ARROYO GRANDE, Calif. – Sorry investors, but you're at a distinct disadvantage, running a handicap race. You're one of America's 94 million Main Street investors and the odds are 100:1 against you given the enormous firepower of Wall Street. And thanks to behavioral finance, it's getting worse, the gap's widening.
On cable, in ads and sales pitches The Street panders to your ego: You're "the man," a "rational man." You can beat the averages, the indexes. But behind your back, they laugh; they know you're irrational when it comes to investment decisions. Moreover, they actually prefer a market filled with irrational investors. That way, they can manipulate you easily without you ever really knowing it.
Oh, they'll let you make modest gains, enough to keep you in line, to prevent a full-scale rebellion. But the playing field's not level and they're backed by an elite force of roughly a million in the financial-services industry — brokers, salesmen, advisers, analysts, talking heads, slick admen, slicker lobbyists — "foot-soldiers" armed with superior tools, advance data, huge monetary incentives and the protection of friendly legislators and regulators.
But you already knew all this, right. Since the Buttonwood Agreement created the NYSE in 1792, Wall Street has always been able to control the markets and manipulate investors to its advantage. It's been a one-way street for a long time.
So what is new? Behavioral finance, the new science of irrationality, also known as behavioral economics, quant-trading, neuro-investing, etc. Wall Street has added this powerful new "weapon of mass manipulation" to its arsenal. And with it Wall Street has refined "mind control" to a high art, making absolutely certain you do not stand a chance trading.
Behavioral finance is going through a major transition that will impact the future of investing worldwide. The old behavioral finance has been around for several decades, dominated by psychologists studying irrational human behavior. Recently a newer, more secretive and potentially dangerous version has emerged. Psychologists are being sidelined by mathematicians speaking a language as foreign to Main Street investors as ancient Mayan without subtitles.
This shift will have a profound effect on your investment strategy, so please listen closely. Here's some background on this historic shift from psychology to mathematics in the mysterious world of behavioral finance:
1: The old science of irrationality
Although the history of behavioral finance goes back several decades, centering on the research of Daniel Kahneman, a psychologist and Nobel Prize winner, the 2000 market crash can be seen as the watershed moment shifting emphasis away from psychology, emotions, brain scans and MRI machines to the cold, hard, unemotional world of quantitative mathematical equations.
The turning point was captured in Robert Shiller's 2000 classic "Irrational Exuberance." Shiller says irrationality is simply "unjustified optimism ... wishful thinking on the part of investors that blinds us to the truth of our situation." Irrationality makes us our own worst enemy, and prey for sophisticated market predators.
In the 1990s our irrational exuberance blew a huge bubble. Then irrational pessimism popped it. It'll happen again. Because investors are irrational, cycle after cycle, day in/day out. That will never change. We are irrational investors.
Wall Street knows this, and thanks to their new behavioral-finance allies, knows how to capitalize on this weakness in the investor's psyche, use our naiveté and weaknesses against us and beat us in the market. Moreover, they have no incentive to share what they know; worse yet, they prefer we stay irrational!
2: The new science of quant mathematics
Throughout history, new trends often move quietly in the shadows, then suddenly take over and become the conventional wisdom. Here, however, the new version of behavioral finance may continue in the shadows for some time. Why? Because the language, quant mathematics, is foreign to the average investor.
The leader of this new version is University of Chicago finance professor Richard Thaler. He edited "Advances in Behavioral Finance;" the latest, a 712-page second volume, consists of 19 articles loaded with cryptic math equations, understood only by quant math insiders and their Wall Street portfolio-manager clients.
Unlike the earlier psychologists, Thaler and the new generation of quants don't really care "why" investors are irrational. The new leaders in behavioral finance begin with the assumption that financial markets and investors are irrational and always will be. They don't care what motivates investors to behave irrationally. Their goal is very simple: Using sophisticated quant math programs, their goal is to take advantage of the irrationality and vulnerability of the masses as we move through the cycles of greed/fear, bull/bear, bubble/bust.
Proof? The term "irrational" is rarely mentioned in this behavioral-finance bible. The new behavioral-finance leaders and their Wall Street clients have a totally detached attitude toward the masses of American investors.
Thaler captures the icy detachment of the new generation of behavioral-finance quants in a brief comment: Wall Street pros need "investors who are ... irrational, woefully uninformed, endowed with strange preferences, or for some other reason willing to hold overpriced assets." Get it? In order to succeed, Wall Street needs "irrational investors," that's spooky!
And in one article, Thaler and his co-author note: "We use the term 'irrational' for the lack of a better word, but without wishing to engage in any deep philosophical debate about rationality." However, they conclude with this simple equation: "It seems reasonable to equate nonpecuniary with irrational." To the quants, if your behavior can't be described by a mathematical equation, you're irrational.
3: New quants already fighting the war
The driving force in this new phase is Barclays Global Investors. Here's how a recent Business Week feature described the secretive world of BGI and its team of 100-plus research PhDs: "BGI's ascendance highlights the coming age of quantitative investing, which seeks to purge money management of human fallibility through the rigorous application of the scientific method."
In less than a decade BGI has become the world's largest money manager with $1.62 trillion, bigger than Fidelity, Vanguard, Merrill and other traditional Wall Street leaders. About $1.1 trillion is in low-risk market-matching index mutual funds and ETFs. Much of BGI's remaining assets are in higher-risk market-beating arbitrage, hedge and alternative investment opportunities for institutions and high-rollers.
However, Business Week is quick to warn: "You and I can no more hope to do what BGI does than we can hope to rival such famously heroic stock-picking personalities as Warren Buffett and Peter Lynch. Quant-investing BGI style requires a fluency in applied mathematics as well as access to the prodigious computing power needed to continuously crunch the numbers for 10,000 stocks and 2,500 debt issues and execute thousands of trades a day. With 2,640 employees ..."
There's lot's more, but you get the picture: You and me and the rest of America's Main Street investors are outgunned and outsmarted in this game. We can't even speak their language, and what they do is cloaked in secrecy. And the odds against us are getting worse every year! So thanks to the new behavioral finance quants, Wall Street is more powerful than ever!
What can you do? Very simple: Since you can't beat them, don't play their game by their rules. Build a lazy portfolio. Then leave it alone. Let it do its job automatically. Build wealth doing something you love in a business or profession you enjoy, and spend as much time as you can with family and friends.
Forget the irrational markets. With the quants now beefing up Wall Street, you're just wasting your time anyway ... surrender!