Chapter 10: Investment psychology and trading Flashcards
List seven human characteristics that are essential components of a good investment trader.
Essential human characteristics
- discipline and drive
- competitive mentality
- the ability to form a personal investment narrative
- a logical approach
- good intuition
- imagination
- impulse and energy
It can be argued that the ability to form a complex personal narrative is the most important, and that the others are helpful in this respect.
Describe the meaning of the following terms:
* psyche
* nous
* logos
* pyr
Psyche
This is the human mind.
It is considered to be made up of a person’s nous, logos and pyr.
Nous
This is the way that an individual perceives the world around them.
It consists of imagination, reflection and thoughtfulness.
Logos
This is the ability to apply logic and rational thinking.
It is used to rationalise the mental picture created by nous.
Pyr
This is the animal spirit or energy.
It is required to ignite and give energy to the psyche.
Which of the following Greek terms on the left can be matched to which of the English terms on the right?
Nous Guts
Logos Heart
Pyr Head
Matching terms
Nous:
is the Heart and the way people perceive their surroundings.
Logos:
is the Head that provides the rational thought.
Pyr:
is the Guts that give the impulse and drive for life.
Describe the term ‘ego’ and explain the impact that it can have on an individual, depending on whether they have too much ego, the right amount of ego, or too little ego.
Ego
Ego is the filter through which people view the world and events around them.
An individual with too much ego might be so self-confident that they ignore facts and events that happen if they do not agree with their own beliefs and opinions. This can lead to poor decision making.
Those with the right amount of ego will have the confidence to pursue their investment goals, but will view the world as it really is, and question their opinions when information appears that contradicts their view.
Someone with too little ego might not have the confidence to take decisions necessary to be an investment trader.
Often people warp or reinterpret events that contradict their views to preserve their ego. This is called an ‘ego defence mechanism’.
Explain how a person’s rationalisation and views can be created and distorted by ego, logos, nous and pyr.
Rationalisation, and the connection to ego, nous, logos and pyr
If someone does not have pyr, they might not have the energy or drive to create any views or rationalisations. They might simply accept other people’s opinions. This does not create a deep narrative.
A person’s logos will create the logical structure that supports the person’s views, but this may be distorted by the person’s ego if this is too strong.
The complexity of the view or rationalisation will be affected by the amount of imagination or nous that is applied. A lazy person might not apply nous and may end up with a one-dimensional view.
An investor receives a great deal of research on the companies in the FTSE100 on a daily basis. The task of the investor is to select the research that will drive the investment decision, or to reject it all.
Describe how nous, logos and ego might be used in this task.
The impact of nous logos and ego in the investment selection task
With insufficient nous, the investor might not have the thoughtfulness to distinguish between the various views expressed in the research.
They may all seem reasonable, and it becomes impossible to make a decision.
With the confidence that comes from a strong ego, the investor would be able to come up with their own opinions.
These might cover geo-political events that may occur, economic forecasts for the future, and considerations on company managers’ abilities.
Too much ego might drive the decision down one restricted path on the basis that there is no doubt in the investor’s head that their view is correct.
The correct amount of ego might result in some research being selected for one outcome, and some for a different one.
Logos provides the logic that binds the various decisions together and makes sure that they do not contradict one another.
It may create the logical connections between the various views and opinions that are selected and those that are rejected.
An investor has selected a share after considering the various opinions of experts, and considering their own views on the outlook for the sector, the market and the company.
Over the following 6 months the share price falls to half its original level. Explain how the investor’s decision to sell, buy more, or to hold could be affected by their ego, and by their pyr.
Decision to sell, buy more or to hold
Sell:
If the investor has too little ego, they might decide that they had made a terrible mistake, and that all their decision-making processes were wrong about the share. They would then sell and try to forget about the incident.
Buy more:
If the investor has a great deal of pyr, the burning desire to make money from this investment might drive them to make an irrational decision to simply double the bet and buy more at the new lower price. This could also be driven by the investor’s over-inflated ego. The investor’s self-belief could convince them that their original analysis could not be wrong, and that the market must be getting it wrong, so the share must be even cheaper.
Buy more/Hold:
With the correct amount of ego the decision would be re-appraised using any new information that has come to light. If nothing material has changed and the decision still stands, then more may be purchased. If some new information has been uncovered, but the price already reflects it, then a decision to hold might be made.
Explain how logos and ego might be at odds with one another.
Logos and ego at odds
Logos requires a disciplined and rigorous approach to a problem. This is not easy and requires energy and discipline.
A person’s ego might be encouraging them to go with a certain decision as it reflects what they would ‘like to’ believe about their environment.
This is usually an easy route, and requires little effort or discipline.
Whether the rigorous approach is taken or not will depend on the individual’s energy level (pyr?) to apply the logos.
Explain why logos and ego alone cannot create an investment narrative.
Logos and ego alone
Most investment decisions involve a prediction of the future, which cannot be ‘logically’ calculated.
The future will hold unknowns which must be guessed or predicted from intuition.
Ego alone will also not help as it will encourage the individual to base all decisions on an existing narrow range of personal beliefs.
To create a deeper investment narrative will require more than simply logic and personal self-belief.
It will require some flair, intuition and foresight.
This may be helped along the way if an individual has ego and logos, but these alone will not be sufficient.
It will require pyr to complete the process and fully engage the individual’s nous.
Explain the impact of education on an individual’s psyche.
The impact of education on an individual’s psyche
On the one hand the individual may benefit from the wisdom of the educator or teacher.
This teacher may have experiences and logical mechanisms that help the individual to form their own views and logical processes. Teachers can also inspire people to go out and create new narratives using their pyr.
In these environments, an individual’s ego is likely to be enhanced and strengthened.
On the other hand the individual could simply accept the views and opinions of the educator and therefore extinguish their own pyr.
They could simply use the logos that they have been taught on a repetitive basis, and never question whether the world has changed such that logic has to be applied in a different way.
If the individual has limited nous, they may not see any alternative approaches and accept the continuation of the old.
The psyche is the combination of the nous, pyr and logos through the filter of the individual’s ego.
Describe reasons why herd behaviour might be caused in investment markets, using the components of individuals’ psyche
Herd behaviour
Ego is a strong driver for individual investors. It is painful for an individual’s ego if they choose to be different, and then find out that they were wrong.
As a result most choose to invest with the herd because it is easier (on the ego) to fail together.
Herd behaviour can drive prices for very long periods of time, inflicting a great deal of pain.
Many investors do not have the pyr to create their own view of the world.
With insufficient drive a simple narrative will result and the investor may have little confidence that their simple narrative is worth pursuing.
So the inevitable consequence is that they accept the herd opinion.
Some investors may have insufficient training to have the logos to analyse the financial world.
As such they dare not try to make their own analysis, and therefore follow the herd.
Nous is the intuition, spark and the foresight to make a prediction.
Many do not have such qualities and will therefore have no option but to accept the popular opinions.
Describe how herd behaviour can be utilised by an investor with the ability to fully engage the psyche.
Utilising herd behaviour
Herd behaviour can drive prices to unsustainable levels, which cannot be justified using a logical approach.
Price levels may reach very low levels due to a scare story which may be based on a shallow narrative.
Or they may be driven unjustifiably high due to a sustained single narrative which is accepted by the herd.
A talented investor that applies their psyche, makes the appropriate analysis, and has the ego to take the opposite decision can make money from the under or over-priced shares.
However, this would not be an easy decision.
Nor would it be likely to reverse in the short term.
A strong ego would be required to preserve the decision, whilst constantly reviewing it based on new evidence.
Describe the benefits of the efficient market hypothesis (EMH) from the standpoint of the human psyche.
Benefits of the EMH
The rational analysis involved in the EMH gives a logical approach to analysing share and bond markets.
The theory is logical and does not conflict with itself at any point. The EMH allows further rationalisation to be built on top (such as the capital asset pricing model) that allows shares and markets to be analysed individually, and allows a determination about whether to buy or to sell them, which is very useful.
It allows individuals to apply logos to the investment world.
It is one of very few frameworks that has ever been created that gives such useful outcomes.
Others such as behavioural finance, technical (chartism) analysis or quantitative analysis are less objective and often do not give clear outcomes.
Describe the term ‘group ego’ and explain its consequences.
Group ego
Group ego is the strong sense of belonging that comes from being in a group that has the same beliefs.
An investment team might feel better if they all express confidence in the fundamental cornerstones of their investment policy (for example, the belief in a strong economic recovery, the belief that the political environment will be stable, or the belief that the currency cannot fall any further than it has).
Individuals within the group dare not express contrary opinions because it will upset the group’s collective ego, therefore contrary views are not aired.
Describe the drawbacks of the efficient market hypothesis (EMH) from the standpoint of the human psyche.
Drawbacks of the EMH
The framework is built on certain assumptions that are questionable.
The fact that investors are rational, for example, is often not justifiable.
The herd behaviour caused by humans’ egos and group ego, lead to great inefficiencies and distortions.
Likewise, not all information is priced into share markets.
Often outcomes that seem predictable after the event, are not discussed or debated prior to the event.
So even though the information was arguably available, it was not priced into the market.
Again this can be caused by group ego, and the inability to question an accepted logic.
The EMH also causes weaker minds to simply accept the logic of the framework, and to switch off their own nous, and to extinguish their pyr.
