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Mind Over Money

The psychology of investing has become such an important area of research that major hedge funds are building trading strategies around human behavioral patterns. In Mind Over Money, Kevin Cook explores the crossroads where markets and brains collide, delving into the two sciences – neuroscience and behavioral finance – that show why investors are often highly irrational when faced with economic decisions, uncertainty, and risk.
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Now displaying: 2016
Dec 20, 2016

How one of the smartest minds on Wall Street was blinded by belief and abandoned due diligence

 

VRX, CP, MTN, HLF, CMG

 

Welcome to Mind Over Money. I’m Kevin Cook, your field guide and story teller for the fascinating arena of Behavioral Economics.

 

I’m back after a 3-week bout with bronchitis. I’ve got a funny story about what I learned at the doctor that ties into a great neuroscience topic: how we acquire new skills. But first, let me preview our main topic for the show today...

 

As 2016 winds down, I want to re-cap one of the biggest stock market implosions of the past 18 months and the big name investor who last week began some tax loss selling after a 95% drop in the shares.

 

The stock is that of Valeant Pharmaceuticals (VRX). And the big investor is Bill Ackman of Pershing Square Capital Management. His funds have lost billions of dollars because the Valeant implosion. And the story I am going to tell you will definitely interest you if you are at all curious about how smart people make really disastrous decisions.

 

Okay, so what happened at the doctor? As part of my exam, they gave me a chest X-ray to check for pneumonia. The good news is that I didn’t have pneumonia. The more interesting news the doctor shared on her way out… “Oh, by the way,” she said. “You have two cracked ribs.”

 

Be sure to listen to today's podcast to hear where those cracked ribs came from and what it has to do with "carving" new neural pathways. I'll give you a clue: I had to retire from snowboarding at the ripe young age of 37.

 

The Valeant Implosion

 

Valeant Pharmaceuticals stock was trading around $260 per share at its peak in the summer of 2015. Today, it’s trading $15. The story of the collapse has to do with an ambitious CEO named Mike Pearson and his company’s strategy to quickly become one of the top 10 pharmaceutical corporations in the world. Buying Bausch & Lomb for over $8 billion dollars was solid proof that they were very serious.

 

Pearson’s stated goal was actually to get Valeant in the top 5, among the likes of Pfizer, Johnson & Johnson, Novartis, and Merck.

 

I know a little about this story because I was an investor in VRX in 2013 and 2014, catching several pieces of its rise from $65 to $145. The fundamental growth story, both in terms of sales and profits, was impressive. But I was also following on the coattails of some of the smartest money on Wall Street, including legendary investors like Ruane, Cunniff, and Goldfarb who ran the Sequoia fund.

 

In many investments, I often trust the research skills and judgement of several big investors more than my own analysis. Based on Pearson’s goal, he would have to grow Valeant from a $20 billion company, in terms of its market capitalization, to a nearly $200 billion company. That would be a 10X feat. Everything I saw showed that he might have a shot.

 

And the only reason I didn’t ride the stock higher in 2015 when it vaulted from $145 to $175 in a few weeks was because I was waiting for a pullback to get in.

 

Enter Bill Ackman who, it was revealed through SEC filings in February of 2015, was acquiring a sizable nearly 10% stake in Valeant and partnering with the company to buy another pharmaceutical firm, Allergan. Shares of VRX shot up to $200 in late February and never looked back until they peaked in August of 2015 just over $260.

 

So what happened? Why did Valeant, as an investment and as a company, begin to fall apart? The details of the collapse are complicated and part of a much longer story that involved accounting irregularities, egregious drug pricing practices, and questionable pharmacy partners cooperating in questionable sales reporting practices.

 

In the Mind Over Money podcast I share a timeline of the events of August through October by Stephen Gandel writing for Fortune magazine on October 31, 2015.

 

And the most interesting questions I'm trying to answer are about how Bill Ackman ignored the clues about Valeant's messy business practices and rode the stock -- with a position in the tens of millions of shares -- to stunning losses.

 

Not only that, even when the wolves were out, from Congress to research firm Citron, and shares were quickly collapsing to $100, all Bill could think of was massively increasing his position by buying tens of millions of dollars’ worth of options.

 

You can learn more about those options strategies in this video...

 

Synthetic Stock: How Ackman Double-Down on VRX

 

This whole Valeant-Ackman saga will be studied for years for its lessons in behavioral finance and decision-making. I hope I've helped you understand it better so you can see how we can all be blinded by our hope and greed.

 

Kevin Cook is a Senior Stock Strategist for Zacks Investment Research.

Nov 22, 2016

While Renaissance Technologies makes most other hedge funds look foolish, even the independent trader can copy their discipline

 

NFLX, PANW

 

Long-time followers of mine in this bull market know that every quarter I go over the holdings of hedge fund Renaissance Technologies because they were one of the early quant houses that made algo trading so successful and popular.

 

The founder, Jim Simons, was a mathematics professor in the 1970s who never thought about the markets much. He sort of stumbled into testing some theories on stocks, and the rest is history as he was pulled headlong into the markets and created a powerhouse with over $50 billion AUM (assets under management).

 

And Simons made a point of not hiring MBAs, traders, or anyone with a background in finance. He only wanted physicists, engineers and other quantitative problem-solvers to come work for him and mine the data of markets to find unique correlations, patterns and new edges.

 

What kind of data patterns and correlations are they after? Well, with 90 Ph.Ds. on staff, mostly math, science, and engineering types, we can only guess that they are sifting through mountains of fundamental, price, economic, weather, and consumer patterns, looking for those small anomalies between individual stocks and industries and other asset classes.

 

Mining Data Others Ignore

 

If it’s a popular, well-known correlation, they don't want anything to do with it. They hunt in the noise of tons of data for things that others can't see, or are not even looking for.

 

This week, Matt Levine at Bloomberg View wrote briefly about Renaissance after colleague Katherine Burton published a full story on the company and its funds and practices for the December/January issue of Bloomberg Markets magazine. Here's how Levin opens his piece, quoting data from Burton's story...

 

The big problem with Renaissance Technologies, the Long Island-based "pinnacle of quant investing" founded by Jim Simons, is that its Medallion fund makes too much money.

 

Medallion was up 21 percent for the first six months of 2016. It was up 35.6 percent last year, 39.2 percent the year before, 46.9 percent the year before that. This keeps going. The last down year was 1989. The fund had a rough few days in August 2007, but ended the year up 85.9 percent. It has returned about 40 percent per year, on average, net of fees, since it started in 1988.

 

Of course it can't keep compounding returns that way because of the size factor. What you can do well with a 5 billion dollars you can't necessarily as well, much less better, with 50 billion. And that's why they are forced to simply return profits to investors, who are primarily employees now since the fund was closed to new investors in 2005.

 

Matt Levine's piece on Bloomberg View can be found here and the full Burton story is linked above.

 

Can a Human Trader Copy Black Box Success?

 

While the computer programs that work for Renaissance are still a big mystery -- like we don't know how many strategies just trade intra-day to make money -- it's safe to say that they create a lot of turnover in stocks, exploiting new patterns or "edges" in thousands of stocks.

 

But doesn't that mean a lot of extra risk?

 

What most people miss about the success of the algos and black box trading systems is that they run through markets with big size in thousands of stocks and instruments because the risk control is automated too.

 

It’s not like you or I trading 100 stocks at once and going crazy trying to keep track of the risk and profits. They program the computer models to seek and destroy profit opportunities and to manage the risks in real-time too so that they are never destroyed.

 

So speed and continuous, instant access make the difference too, especially if the model is wrong about an opportunity. In that way, they take human emotion completely out of the decision-making equation.

 

With that I want to introduce you to our guest today, who is like David to the Goliath Renaissance. Jeremy Mullin is a colleague of mine at Zacks where he starts with a simple quant model built on earnings momentum – the Zacks Rank -- and then overlays his own suite of technical trading filters and what I will broadly call “behavioral analysis” because he pays attention to extreme moves in stocks that are often driven by algo trading that is exploiting investor fear and greed in the markets, which therefore sets up new opportunities for him.

 

Jeremy has spent the last 13 years as an equity, futures and options trader. His main focus when trading stocks is high beta equities and earnings moves. He uses technical tools when entering and exiting trading setups, but also watches order flow to get a “feel” for market direction.

 

Check out the Mind Over Money podcast, episode 4, to hear my interview with Jeremy.

 

Kevin Cook is a Senior Stock Strategist with Zacks Investment Research where he runs the Tactical Trader service.

Nov 15, 2016

In today's Mind Over Money podcast, I took a closer look at decision-making. Specifically, I wanted to explore what often gets in the way of good decision-making, especially when the financial landscape is shifting like it is now.

 

And that means we have to focus on the cognitive biases, those mental short-cuts, filters, and processes that help us make decisions faster.

 

Because those same short-cuts just as often short-change us from the best outcomes in everything from stock-picking -- and its twin challenges of risk and profit management -- to car shopping and job hunting.

 

Remember that this podcast wants to come at our “brains on risk” from 3 distinct angles:

 

Angle #1 is behavioral finance. This is the field of cognitive biases and heuristics that Daniel Kahneman and Amos Tversky broke big ground for in the late 1960s and 1970s. I call this way of knowing about our decision-making the OUTSIDE-IN approach because the behavioral researchers and social scientists are conducting problem-based experiments and questionnaires with thousands of people. They examine behavior in different, repeatable “decision situations” and then draw conclusions from the data patterns about what we humans tend to do and why.

 

Angle #2 is neuroscience. What science has discovered about our brains through advanced imaging techniques in the past two decades could fill lifetimes of research projects for the next few generations of curiosity seekers. I call this way of knowing about our decision-making the INSIDE-OUT approach because the neuroscience researchers are focused on the brain structures, functions, and biochemistry that cause our behavior.

 

And this reminds me to remind you about episode #2 of Mind Over Money recorded on Nov 8 where I spoke with Denise Shull of The ReThink Group. Shull earned her Masters in the Neuroscience of Emotion at the University of Chicago and then went on to become a trader and a trader’s coach, working for many top banks and funds. We had a great discussion about understanding how emotion is involved in all our decisions.

 

Shull’s consulting work really took off in 2003 when she combined her research with that of Antonio Damasio, Professor of Neuroscience at the University of Southern California. Damasio and his colleagues found that if emotional centers of the brain were damaged or in some way disabled, we wouldn’t be able to make decisions at all, or at least not with the ease and effectiveness we do hundreds of times during the day.

 

So Denise Shull trains her clients to become more aware of their emotions during trading, not to shun them. And she also started doing this in 2016 for the US Olympic Snowboarding Snowcross team. Be sure to catch episode #2 of Mind Over Money with the title “Train Your Brain for Better Trading” to hear all about her work.

 

How Smart Traders Re-Wire Their Brains

 

The third angle that I approach the collision of psychology and markets through is the investors and traders themselves, from the so-called Market Wizards, the books by Jack Schwager that interview the highly successful, to the rogues and gamblers who lose it all. This 3rd angle of knowing about our “brains on risk” was actually where I started my intellectual journey here 20-some years ago, observing traders in the commodity and futures pits of Chicago.

 

That’s because smart traders who’ve learned to survive in the pits or behind the screen share many common traits that the scientists would admire in terms of being aware of their biases and emotions so that they can make better decisions, more consistently, for long-run success. Short-term trading is arguably one of the most mentally-challenging occupations there is because, as I used to argue, our brains are hard-wired to make quick decisions that break the golden rule of trading.

 

That rule is: cut your losses short, and let your winners run. Most new traders seem to instinctively do the opposite because they are loss averse and eager to capture gains. This is the mathematical recipe for failure in trading because it guarantees that even if you are right 60% of the time, you will lose everything as you let losses pile up bigger than winners.

 

Ray Dalio on the Big Shift

 

Speaking of Market Wizards, Ray Dalio, the head of the largest hedge fund in the world, Bridgewater with nearly $200 billion AUM, put out a new investment letter today, November 15, to opine on how the global-macro investing landscape will change over the next few years after last week’s GOP election sweep. Obviously we are seeing many of these new trends already emerging in full force, like the bond bubble popping, and the US dollar rallying as inflation expectations rise, and the flood of money into domestic small-cap companies, especially Financial and Industrial/Manufacturing stocks, at the expense of big-cap Tech

 

Dalio suggests that these big shifts could rival the reversals of prior decades. Here’s what he said...

 

"...the main point we’re trying to convey is that there is a good chance that we are at one of those major reversals that last a decade (like the 1970-71 shift from the 1960s period of non-inflationary growth to the 1970s decade of stagflation, or the 1980s shift to disinflationary strong growth). To be clear, we are not saying that the future will be like any of these mentioned prior periods; we are just saying that there’s a good chance that the economy/market will shift from what we have gotten used to."

 

Now, when we are trying to adjust to new market conditions, this is when we need to be aware of our biases and emotions even more. Heck, the last 7 years of this steady bull market and QE and a 2% GDP economy still fooled people into following their biases and emotions instead of following the market higher by “BUYING the DIPS” with a clear, long-term investment plan.

 

So it’s never easy. But as I teach people both with short-term trading and long-term investing, having detailed plans of what you will do under different scenarios is the key to effectively managing any type of change or surprise. Market dips in a growing economy, for instance, become recognized as great opportunities, not sources of fear and loathing.

 

Most investors don't review their portfolios and make new plans for re-allocation often enough. And there are many blindspots and biases that prevent us from opening up that hood and getting a much-needed tuneup.

 

But now would be an especially good time to confront those obstacles and get ready for the next new trends.

 

Kevin Cook is a Senior Stock Strategist for Zacks Investment Research where he runs the Tactical Trader portfolio.

Nov 8, 2016

Learning how to use the 90% of brain insights underneath conscious awareness

 

When Denise Shull earned her Masters in Neuroscience from the University of Chicago in 1995, she didn’t imagine she would become a go-to consultant and coach for world-class traders ten years later, much less for Olympic athletes this year.

 

But that’s what has transpired in her career as someone deeply interested in human emotion and decision-making. In this episode of Mind Over Money, I invited Denise to discuss her work and her recent joint venture with Bloomberg Tradebook to train trader brains.

 

Based on her many years of research on how traders make decisions and deal with emotional responses – including several years as a professional trader herself – Shull and her team at The ReThink Group developed trader training software that she’s inviting anyone to try at https://traderbrainexercise.com/

 

Trader’s “Gut” in a World at “Max Algo”

 

Shull’s insights about how we can tap into subconscious pattern recognition and cognitive-emotional “intuition” are powerful in a field that for decades has told traders to remove their emotions from trading.

 

She has been a lone voice teaching traders that it’s not only impossible to separate emotion from decision-making, but that we actually make better decisions when we are conscious of our feelings. And her hedge fund clients now recognize that the death of the high-performing trader has been greatly exaggerated in a world she believes has reached “max algorithm.”

 

Be sure to listen to my full interview with Denise to learn about her training and coaching work with top trading firms and with the US Snowboarding Team. She tells a great story about “emotional” snowboarders being some of the top performers of the bunch.

 

Kevin Cook is a Senior Stock Strategist with Zacks Investment Research where he runs the Tactical Trader portfolio.

Nov 1, 2016

Today marks the kick-off edition of Mind Over Money, the only podcast that exposes the psychology of investing. I’m Kevin Cook, your field-guide and story-teller for the fascinating arena known as behavioral economics, which includes the sub-field behavioral finance and also draws in the related research from neuroscience, where brain imaging “sheds light,” if you’ll pardon the pun, on how we make decisions about money, uncertainty, and risk.

 

Jason Zweig described these merging fields in his 2007 book Your Money & Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich.

 

Zweig, as you may know, wrote for Money magazine for years and was the editor of the revised edition of Benjamin Graham’s The Intelligent Investor. He now writes for the WSJ. So he wasn’t just a journalist describing an investing fad. He’s schooled in classical investing methods and knew he was on to something of enduring importance when he either coined, or at least put on the map, the term “neuroeconomics.”

 

He opens his book, which I consider must-reading for all students of the market, this way…

 

“How could I have been such an idiot?” If you’ve never yelled that sentence at yourself in a fury, you’re not an investor. There may be nothing across the entire spectrum of human endeavor that makes so many smart people feel so stupid as investing does.

 

But actually, I didn’t discover Jason’s book until about 5 years ago. And I had been working on the same ideas as him prior to the financial crisis. In fact, I published part of my thesis that “Your Brain Wasn’t Made to Trade” in 2008 in an industry magazine called SFO, which stood for Stocks, Futures, and Options.

 

My objective with Mind Over Money is to inspire you to be nearly as interested in behavioral economics, behavioral finance, and neuroscience as Mr. Zweig and I both are. And of course, we both give you plenty of other experts and resources to aid in that endeavor. That’s because so many great and dedicated researchers came before us and created the invaluable insights of these fields.

 

My unique contribution is that before I discovered behavioral finance or became passionately interested in brain science, I was studying great traders and terrible traders, through their successes and their failures, on the trading floors of Chicago since the mid-1990s.

 

This Is Your Brain on Risk

 

There are a lot of forces and players on Wall Street that can separate you from your money. But our greatest financial enemy is often ourselves.

 

Three great areas of study give us insight about this self-sabotage: behavioral finance, neuroscience, and the collective wisdom of great investors and traders who discovered through hard-won experience what those two sciences now teach us.

 

When we study these areas, we can become more aware and better equipped to spot how our own minds and habits either get in the way or help us make better decisions when it comes to money, uncertainty, and risk.

 

One group of researchers studies people from the outside-in, the behavioral finance group, who owe much to the ground-breaking work of Daniel Kahneman and Amos Tversky in the 1970s.

 

The other group, the neuroscientists, studies our behavior from the inside-out, as they pinpoint what brain structures and functions are involved in different types of decisions and responses.

 

What happens when our minds meet markets has been a passionate area of interest for me for over 20 years, ever since I first walked on the trading floors of Chicago and watched the good, the bad, and the ugly among professional speculators.

 

So how did I come to the conclusion that “your brain wasn’t made to trade?” It’s a bold statement. But once I show you the evidence behind it, I bet you will agree.

 

The Era of Rogues and Geniuses

 

In 1995, when my trading career was first getting started, the oldest bank in the world collapsed because of the rogue actions of one employee. Founded in 1762, Barings Bank was wiped out by trader Nick Leeson who was taking on exceptionally large trades – and losses – in Japan’s Nikkei futures market.

 

And he was able to hide them for a time until the risk managers finally woke up and started to notice that accounts were not balancing.

 

At the time, it seemed people everywhere – from journalists and regulators to traders, bankers, and the man or woman on the street – were all shocked that something like this could happen.

 

I started tracking stories like this, especially as they seemed to be occurring more often. In 1998, we saw the biggest hedge fund failure ever – up to that time. It is dwarfed by comparison since then.

 

Long-Term Capital Management had to be bailed out by 16 Wall Street investment banks, in a campaign orchestrated by the Greenspan-led Federal Reserve, because their losses in interest rate sensitive markets around the globe were viewed as threatening to financial markets.

 

The bailout at over $3.5 billion is considered paltry by today’s “too big to fail” standards. But the truly notable dynamic was that the fund was run by some of the smartest minds on Wall Street, like Myron Scholes who had just won a Nobel prize in Economics the year before.

 

I also kept track of the big blow-outs I witnessed in the trading pits in Chicago. New floor traders would always come and go on a regular basis. But the surprises came when a 20-year veteran would suddenly vanish because he took exceptional risk that went way wrong and wiped out a multi-million dollar account.

 

Rogues, Gamblers, and Wizards: What can we learn from them?

 

As I watched the rogues and the blowouts, I also read about the great traders. Jack Schwager’s books about the Market Wizards are really required reading for anyone who wants to become a full-time trader. They are in-depth interviews with big successes like George Soros, Paul Tudor Jones, Michael Steinhardt, and options wizards like Blair Hull.

 

As I read these dozens of interviews across 3 of Schwager’s books, I found six themes all these great traders and investors had in common. I’m going to list them for you because even before I had ever heard of behavioral finance or became interested in brain science, these “street-smart” winners had cornered the market on the principles of being in command of their own minds and trading behavior:

 

1.    Psychology: emotional decision-making was a paramount discovery

2.    Discipline: having lost big without them, rules became lifesavers

3.    Risk Management: the “golden rule” is to cut losses quickly and let winners run

4.    Probability: repeatable methods & mechanics of risk/reward evaluation

5.    Consistency: steady compounding was better than windfalls and wipeouts

6.    Systems: putting the first 5 together in routines of planning & preparation

When I became a professional currency trader in 1999 upon the introduction of the euro, I noticed that even bank traders were an emotional and irrational bunch. As I studied the two sciences, I concluded that our brains were “hard-wired” to break the “golden rule” of trading.

 

In other words, our fear-driven, excitable, and emotional brains preferred (1) to avoid losses at all costs (so we would only take them when it was almost too late) and (2) to take gains quickly. This irrational and upside-down approach to risk/ and reward was the mathematical road to insolvency.

 

So I started researching how to train “trader brains” and I developed a probability simulation called Masters of PROP: Probability, Risk, and Optimal Profit. That trader training never goes out of date because its subject material, human brains, remain irrational, decade after decade.

 

Is It All Just About Greed?

 

So if the Market Wizards principles of the world’s best traders and investors worked so universally, what were the rogue traders and reckless fund managers doing – just the opposite?

 

Well, it’s a little more complicated than that. Because while there might be a half-dozen ways to do things right, there are many dozens, if not hundreds, of ways to make our money go away.

 

What always gets highlighted with rogues and “geniuses” that fail is that they were just greedy. But as I put together my thesis that “Your Brain Wasn’t Made to Trade” in the early 2000s, I came up with 3 more distinct and important drivers of financial bad behavior…

 

#1: Ego and the desire to be seen as “the great trader.” This was evident in so many of the rogue trader stories, like John Rusnak accumulating $700 million in losses for Allied Irish bank between 1997 and 2002.

 

#2: Irrational or immature beliefs about money, success, self-worth, and happiness such as “I deserve it!” or “This needs to happen now!” or “Once I win this back, I’ll make everything right again.” This kind of stuff tends toward either unconscious or full-blown narcissism with lots of emotional immaturity in between.

 

#3: Ignorance or lack of skill with probability

 

The primary reason I think we gain so much from studying rogues and other reckless gamblers is because what the rogue does to a billion dollars of other people’s money, we can do to our own accounts if we are not aware of our mental habits and cognitive biases as they impact our decision-making with money and risk.

 

And here, I have a confession to make.

 

While I could be as guilty as any investor-trader of any of these faults, the one I knew I had to immediately do something about was Probability. As a trading floor clerk in the late 1990s, I realized I had to make up for my lack of understanding and skill with probability.

 

And since equations were not my favorite things in high school or college, I found that the stories of how probability was invented and how it was used – in the options markets, in Vegas, in sports, and in weather modeling – pulled me in and gave me a practical way to learn the math I needed to know.

 

I must have read the stories of how Pascal and Fermat invented modern probability theory in the 1650s a dozen times before it started to sink in and I could make sense of all the equations that came after.

 

But you’re probably still wondering where I get the nerve to say Your Brain Wasn’t Made to Trade?

 

It’s all in this week’s podcast.

 

And be sure to check out my weekly video where I expose the psychology of investing with behavioral and cognitive biases. My most recent gives a great example of mental accounting.

Oct 19, 2016

The psychology of investing has become such an important area of research that major hedge funds are building trading strategies around human behavioral patterns. In Mind Over Money, Kevin Cook explores the crossroads where markets and brains collide, delving into the two sciences – neuroscience and behavioral finance – that prove investors are often highly irrational when faced with economic decisions, uncertainty, and risk.

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