THE PSYCHOLOGY OF RISK: THE FEAR FACTOR

THE PSYCHOLOGY OF RISK: THE FEAR FACTOR

GARP

FEBRUARY 28, 2012

FRANK F. MURTHA, PH.D. RICHARD L. PETERSON, M.D.

INDIVIDUAL DECISIONS COLLECTIVE IMPACT

MARKETPSYCH GROUP RESEARCH

YOUR INTERESTS

• How do you work with risk? Individuals, corporations, insurance, trading?

• What do you hope to gain from today?

3

ACTUAL RISK VS. RISK PERCEPTION

• Market risk is a function of human behavior. • Fear is the emotion of risk perception. • How do our perceptions deviate from reality?

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AGENDA • RISK IN THE BRAIN

• NEUROECONOMICS OF RISK • PROSPECT THEORY AND ROGUES

• PERSONALITY AND RISK MANAGEMENT • FEAR AND MARKET PRICES

• OVERREACTION • UNDER-REACTION • BUY ON THE RUMOR

• CAPITALIZING ON RISK

"Success in investing doesn't correlate with I.Q. once you're above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing. ~Warren Buffett

• How do we know if we’ve got the

right temperament?

•QUOTE: Keynes - "The market can remain irrational longer than you can remain solvent."

WHAT EMOTION IS THIS?

RISKY DECISIONS

• You have a choice. • Either:

1) You will win $1000, or 2) You can take a 50/50 gamble

• If you take the gamble, you will either win $2000 or get nothing.

• The result of the gamble depends on the outcome of a fair coin flip.

• What do you do?

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NOW, WHAT EMOTION IS THIS?

UNCONSCIOUS EMOTIONS

• INCIDENTAL fearful/angry faces cause decreased risk-taking in a gambling experiment.

• Happy faces increased risk-taking. • Subjects denied that the faces had

affected their judgment. • 30% difference in risk taken. • Due to denial they could never learn

to correct for the effect. • So what can we do about this?

• (Winkelman et al, 2007)

EMOTIONAL PRIMES

Kuhnen and Knutson, 2005.

NEG

POS

THE BRAIN

• The brain’s structure explains some of our economic behavior.

• Frontal Cortex – Executive function – Judgment

• Subcortex: Limbic system – Emotions – Drives – Desires

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“X-ray” view through the brain

RISK PERCEPTION

GENES AND INVESTMENT RISK TAKING

Kuhnen and Chiao, 2009.

GENES ABNORMAL VARIANT

PERSONALITY TRAIT

Serotonin transporter 5-HTTLPR (s/s allele)

Anxiety and depression sensitivity, and take 28% less investment risk.

Low Emotional Stability (Neuroticism)

Dopamine D4 receptor (7-repeat allele carriers)

Novelty and sensation seeking, and take 25% more investment risk.

High Extraversion

• Unconscious emotions underlie investment decisions.

• These emotions arise via “priming” by recent events, our genetic susceptibility, and recent life experiences.

• Sometimes the emotions are useful (e.g., Soros), but other times they are destructive.

• Learning to identify positive and negative emotions is personal and requires work.

INVESTOR’S BRAIN SUMMARY






NICK LEESON: THE ROGUE TRADER

• From 1992, Leeson made unauthorized speculative trades that at first made large profits for Barings Bank, accounting for 10% of annual income.

• Losses exceeded £208 million by the end of 1994.

• "I was determined to win back the losses. And as the spring wore on, I traded harder and harder, risking more and more. I was well down, but increasingly sure that my doubling up and doubling up would pay off ... I redoubled my exposure…. It became an addiction."

HOLDING LOSERS TOO LONG

• Tendency to weigh down your portfolio by holding to losing positions for extended periods of time; aka “break even-itis.”

ANOTHER ROGUE: TOSHIHIDE IGUCHI

• Lost over $1 billion of Daiwa Bank’s capital trading copper in New York City through 1995

• “I didn't set out to rob a bank. At the same time I was not strong enough to admit my mistake. In hindsight, yes I could have stopped myself along the way. I wish that someone else would have stopped it for me.”

• Driven by shame to hide 30,000 illegal trades and increasing losses over several years.

A PROFILE OF THE ROGUE TRADER

• “Formerly successful traders … suffer more readily from the mistaken belief that any downturn in their fortunes must be temporary and, if hidden … for a short time, can be made up through riskier trades.”

• Isolation, too, is a common thread in the history of rogue activity. • Often a trader's attempts to evade risk and loss limits are

“rational” once the losses have begun. • That is, traders get potentially higher rewards - and status - for

taking higher risk, while the costs of losses can be hidden (e.g., Jerome Kerviel at Societe General where he lost $7 billion).

• But some traders are also thrilled by the high-risk strategies and so are motivated by gambling urges.






PERSONALITY TRAITS

• What is Personality? • People rate their

agreement with thousands of adjectives and phrases.

• The “Big Five” emerge.

See: www.marketpsych.com/personality_test.php

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THE BIG FIVE

Emotional Sensitivity Extraversion Openness Agreeableness Conscientiousness

Emotional Stability Introversion Traditionalism Self-Interest Spontaneity

INVESTOR PERSONALITY TEST

• Sample of 2,600 investors from 2005-2010.

• Took “Investor’s Personality Test” at marketpsych.com

• 19% women. • Reported largest historical

drawdown and past five years investing returns as dependent vars.

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THE BIG FIVE

Emotional Sensitivity Extraversion Openness Agreeableness Conscientiousness

Emotional Stability Introversion Traditionalism Self-Interest Spontaneity

GEORGE SOROS LOOKS FOR RISK

• Intellectually curious and emotionally stable.

• “Belief in fallibility”, “Open Society Institute”

• "To others, being wrong is a source of shame. To me, recognizing my mistakes is a source of pride. Once we realize that imperfect understanding is the human condition, there’s no shame in being wrong, only in failing to correct our mistakes.” -- Soros on Soros

WOMEN AND MEN

WHY THE DIFFERENCE?

• Testosterone, cortisol, or oxytocin effects?

THE BEST INVESTORS

• Open to New Experiences • Emotionally Stable • Women






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EMOTIONAL ARBITRAGE

• Overreaction • Underreaction • Buy on the Rumor,

Sell on the News

“And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful.” ~Warren Buffett

• How do we know if others are

fearful or greedy?

•QUOTE: Keynes - "The market can remain irrational longer than you can remain solvent."

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OVERREACTION • The Overreaction Hypothesis (DeBondt and Thaler, 1985;

Kahneman and Tversky, 1982)

• Investors respond to new information by: •Overweighting recent information and •Underweighting prior information.

• Effect strongest for small cap stocks (Chopra, Lakonishok, Ritter 1992).

• Stronger overreaction to bad news than to good. • Stable environment, noisy information.

FEAR OVERREACTION

4/25/09: WHO director declares a “public health emergency” due to “Swine Flu”.

Anxiety rises in AMR social media (see grey line).

4/27/09: Pandemic alert level to Phase 4.

4/30/09: MarketPsy bought AMR at $4.81/share.

5/6/09: MarketPsy sold AMR at $5.95/share.

American Airlines (AMR) stock price

Expressions of fear about AMR stock.

BUY

SELL

35 Copyright © 2006 Richard Peterson

MIS-PRICED RISK

• Premiums are raised just after destructive events, but the probability of another remains near its base rate.

– Wilbur Ross and Warren Buffett both bought re-insurance companies after hurricane Katrina.

– Low probabilities are overweighted if they are emotional (“affect-rich”)

• People over-prepare for recent or known risks

• They are under-prepared for rare events






"Markets can remain irrational a lot longer than you and I can remain solvent." ~John Maynard Keynes

• How do we use sentiment to time

long and short positions?

39

UNDER-REACTION • When a stock or market does not account for all positive

information.

• As investors realize the good news, the stock gradually climbs, resulting in a price increase over days to weeks.

• Investors were not paying enough attention, but they gradually wake up to their error

• May affect stocks over the short term or the long term

• Unstable environment, precise information.

OVER VS UNDER-REACTION

• Studied 40 most liquid long-only ETFs from Jan 2000 to May 2011. Monthly rebalancing . Highest 50% with Good Accounting news.

• Market Neutral: Long ETFs with Joy<50%. Short ETFs with Joy>50%

• Overreaction and underreaction are differentiated by emotion.

Low Joy

High Joy

EQUITY CURVE OF MARKET NEUTRAL ETF STRATEGY






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“BUY ON THE RUMOR”

• Earnings announcements of 393 internet firms over 1,875 firm-quarters between January 1998 and August 2000.

• Purchasing an internet stock five days prior to its earnings announcement and then selling that stock at the open on the day immediately following the earnings release yielded 4.9%.

• Shorting the same stock at the open the day after its earnings release yielded 6.4% when the short was covered at the market close five days later.

• Trueman, B., Wong, F.M.H., & Zhang, X-J. (2001). Anomalous stock returns around internet firms’ earnings announcements. Journal of Accounting Research.

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MSO: FEAR AND RELIEF

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RELEASE FROM PRISON

MSO Stock Price






“In sum, stock prices clearly have a life of their own; they are not simply responding to earnings or dividends…. In seeking explanations of stock price movements, we must look elsewhere. ~ Robert Shiller, Yale University (2000).

• How can we understand stock prices’ “inner life”?

“140 characters isn't much, but multiplied by 1 billion, it has a profound impact.”

ARAB SPRING

RISK-RELATED PERCEPTIONS

TEXT ANALYTICS

PREDICTIVE VALUE OF SENTIMENTS

MARKET RISK INDEX

MARKETPSY LONG-SHORT FUND L.P. (Gross Equity Curve, Audited Track Record)

53

Closed fund here

16 months later, after gradual downward drift…

S&P here

SENTIMENT-BASED TOOLS

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Newsletter (www.marketpsychdata.com)

Sentiment event tools

Sentiment dashboards

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INTERNET RESOURCES

• INTERNET: – MarketPsych.com

(free investing personality tests) – MarketPsychData.com (sentiment

data and newsletter) – Investopedia.com – Behaviouralfinance.net – Seekingalpha.com

Courtesy of www.JacobKozinn.com

57 Copyright © 2007 Richard Peterson

HAPPY INVESTING!

Trainings MarketPsych, LLC www.marketpsych.com [email protected] Ph: +1.310.573.8523 Sentiment Data MarketPsych Data, LLC www.marketpsychdata.com [email protected] Ph: +1.310.573.8523

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THE PSYCHOLOGY OF RISK: THE FEAR FACTOR