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The Psychology of Successful Trading

 

Getting your trading psychology right and understanding that of others are both essential prerequisites to successful trading in financial markets. I discuss the most important elements of trading psychology in my new book.

Buy the book here:

Thanks to Karine Sawan and film crew for video production.

#TheAffair And #Nietzsche’s Perspectivism

I will argue that The Affair is a philosophically interesting piece of TV drama which raises deep questions in the areas of memory and our access to “the truth.” Some of these may be understood by reference to Nietzsche’s account of truth (and some of them relate to interpretations of quantum mechanics!) There are no significant spoilers and no references to events beyond the first episode.

The aspect of The Affair that is most immediately apparent is that it is told from multiple perspectives. This is made dramatically arresting by the way it becomes clear that the different perspectives are incoherent with each other — and probably with themselves. In this, the situation parallels real life.

Moreover, the cinematography seems to reflect this. Noah’s view seem somewhat brighter literally and metaphorically. Alison seems more beautiful, which partly perhaps reflects the way she smiles more in his section and could also mean that he perceives her as being more beautiful than she perceives herself to be. It is also a reflection of her affective state, presumably. There are interesting feminist points to be made here also about the male vs the female perspective.

I will focus on a single tiny episode and note the multiple readings. As a preliminary, I should point out that the story at this point is being told in flashback from a subsequent police interview.

The episode in question is when Noah is approaching up the driveway of Alison’s house while she is having sex with her husband in the driveway. The sex is rather aggressive and it is unclear to Noah whether an assault is taking place. The precise event I wish to discuss is that in Noah’s version, Alison shakes her head. Noah appears to interpret this as meaning “no, this is not an assault.”

The head shake does not appear in Alison’s version. There are at least seven readings of this.

  1. Noah remembers it because it happened but Alison does not remember it.
  2. Noah remembers it falsely and Alison does not remember it because it does not happen.
  3. Noah does not remember it because it did not happen but is reporting it to the police for reasons of his own.
  4. Something happened which Noah remembers as a head shake but which Alison remembers as something else.
  5. Noah remembers the head shake correctly but Alison has forgotten it.
  6. Both Noah and Alison remember the head shake correctly but Alison has omitted to mention it because it does not seem important to her.
  7. Both Noah and Alison remember the head shake correctly but Alison has deliberately not reported it for reasons of her own.

I hope it will serve as an indication of the dramatic quality of this production that this amount of consideration needs to go in to a single micro-event!

How does this relate to Nietzsche?

The starting point of Nietzsche’s doctrine of Perspectivism holds that we need to take multiple perspectives to approach the truth. In a way, it is post-modern in that it denies there is any one truth. There are only truths from a perspective. Put another way, since god is dead, there is no omniscient unbiased perspective from which there could be a single truth.

This does not mean Nietzsche is a nihilist or someone who thinks there can be no better or worse ways of proceeding. He instead claims that the optimal approach is one that adopts multiple perspectives. He then adds a couple of typically radical Nietzschean riders which really give the position a strong flavour.

Many philosophers would proceed thus far and then say “but it is important to avoid contradictions.” Not only does Nietzsche not do this, he does the exact opposite. He says that the wisest choice is to hold multiple perspectives especially when they are contradictory!

This is what I think is being brought out in The Affair with great aplomb and intelligence. I commend it to you.

(I won’t discuss the many worlds interpretation of quantum mechanics here, but I think it is also in play, not least because it is actually mentioned by Noah.)

See Also:

What Is “Theory Of Mind?”

The Psychology Of Successful Trading – Behavioural Strategies For Profitability

#Proust: An Argument For #SimulationTheory

The #Bitcoin Bubble Is Caused By The Halo Effect

#McDonnell’s Share Proposal Takes Assets From #Shareholders And Does Not Give Them To #Workers

I will argue that the recent McDonnell proposal on share ownership for workers does not achieve its objectives and is unfair to shareholders.

The BBC* reports the proposal as follows:

“Under Labour’s “inclusive ownership fund” proposal, Mr McDonnell said workers would be given a financial stake in their employers and more say over how companies are run.

Firms would have to put 1% of their shares into the fund every year up to a maximum of 10%.”

This is outside the usual run of taxation because it has the same effect as removal of assets from existing shareholders, since it is uncompensated.  It is also unreasonable to describe it as an inclusive ownership fund since it mostly generates cash for the government.  This is the case since there is a cap (£500 per employee) above which the dividends go to HMRC.

What Is The Proposal?

Every year, companies listed in the UK will have to put 1% of their equity in a misnamed “Inclusive Ownership Fund.”  This will continue for ten years so we can expect that after that period, 10% of the equity of all such companies will be placed in a fund.  The current situation today is that existing shareholders have a claim on the future cashflows of the company in proportion to their shareholding.  I will explain below why this will affect shareholders immediately since shares are valued on a forward-looking basis.

Right now, all the shareholders together can expect to benefit from 100% of the companies’ cashflows.  If the McDonnell proposal takes effect, they will only be in a position to expect the benefit of 90% of future cashflows, because there will be another 10% of new shares in issue.

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It might be thought that the shares issued will not be new ones.  This is not the case because the proposal is unfunded.  There is no plan to compensate existing shareholders.  As will become clear when I consider objections to my account below, many of the problems with the proposal flow from its uncompensated nature.

We may safely assume that the proposal does not include compensation even though this is not stated for three reasons.  Firstly, McDonnell has a track record of proposing uncompensated asset seizures.**  Secondly, I estimate that the costs to FTSE-100 firms alone will exceed £100bn.  This is the case since there are 100 firms in the FTSE-100 of a similar size to Shell and the proposal applies to the much larger group of all companies listed in the UK.  The UK Government does not have access to sums of that nature.  Finally, it would be extraordinary to fail to mention such an aspect of the policy when discussing it since that would make it much less unjust.

It is important to note that one reason this is a problem is that the new shares will not be paid for.  This is one defence against dilution — the issuing of new shares which is detrimental to existing shareholders — under normal circumstances.  If a company issues new shares on the stock market, they are sold at market value.  The company then owns that cash, and shareholders have a claim on it.  Similarly, they have a claim on a share of anything the company does with that cash.  Ideally, it will invest it in growing its existing business or starting new ones, and everyone is happy.  

The McDonnell proposal does not involve any compensation.  So it will just be a dilution of existing shareholders by 10%.  Given the forward-looking valuation I will describe below, this means that all existing shareholders will see their share prices decline by 10% immediately.  That is why this proposal amounts to an asset confiscation.

Simon Jack, the BBC’s Business Editor, summarises the effects of this disastrous policy as follows:

“workers will not be able to buy and sell the shares – so they won’t really “own” them in a traditional sense. They will be eligible to receive dividends on the shares up to a value of £500 per worker per year. The government gets the rest.

The Labour Party reckons this will raise about £2bn a year. It could end up much more. Let’s take just one company – bumper dividend-payer Shell. Ten percent of its £12bn annual dividend comes to £1.2bn.

If each of its 6,500 UK employees got £500 each (totalling £3.25m) that leaves £1.116bn for the government. That’s just from one company – every year. Wow.”

This clearly means that calling the proposal an Inclusive Ownership Fund is a misnomer since in the case of Shell, the total cost to the company of £1,119.25m would be divided between employees, who would get £3.25m or 0.29% of the cost and the government would get £1,116m, or 99.7%.  So in fact the amounts going to employees are irrelevant.

Share Valuation

Share valuation is based on fractional ownership of a company — this is why it is called a “share.”  This means that if I own a share of a company, I am entitled to a small percentage of the value of that company.  If the company has issued ten shares and I own one of them, I own 10% of the company and I can expect to benefit from 10% of it’s future cashflows.  Note immediately that it is important to avoid what is known as “dilution.”  This, as mentioned previously, is the issuing of large numbers of new uncompensated shares.  That dilutes the claims of existing shareholders which is obviously unfair and so this area is highly regulated.  It is not legal to dilute existing shareholders; McDonnell’s proposal is dilution on a massive scale.  Again, as I mentioned above, this cannot be avoided by buying the shares on the open market unless funding is provided and there is no proposal to provide such funding.

Share valuation must also take account of the fact that shares are a claim on future cashflows.  These must be therefore be considered on a Net Present Value (“NPV”) basis, to reflect the fact that money in the future is worth less than money today.  This is because in a world of positive interest rates, it is slightly better to have money today than money in a year from now.  

For example, imagine you have £90 today and interest rates are 10%.  This means you could save the £90 for a year and at the end of a year, you would have £99.  Turning this around, we can say that the value today of £99 to be received in a year from now is £90, if interest rates are 10%.  We need to discount the values of all future payments by the amount of interest we would receive over the period between now and the time of the payment.  So clearly, payments far in the future are worth much less today than payments closer to the present.

Discounting all the future cashflows like this gets you the NPV.  A share of a company is worth the NPV of the expected future cashflows.  It has to be, because if it moves out of line with that, the market will either buy it or sell it so it moves back in line.

The reason this is a serious problem is that it means proposals to take value away from shareholders in the future cost them money today, since that is how shares are priced.

Before considering some objections to my account, I will finally mention that the effects of this policy could easily avoided by companies if they simply delisted from London.  Many large companies already have multiple listings in places other than London, such as New York or Frankfurt.  It would be wise to avoid giving them a powerful reason to delist from London, especially give the strong commercial disincentives created by Brexit.

Objections

  1. The Conservatives are in power and Brexit is a disastrous economic policy.  (This objection is aimed at showing that Labour is a better choice than the Conservatives on economic grounds.)
    1. 1.1.True, but irrelevant for two reasons.  Firstly, the fact that the alternative is dire does not make this a good policy.  Secondly, the Labour Party position is also Brexit plus this share appropriation proposal, which is worse.
  2. 1% a year for ten years is less than 10%
    1. 2.1.This is true but extremely minor as an adjusting factor.  There is some benefit to not having this policy come in in full immediately, but since shares are valued on an NPV basis, it won’t help much.
  3. The shares could be sourced from the market and so this would be fine
    1. 3.1.That would in fact be fine, because it would mean buying the shares from existing shareholders rather than causing them to be issued and diluting existing shareholders.  However, as noted above, this is not the proposal, since that proposal would require funding to be provided on an unrealistic scale.
  4. Some continental companies (e.g. Equinor/Statoil) already do this so it is fine
    1. 4.1.No, because the cost is already “in the price.”  It is fine to sell people shares on the basis that they will only get 90% of the cashflows; it is not acceptable to change a situation in which they paid to own 100% of the cashflows into one where they own only 90% without compensation.
  5. You would only “lose cashflow” if the company you owned failed to grow by more than 1% a year
    1. 5.1.False.  You lose 10% of whatever the cashflows turn out to be.  Currently you own 100% of the cashflows with growth of X and afterwards you own 90% of cashflows with growth of X.
  6. This will be compensated for by reduction in salaries
    1. 6.1.False.  Firstly, that would likely be contrary to employment law.  Secondly, the employees are only getting 0.3% of the funds in the case of Shell, so even if they do compensate for that through reduced salaries, there is no compensation for the other 99.7%.
  7. The Labour Party claims that the policy only raises £2bn a year so it will be fine
    1. 7.1.The policy raises £1bn a year just from Shell, which is just one of 100 major companies that are members of the FTSE-100.  So it looks as though this policy will raise more than £100bn a year.  Either that, or the Labour Party does not understand its own policy, which is another reason to avoid implementing it.
  8. The cost of the proposal would only relate to UK activity and so would be less than the calculated amount of e.g. £1bn for Shell.
    1. 8.1.This is not stated and the London listed shares of Shell represent a claim on the value of all global activity of Shell and all of its cashflows.  So such a proposal could not be implemented based on shares.
  9. This will not be so bad because companies can easily avoid it
    1. 9.1.True.  They can delist in London.  Why is that positive?  Should we not construct policies with some intelligence?
  10. Shareholders have been stealing from the public purse so this is fine
    1. 10.1.This objection is at least honest in that it admits that this proposal is theft.  It seeks to say that shareholders have unreasonably benefitted from the provision of public goods such as roads and an educated populace.  It would therefore require a major economic research programme to back it together with a determinate ethical view.  Neither are forthcoming.

I conclude that this is a bad policy.  Since pension funds are major shareholders, it would have major negative financial implications for current and future pensioners as well.

https://www.bbc.co.uk/news/business-45626043

** See PFI: The Real Problem with “Bringing the Contracts In-House” Will be the Bonds

— where the proposal is to cancel existing contracts without compensation current holders of bonds (which we know for the same reason as above, it is unaffordable).  In addition, the proposal to renationalise water companies involves swapping equity for government bonds.  Even if done on reasonable terms, that is a compulsory change of asset class.

See Also:

John #McDonnell’s Characterisation Of #Finance Is Misconceived

Optimal #Trading #Psychology

The Psychology of Successful Trading

The Illusory Truth Effect And Financial Markets

Optimal #Trading #Psychology

Understanding  basic psychology is one of the most important but also most neglected tasks for investors.  Of course, everyone realises that they need to analyse the investments they are considering buying.  But many traders do not realise that winning in investment is also about successfully predicting what other market players will do.  And that is a psychological task.

Most of the advice on the internet is not really psychology.  It is quasi-psychology.  You might get famous traders telling you things like “I always played tennis in the morning before my best trades to make sure I felt good.”  This is useless.  By all means, study what these guys do to get insights into how they analyse opportunities and maybe any tricks they have for bouncing back from a loss.  But famous traders don’t have any specific training in psychology so if you are specifically wanting to improve your own trading psychology, adopting their tips (such as the tennis one above) won’t really help you in achieving that goal.

Alternatively, there are some actual psychologists who write on the topic and are experts in the field of psychology.  But be careful about their specialisms.  Someone who is a clinical psychologist may be an expert  in schizophrenia but not necessarily other aspects of human psychology.  And of course the main thing is that these experts do not have any serious trading experience, so they also can’t help you improve your trading psychology.

photo of head bust print artwork
Photo by meo on Pexels.com

To identify the right sort of person, you need to ask two questions: does this person have significant trading experience and are they qualified in a related field?  I am one of these people.

To try to convince you of this, I will outline my ideas on how to optimise your trading psychology.  The first thing to know about is that we have a lot of cognitive biases —  mental shortcuts that are often useful when we want a quick and dirty answer and often very unhelpful when we are trying to get something right.  One example is Confirmation Bias, where people look only for evidence that supports what they already believe.  There have been many robust psychology experiments published, that show time and time again that we do this often and consistently.

The first thing to note here is that if you use this bias when making your own trading decisions, you will make bad decisions.  Every time!  So you will definitely not be optimising your trading psychology.  But here’s the key point: everyone else in the markets will be doing it too.

So what does that mean?  It means you need to know about Confirmation Bias and think about it in a market context.  Look out for it in yourself and be careful.  Expect it in other market players and trade accordingly.  

That’s how you stand the best chance of optimising your trading psychology. 

See Also:

The Psychology Of Successful Trading – Behavioural Strategies For Profitability

Why #Value Investors Should Buy #Bank Stocks

The Illusory Truth Effect And Financial Markets

Bad Arguments for the Permanence of Bitcoin

 

#Strumia Is Wrong To Claim That “Smarter People Are Less Affected By Implicit #Bias”

Strumia made the claim of the title in a controversial talk at CERN.*  I will show that this claim is falsified by the psychological literature.

There are a large number of cognitive biases operative in our psychology: over 180 at the last count, and that is just the ones we know about so far.  All of these biases share the characteristics of being largely invisible to us in their operation and extremely hard to eradicate.  Data show for example that significant financial incentives do not cause reduction of the effects of some of these biases.  And I have discussed myself at length (Short, 2017) the way biases can cause highly suboptimal decision-making, even when there are very serious financial consequences.

The types of bias I mean would be exemplified by Confirmation Bias, which occurs when people look for evidence which confirms hypotheses they already believe.  I think we should also consider Gender Bias in this same arena, though the claim we should not represents an objection to my position.  I will show below that my position has adequate resources to defeat that objection, but first I will show that intelligence offers no protection against implicit biases.

I will do that by mentioning three types of bias where it was not the case that more intelligent subjects exhibited less bias, and then making a broader point.

  1. Myside Bias — this is related to Confirmation Bias.  It occurs when people evaluate and generate evidence or test hypotheses in a way that conforms to their prior opinions and attitudes.  Stanovich, West and Toplak (2013, p. 259) found that the “magnitude of the myside bias shows very little relation to intelligence.”
  2. Dunning-Kruger Effect — this is best known as the claim that unskilled persons also lack insight into their relatively poor abilities in an area.  However, similar bias effects operate at the other end of the spectrum.   Schlösser et al. (2013, p. 85) report that their model “partially explained why top performers underestimate their performances.”  (I am assuming a correlation here between high intelligence and an ability to be a top performer in the fields of endeavour examined by the authors.)  But here we see that intelligent subjects are also not immune from a variant of the Dunning-Kruger Effect.
  3. The Gambler’s Fallacy — this is the tendency to think that fixed probabilities are altered by past events.  For example, the odds of getting heads on throwing a fair coin are always 50%, irrespective of what has happened previously.  If someone sees heads ten times in a row and then says either “it must be heads again next” or the opposite, they are exhibiting this apparently maladaptive heuristic.  Xue et al. (2012) found that “individuals’ use of the [Gambler’s Fallacy] strategy was positively correlated with their general intelligence.’’

More generally, we may note that many experiments in social psychology are conducted on psychology undergraduates.  This has been mooted in the past as a potential “ecological” objection, meaning that the results could be unrepresentative of the general population.  Nevertheless, robust and widely replicated data exists to show the existence of 180+ cognitive biases.  We may assume that undergraduates in psychology are a more intelligent subset than the population in general.

I will close by considering one potential objection to my account.  This is that Gender Bias is not a cognitive bias and should not be considered in the group above where intelligence is not a protective factor.  I will counter this objection in a number of ways.

  1. If Gender Bias is not a cognitive bias, what is it?  It results in a systematic slanting of judgements away from what would be strictly rational, and that accords precisely with my working definition of a bias (Short, 2015).
  2. I do not need to assume a narrow and precise definition for Gender Bias.  I am including within it all of what people refer to by the terms Sex Discrimination, Sexual Discrimination, Homophobia, Anti-LGBTQ+ prejudice etc.  These discriminations often take place via stereotyping — assuming that everyone in group X has certain characteristics which may in fact be possessed by only some or indeed none of the members of group X.  Stereotyping appears on the standard list of cognitive biases.
  3. Krieger (1995) explicitly considers racial bias within a cognitive bias framework and includes also discussion of Gender Bias. 

I conclude that this objection fails, and that therefore the claim that intelligence protects against implicit bias is false.

*According to a letter published by the Office of the Chair, Department of Physics and Astronomy, University of California, Irvine on 01 October 2018. 

See Also:

The Psychology of Successful Trading

#Proust: An Argument For #SimulationTheory

Women Are Better Traders Than Men

The Importance Of Hindsight Bias In Financial Markets

 

References

  • Krieger, L H  1995. The Content of Our Categories: A Cognitive Bias Approach to Discrimination and Equal Employment Opportunity. Stanford Law Review  47.6 pp. 1161–1248
  • Schlösser, T, Dunning, D Johnson K L, Kruger J  2013  How unaware are the unskilled? Empirical tests of the “signal extraction” counterexplanation for the Dunning–Kruger effect in self-evaluation of performance  Journal of Economic Psychology 39, December 2013, pp. 85–100, DOI: 10.1016/j.joep.2013.07.004
  • Short, T L  2015  Simulation Theory: A psychological and philosophical consideration, Psychology Press,  ISBN 9781317598145
  • Short, T, L  2017  The Psychology of Successful Trading: Behavioural Strategies for Profitability, Routledge, ISBN 9781351601016
  • Stanovich, K E, West, R F and Toplak, M E  2013  Myside Bias, Rational Thinking, and Intelligence, Current Directions in Psychological Science, 22. 4, pp. 259–264, DOI: 10.1177/0963721413480174
  • Xue, G,  He, Q, Lei, X, Chen, C,  Liu, Y,  Chen, C, Lu, Z-L, Dong, Q, Bechara, A  The Gambler’s Fallacy Is Associated with Weak Affective Decision Making but Strong Cognitive Ability PLOS One, October 5, 2012  DOI: 10.1371/journal.pone.0047019

What Is A #Bear #Market?

People often ask what the common stock market terminology of bullish or bearish means.  While these have standard meanings in normal speech — bullish being positive or optimistic, and bearish being the opposite — at least the term “bear market” has a precise technical definition in the arena of stocks.  I will explain this here.

The formal definition of a bear market is a market that has declined 20%.

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The first item to clear up on the way to understanding the definition is “what do we mean by a market?”  Normally people will be talking about a particular stock market index, such as for example the Dow Jones Industrial Average (“DJIA”), the S&P 500 or the Nikkei-225 (“N-225”).  So now we want to know what a stock market index is.

Individual shares go up and down all the time.  One cannot say what is happening in more broad terms to “the market” by looking at single shares because of this volatility.  So instead, one looks at a basket of shares.  That is what an index is: a basket of shares listed in a specific location.  There are thousand of these, and they can be selected in many different ways.  

To illustrate this, the DJIA is a basket of 30 major US shares that are selected so that they represent a good spread of major US stocks in different sectors such as computers, aircraft manufacture and banking.  The S&P 500 is a broader basket of shares issued by the 500 largest public companies listed in the US.  The N-225 is somewhat different as it is made up of the 225 largest stocks listed in Tokyo.  It is price weighted, meaning that more expensive stocks will be more heavily influential in the movement of the index.

So, put simply, if all of the component stocks in the DJIA go down 20% in a period, the whole index will also go down 20% over that time.  Since this index and the others are a broader measure of market sentiment than any single stock, if the DJIA goes down 20% in a period, we can say that it was a bearish episode for the market.  Since that is an approximate measure of the health of blue chip US equities, one would also be justified in saying that that period was a bearish period more generally for major US companies.

The DJIA has been published since 1896.  The graph looks like a long uptrend punctuated by occasional bear markets.  You can see this below.

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People tend to talk less about the technical definition of a bull market — they will often use it more colloquially to just mean “stocks are going up.”  But if one wanted to be precise, it would just be the opposite of a bear market.  It would mean that a particular index had increased by 20% from a trough.

See Also:

The Psychology of Successful Trading: see clip below of me explaining my new book!

Why #Value Investors Should Buy #Bank Stocks

What Is “Theory Of Mind?”

Cognitive Biases And How They Affect Stock Markets

Why #Value Investors Should Buy #Bank Stocks

I recently discussed (in Investment Styles) the two major different styles of investing: value and momentum.  One difficulty with following a value approach is the difficulty in measuring value, since much of it these days is tied up in intangible assets.  I will suggest here that, counter-intuitively, buying bank stocks is the solution to this problem.

bank bars business commerce
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The value approach to investing is simple to understand, though perhaps a little harder to implement.  The basic idea is that you buy things when they are cheap.  Finding cheap assets would classically rely on looking at concepts like “book value,”  which is just the accounting value of everything owned by the firm in which you are thinking of investing.

In previous decades, book value would have been simple to calculate: you could just look at the published accounts and examine how much the accountants said each asset was worth.  A company making cars, say, would own a lot of items like factories, car parts, machinery and land.  You could look at all of those items that you could walk up to and touch, and add up all the values, and that’s it: you have calculated book value.  If you can buy the stock for less than book value per stock, you have made a good investment.  If the company sold all of its assets, and turned that book value into actual cash, each shareholder would get more than book value.  That’s why value investing is a good idea, and why you should try to buy stocks at less than book value.

This simple approach is more difficult in modern times, because IP — Intellectual Property — is much more important than it used to be.  IP is anything the company owns which is valuable but that you can’t touch.  It could be a suite of software, the value of a brand, or

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simply the know-how involved in producing the products or services that the company produces.  To illustrate the scale of this IP problem for value investors, consider the following estimate.  Ocean Tomo, an investment bank, reckoned that the proportion of the value of S&P500 companies which was tied up in IP increased from 17% in 1975 to a huge 84% in 2015.  So it is clear that there is a very serious problem in adopting a value investment approach these days, and that’s unfortunate because in my opinion, it is the only approach that works.

So what should investors do about this?  I think they should look at bank stocks.  This will seem dramatically strange at first sight, because banks own hardly anything at all that is tangible.  However, we already saw above that this is true for all companies now, so it can’t be avoided.  The key point though is this: there is a well-determined market value for everything owned by a bank.

business charts commerce computer
Photo by Pixabay on Pexels.com

If you look at the balance sheet for Deutsche Bank, for example, you will see a very large number of items.  They will all have market values though.  That will be true of shares, bonds, interest rate swaps, credit default swaps, loans to corporates, futures and options, office buildings, warrants, cash in various currencies and any of the other myriad financial assets.  There will also be a certain amount of brand value but I think that will be fairly low in the mix.  So basically everything owned by Deutsche Bank could be turned into cash, and a known amount of cash, quite quickly.

Banks typically traded at 2.0x book value before the crisis.  The rule of thumb for value investors in the sector was “buy at 1.0x book value, sell at 2.0.”  Something like this is still true: you can buy Deutsche Bank at 0.3x book value and I think you should.  That’s the right approach for value investors today.

See Also:

Investment Styles

What Is “Theory Of Mind?”

The Illusory Truth Effect And Financial Markets

The #Bitcoin Bubble Is Caused By The Halo Effect

Investment Styles

An Introduction To Different Ways To Invest

There are two major investment styles which take completely different approaches.  They are value investing and momentum investing.  The former, also known as contrarianism, seeks to find cheap assets to buy.  It is called contrarianism because often it involves looking for assets which are cheap because no one likes them.  Momentum investing is simpler.  This simply observes that often, assets that have been performing well continue to do so.  So investors adopting this style just look for assets which have gone up and hope that they will continue to do so.

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I favour value investing.  One reason for this is because the problem with momentum investing is that assets which have done well continue to so until they don’t.  There is no way to tell when something which has gone up will stop doing so.  And we definitely know that nothing will appreciate forever!

The difficulty with value investing is knowing when an asset is cheap.  In the early days of investing, the concept of book value was very useful.  This is simply the accounting value.  If a company owns a factory and some machinery, the book value will be close to the value for which the factory and the machines could be sold. If you can buy a share, or a slice of the company, for less than the book value per share, you should.  

Book value is still very useful on many occasions.  But modern companies are very complicated, and often much of what they do cannot be valued simply.  A lot of their worth might be tied up in software, for example, which is harder to value than a building.  Or they might own a lot of IPR — intellectual property which again, is intangible and hard to value.  But the effort is worth it.  Finding a cheap company to buy is one of the best ways to trade successfully. 

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I have written a lot about the importance of psychological factors in investing.  It is absolutely crucial that you understand these, for two reasons.  Knowing about your own psychology will help you understand and improve your decision-making processes. It will be especially valuable to know when cognitive biases are likely to cause you to make errors in evaluating investments.  But just as important is knowing how other investors will think — after all, they have the same psychology as you do!  And knowing what other investors are likely to think of an asset is the key.  Because you want to find an asset which is not just cheap — but unjustifiably so.  Then you can expect it to go up sustainably.

See Also:

The Discerner Art Publication

What Is “Theory Of Mind?”

The Late Evaluation Effect And Financial Markets

The Psychology of Successful Trading: see clip below of me explaining my new book!