What Type of Investor Are You?
Beating the
market with
Psychonomics
The following is an interview with Jonathan Myers, author of Profits Without Panic: Investment Psychology for Personal Wealth.
Q: How do you beat the stock market using psychology?
A: It's all about applying a systematized, common sense approach to choosing stocks and getting our market timing right. In other words: accentuate the positive, eliminate the negative in your investment thinking and do this repeatedly until it becomes second nature. Know yourself. Once you understand how your personal drives, as well as the drives of other investors in the market crowd cause stocks to alter in price, you can more clearly see when these stocks are mispriced and where there are dealing opportunities.
Q: What evidence is there that an understanding of human nature leads to increased profits?
A: Behavioral finance researchers have shown that investors are often irrational in their decision-making due to personal biases, desires, expectations and false perceptions. In particular, news and stories often lead investors to act inappropriately. Harvard psychologist Paul Andreasen's studies, for example, set up mock trades under simulated market conditions with or without news. The results showed that in the absence of news, `investors' bought as prices fell and sold as prices rose. But given news that could have explained price changes, `investors' drove rising stocks higher and sold out of falling ones far too early. The upshot this behavior was that hardly any `investors' using news made a profit. Hence, if you understand how you are being influenced and how your market perceptions are being changed, you can make more informed investment decisions.
Q. What is psychonomics?
A. This isn't simply a contract of the words `psychology' and `economics' but refers to the way in which diverse pieces of information must be accessed and integrated for a solution to a particular problem. Applied to the analysis of stocks and investments, a psychonomic approach helps investors become aware of both their internal market (the one inside their heads that contain all their personal motivations) and the external market which can influence decisions due to crowd pressure and hype.
Q: How can psychonomics help investors assess the real value of an investment?
A: Psychonomics departs from analytic finance and other traditional approaches by showing that there are only two key ways to working out the real value of a financial opportunity: 1) Determine the intrinsic value of an investment by combining its `weightless' component(brand loyalty, corporate relationships, human capital, and creativity) with its fundamental or tangible value. These weightless or intangible assets can often be the real drivers of business value. 2) Reduce the chance of making the same systematic errors again and again by increasing an individual investor's understanding of his/her personal motivations, desires, and needsand how those personal traits feed into individual investment decisions.
Q: How can understanding differences in investor personality lead to improved financial returns?
A: The way to improved financial returns is to match investments to your personality and your needs as an investor. Every investor is different, yet investors often make repeated errors because they do not fully appreciate how their personalitiestheir individual needs, biases and propensity for riskcause them to make particular market decisions. The key to overcoming the problem and to developing investment prowess is to know what type of investor you are. Each type has particular traits that will draw investors to certain classes of investments or make them shy away. You could be Cautious, Emotional, Technical, Busy, Casual, or Informed, or even a mixture of each. Profits Without Panic offers several questionnaires and tools to help investors determine which characteristics reflect their investment personality.
Q: How does psychonomics relate to an investor's perception of risk?
A: Whatever your dominant characteristic is, be it Cautious, Emotional, etc., you could have a low, medium or high propensity for risk. For example, a Cautious investor with a high propensity for risk has different investment needs than does a Cautious investor with a medium propensity for risk. Using the psychonomic profile allows investors to pinpoint suitable stock classes or investment vehicles which are right for them.
Q: How should you treat volatility in the market and in stocks you've picked?
A: With a psychonomic approach the idea is to choose the best stocks in the market that have excellent financial fundamentals and strong non-financial elements (e.g., good management, effective communication between departments and levels, a committed and happy workforce, effective use of employees and their ideas). These are companies that are going somewhere and their profits will reflect this. Under these circumstances, market volatility simply reflects investor momentum. So if you have a good stock, sit on it. Remember, that over time good stocks will do well, bad stocks will do badly. Sounds simple, but it's easily forgotten in the rush for riches.
Q: Does the application of a psychonomic approach make any difference depending on whether you're a short- or long-term investor?
A: Psychonomics is essentially a long-term approach. The psychonomic ideal is to find a good, strong stock that shows year-on-year profits and earnings growth coupled with solid potential in the form of expansion, development, new markets and new products. These are stocks that should be tucked away for the future.
Q: Can psychonomics be used in day trading?
A: For the really short-term trader, dealing decisions are psychologically driven based on price movements, not on the stocks themselves. Psychonomics is a synthesis of methods used to determine investment value, with psychology being only one part. For novice and pro investors alike, psychonomics offers a safer and more accessible approach because it focuses on the longer-term and is based on a deeper understanding of the company being invested in.
Q: If psychonomics advocates a more cautious investment approach, would that mean missing opportunities in areas such as high tech stocks or emerging markets?
A: Not at all. There are opportunities in a variety of industries and geographic markets. What a psychonomic approach is advocating is maximizing your chances of success by assessing with rationality and self-honesty the ramifications of your investment decision and the quality of the company you're proposing to invest in. In other words, do your homework to the best of your ability and don't rely on fads, hot tips or rising ticker prices to dictate your eventual choice.
Q: Where does contrarianism fit into a psychonomic approach?
A: An often misused concept that many investors take to mean that when the market is selling they should be buying and when the market is buying they should be selling. Although sometimes this may be true, a psychonomic approach dictates that all the pros and cons are weighed before acting. Simply making a decision based on the reverse of what everyone else is doing is an irrational response and the route to losing money. The reality may be that if every investor is buying it actually might be a good time to buy. The trick is to know when to go with the crowd and when to go your own way. You can only do that by knowing the real worth of the investment you want to deal in and understanding the general market conditions.
Q: How do men and women differ in their investment behavior:
A: Although research shows that men trade 45 percent more than women, men earn returns that are 1.4 percent less than women earn. The reason, as psychologists have noted, is that men and women differ in their attitudes toward money and finance. It's a generalization, of course, but one based on the idea that men and women have different styles and different attitudes toward risk. For example, men tend to be focused on results, goal directed and single-minded in their investment approach, risk tolerant, competitive, often overconfident, and looking to share their gains to create intimacy. On the other hand, women tend to be multi-focused in their investment approach, process directed and less driven than men, more safety conscious and conservative, more intuitive and sensitive to a variety of information, accommodating rather than competitive, less prone to overconfidence, and looking to use their gains to retain individuality within intimacy. Psychonomics recognizes that all men and women have investment attributes that are useful. The route to success lies in becoming aware of when these characteristics are positive and when they are negative or counterproductive.
Q: Can financial professionals learn anything useful from investment psychology?
A: Many professionals are already using psychological and behavioral finance techniques to select stocks, select investment portfolio managers, and assess financial market timing. There's also presently around $72 billion invested in funds that base their investment decisions on a psychological approach (LSV Asset Management is one example). One area that is still in its infancy is that of investor profiling, although those financial companies that have pioneered the use of this technique have already demonstrated how it can greatly increase their ability to provide clients with tailored investment vehicles to meet very targeted client needs.
Q: What are the differences in approach and technique between you and the highly successful investors like Warren Buffett?
A: The best and most famous investorsfrom Warren Bufffett to Peter Lynchgenerally typify the principles of psychonomics. They have acquired significant knowledge of the industry and company they want to invest in and they handle perceived risk very well. More importantly, perhaps, is that they don't base their investment decision solely on a company's financial figures, but also on non-financial informationwhat Phillip Fisher, in his classic book Common Stocks and Uncommon Profits, refers to as `scuttlebutt'. In addition to statistical data, successful investors look at the type of weightless factors that are an integral part of the concept of psychonomics: the management of the company, how well products are being developed and marketed, the latest word on Wall Street, and so forth.
