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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Small groups of individuals buy a stock and tout it in a misleading hyperbolic wayIn this way a trading strategy, if looked at in a small population of investors and stocks, can give the strong illusion that it is effective when only chance is at work. Data mining, the scouring of databases of investments, stock prices, and economic data for evidence of the effectiveness of this or that strategy, is another example of how an inquiry of limited scope can generate deceptive results. The problem is that if you look hard enough, you will always find some seemingly effective rule that resulted in large gains over a certain time span or within a certain sector. (In fact, inspired by the British economist Frank Ramsey, mathematicians over the last half century have proved a variety of theorems on the inevitability of some kind of order in large sets.) The promulgators of such rules are not unlike the believers in bible codes. There, too, people searched for coded messages that seemed to be meaningful, not realizing that its nearly impossible for there not to be some such messages. (This is trivially so if you search in a book that has a chapter 11, conveniently foretelling many companies bankruptcies.) People commonly pore over price and trade data attempting to discover investment schemes that have worked in the past. In a reductio ad absurdum of such unfocused fishing for associations, David Leinweber in the mid-90s exhaustively searched the economic data on a United Nations CD-ROM and found that the best predictor of the value of the S&P 500 stock index was-a drum roll here-butter production in Bangladesh. Needless to say, butter production in Bangladesh has probably not remained the best predictor of the S&P 500. Whatever rules and regularities are discovered within a sample must be applied to new data if theyre to be accorded any limited credibility. You can always arbitrarily define a class of stocks that in retrospect does extraordinarily well, but will it continue to do so? Im reminded of a well-known paradox devised (for a different purpose) by the philosopher Nelson Goodman. He selected an arbitrary future date, say January 1, 2020, and defined an object to be grue if it is green and the time is before January 1, 2020, or if it is blue and the time is after January 1, 2020. Something is bleen, on the other hand, if it is blue and the time is before that date or if it is green and the time is after that date. Now consider the color of emeralds. All emeralds examined up to now (2002) have been green. We therefore feel confident that all emeralds are green. But all emeralds so far examined are also grue. It seems that we should be just as confident that all emeralds are grue (and hence blue beginning in 2020). Are we? A natural objection is that these color words grue and bleen are very odd, being defined in terms of the year 2020. But were there aliens who speak the grue-bleen language, they could make the same charge against us. Green, they might argue, is an arbitrary color word, being defined as grue before 2020 and bleen afterward. Blue is just as odd, being bleen before 2020 and grue from then on. Philosophers have not convincingly shown what exactly is wrong with the terms grue and bleen, but they demonstrate that even the abrupt failure of a regularity to hold can be accommodated by the introduction of new weasel words and ad hoc qualifications. In their headlong efforts to discover associations, data miners are sometimes fooled by survivorship bias. In market usage this is the tendency for mutual funds that go out of business to be dropped from the average of all mutual funds. The average return of the surviving funds is higher than it would be if all funds were included. Some badly performing funds become defunct, while others are merged with better performing cousins. In either case, this practice skews past returns upward and induces greater investor optimism about future returns. (Survivorship bias also applies to stocks, which come and go over time, only the surviving ones making the statistics on performance. WCOM, for example, was unceremoniously replaced on the S&P 500 after its steep decline in early 2002.) The situation is rather like that of schools that allow students to drop courses theyre failing. The grade point averages of schools with such a policy are, on average, higher than those of schools that do not allow such withdrawals. But these inflated GPAs are no longer a reliable guide to students performance. Finally, taking the meaning of the term literally, survivorship bias makes us all a bit more optimistic about facing crises. We tend to see only those people who survived similar crises. Those who havent are gone and therefore much less visible. Rumors and Online Chatrooms Online chatrooms are natural laboratories for the observation of illusions and distortions, although their psychology is more often brutally basic than subtly specious. While spellbound by WorldCom, I would spend many demoralizing, annoying, and engaging hours compulsively scouring the various WorldCom discussions at Yahoo! and RagingBull. Only a brief visit to these sites is needed to see that a more accurate description of them would be rantrooms. Once someone dons a screen name, he (the masculine pronoun, I suspect, is almost always appropriate) usually dispenses with grammar, spelling, and most conventional standards of polite discourse. Other people become morons, idiots, and worse. A posters references to the stock, if hes shorting it (selling shares he doesnt have in the hope that he can buy them back when the price goes down), put a burden on ones ability to decode scatological allusions and acronyms. Any expression of pain at ones losses is met with unrelenting scorn and sarcasm; ostensibly genuine musings about suicide are no exception. A suicide threat in April 2002, lamenting the loss of house, family, and job because of WCOM, drew this response: You sad sack loser. Die. You might want to write a note too in case the authorities and your wife dont read the Yahoo! chatrooms. People who characterize themselves as sellers are generally (but not always) more vituperative than those claiming to be buyers. Some of the regulars appear genuinely interested in discussing the stock rationally, imparting information, and exchanging speculation. A few seem to know a lot, many are devotees of various outlandish conspiracy theories, including the usual anti-Semitic sewage, and even more are just plain clueless, asking, for example, why they always put that slash between the P and the E in P/E, and is P price or profit. There were also many discussions that had nothing directly to do with the stock. One that I remember fondly was about someone who called a computer help desk because his computer didnt work. It turned out that he had plugged the computer and all his peripheral devices into his surge protector, which he then plugged into itself. The connection with whatever company was being discussed Ive forgotten. Taking advice from such an absurdly skewed sample of posters is silly, of course, but the real-time appeal of the sites is akin to overhearing gossip about a person youre interested in. Its likely to be false, spun, or overstated, but it still holds a certain fascination. Another analogy is to listening to police radio and getting a feel for the raw life and death on the streets. Chatroom denizens form little groups that spend a lot of time excoriating, but not otherwise responding to, opposing groups. They endorse each others truisms and denounce those of the others. When WorldCom purchased a small company or had a reversal in its Brazilian operations, this was considered big news. It was not nearly as significant, however, as an analyst changing his recommendation from a strong buy to a buy or vice versa. If you filter out the postings drenched in anger and billingsgate, you find most of the biases mentioned above demonstrated on a regular basis. The posters are averse to risk, anchored to some artificial number, addicted to circular thought, impressed by data mining, or all of the above. Most boards I visited had a higher percentage of rational posters than did WorldComs. I remember visiting the Enron board and reading rumors of the bogus deals and misleading accounting practices that eventually came to light. Unfortunately, since there are always rumors of every conceivable and contradictory sort (sometimes posted by the same individual), one cannot conclude anything from their existence except that theyre likely to contribute to feelings of hope, fear, anger, and anxiety. Pump and Dump, Short and Distort The rumors are often associated with market scams that exploit peoples normal psychological reactions. Many of these reactions are chronicled in Edwin Lefevres 1923 classic novel, Reminiscences of a Stock Operator, but the standard pump and dump is an illegal practice that has gained new life on the Internet. Small groups of individuals buy a stock and tout it in a misleading hyperbolic way (that is, pump it). Then when its price rises in response to this concerted campaign, they sell it at a profit (dump it). The practice works best in bull markets when people are most susceptible to greed. It is also most effective when used on thinly traded stocks where a few buyers can have a pronounced effect. Even a single individual with a fast Internet connection and a lot of different screen names can mount a pump and dump operation. Just buy a small stock from an online broker, then visit the chatroom where its discussed. Post some artful innuendoes or make some outright phony claims and then back yourself up with one of your pseudonyms. You can even maintain a conversation among your various screen names, each salivating over the prospects of the stock. Then just wait for it to move up and sell it quickly when it does. A fifteen-year-old high school student in New Jersey was arrested for successfully pumping and dumping after school. Its hard to gauge how widespread the practice is since the perpetrators generally make themselves invisible. I dont think its rare, especially since there are gradations in the practice, ranging from organized crime telephone banks to conventional brokers inveigling gullible investors. In fact, the latter probably constitute a vastly bigger threat. Being a stock analyst used to be a thoroughly respectable profession, and for most practitioners no doubt it still is. Unfortunately, however, there seem to be more than a few whose fervent desire to obtain the investment banking fees associated with underwriting, mergers, and the other quite lucrative practices induces them to shade their analyses-and shade may be a kind verb-so as not to offend the companies theyre both analyzing and courting. In early 2002, there were well-publicized stories of analysts at Merrill Lynch exchanging private emails deriding a stock that they were publicly touting. Six other brokerage houses were accused of similar wrongdoing. Even more telling were records from Salomon Smith Barney subpoenaed by Congress indicating that executives at companies generating large investment fees often personally received huge dollops of companies initial public offerings. Not open to ordinary investors, these hot, well-promoted offerings quickly rose in value and their quick sale generated immediate profits. Bernie Ebbers was reported to have received, between 1996 and 2000, almost a million shares of IPOs worth more than $11 million. The $1.4 billion settlement between several big brokerage houses and the government announced in December 2002 left little doubt that the practice was not confined to Ebbers and Salomon. In retrospect it now seems that some analysts ratings werent much more credible than the ubiquitous email invitations from people purporting to be Nigerian government officials in need of a little seed money. The usual claim is that the money will enable them and their gullible respondents to share in enormous, but frozen foreign accounts. The bear market analogue to pumping and dumping is shorting and distorting. Instead of buying, touting, and selling on the jump in price, shorters and distorters sell, lambast, and buy on the decline in price. They first short-sell the stock in question. As mentioned, that is the practice of selling shares one doesnt own in the hope that the price of the shares will decline when it comes time to pay the broker for the borrowed shares. (Short-selling is perfectly legal and also serves a useful purpose in maintaining markets and limiting risk.) After short-selling the stock, the scamsters lambast it in a misleading hyperbolical way (that is, distort its prospects). They spread false rumors of writedowns, unsecured debts, technology problems, employee morale, legal proceedings. When the stocks price declines in response to this concerted campaign, they buy the shares at the lower price and keep the difference. Like its bull-market counterpart, shorting and distorting works best on thinly traded stocks. It is most effective in a bear market when people are most susceptible to fear and anxiety. Online practitioners, like pumpers and dumpers, use a variety of screen names, this time to create the illusion that something catastrophic is about to befall the company in question. They also tend to be nastier toward investors who disagree with them than are pumpers and dumpers, who must maintain a sunny, confident air. Again there are gradations in the practice and it sometimes seems indistinguishable from some fairly conventional practices of brokerage houses and hedge funds. Even large stocks like WCOM (with 3 billion outstanding shares) can be affected by such shorters and distorters although they must be better placed than the dermatologically challenged isolates who usually carry on the practice. I dont doubt that there was much shorting of WCOM during its long descent, although given whats come to light about the companys accounting, short and report is a more faithful description of what occurred. Unfortunately, after Enron, WorldCom, Tyco, and the others, even an easily generated whiff of malfeasance can cause investors to sell first and ask questions later. As a result, many worthy companies are unfairly tarred and their investors unnecessarily burned. |
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