PHYSCHOLOGY OF INVESTING IN IRRATIONAL TIMES

FEBRUARY’S NEWSLETTER

SPECULATING vs INVESTING

The first thing to set clear is that speculating and investing are not the same thing: while speculating implies spending money on high-risk instruments whose volatility can be directly affected by external forces that cannot be expected at the beginning; investing means to buy and hold an asset for the long term with the expectation of a future profit, also providing periodical earnings such as dividends and interest payments. Besides, investments imply the necessity of research (commonly fundamental analysis) to evaluate the market´s situation, patterns, and events that can affect their money.

In the same line, both strategies consider (lower or higher) risk, and according to Cambridge Dictionary, risk means the possibility of something bad happening, however, amid the financial markets, it would be accurate to assume that the concept also includes the possibility of positive scenarios occurring with the same probability.

Risk tolerance and psychology of investing

“For many people, investing has become a game of lottery and odds, but having that strategy can be the fastest way to lose money,”- Benjamin Boehner, director of Investment Consulting for Central and Latin America at Credit Suisse.

Once a person has decided to become an investor, it is highly important to define the risk they are willing to withstand, which means the necessity to analyse objectives, feelings, and financial situation to be completely sure of how much loss the person will endure without feeling worries and withdraw their money anticipatedly. Correspondingly, it is well known that as investors get older, they modify their portfolios to reduce the risk of losses, so that they can protect the money saved and for retirement.

Notably the most common roisk tolerance profiles are:

  • Aggressive: People that accept high volatility and mostly tend to speculate.
  • Moderate: Strategy that combines high volatile and riskless instruments, such as stocks and government bonds.
  • Conservative: People who are not willing to accept volatility on their portfolios.

For this reason, the two last profiles tend to invest, showing preference in instruments such as stocks, ETF´s, treasury bonds, and mutual funds. On the contrary, there are different examples of nonchalant speculative traders and financial derivatives used, such as day traders, swing traders, futures contracts, and short-selling, just like we recently saw with GameStop stock price.

No matter how great the talent or efforts, some things just take time. You can´t produce a baby in one month by getting nine women pregnant”- Warren Buffet.

Speculative traders used to buy assets for a short time with the intention of sell when their value gets higher so that they are frequently moving into and out of a position. As a result, when there are inflated expectations of growth or price action for a particular asset, values will rise, increasing trading volume and leading to a possible financial bubble.
Therefore, speculators might look more at market or investor psychology, trends, and related factors choosing where to put their money with the hope of capitalization and a quick profit.

“It isn´t the head but the stomach that determines the fate of the stock picker”- Peter Lynch.

The three emotions that tend to deviate from strategy when investing are stress, greed, and fear:

Firstly, when stress overtakes the investors, they likely make the wrong decisions because of their impulses, leading them to fall into carefree speculation. To avoid this point, it is good to find a balance between feeling comfortable and have control of the situation.

Greed, as a consequence of overconfidence, typically causes considerable losses due to having assumed too much risk. For this reason, being humble and understand that it is not a competition with other investors will save several amounts of money on the path as investors.

Finally, the effect of fear can cause two different situations on the investor: paralyze before the uncertainty or rush before the falls. For example, when the investor opens a trade which they were not sure of and the price starts to decline slowly, fear begins to take over, finishing the trade at a loss, ignoring the possibility to define either a “stop-loss” or “break-even” orders.

To sum up, the following image shows the differences between investing and speculating.

But which is better? As expected, there is no certain answer for that because it involves people preferences and risk tolerance, so it is recommended that every person should analyse their objectives and behaviour to define whether investing or speculating fits better to follow a path on their financial life considering the information that was provided to you in these lines.

DOES OPTION ACTIVITY MOVE THE MARKET

Option Open Interest and the Impact on the Underlying

Throughout 2020 we witnessed renewed interest by young investors in the options market. This theme continues into 2021, as the 7 of the 10 largest volume days in history in the call option side have occurred in January of this year. Small order size trades currently constitute of 25% of the total volume in the options market, compared to 10% in 2019.

Normally, when there is a large, unusual open interest on a call or put option with an out of the money (OTM) short dated strike price, the underlying stock tends to move in that direction, but not empirically. This is due to several factors that will be discussed next. But the actual placing of these orders in unusual volume transmits a conviction sentiment from the buyer that the underlying is going to move in that direction. This could be through insider information on a particular matter, earnings reports, expectations of a large move not priced in, simple hedging strategies, and as we have seen more often, social media trend following. A great example of a possible insider information bet was the case of Intel on the 12th of January of 2021. After Activist Investor Dan Loeb built up a position in Intel through Third Point LLC and made it public late in December of 2020, he urged the company to explore strategic alternatives. This was received well by the general public, since Intel was severely underperforming against its peers through lack of innovation while simultaneously giving out handsome compensation packages to its management board.

On the 12th of January, an unusual volume of roughly 13 thousand call options with a strike price of $58 expiring on the 29th were bought, equivalent to 1.3 million shares (a single option contract is equivalent to 100 shares of the underlying stock, and an option contract gives the buyer the right to buy, in case of a call option, or sell, in case of a put option, 100 shares of the underlying stock at a predetermined strike price until a predetermined date), with the underlying stock trading in the 52-53 dollar range that day. Sure enough, the very next day, Robert Swan announced that he would step down from his position as CEO on February 15th. The result was almost a 12% gap up in the stock the next day when the market opened. Many times, people try to time the market. In reality it is almost impossible due to the chaotic nature of the world. It is far more rewarding having time in the market instead.

Market Maker/ Dealer Hedging

When an individual or institution buys an option contract, there is another party taking the other side of the trade. These option sellers could be individual investors and institutions selling covered calls/puts for extra income. Most of the times they are Market Makers. Market Makers do what their name suggests, they post a bid and an offer (buy and sell prices) for one or more securities in order to provide liquidity to the market. In many cases, they do not possess the underlying shares that the option contract requires them to sell if the contract were to be exercised. In order to cover that risk, market makers need to buy shares at the rate of the Delta and Gamma of the option. Delta tells us by how much the price of the option will change when the underlying moves $1. Gamma tells us by how much the Delta of the option will change when the underlying moves $1.

If a Market Maker is exposed to a large number of OTM calls, it will be subsequently exposed to Delta and Gamma. The price of the option will move in an exponential fashion as it nears its strike price.

What happened in the case of GameStop was a very peculiar matter. There were 50 million registered shares, where 70 million were sold short and 150 million shares were traded through call options. Market Makers and option sellers were enormously exposed and had to cover their risk.

And what was a short squeeze, became a Gamma squeeze because the call option sellers had to buy shares at huge volumes in order to cover their Delta and Gamma exposure.The result could have been catastrophic for the system had the call options been exercised. This would mean that the call option sellers would have to buy 150 million shares when there were only 50 million shares available, and the short sellers would have to buy back 70 million shares to close their positions. Theoretically, the price of the stock could have been pushed up into the several thousands of dollars.

Pricing in Volatility

Are the options market correlated with the stock market? Can the options trading data predict where the stock markets are going? These are some pertinent questions that investors arise when studying options and stocks.
There are some meaningful methods that use options indicators to predict the market direction, such as the put-call
parity, put-call ratio and volatility indexes (for example, VIX or CBOE volatility index). It is, however, important to distinguish between implied and historical volatility. The latter are also known as statistical volatility and measures the speed at which a given security changes price over a certain time (generally, a higher historical volatility will lead to a higher option price). The implied volatility is the one that deserves the focus of this research since it is often used to price the respective options. Implied volatility is a specific concept to options market and measures the degree to which the underlying security is expected to move in the future.

Empirically, it is the real-time prediction of the price of an asset as it is traded, providing the estimation volatility of the options underlying asset over its lifespan.

Options are priced using several mathematical models (like Black-Scholes Merton Model, Binomial Trees Model, Montecarlo Simulation Model) and they take implied volatility into consideration, among other variables. Consequently, it is possible to use reverse mathematical engineering on the valuation formulas in order to arrive at an implied volatility value through the respective option market prices.

Having this in mind, options based VIX values are regularly used to predict the market direction, both in short and long-term (see picture).

Left and Rigjt Tail Events

Left and Right tail events can also be called tail risk. Tail risk is a form of portfolio risk that captures the probability of an investment to move more than three standards deviations from its mean. It is important to point out that most of the modern investment portfolio theories (like Mean-Variance Theory) and option pricing theories (like Black-Scholes Merton) assume that the expected return of the stock market follows a Gaussian distribution.

Nevertheless, tail risk is real and must be considered, even though its probability of occurrence is 0.3%, assuming a normal distribution. Crashes like the financial crisis in 2008, events like the pandemic that we are facing right now are examples of this tail risk. Technically, the tail risk refers to both right and left tail events, so, the probability of abnormal high return should also be taken into consideration (consider the GameStop case as an example). However, most people are concerned with the left tail, that is, with losses.

Another interesting factor to include is the black swan theory, which was developed by Nassim Nicholas Taleb and said that there is a tendency for people to inappropriately rationalize surprise events, giving them a higher probability of occurrence just because they have occurred in the past. With that stated and facing the fact that this is one of the more unpredictable times of our history, options have a role to play in this story. The hedging of investments was never discredited, nevertheless, it may assume a crucial role in these times.

The fear of uncertainty and the continuous non-rationalization of financial markets (GameStop, Dogecoin, Bitcoin, Tesla, etc.) make conventional theories lose some of their value. There are more and more people willing to invest in the financial markets and many of these people do not have the necessary knowledge to do so. Will specialists make more use of the options markets as a way of protecting their investments and preventing previous non-rational situations from happening again?

THE HIGHS AND THE LOWS

Introduction

As we all know, humans are not fully rational, we have a limited capacity to process information. When we start investing, we are exposed to a world full of information, news and rumors, a very chaotic world and, as a result, most people feel overwhelmed when they start. This feeling of information overload, combined with the normal irrationality of human beings, can lead to serious problems for investors when they first start, but also when they are more experienced. These problems can range from a false perception of success and knowledge when things are going well to a feeling of depression and cluelessness when things start to fall apart. Investing is like a rollercoaster with its highs and lows and all investors need to understand how to cope with both to be successful.

The Highs

Usually, when people start investing, they get excited and curious, so they begin by rushing in and buying stocks with the little knowledge that they have and without any research at all, as a result, the stocks that they buy are heavily influenced by what others say because they do not know how to do their research about the companies and the markets. However, sometimes those investments turn out to be good and the newbies end up making a profit owing to the so-called beginner’s luck. Thus, some newbies start in a good position, nevertheless, this is not always a good position to start (even for experienced investors, at times, they get tricked by being in a position like this one), due to some reasons that will be explained in this topic.

When investors are in a high, they are struck with a feeling of overconfidence: they start believing they are invincible, that they have more control over their investments than they truly do, hence overestimate their abilities to identify successful investments. This overconfidence, usually, comes from the fact that they assume this good phase they are in is 100% a result of their work and there was no luck involved. Frequently they are fooled by randomness or, in other words, they establish causal links between factors that are purely random. Due to this sense of success, they begin feeling confident in their strategy and knowledge (which is, normally, very low for newbies), this is called the self-attribution bias. This bias occurs when investors attribute successful outcomes to their own actions and bad outcomes to external factors, which leads to a false feeling of success. In fact, experts often overestimate their abilities more than the average person
does as shown in various studies, that is to say, that the problems at hand also occur to very experienced investors.
Furthermore, this overconfidence and greed will lead them to dangerous behaviors. Typically, these behaviors can be an increase in the volume and frequency of trading or, an increase in investments with high levels of risk. The first one is evidenced in multiple studies, such as, the one from Irwan Trinugroho and Roy Semble (2011), where the results (Table 1) show that there is a difference in trade activity between high and low confidence investors, high confidence investors have a higher frequency and larger trading volume than low confidence investors. The latter one is also a common behavior for investors with high confidence levels since they strongly believe in their knowledge as well as in their strategy.

As a result, they will not be as affected by bad news that contradict their decisions as low confidence investors, due to this, their ability to evaluate the risks of certain investments will be affected. This is also shown in the results (Table 1) of the study referenced before, where investors with high confidence have a much higher frequency and volume of trading after bad news than low confidence investors, which goes to show that investors when in a high have a very strong belief in their abilities, as was previously mentioned.
Consequently, these risky behaviors at hand will lead investors to worse returns on their investments as proven in various studies, such as, the one that we have referenced earlier (Table 1), in this study high confidence investors have a minimum profit of -21.65% and a maximum profit of 5.64%, whereas investors with low confidence that have the opposite behavior have a minimum profit of -10.13% and a maximum profit of 6.64%, which goes to show that the dangerous practices caused by overconfidence entail people to worse returns.

The Lows

A low situation is not necessarily an economic crisis or the deepest point in the stock market cycle, but a state where there are not profits or positive growth rates in our portfolio. Lows are losses.
What would you do if your portfolio loses 1% daily for one week? If you or your portfolio manager think you allocated your assets correctly, would you rebalance your portfolio or left it as it is? Most of the times, the self-attribution bias appears, and investor attribute the bad performance to the market, thus an investor cannot even realize if he is in a low. Other times when the economy is in recession or has experienced a shock the investors react with fear.

The self-attribution bias, as mentioned previously, emerges in the first scenario and comes from a human necessity we all have to protect ourselves of loses and critics. A self-protection that instead of increasing profits leads to underperformance, because the overconfidence of investors guides them to continue to hold the same assets rather than selling them or applying another strategy.
At the same time the investor is being victim of the sunk cost trap or Concorde fallacy, this is the tendency for people to irrationally follow through on an activity that is not meeting their expectations. It happens when the investor does not accept to lose the money already invested or when he does not want to accept that he has made a bad investment. Under the sunk cost trap the investor prefers to continue with his initial decision as long as it looks like a well-thought-out strategy.
On the other hand, when markets present a period of losses, a low can be feedback by the reactions of the investors. In this case fear is the protagonist of the herd behavior, in which the investors do what everyone else is doing, sell their stocks and look to protect their returns. The instinct to act collectively is explained by the simple idea of feeling like we belong to a community, the same happens when a stock is rising and everyone, instead of doing their own analysis and research, buys it because that is what everyone else is doing.
Finally, in table 1 we can see the difference in trading when investors are experiencing a high and low overconfidence. Bad and good news do not have the same impact in a low scenario, the most important indicator is the standard deviation, note that investors tend to be closer to the mean and that in general their actions are lower than in the high scenario.

Conclusion

Concluding, when investing highs and lows are unavoidable, just as emotions. The optimal way to mitigate reactions to market fluctuations is by creating a goal list where investors establish a cap and floor price to their securities. Making decisions based on historical experience and on analysis are also good methods to not divert from our portfolio objective.

IRRATIONAL BEHAVIOUR OF INVESTORS

Would you prefer 1.000€ in hand or 10.000€ with a 10% chance of winning? Well, you can speak for yourself, and the expected value of both offers are actually the same, but what if you had to choosebetween losing 1.000€ or have a 10% chance of losing 10.000€? Is your answerstill the same? Probably not.
According to Prospect Theory, most people are averse to risk regarding gains, and prone to risk regarding losses. This follows the popular motto “better a bird in hand than two in the bush”, and by failing to analyze this problem rationally, people are biased on their risk management decisions, and are more likely to use improper risk-taking/risk-avoidance strategies.

The Lottery Case

But then, why do people bet on the lottery?
Would it not be better having 5€ in your hand than a 0,1% chance to win 5.000€? Actually, when the odds are very low, people tend to overrate such odds, having the general opposite effect of the example given on the first paragraph. In such cases, people prefer not to keep 5€, and instead choose to spend them on the lottery, for the incredibly slim chance of a major prize.
The average EU citizen spends 164€/year on lottery-like games, and of course have little to no expectations of seeing such huge amounts of money in their lifetime. In the case of those who spent 10€ every two weeks for 10 years on EuroMillions for a total chance of 0.00309% of winning 52M€, we can consider it an investment of 4320€. In 20 years, it is an investment of 8640€. Just imagine investing that money through time in companies like Amazon, Apple, Microsoft or even Domino’s Pizza.

Entering the Market

And if you are an investor, how did you fare when you first entered the market? Did the fact that you won or that you lost
change the way you approached investing? It is common for the first drastic change of the value of your portfolio to have a severe impact on future decisions. With the high volatility of the stock market, there is a high chance that one loses when first investing, and since “Losses have about twice the emotional impact of an equivalent gain” (according to Nobel Prize winner Richard Thaler), it is common to quit right away, and bet on safer options, like bonds and treasury bills, even though they provide far lesser gains.

If such an investor had chosen to buy 1.000€ of 20+ years Treasury Bills in 2003, he would have 1481.7€, but if he instead opted by buying an S&P 500 ETF, he would have 3919.5€, around 6x more gains comparatively. This means less money for a house, a car or for retirement.

Casual Investors

Small-time, casual investors tend to rely on emotional factors to drive their actions, mainly because they do not know many technicalities and/or are not well educated in finance. In general, but especially in such cases, people tend to hold on to their losses while quickly selling their gains, the so-called disposition effect, mainly because if you sell at loss, you need to face your defeat, that you made a mistake and people do prefer to avoid that. This, of course, is not rational investing. We can also see it in the many cases when people are afraid of the trend, so if it is in a downturn they sell, afraid of incurring more losses, instead of following a continuous, duly substantiated investment strategy, instead of believing in the assumptions they made for the company.

Financial Literacy

But how can one have good assumptions about a company without having the proper financial literacy to back them up? How can lawyers or doctors spend around a decade studying their own fields, to earn around 40.000€/year in Portugal, and take just a couple minutes investing their savings? Of course you cannot expect good or even positive results of a work that you did not study or research for.

In 2015, research firm Dalbar found that in the 17-year period prior, “the average equity mutual fund investor underperformed the S&P 500 by a wide margin of 8.19%”, having returns less than half of those of the broader market. This shows that the average investor could benefit from developing their financial literacy. In fact, as can be seen in the graphic below, financial literacy is a topic worth debating.

In Portugal, we have as little as 26% of adult population instructed in finance. With numbers such as these, we can see the urgency to invest in financial literacy, not only in Portugal but in so many other countries, being important to avoid riskier and bankrupting investments, pyramid-schemes and to overall improve the finances of the populations.

Conclusion

Humans have inherent biases (behavioral deviations) that influence their investment decisions, but those biases can, and frequently are, suppressed by knowledge, research and experience in the area. In such a quantitative field, rationality should triumph over emotion. Study, watch videos, read articles, get involved, get informed, and you are more likely to improve your returns.

SOURCES

ESPECULATION vs INVESTING

DOES OPTION ACTIVITY MOVE THE MARKET

THE HIGHS AND THE LOWS

IRRATIONAL BEHAVIOUR OF INVESTORS

AUTHORS

EDGAR SOTELO

GONÇALO RAYAGRA

ALEJANDRO AVILA

RUI RIBEIRO

LOURENÇO CARDOSO

LAURA DÍAZ

DAVID TITA

CONSTANÇA MOREIRA

Published by lisboninvestmentsociety

INVEST IN YOURSELF

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