In Bullmarkets Everyone Is A Genius, Not!

``Moreover, life is not long enough;- human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate. The game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll.”–John Maynard Keynes

I would beg of your indulgence anew because I’d be dealing with issues that would defy the wisdom of the consensus.

For some, such may deemed as blasphemy, but for us, it has been a mission to disseminate our version of the truth or reality as we see it. It’s called prudent investing in our terms.

That’s because we’d like get protected from the worst enemy that any market participant or investor has always been confronted with; that’s no less than ourselves or our inflated egos.

As Friedrich Nietzche, ``But the worst enemy you can encounter will always be you, yourself; you lie in wait for yourself in caves and woods."

Self Attribution Bias: In Bullmarkets Everyone Is A Genius

There’s an aphorism that everybody’s a genius in a bullmarket.

In a sense that would be true, that’s because bullmarkets are basically tolerant or permissive of our mistakes.

Missed the bottom? Sold “low” or too early? Bought “high” or too late? Don’t you worry, markets will eventually redeem our positions! That’s because “High prices will go higher”!

In the same dimension, we have myriad of reasons for taking on positions: corporate or economic fundamental analysis, chart patterns or momentum triggers, recommendations from an expert, a “tip” from an associate or from social circles such as stock forums or parties over an insider info on M&A, joint venture, corporate buy-in, capital infusion or etc…, or simply because a friend said so- they’ll all be proven correct for basically the same principle!

Every trading success builds on our self confidence, even if they are founded from logical mismatches. For instance, conventional fundamental analysis is a long term proposition whereas assessing or weighing on ticker tape price gyrations by typical market participants are very short term in nature-so how does short term price watching square with the long term developments?

Yet with every success comes the attribution of our skills into the performance of our trading positions or our portfolio. A clear manifestation of this would be in social gatherings, where people would bluster about having bought stock ABC at the price X (bottom or near bottom) or sold the same stock at the price Y (top or near top).

Nonetheless, our so called “genius effect” is a common psychological foible known as the Fundamental Attribution Error or the ``cognitive tendency to predominantly over-value dispositional, or personality-based, explanations (i.e., attributions or interpretations) for the observed behaviors of others, thus under-valuing or failing to acknowledge the potentiality of situational attributions or situational explanations for the behavioral motives of others. In other words, people predominantly presume that the actions of others are indicative of the "kind" of person they are, rather than the kind of situations that compels their behavior.” (wikipedia.org)

In market terms, the Fundamental Attribution Error or the Self Attribution Bias is the tendency for people to attribute success to skills and of failures to bad luck or adverse fortune, when the reality is that they have only been responding to situational developments.

Here is a matrix of how the Self Attribution Bias works…

And perceptibly this has been the same reason why during bear markets people from the industry have been in the receiving end of brickbats.

Example, in the US uproar over the executive compensation brouhaha could partly be construed as the receiving end of the attribution bias. [As an aside, the financial industry has been the primary funding conduit of the US real estate bubble as a result of government policies that has vastly skewed their operating incentives see US Home Bubble Cycle: Upside Directly Proportional To Downside. While they are partly to blame as much as those who assumed the risk, the prime culprit would be government policies that fueled such mania. In a gold standard, none of these would have transpired in spite of market irrationality.]

So instead of having to take full responsibility over one’s decisions, in bear markets where decision errors have been glaringly penalized, the attribution errors by the sundry of market participants find an outlet in the blaming of others.

Despite the armies of so-called experts [economists, risk managers, statisticians, actuarial managers, lawyers, accountants, quant modelers etc… for both the buy and sell side institutions] in assessing the risk environment, isn’t it a wonder that most of those who suffered forget that risk ever existed at all?

Now, the consequence has been a barrage of lawsuits.

Profit From Folly

To quote Edwin Lefèvre in behalf of legendary trader Jesse Livermore in the classic Reminiscences of a Stock Operator, ``In a bear market all stocks go down and in a bull market they go up...I speak in a general sense.”

I would add that the phenomenon of blaming of others can be extrapolated as “in a general sense, in the ambiance of bullmarkets, relationships are harmonious and in bearmarkets they turn acrimonious.”

Why? Because as noted above, markets are fundamentally powered by psychology. (see figure 1)

Figure 1: Market Cycle Equals Psychological Shifts

As you can see, the fundamental attribution bias segues into “overconfidence” at the apogee of the every market cycle.

However, such psychological extremes eventually swings like a pendulum as the market transitions towards the opposite end, hence the accompanying psychological frictions in between the cycles.

Let me add that I have personally envisaged some instances of such “relationship disharmony” from this crisis. So this should come naturally or even intuitively for those who understand or have been disciplined on how the market cycle works.

Nevertheless, since markets always operate over the same process, then we should learn how to take advantage of the psychological lapses than fall prey to them.

As Warren Buffett have long admonished, ``Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it."

Thereby, the underlying goal of any serious investor should be to remain composed or calculably rational over the transitional phases of the market cycles while being cognizant of the progressing dynamics of the risk spectrum and likewise be insouciant to the wild swings of market psychology.

Taking away all that ego oriented stuffs diminishes the oomph of the markets, such a killjoy isn’t it?

Madoff Ponzi Scam and Boom-Bust cycles

“At any given time there exists an inventory of undiscovered embezzlement in — or more precisely not in — the country’s business and banks. This inventory — it should perhaps be called the bezzle — amounts at any moment to many millions of dollars. It also varies in size with the business cycle.”- John Kenneth Galbraith, “The Great Crash of 1929”

``Commercial and financial crisis are intimately bound up with transactions that overstep the confines of law and morality shadowy though these confines be. The propensities to swindle and be swindled run parallel to the propensity to speculate during a boom. Crash and panic, with their motto of sauve qui peut induce still more to cheat in order to save themselves. And the signal for panic is often the revelation of some swindle, theft embezzlement or fraud” wrote Charles Kindleberger in Manias, Panics and Crashes.

When people generally feel safe, they take in more risk than is necessary even to the point of dispensing with the necessary appraisal or due diligence.

The recent boom bust cycle underscores this; for instance, institutions that bought into financial assets backed by questionable collateral did so because they put their trust on credit rating agencies, they reached for additional yields, they believed that they can “time” (or exit) the markets, they believed that the boom cycle was in a perpetual motion and most importantly, because everyone else have been doing it (herd mentality). And when the tide did go out, most of them got caught swimming naked, to paraphrase Warren Buffett.

Thus, it is no different when Bernard Madoff bamboozled $50 billion off from the who’s who list which includes top rated financial institutions among them banks, (e.g. BNP Paribas, Banco Santander, Fortis Bank Netherlands, HSBC Holdings, Nomura Holdings, Royal Bank of Scotland and etc.) insurers (CNP Assurances, Clal Insurance, Harel Insurance) and Hedge funds (Tremont Group Holdings, Fairfield Greenwich).

To consider, these institutions account for as supposedly smart money outfits since they are backed by an army of “elite professionals”, e.g. economists, accountants, risk managers, quants etc…). Yet at the end of the day, smart money seemed like everybody else; they got what they deserved because they substituted prudence with fad.

When something turnouts too good to be true they always end up as being a fleeting anomaly or a scam.

Yet markets can’t be blamed for these, in fact, there had been some efforts to expose the Madoff PONZI scheme (a fraudulent scheme which involves paying abnormally high returns to investors out of the money paid in by subsequent investors, rather than from the profit from any real business-wikipedia.org) from the private sector as Aksia, a firm that does due diligence on investment advisers or by trader Harry Markopolos, who in 1999 wrote that "Madoff Securities is the world's largest Ponzi Scheme," in a letter to the SEC (WSJ).

Figure 2 Wall Street Journal: US SEC budget

Unfortunately, the Security and Exchange Commission, as the oversight body with about 3,371 employees (as of 2007) and with a ballooning (almost tripling) of budget (see figure 2) has failed to detect the fraud until the recent bust conditions heightened risk aversion which ultimately forced the unraveling of the grandest fraud.

This only goes to show how bureaucracy almost always lags the social or market dynamics because to quote Ludwig von Mises in Bureaucracy, ``The bureaucrat is not free to aim at improvement. He is bound to obey rules and regulations established by a superior body. He has no right to embark upon innovations if his superiors do not approve of them. His duty and his virtue is to be obedient.”

Another, again it’s that feeling of safety but this time from the comfort of regulations that exposes people to more risk taking. As James Grant recently argued “the commission is worse than useless because not only is it always behind the curve, its very existence gives many investors a false sense of comfort that a big agency is looking after their interests.”

Regardless of boom or bust conditions it is our duty to conduct the necessary due diligence and depend less on government or its bureaucracy to their work for us, otherwise suffer from similar consequences of fools parting with their money as above. We should never keep our guards down because there will always be a prowling Charles Ponzi or Bernard Madoff in different forms.

As the Wall Street Editorial goes, ``There's a lesson here for investors and Congress. Instead of shoveling more money and power to the regulators who already had plenty of both, let's take care not to overregulate the people who actually warned about Mr. Madoff's miracle returns. Law enforcement is useful in punishing wrongdoers after the fact, which will deter some crooks. But expecting the SEC to prevent a determined and crafty con man from separating investors from their money is no more sensible than putting your life savings with a Bernard Madoff.”

Finally today’s environment brings other possible scams to the surface that have not been widely reported as in Colombia’s Ponzi DMG card and Canadian hedge fund run by Otto Spork dealing with glacier investments.

Yet the Madoff Ponzi scandal also reflects on today’s crisis which stemmed from the debacle of the previous credit bubble borne out of Ponzi financing “securitization-derivatives-shadow banking” structures.

As an aside, possible future crisis emanating from similar Ponzi type of operations, but are clothed with legitimacy as the Social Security entitlement program (AEIR, James Quinn) and the Fractional Reserve Standard (JS Kim, Dr. Ellen Brown) should be closely monitored.