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Alpha Theory Blog - News and Insights

« July 2014 | Main | September 2014 »

1 posts from August 2014

August 27, 2014

Bubble Brain – and why it is ok to sell “too early”

“We as a firm are always going to buy too soon and sell too soon.  And I’m very at peace with that.” –Seth Klarman, Baupost Group

When JP Morgan was asked how he had become so rich he replied, “I sold too early.” – JP Morgan, famous financier

“The riskiest moment is when you’re right.  That’s when you’re in the most trouble, because you tend to overstay the good decisions.” – Peter Bernstein, legendary investor

“Make a rule:  Whenever an investment doubles in price, find out who has the most negative view of it and give this devil’s advocate a full hearing.” – Jason Zweig, author of Your Money and Your Brain

“I made my money by selling too soon.” – Bernard Baruch, financier and investor

“Be fearful when others are greedy, and greedy when others are fearful." – Warren Buffett, legendary investor

 

Even though sage value investors espouse the virtues of selling, it is hotly debated because there is strong evidence against it (i.e. the stock went up past where it was sold). But let’s face it, the markets are not efficient and there is momentum. It can drive value investors crazy but it is more blessing than curse, for without it, there would never be opportunities to invest.

 

So why are there some investors that ride the waves too long and others that get off too early? What makes value investors different? The source seems to be an active anterior insula (a risk alerting part of the brain). According to research out of Caltech, bubbles form, in part, when traders’ overactive pleasure center of the brain (nucleus accumbens) are not kept in check by their risk sensing part of the brain (anterior insula).

 

    “We show that aggregate neural activity in the nucleus accumbens (NAcc) tracks the price bubble and that NAcc activity aggregated within a market predicts future price changes and crashes. Furthermore, the lowest-earning subjects express a stronger tendency to buy as a function of measured NAcc activity. Conversely, we report a signal in the anterior insular cortex in the highest earners that precedes the impending price peak, is associated with higher propensity to sell in high earners, and that may represent a neural early warning signal in these subjects.” – Smith, Lohrenz, King, et al (2014) “Irrational Exuberance and Neural Crash Warning Signals During Endogenous Experimental Market Bubbles”

 

Basically, experimental stock price bubbles formed when traders experienced a positive feedback loop of rising prices and pleasure. The traders that performed the worst were getting the strongest pleasure response and the ones that performed best were getting signals from a different part of their brain alerting them that the feedback loop was dangerous. It is amazing to see revered wisdom (i.e. the quotes above) boiled down to chemical reactions, over which, we have very little control. Maybe we can “train our brain” and improve our anterior insula response. Maybe that is what “experience” really is. Those that can use conscious and unconscious self-reflection to deepen the connections and responses of the brain that give positive results, not positive feelings, would essentially be building a better brain. A machine better prepared to deal with future decisions…experience. Or maybe it is as Seth Klarman says:

“…the concept of value investing is like an inoculation – it either takes or it doesn’t…”