorLink® Program, you can find strategies that employ some of the same “quant” methods used by the big Wall Street firms, plus others that are based on technical analysis, fundamental analysis, long/short trading, momentum strategies, etc.  All of these strategies share the same goal of managing the risks of being in the market, while also providing the potential for meaningful gains sufficient to meet your long-term investment needs. 

The ARP program is similar to a buy-and-hold approach, but only in that a portfolio of mutual funds is bought and held.  The big difference between ARP and traditional asset allocation is that the funds used in the ARP portfolios are specialized funds that have historically provided consistent positive returns in different market environments.  In fact, many of these funds employ the same types of sophisticated strategies that are employed by our AdvisorLink® programs.  Thus, there’s more than just asset class diversification working on your behalf.

Best of all, you can incorporate these strategies into your portfolio with a minimum investment of as little as $15,000, far short of the millions it takes to access some of the big Wall Street alternative investment programs.

Of course, it’s important to note that the past performance of the AdvisorLink® and ARP programs is not a guarantee that their future performance will be as good.  However, the same is true of every asset allocation program being promoted by Wall Street and the financial press.

Conclusions

While Farrell’s recent article should probably be best interpreted as a tongue-in-cheek critique of Wall Street’s approach to behavioral finance, it does highlight Wall Street’s practice of treating its rich clients differently than its “average” clients.  This is something we have known for a long time, but it may be news to many of my readers.

It also helps to shed light on the whole issue of irrational investors, and the science of behavioral finance that is now studying and quantifying the various tendencies and relationships that are involved.  It might also help you to recognize some of the irrational investment actions you may have taken in the past, and how these actions might have negatively affected your portfolio.

Ultimately, I hope that my critique of Farrell’s article will lead to a more critical reading of Wall Street promotional material and hype.  You should realize that Wall Street has lots of money to hire marketing firms in an effort to produce investment promotions that will push the right emotional buttons on investors.  Whether this rises to the level of being “weapons of mass manipulation” as charged by Farrell, I don’t know.  What I do know is that you have a choice of whether or not you fall for Wall Street’s “money trap.”

If you are tired of being treated as an off-the-shelf investor and want to access the type of investment alternatives that some big Wall Street firms save for their biggest customers, then please contact us at Halbert Wealth Management.  One of my experienced Investment Consultants will be happy to explain our various AdvisorLink® and Absolute Return Portfolio programs and help to determine if one or more of them are suitable for your individual needs.  You can contact us by calling 800-348-3601, sending us an e-mail at info@halbertwealth.com, or clicking on the following link that will take you directly to an online request form

You can also access detailed descriptions and performance information of our investment programs by going to our website at www.halbertwealth.com.  Just move your cursor over the tab entitled “Absolute Return Strategies” on the left-hand side of the page, and a drop-down menu will appear.  Just click on the programs you want to learn more about.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES:

The Irrational Investor
http://www.findarticles.com/p/articles/mi_m1175/is_1_32/ai_53479097

Clinton Defectors Boosting Obama
http://www.nypost.com/seven/04092007/news/nationalnews/n_y_s_barack_tars_nationalnews_ian_bishop__post_correspondent.htm

Obama Tells Letterman VP Not For Me
http://www.cbsnews.com/stories/2007/04/10/politics/main2666818.shtml


Read Gary’s blog and join the conversation at garydhalbert.com.


Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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