Delusion, 'Non-Bottom Callers' & The Afflictions of the Investor's Mind

"The ignorant mind, with its infinite afflictions, passions, and evils, is rooted in the three poisons.  Greed, anger, and delusion." ~ Bodhidharma

We certainly have observed a wide range of emotions in financial markets over the past several months and we have analyzed them at length here at TFP.  Today, we will not necessarily analyze emotion but the delusion of making attempts to accurately recognize emotion as it occurs, and thereby making the mistake of investing according to this delusion... 

It seems the currently favored pastime in the world of financial news punditry is "bottom calling."  There are two primary camps in this prediction game:  Those who say we are at (or near) a bottom for broad market stock prices and, as you would expect, those who say we are not at a bottom and prices will fall farther...

"Until a man has expressed his emotion, he does not yet know what emotion it is..." ~ R.G. Collingwood

What I find especially interesting to observe is not the foolishness of the bottom callers, but the foolishness of the non-bottom callers, if you will, who believe that they are being wise in saying we are not at a bottom.  They appear quite confident and proud in their self-professed virtues of patience, experience and foresight.  They believe that it is the bottom-callers who are acting as fools and it is they, the non-bottom callers, who are acting prudently.

The preferred basis for which the non-bottom callers refuse to call a bottom is their self-professed ability to recognize market sentiment (emotion) as it occurs, specifically in current market conditions, the absence of panic and capitulation -- the primary emotions present when stock market prices hit a cyclical bottom. 

This is where the delusion takes place... 

While it is historically evident that bear market bottoms have been marked by the emotions of panic and capitulation, the non-bottom-callers fail to realize that these emotions come in different shapes, sizes and forms in each unique market cycle.  Put simply, it is widely known what will occur and what emotions will accompany the occurrence but it is virtually unknown how and when the emotions will appear.  Furthermore, once the emotion occurs, it is already in the past; therefore, it is impossible to accurately "call a bottom" in real time, with the exception of happenstance.

"Those who have knowledge, don't predict.  Those who predict, don't have knowledge." ~ Lau tzu

I've read this quote from Lau-tzu many times and have not fully applied its meaning or quite appreciated its profundity until now:  There are those who are aware of their own ignorance and those who are not.  Those who are aware of their own ignorance, do not predict.  Those who predict, are not aware of their own ignorance..

To say that we are (or are not) at a market bottom, are both forms of prediction (and foolishness), which is precisely my point:  While an investor may know that the next market bottom, if it has not already occurred, will be marked by panic and capitulation, that same investor will not be able to recognize the emotions as such until after they have come and gone.

Perhaps the lesson we may derive from this analysis of delusion is that we should not fool ourselves into believing that, just because we are taking the opposing side of an opinion we believe to be foolish, that our side must be the wise one.  We should remember that it is quite possible that both sides of a prediction have equal potential to be incorrect and that we would be better off not taking either position but to be a passive observer.

Here are more examples of two-sided opinions where there are beliefs or ideas on both sides that may be equally as foolish as the other:

• The market has hit a bottom. -- OR -- The market has not hit a bottom.
• It's different this time. -- OR -- It's the same this time.
• Tomorrow it will rain. -- OR -- Tomorrow it will not rain.
• If this happens, I will be happy. -- OR -- If this happens, I will be unhappy.
• This will make me money. -- OR -- This will not make me money.
• Stocks are risky. -- OR -- Stocks are not risky.
• Debt is good. -- OR -- Debt is bad.

Can you think of others? 

If we simply admit (and submit) to the wisdom that there is much that we do not know, and be contented with the certainty of uncertainty, we may guide our decisions (or indecision) accordingly, and our lives will be the better for it...

Related Posts:

Bull vs. Bear vs. 'Right' 

Weekend Wisdom: The Certainty of Doubt

Comments

[Soullfire]

Kent,

I have no doubt that many market timers fail to achieve the level of returns of buy and holders, but I would ascribe that to the failure of people correctly implementing timing methods rather than failure of the methodology in and of itself.

What I find interesting is that most studies on the advantages of buy and hold over market timing deal with the scenario of what would happen if the market timer missed the best days of the market without considering the alternate scenario of the timer missing the worst days of the market. I wrote an entry on this that you might find interesting: http://weblog.xanga.com/SoullFire/651892700/timing-the-market---path-to-riches-or-fools-errand.html

As you have stated, taking definitive actions based on predictions and failing to understand the consequences of our decisions can be quite harmful. Market timing involves taking an action to move funds into or out of the market, but action is also involved in buy and hold, with the action being "do nothing and remain in the market". Each of these decisions come with their own associated risks that can lead to subpar investment returns if ignored. There are many people who maintained a buy and hold strategy during the dot com implosions and watched many of their holdings become worthless. A more recent example would be those holding on to their financial stocks from last year which have suffered 70+% declines in value. No matter what decision we make to minimize risk, we must to be willing to change course if our initial assumptions are proven false.

Maintaining neutrality when dealing with predictive data can be done at times, but sometimes we must take definitive action based on a prediction. Keeping an umbrella in the car regardless of whether the prediction is rain or sunshine is a good idea, but what if you're planing a big outdoor event? In this case, the weather forecast would have a direct impact on decision making as to when to schedule the event.

Thanks for the link- another thought provoking post.

[Risk Averse Alert]

"Laziness is a loss leader."

The emotional state of the market is easier to discern than your commentary leads on to.

Just as a cold front possesses different qualities in summer than in winter, conditions reflecting extremes in sentiment have different qualities in a bull market than in a bear market, and at varied points along the way in each instance. The same goes for notions of "over-bought" and "over-sold."

Per the matter of discernment, actions speak louder than words and there are countless ways actions in the market are measured.

[The Financial Philosopher]

Soullfire:

Your linked post is quite interesting; however, the first sentence in your most recent comment here sums up the market timing issue: Poor returns as a result of timing the market is not a reflection of the methodology but a reflection of the person implementing it.

A primary theme of mine as a blogger and as an investment advisor is, as Ben Graham said, "the investor is his own worst enemy." Emotions of the investor and that of the market as a whole are not conducive to scientific methods just as love is not something that can be explained by reason or logic.

As a similar example, it is not impossible to play a perfect game of golf, even for an anamateur, but it is extremely unlikely. Yet still, people continue trying... I would submit that the greatest players, such as Tiger Woods, have great technical skill but their self-awareness, via emotional intelligence, is what makes them champions...

For my personal investments, I ascribe to the "buying into weakness / selling into strength" strategy, which is not unlike market timing. I do not attempt to pick a high or a low -- I simply sell higher and buy lower and limit trades to about one or two per month and I'm never completely out of the market.

For example, I started building cash (selling into strength) in early 2007 and started buying into weakness in 2008, especially at the January, March and July lows.

At the same time, a core amount of my investment assets are passively managed (i.e.) index.

The bottom line is self-awareness: If we are not aware of our emotions, we make ourselves vulnerable to their control and ultimately to their potential damage...

Thanks for the comment and the link to your blog. Both were thought provoking...

Kent

[The Financial Philosopher]

Risk Averse Alert:

I agree and my response to you is similar to the last one I gave to Soullfire: Timing the market is certainly possible and, as you stated, the emotional state of the market is not difficult to discern...

If I were to write a longer post, I would likely mention that bear market emotions are especially difficult to navigate, primarily because fear and panic manifests itself much quicker than greed.

Once panic is evident, it is in the past... With that said, however, I will say that oversold and overbought and various other dislocations can be leveraged by an emotionally intelligent trader or investor but the vast majority fail at making predictions and/or timing the market.

As for the "countless ways actions in the market are measured," you are also spot on. The challenge here is that emotions are an ever-present factor in market movements, especially in extreme conditions, and emotion is not something that can be accurately quantified...

Thank you for the thought-provoking comment. I see myself as a perpetual student and I have learned much from my readers and those who have commented on my posts...

Thanks again and please comment in the future...

Kent

[Steve SSK]

Hello Kent, I agree with your comment regarding emotional intelligence as it relates to sucsess in general and in the markets. Dr. Brett Steenbarger has excellent material regarding that point. The first step in my case was allowing my "Mind to be its mentor". Understanding how we ourselves think, allows us to be prepared to break down negative behavioural patterns,and replace them with new ones. The journey is long, but rewarding. Best, Steve SSK

[The Financial Philosopher]

Steve SSK:

Thanks for the comment. I also am a fan of Dr. Brett.

As you may know, I believe the ancient philosophers intuitively knew what neuroscientists are just now proving with science: We can change the structure of the brain with our thoughts!

As you stated, "the journey is long, but rewarding." This journey is long because it takes time to mindfully form good habits (re-wire the brain) while overcoming and replacing bad ones.

If you have not read my "Mind vs. Brain" series of posts, you may find it interesting:

http://financialphilosopher.typepad.com/thefinancialphilosopher/2008/05/mind-vs-brain-p.html

Thanks for the comment...

Kent