MarketPsych: Profiting from investor pychology — with Dr. Richard Peterson (transcript)

This is a transcript of our interview with Dr. Richard Peterson, author of MarketPsych: How to Manage Fear and Build Your Investor Identity, which came out this year. Check out the archives of our show. Subscribe on iTunes.

Peterson:   There’s a lot of literature in behavioral economies and behavioral finance about the mistakes that people make, like holding their losers too long, or impulsively chasing after stocks. But there isn’t much work about how do you help people to not make those mistakes. So, we’ve really got interested in how do we change people’s decision-making for the better.

Live from the internet, it’s Tradestreaming Radio, with your host, Tradestreaming.com’s own, Zack Miller.

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Miller: I hope listeners of Tradestreaming Radio don’t have their investments on a prayer.

Hi, I’m Zack Miller, author of the recent book, Tradestream Your Way to Profits: Building a Killer Portfolio in the Age of Social Media. You’re listening to Tradestreaming Radio, our home in the internet radio space. This is our place to discuss how technology is helping investors become better, smarter, and more accurate at what they do.

You can find this podcast on iTunes, you can also find lots of other material relating to this podcast, as well as archives of our programs on my website, www.tradestreaming.com There’s lots of great content there as well. I recommend you check out. You can also stay in touch with me on Twitter. I’m @NewRulesInvest; that’s @NewRulesInvest.

Listeners to my show know that we talk a lot about psychology, technology, and their intersection with investing. There are a lot of different ways that we’ve approached this. Last week’s program focused on using Google data to somehow quantify investor intention, and we had a guest on, a professor at UNC who had found a connection between trends in Google search data and stock price movement. We even outlined a profitable trading strategy to look at that.

There are other ways to gauge investor sentiment. One is by looking at unstructured text online, or in social media; being able to quantify that somehow, and then turning that into some type of investible strategy.

Today’s guest works at the intersection in investor’s psychology and financial markets. We’ll have Dr. Richard Peterson. He’s an M.D. Through his training firm, Market Psych, he instructs financial professionals in the use of psychological insights to improve their investment decisions and strengthen client relationships. He’s also the managing director of MarketPsych Capital, a  psychology-based asset management and market research firm.

His financial psychology research has been published in leading academic journals, textbooks, and profiled in the financial media, including NPR, CNBC, The Wall Street Journal, The Financial Times, and the BBC. His previous book, Inside the Investor’s Brain, was praised as “outstanding,” and, “A seminal text,” by Barron’s . With Frank Mertha, he co-authored MarketPsych: How to Manage Fear and Build Your Investor Identity, which came out this year.

Dr. Peterson earned cum laude degrees in electrical engineering, arts and medicine from the University of Texas, and performed post-graduate neuro-economics research at Stanford University.  Additionally, he’s board certified in psychiatry.

I found our discussion with Dr. Peterson really illuminating, because in my practice, my financial practice, I meet with clients, we talk about risk, we talk about behavior, yet I feel like many professional investors still lack sort of the tools to be able to describe what’s going on in the brain, describe our behavior, not only to describe it, but also to take it, map it out, and to find ways to improve upon that behavior.

Some of the academic texts, particularly in behavioral finance, behavioral economics talk about some of our feelings. Some of the best selling books on Amazon refer to some of these things. But Peterson’s book, Market Psych was the first one that I’ve read that actually provides me with checklists and tools to be able to say, “Hey, here’s what you’re good at… Here’s what you’re not good at… Let’s focus on what you’re not good at, limit the downside, and find a way to make that better.” That’s part of Peterson’s business.

The other part, which is also extremely intriguing is his firm’s data. Instead of looking at seven or eight parameters to measure sentiment analysis, he’s been able to mark up about 400 different markers through unstructured text online. Now, being an investor himself has, I think, embellished the platform in the sense that not only are they sort of saying, “Well, you know, this term means that somebody is positive on the stock. This term means somebody is negative on the stock,” but through a vertical analysis Peterson and his firm have said, well, in the technology sector, what’s important for stock price growth is “innovation,” right? So, “How do we quantify companies that are being described as innovative online and see how they impact stock prices.” So, his firm is doing that.

I’ll quickly turn it over to Peterson to let him describe what they do.

Again, this is Tradestreaming Radio; I’m Zack Miller. We always welcome your feedback at the blog: Tradestreaming.com Please check us out on iTunes. If you’re listening to us on iTunes, please take a second and go and rate this podcast, tell us what you think about it, so everyone else knows. And, hopefully we’ll check in with you again soon.

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MarketPsych: Profiting from investor psychology and the Internet by tradestreaming

… really a unique approach, I think, at least to mass-market investor-side and how you’re approaching investing. Can you talk a little bit about that?

Peterson:   Sure. I guess we’re approaching investing from the perspective that it’s more about what people think about the markets than it is actually about the markets themselves, or about the fundamentals of markets. So, that’s not always the case. It tends to be the most true during periods of volatility, when news or new information hits the markets, at that point in time that’s when you want to know what other people think.

Miller: Behavioral economics is sort of talked about, the individualized, sort of a person with feelings and with behaviors that we can map, sometimes follow a formula, and sometimes don’t. What I found interesting about the way you approach it is that you actually, essentially coaching investors, to help them know themselves better.

Peterson:   Yeah, so we — I think the really interesting thing about our business is that we have three different angles on it. The first is we got into this business because we were interested in how to help people make better decisions, especially financial decisions. We’ve done a lot of research over, I guess, about 15 years into how people make decisions, where they go wrong in their decisions, typically, and then what we can do to help them get better.

There’s a lot of literature in behavioral economics and behavioral finance about the mistakes that people make, like holding their losers too long, or impulsively chasing after stocks, but there isn’t much work about how do you help people to not make those mistakes. And, so we’ve really got interested in how do we change people’s decision-making for the better.

So, that’s one side of our business, is the coaching, and training.

Interestingly, a lot of work is with financial advisors, helping them to help their clients make better decisions. So, we train financial advisors quite a bit.

Then also portfolio managers.

And, that brings me to the second side of our business. I’m, myself, a registered investment advisor, and have been a portfolio manager for over two years. That side of the business is based on the linguistic analysis technology that we’ve built over about seven years, which is the third business, which is our data business.

So, essentially our technology reads online conversations among investors and executive interviews, and also a lot of news media reports, and regulatory filings, like SCC filings. And, it finds when there are — what should you call it? I guess outliers, or anomalies, when people are all optimistic, all pessimistic, or when a CEO suddenly starts thinking more about risks, for example.

It has found that a number of these anomalies are somewhat predictive of stock prices. As a result of identifying that we first began trading a hedge fund, starting — September 2^nd, of 2008, is when we launched it. It was market neutral and it ended up out performing the S&P just substantially over the next 2.5 years; I think more than 25% out performance.

We had trouble raising capital, because we weren’t from Wall Street, and it was a small fund, so we ended up realizing a better business might be to go into data. We took that software that was providing the hedge fund with its data, and we spun it out as a data business.

That’s the third business we do, is selling the psychological data, and what people are thinking and feeling, both executives, and the news media, and individual investors.

Miller: Are you feeding out that data sort of in raw form, or have you overlaid your findings in how some of those changes and sentiment impact stock prices?

Peterson:   Well, a bit of both. Most quant funds that we’ve approached want just the raw data, so they’ll process it themselves through their own engines. But others, especially, for example, portfolio managers who are looking at the data graphically, they want us to give them some tips, some advice about where to look, because there are a lot of places to look. We do that as well. We help direct people to some of the more profitable patterns in that data.

Miller: Is your investment advisory business based upon some of the portfolio management that you were using at the hedge fund, and you just turned it into sort of a managed account type thing?

Peterson:   Well, the hedge fund itself, we’ve hibernated that, so that is — we’re probably going to go back into asset management in about a year. But for now we wanted to really work on the software and get it up to commercial quality, get all of the kinks worked out of it.

There’s always — as you know, this kind of technology there’s — it’s one thing to be 80% — to have 80% of it locked down, with 20% of the effort, but then the last 20% takes 80% of the effort, and to have it commercially viable product you’ve really got to get that last 20%. So, we’re making it all fall tolerance, failure resistant, and things like that. So, that’s the last of it that we’re working on it, with the data software right now.

Miller: Do you envision that as begin sort of the mainstay of your business going forward, or do you basically imagine these three facets sort of — I mean they’re obviously self — each one sort of builds the other, so self-reinforcing. Are you planning on focusing on one of these three bits?

Peterson:   Well, actually right now we’re really focused on the data, so most — we have, I think, 12 people right now all working hard on getting the data, very compelling with visuals, and of course getting the software to be fully reliable and finding new sources to scan, and finding new patterns in that data. So, we’ve got a lot of people working on that.

On the training business we’ve got three people doing trainings. That’s a lot of fun. We really enjoy that. It’s fun to both find where people are making mistakes, but also to help people not make those mistakes feels pretty good.

And, then the third thing, the hedge fund, we’ll go back to that in about a year, I think once we get the —

Miller: Are you also working on tools, at least on the data side for individual investors, or are you going to maintain a focus sort of on the institutional?

Peterson:   Well, Zack, that’s a great question. We’ve found that individual investors don’t typically understand our data. So, a lot of commercial products out there, like VectorVest, they tell you what to buy and what to sell. That seems to be what most retail investors —

Miller: They want a system.

Peterson:   — are looking for. They don’t get it. They don’t really understand the markets, or maybe they don’t spend — they don’t have the time to really look into the details of what drives markets. “Just tell me what to buy. Tell me what to sell.”

Discretionary managers, like mutual fund managers, they often want to know what’s moving things. If you’ve been to the markets more than a few years you realize that an earnings report may come out and be extremely positive, but the stock plummets 5-10%. And you start to realize, “This isn’t just about the earnings. There’s something else going on here.” And that’s the psychology side.

Then people become interested in our data and say, “Well, can you tell me what’s the tone of investors before that earnings call? Why did it drop 10% when it had blow out earnings?” So we can say, “Well, look, people were already very optimistic, to the point where they were probably expecting a 15% price jump. Everybody was lined up expecting a earnings beat — expecting beating the estimates.” In that case it’s almost guaranteed to fall, no matter how good the earnings are. They realize it’s more about what the herd thinks then about the actual numbers that come out.

Miller: You shared with me before this call something for investor relations, I guess a demonstration of sort of your tools, which I think is a very interesting application for what you’re working on. Is that going to also be a focus going forward? Or was that just sort of throwing some stuff up on the wall and seeing if it stuck?

Peterson:   Well, it is currently a focus because we’ve found that we can create some very compelling graphics, and I’ll give you an example. One is if you can look at trust levels among investors about different banks, that was obviously very important recently, when you could really measure which banks do people believe were trustworthy, and likely to remain sound during the crisis, and which ones were likely to, you know, go under. Bank executives want to know that. They want to know, “How do people think? What do people think about my bank?”

They also want to know, and this is where we go beyond what other IR firms do, they also want to know, “When I release a communication, or a new advertising campaign, what impact does it have on people’s perceptions, but more importantly what impact does it have on my stock price, on my revenues, on the visits to my store?”

As a hedge fund we created a lot of predictive analytics software. We not only can tell you what people think about you as a company, but if that matters because a lot of times — you know, people may not trust a clothing retailer, but they think they make really cool clothes, and so they’ll buy them anyway.

We find which factors, which psychological factors matter.

We’ve found with retailers a factor we call esteem matters, which is like a combination of quality and coolness. And so we have different factors in different industries that correlate with stock price movement. Each industry has a different one. Technology is innovation, so how innovative do people think your tech company is, that predicts our performance —

Miller: To create this platform you’ve had to go through, on a vertical basis, different industries and sort of find what the driver is there, to find what that is, right? And then go out and measure it?

Peterson:   Right. Exactly. It was interesting. Doing that research we realized that we have very granular sentiment data. Traditional sentiment analysis uses NLP or statistical learning. We actually went through and created, over several years, what we call an expert ontology, it’s like a — you basically read financial and business literature and you, for years, with a lot of people, you polish up what each phrase means because they’re different in different contexts. In the business literature words and phrases have unique meanings.

So, we’ve gone through and created this unique categorization. As a result we were able to get about 400 different sentiments, or tones, and topics, major topics out of the data. As a result we can build complex concepts, like, what do people think about an upcoming event, or, like an earnings event, or what do people think about the lay offs that this company just announced? Are they happy about the lay offs, or are they sad about the lays offs? So we can correlate topics with different tones.

In the investment world that tends to matter, because it predicts stock price. Sometimes.

Miller: Do you see yourself, and your background, as an academic, and the systems you’ve built, do you see this as sort of a little more nuanced in terms of some of the other semantic analysis engines out there?

I guess my question is how are you differentiating yourself, because it seems to me your approach to investing is not purely quantitative. You’re bringing sort of this whole other world into what you’re doing. I assume that’s got to impact the results, in terms of what you’re looking at.

Peterson:   Well, there are a couple of questions there, I guess. The first is our differentiators, and really our primary differentiator is our granularity. So, as you pointed out 400 is much different than, say, 8, 12 sentiments, types of sentiment indicators. Most people are tracking fear, or greed, optimism, things like that. But we’re tracking disgust, and a lot of nuances, joy versus liking, and affection versus — all kinds of nuances of different sentiments.

So, yeah, that’s a differentiator, but I think for a lot of firms, especially in the institutional space, what they found very compelling is that we’re actually quant — we are quants. All of our data is boiled down into quant factors. We put them together in quant models, we can find what the most predictive sentiments are of different factors, like stock prices —

Miller: You got cut off. You were talking about your differentiation. One was the granularity.

Peterson:   Yeah, the granularity, the 400 factors. The second one is the predictive quality of our research. So, most firms will tell you, “OK, your users like your brand, and they like it more than –” they like Nike more than Adidas, for example. And maybe they can even break it down regionally, but we can say, “OK, but does that affect your revenues? Does it affect your stock price or your earnings?” So we can actually look at predictive quality. It’s quite possible that if people like your brand or not, it doesn’t lead to sales. It’s how cool they think your brand is, or maybe there’s some other factor. We’ve found in different industries that there are different factors that predict sales, revenue, and ultimately stock price movement.

Miller: That’s so interesting. One of the last questions I ask of all the guests on the podcast are what resources are you using when you’re individually investing, or researching stocks, or the market, or something like that? Things you could share, tools, or resources that you just find that are useful to you?

Peterson:   Well, for us, we use our own data. So like our hedge fund it was all about the quant signals that came for us. Then once we started creating visualizations of that data it became even more interesting.

Unfortunately it’s our own tools. In fact, in a way I created them because I felt like all the other tools out there were inadequate. So, we’ll often look at, say, Yahoo Finance, look at different price patterns and things, and then we’ll look and say, “Well, what does our data say about this?” And once we lay it on top then we get a pretty good sense of what we want to do.

Miller: I guess going back to the first part of your business, which I guess it sounds like is a quarter of what you do, but not necessarily the focus going forward, but I do think it’s sort of the crux of some of your writing. Can you give us an example of how you would coach an individual investor, or a broker — the issue that you mentioned before, holding onto losers too long? How would you work with them to sort of become aware of that and move to the next steps to actually sort of change that behavior going forward?

Peterson:   Sure. Well, that’s a great example. So, that’s actually — holding a loser too long is the most common mistake people make in their investing. What often happens is they’ll get involved in a company, you know, like Cyber Nano Biotech, or something. Their friend told them about it. They researched it. They love the new drug that’s coming out, or whatever, the new product. And, the stock goes up. They feel really good about it.

And then over a few months or years it starts — something strange starts happening. They justify it in their mind, “Well, it’s OK. Just because the CEO left — well, there’s a new guy in there. OK.” “Oh, wait, the FDA didn’t approve the drug. My stock dropped by 50%, but they’re working on a  response. OK, so I’ll stick it out for the response.” “Oh, wait, their response wasn’t accepted, but they’ve got another drug in the pipeline, Phase 1 trials,” or something.

They’ll just keep rationalizing and the stock will drop, drop, drop. And, things are looking bleaker and bleaker, but when you ask them about the stock they’ll say, “Oh, no. It’s fine.” You can hear the rationalization and justification, which fundamentally is they don’t want to take the pain.

People don’t like selling a stock that’s down, because it makes them look wrong and dumb. And they just hold on to that hope, because it feels good to hope. As a result they often — that’s the biggest mistakes investors make. You see a lot of people statistically losing a lot of money by holding onto their losing stocks, and as a result missing out on other opportunities.

Miller: Do you think sort of the prevalence of buy and hold philosophy has influenced that? They’re taught almost not to sell.

Peterson:   Well, it’s used as a rationalization. Yeah, if people did buy and hold correctly for the most part it would be OK. You know, buy it, but that would be buy an index and then hold that. But most people, I think, what they do is they buy a few individual stocks to play. And they say, “Well, it’s just play money.” They only say it’s play money after they’ve started losing. Then they’ll say, “Oh, it’s play money.”

So, what we do in our coaching is we help people to realize that, “OK, look, you’ve got to separate your emotions and how much you love the stock, and you love the person who gave you the recommendation, and you love what it did for you before, how much money you made, and how good it felt before it plummeted — look at this objectively. Look at what are the numbers here? What are the earnings? How much cash flow do they have? How long can they go with their current cash burn before they go under?” Look at things objectively and detach it from the emotions.

It’s actually the same thing as selling a house. It’s the same process, where people become very attached to their house. When they give somebody a tour of their house they’ll say, “Oh, this is where my granddaughter was playing with her toys when my daughter was in Italy…” and they’ll go on and on about all the little- they have these memories of the house, which make them overvalue the house.

You’ll see most — I think the number was something like that, most sellers list their houses for about 12 or 17% more than buyers are willing to pay in a normal market, and in a down market it’s something like 26%. People list their house much higher, and as a result that’s why houses stay on the market so much longer in a down market, because people don’t transact a house as if it were just a material good, like a trade. It’s more of a — it’s an emotional thing that they have to let go and they don’t want to, because they’re attached to it.

Miller: Is it fair to say that you work with investors or professional advisors to, as you say, take the emotions out of the investing and make it much more, I guess, methodical? Do you go so far as to give them exit strategies? Do you recommend that?

Peterson:   No. It’s actually a lot more complicated. It’s really easy to slip into the sense that we’re telling people to control their emotions, but we’re actually not at all. It turns out that every financial decision uses emotion, every one, all the good ones, all the bad ones. There’s always emotion involved. You can’t make a decision without emotion, a good decision. In fact there’s people who have lost part of their brain that integrates emotion and rationality and they make worse decisions about risk than regular people.

Now that said, there are periods of time when emotion becomes excessive, when people are purely driven by fear, or purely driven by greed, or excitement, or like I gave in the case of the house example, when it so colors their thinking that when they think they’re being rational they’re not. It’s just based on their emotion, and not wanting to lose something that they love.

So what we do is help people to really understand basically, “What’s going on with my thinking about this? Do I need to sell this house? Do I need to own this stock right now?” We help them to understand, with them personally, “What does it feel like when I’m in a excessive emotion, versus what is a good balance say for me?” Because everybody is different. For some people they’ll always be able to feel something around their investment. “Oh, I’m always a little nervous, but in the past whenever I was nervous it always worked out well.” Or, they’ll say, “Actually, I’m not nervous at all. Actually, in the past when I wasn’t nervous I got in trouble. So, I need to be careful.”

So we help people really look at what are the patterns in their own decision-making. So that’s more of what we do.

Actually we have a lot of workbooks for financial advisors, and we have personality tests online that are free, that we encourage people to take, because they can go to our personality tests and essentially see what are their propensities to making different common investment mistakes. It’s important to have that awareness, just having that awareness is the first step.

Miller: Is it fair to say we’re sort of — and I’ll say it again — I sort of think we’re in a renaissance of investing led by people like you, and your research, and your firm, which is bringing a lot of these insights from science, humanities even, to life, and making them practical and people are making money by utilizing this type of information. Do you see that as sort of the future of where we’re headed, that without these tools you’re sort of going to be left behind, competitively?

Peterson:   Well, it’s tricky because it really requires an investment of time and self-education to figure out how to use most of these niche type tools. So, it’s a good question, but I don’t think most people have the time to really understand, especially individual investors don’t have the time.

What we’re working on are things like adding our information into platforms, like eTrade or Schwab, for example. So when you go to make a trade it will tell you, “Look, by the way you’re excited about this stock and you’re buying it, but guess what? Everybody else is too. So you might want to just pause for a week before you buy the stock.”

Granted most discount brokers don’t want us to stop people from trading. So, want they might want is something else, like, “By the way this stock has been tracking down for a while, there’s a lot of bad news. You’re probably wanting to hold on, but that might not be a good idea.” So, they might want us to insert something like that.

But unfortunately in the finance industry, as you know, there are a lot of mixed incentives. Most people — and I think that’s what we’ll see going forward. Rather than this, like, social media providing information for people, what you’ll see more of is better tools to help people make better decisions that have less conflict of interest from their creators.

So, eTrade won’t tell you, “OK, don’t make this trade. It’s probably a bad idea,” because they want the commission, and I don’t mean to belittle  eTrade, by any means. I think it’s just a natural incentive in most companies.

What I believe is that people will have more information that allows them to make better decisions coming from third parties that aren’t interested in making a buck from them.

Miller: Wow, very insightful. Hey, I really appreciate your time today. This has been really helpful for me, and really engaging. I appreciate your time. And look forward to reading about all the stuff you guys are working on.

Peterson:   Yeah. Great to talk to you, Zack.

Miller: Have a good one. Bye.

That was our conversation with Dr. Richard Peterson, the author of Market Psych: How to Manage Fear and Build Your Investor Identity. That was published by Wiley a little bit earlier this year.

Come back to the blog at www.Tradestreaming.com we’ll have links to the book, we’ll have links to Dr. Peterson’s firm, some more information if you want to learn about what he does and his practice.

Again, thank you for joining us on Tradestreaming Radio. We hope to be back next week. Check us out on iTunes. Please rate us, if you’re listening to us there as well. I hope we’re providing some value here. Let us know — drop by the blog, let us know what you think of what’s going on. Send me an email, we’d love to hear from you.

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More Resources

• Listen to this podcast
• Subscribe to this podcast on iTunes
• Get the book: MarketPsych: How to Manage Fear and Build Your Investor Identity (Wiley Finance)
• MarketPsych/MarketPsych Data