Hooked on a Feeling

"If investing is entertaining, if you're having fun, you're probably not making any money. Good investing is boring."

—George Soros

Jonathan Lebed was 14 years old the first time he was subpoenaed by the Securities and Exchange Commission (SEC). Then at the age of 15, Lebed was again subpoenaed, this time for "pump-and-dump" schemes. Such schemes entail buying the shares of illiquid or infrequently traded stocks, advertising the benefits of the stock widely, and then selling one's shares as other eager buyers snap them up at a higher price. In a press release, the SEC accused Lebed of touting stocks so that he could make a quick profit on their price jumps:

On eleven separate occasions between August 23, 1999 (when Lebed was 14 years old) and February 4, 2000, Lebed, of Cedar Grove, New Jersey, engaged in a scheme on the Internet in which he purchased, through brokerage accounts, a large block of a thinly-traded microcap stock. Within hours of making the purchase, Lebed sent numerous false and/or misleading unsolicited e-mail messages, or "spam," primarily to various Yahoo! Finance message boards, touting the stock he had just purchased. Lebed then sold all of these shares, usually within 24 hours, profiting from the increase in price his messages had caused.1

The SEC explained that Lebed was criminally liable because the stock forecasts that he posted on web sites and through e-mail "included baseless price predictions and other false and/or misleading statements."

Yet Lebed was a marketing genius. According to Michael Lewis, author of the best-selling books Liar's Poker and Moneyball, Lebed learned to gradually hone the appeal of his promotional messages. It should have been apparent to investors buying his recommendations that they were on the wrong side of the trade. Through a trial-and-error process, Lebed learned which aspects of his stock appeals drove investors to buy in spite of any conscious misgivings.

According to Michael Lewis, two days before the SEC's subpoenas arrived, Lebed had logged on to the Internet and posted 200 separate times the following plug for a company called Firetector (ticker symbol FTEC):

Subj: THE MOST UNDERVALUED STOCK EVER Date: 2/03/00 3:43 pm Pacific Standard Time From: LebedTG1

FTEC is starting to break out! Next week, this thing will EXPLODE. ...

Currently FTEC is trading for just $21/2! I am expecting to see FTEC at $20 VERY SOON.

Revenues for the year should very conservatively be around $20 million. The average company in the industry trades with a price/sales ratio of 3.45. With 1.57 million shares outstanding, this will value FTEC at ... $44.

It is very possible that FTEC will see $44, but since I would like to remain very conservative ... my short-term target price on FTEC is still $20!

The FTEC offices are extremely busy. ... I am hearing that a number of HUGE deals are being worked on. Once we get some news from FTEC and the word gets out about the company ... it will take off to MUCH HIGHER LEVELS!

I see little risk when purchasing FTEC at these DIRT-CHEAP PRICES. FTEC is making TREMENDOUS PROFITS and is trading UNDER BOOK VALUE!!!2

Lebed found that he could hide his identity on the Internet. He could send compelling messages, with a veneer of expertise, while none of the readers knew the author was only 15 years old.

Arthur Levitt, chairman of the SEC during the Lebed indictment, described Lebed's scheme in a pithy remark on a 60 Minutes special: "A pump-and-dump is really buy, lie, and sell high."3

The SEC's case against Lebed was settled out of court. Lebed repaid $285,000 (including interest) to the SEC on behalf of investors who had been duped by his pump-and-dump schemes. The settlement allowed Lebed to keep more than $500,000 earned during his stock promotion activities.

As of 2006, at age 22, Lebed continued to do small company research promotions through both his web site (www.lebed.biz) and promotional e-mails.

The SEC indicted Lebed because they claimed he was seeking to manipulate the market. Yet pump-and-dump hyping happens with some frequency. Why do people fall for this scam over and over when it directly and unmistakably leads to financial loss?

Stacie Zoe Berg, writing in TheStreet.com, identifies the lure of the pump-and-dump as playing into investors' "belief that it's easy to find winners." Berg suggests that pump-and-dump scams primarily recruit naive investors: "Others fall for scams because they were late entering the market and want to catch up with the winnings it seems everyone else is reaping. This greed and desperation make investors putty in the hands of those willing to take advantage of them."4 Yet the question remains: what predisposes investors to "greed and desperation," and how is a speculative frenzy ignited?

This chapter examines the origins and the anatomy of investors' excitement, hope, and greed. Recent studies into the financially destructive consequences of excessive excitement during decision making are discussed. Finally, it delves into the anatomy of the promotional language that excites investors.

BROKERS KINDLE IRRATIONAL EXUBERANCE

It wasn't only Lebed who was preying on excited and gullible investors during the Internet bubble. In the late 1990s online brokerage advertisements refined their appeal for day traders' unconscious triggers. Television commercials for online stockbrokers emphasized both the ease and profitability of such trading and were rich in positive emotional imagery.

Professor Brad Barber at the University of California at Davis performed a content analysis of 500 television commercials from 13 brokerages. He found that 28 percent of all commercials between 1990 and 2000 depicted images and messages likely to induce good or positive moods in viewers, and the percentage of such commercials more than doubled from 12.39 percent in 1990-1995 to 32.98 percent in 1996-2000. Barber speculates that because people in moderately positive moods tend to be less thorough and less vigilant decision makers, are more subject to cognitive biases, and rely more on heuristics (than people in moderately negative moods), the brokers were trying to induce such moods in their viewers.5

One Discover Brokerage Direct television commercial depicted a conversation between a passenger and a stock-trading tow-truck driver who owned an island-nation all his own.6 Other television commercials included a stock-trading teenager who owned his own helicopter.7 A series of Schwab commercials featured such celebrities as teenage Russian tennis star Anna Kournikova. An E*TRADE advertisement claimed that "on-line investing is 'A cinch. A snap. A piece of cake.' "8

Former SEC chairman Arthur Levitt said, "Quite frankly, some advertisements more closely resemble commercials for the lottery than anything else. When firms, again and again, tell investors that on-line investing can make them rich, it creates unrealistic expectations____[M]any investors are susceptible to quixotic euphoria.. ."9 New York Attorney General Eliot Spitzer observed that online brokerage advertisements "convey a message of convenience, speed, easy wealth, and the risk of 'being left behind' in the on-line era."10 In a January 26, 2001, report about online trading, the SEC expressed concerns that certain types of aggressive online brokerage ads may cause investors to possess unrealistic expectations over the risks and rewards of investing.11

THE ANATOMY OF STOCK HYPE

Lebed's promotional messages primed readers to buy dubious investments by circumventing their reason and appealing directly to their neural reward systems. He was successful because he included the following reward system activators in his messages. Reward system provocateurs such as those listed below will be discussed further in this and subsequent chapters:

1. Novelty. Lebed suggested stocks in new or overlooked areas of the market, which was sure to stimulate curiosity (another function of the reward system).

2. Anticipation of a Large Gain. Anticipation of monetary gains activates a deep, automatic area of the reward system called the nucleus accumbens. Lebed suggested that investors could expect a "HUGE" payoff. Size matters to the reward system, where extremely large possible gains override a rational ability to incorporate probability information.

3. Information Overload. Lebed's sales pitches were loaded with a plethora of corporate statistics such as projected revenues, earnings, and potential market size. For most people, a long list of detailed statistical information will shut down their critical faculties. Many readers of Lebed's messages threw up their hands in exasperation, asked "What's in it for me?," and skipped ahead to the conclusion. Confused investors were given a simple answer by Lebed: "Buy now, sell at $20."

4. Bargain Buying. He appealed to investors' search for a bargain. He used phrases like "under book value" and "dirt cheap." Buying something at such a bargain implies that one can't lose. On a neural level, good deals have been found to activate the brain's reward system.

5. Author as Expert. Lebed sounded like an authority on each stock. He clearly had done some homework, and he delivered verifiable financial data. Investors were apt to trust his projections based on his depth of knowledge and the thoroughness of his research. Lebed's use of difficult-to-find data heightened his aura of authority.

6. Time Pressure. He appealed to readers' time-discounting functions. If they didn't act "VERY SOON," then they were going to miss out. Time pressure hinders critical analysis and causes limbic system activity to bypass the cognitive considerations of the prefrontal cortex.

In Lebed's promotions, gullible investors were coached to anticipate large gains, as revealed to them by an "expert." The hyped stock was new and interesting, and the investment required immediate action. Little downside risk was apparent, according to the "expert." By the time interested potential investors looked at the latest price quote, odds were that other eager investors (including Lebed himself) had already started buying, and their pressure pushed the price upwards. For an investor considering an opportunity, the idea of missing out overcomes the last remnants of resistance. They jumped in, and Lebed was waiting to sell to them.

GREED: THE BASICS

"An excessive desire to acquire or possess more than what one needs or deserves, especially with respect to material wealth."

—The American Heritage Dictionary of the English Language, Fourth Edition, 2000, Houghton Mifflin Company

"An eager desire or longing; greediness; as, a greed of gain."

—Webster's Revised Unabridged Dictionary,

1998, MICRA, Inc.

"Reprehensible acquisitiveness; insatiable desire for wealth (personified as one of the deadly sins)."

—WordNet 2.0, 2003, Princeton University

For millennia, greed has been identified as a source of financial folly. In the Bible, as one of the seven deadly sins, greed is called avarice. The Buddha referred to greed as desire and called it the source of all human disappointment and suffering. Charity (the antithesis of greed) is one of the five pillars of Islam. In Victorian England, Charles Dickens parodied the greed of his character Ebenezer Scrooge, who today serves as a stark reminder of the loss of human connection that can accompany an excessive desire for financial gain.

Greed has been popularly portrayed in the media as a negative attribute. Michael Douglas, playing the fictional corporate raider Gordon Gekko in the 1987 movie Wall Street, waxed philosophical about the true nature and necessity of greed before the shareholders of a corporation he intended to buy, Teldar Paper. Perhaps the most memorable scene in the movie is a speech by Gekko to a Teldar Paper shareholders' meeting:

The point is, ladies and gentleman, greed is good. Greed works, greed is right. Greed clarifies, cuts through, and captures the essence of the evolutionary spirit. Greed in all its forms, greed for life, money, love, knowledge has marked the upward surge in mankind—and greed, mark my words—will save not only Teldar Paper but the other malfunctioning corporation called the U.S.A.

Gekko's self-serving desire to lay-off Teldar workers and auction off its separate divisions for profit ominously lurked beneath his claimed altruistic motives. Gekko's speech was reportedly based on Ivan Boesky's 1985 commencement address to the graduates of the University of California at Berkeley, in which Boesky declared: "Greed is all right, by the way. I want you to know that. I think greed is healthy. You can be greedy and still feel good about yourself." Boesky was a Wall Street arbitrageur who was later convicted of federal crimes. He paid a $100 million penalty to the SEC to settle insider-trading charges in 1986.

Economists from Adam Smith to Milton Friedman have seen greed as an inevitable and, in some ways, desirable feature of capitalism. In a well-regulated and well-balanced economy, greed helps to keep the system expanding. But it also ought to be kept in check, lest it undermine public faith in the entire enterprise.12

As economist Paul Krugman noted in the New York Times, the theory that "greed is good" for society may contain a fatal flaw: "A system that lavishly rewards executives for success tempts those executives, who control much of the information available to outsiders, to fabricate the appearance of success. Aggressive accounting, fictitious transactions that inflate sales, whatever it takes."13

Among investors, greed leads to financial losses through overtrading, entering investments too late, and inadequate due diligence. It shares a biological foundation with psychological biases such as overconfidence, the illusion of control, and the house money effect. Greed that follows a series of profits is fuel for hubris. Broadly speaking, greed is a result of a convergence of factors: the desire for gain, the motivation to pursue opportunities, the disregard of risks, and a penchant for excess.

On an individual level, greed has deleterious effects on performance, yet greed is a common facet of human behavior. Can learning about greed improve one's profits in the markets (to be sure, a greedy motivation)? For many investors, locating stocks with large profit potential and anticipating their high returns is one of the exciting (and occasionally addictive) aspects of investing. Managing the greed that accompanies a normal investment process is an enduring challenge.

In order to understand the type of greed that drives investors to fall for pump-and-dump scams, chase fast-moving stocks, and otherwise take excessive risk, it's revealing to look inside the brain. Neuroimaging shows how greed arouses the neural circuitry, what types of information intensify greed, and which interventions appear to rein it in.

THE BIAS TASK

Studies by researchers at Stanford University have revealed some of the brain origins and expensive consequences of greed. The researchers have identified a part of the brain that generates excitement about potential gains, occasionally leading to excessive financial risk seeking. Additionally, they found that a different area of the brain is activated when investors fear loss, and that area powers excessive financial risk aversion. Such neuroimaging studies greatly simplify the investment decision-making process due to experimental constraints. Nonetheless, they have provided deep insight into how investors assess and choose investment options.

Since 1999, professor Brian Knutson has performed brain imaging experiments that illuminate the characteristics of an emotional state called positive activation. Positive activation refers to the excited anticipation of a good outcome. Some positive emotions, such as comfort and satisfaction, are not associated with arousal. Other positive emotions, such as excitement and elation, consist of both positive emotion and physiological arousal (activation). Experimentally, an excellent way to induce positive activation is to offer subjects money.

In his first experiments, Knutson found that different regions of the brain's reward system were activated at different times during financial gambles. In particular, he found that anticipating financial gains activated different reward system centers than when those gains were received. A deep brain area called the nucleus accumbens (NAcc) (see Figure 7.2 on page 101) was primarily activated by reward anticipation. An area of the medial prefrontal cortex (MPFC) (see Figure 8.1a and b on page 113), just behind the eyes in the midline, was activated when monetary rewards were received.

In subsequent experiments, Knutson localized areas of the reward system that are activated during anticipation of different-sized gains. As the size of a potential reward increases, the NAcc is increasingly activated. He also identified the brain area where the probability of receiving a reward is encoded. As the probability of getting a reward increases, the MPFC is increasingly activated. Through 2004, Knutson's studies revealed how people anticipate and learn about financial rewards when the magnitudes, probabilities, and expected values of those rewards change.

In 2005, Stanford finance graduate student Camelia Kuhnen (now assistant professor at Northwestern University-Kellogg School of Management) designed a study with Knutson to discern how individuals decide to take investment risk. She hypothesized that areas of the reward system might drive excessive risk taking and risk avoidance. Kuhnen and Knutson refined an investment experiment in which they could visualize the moment of decision making. Their study was the first using functional magnetic resonance imaging (fMRI) to visualize brain activity during investment decisions.14

In their experimental task, called the Behavioral Investment Allocation Strategy (BIAS) task, Kuhnen and Knutson asked subjects to make an investment choice among three alternatives. Two of the alternatives were risky "stocks" (either "Stock A" or "Stock B"), and one was a "bond." After the subjects selected one of the three choices, the results of each option were revealed to the subjects. If the subjects had made money, it was added to their account, but if they lost money, it was subtracted.

One of the two stocks had a net positive payoff over the 10 trials, and the other had a net negative payoff. At the beginning of each block of 10 trials, subjects did not know which stock was profitable or which was money losing, so they learned via trial and error. The "good" stock had a random payoff distribution of +$10 (50 percent likelihood), $0 (25 percent), and -$10 (25 percent), for an expected value per trial of $2.50. The "bad" stock had payoffs of +$10 (25 percent), $0 (25 percent), and -$10 (50 percent), for an expected value per trial of-$2.50. The only difference between the two stocks was a 25 percent shift in the likelihood of the highest value (+$10) and lowest value (-$10) outcomes. The third choice, the bond, yielded a constant return of $1 per trial.

Potential Choice Payoffs of the BIAS Task

Stock A = Averaged either +$2.50 or-$2.50 per trial

Stock B = Averaged either +$2.50 or-$2.50 per trial

While subjects' goal in the BIAS task was to make as much money as possible (they kept their earnings), they did not know which stock was the high-paying one when they first begin playing the game. After watching the payoff of each stock over several trials, subjects would develop a greater sense of certainty about which was the "good" one. To prevent the subjects from always knowing which stock was best, after 10 trials the stocks were randomized and a new block of 10 trials initiated.

Dear Reader: If you're feeling mathematically inclined, decide how you would choose in this experiment. Would you start out choosing a stock? If not, how would you proceed? After how many trials would you know with some certainty which was the high-payoff stock? (Do this quickly before reading on.)

As the first few trials pass, subjects can generate a probabilistic sense of which stock is high paying and which is not. One should optimally begin to choose the "good" stock when 70 percent certain of its identity, in order to maximize expected value. After each trial, you can calculate the odds that a stock is the "good" stock using Bayes's theorem. Subjects made decision "mistakes" when they did not follow Bayes's theorem as they attempted to maximize their profits. Of course, it was impossible for the subjects to mentally calculate Bayesian probabilities in the limited time provided, so they had to rely on general impressions, and they made many mistakes.

In "risk-aversion" mistakes, subjects would choose the bond even though they had enough information to know which stock was the "good" stock with at least 70 percent probability. Activation in an area of the brain called the anterior insula predicted risk-aversion errors (see Figure 7.1) in this experiment.

FIGURE 7.1 These images demonstrate the location of the insula. Note that the anterior insula is the forward portion. The insula is an evolutionarily older type of cortex. Newer cortex (neocortex) tissue in the temporal and parietal lobes folds in over the outside of the insula. Activity of the anterior insula is associated with the experience of pain and predicts risk-aversion mistakes in the BIAS task.

FIGURE 7.1 These images demonstrate the location of the insula. Note that the anterior insula is the forward portion. The insula is an evolutionarily older type of cortex. Newer cortex (neocortex) tissue in the temporal and parietal lobes folds in over the outside of the insula. Activity of the anterior insula is associated with the experience of pain and predicts risk-aversion mistakes in the BIAS task.

In fMRI experiments by other researchers, the anterior insula was activated by pain, loss, and disgust. Kuhnen and Knutson noticed that subjects' anterior insulas were activated when they learned they hadn't chosen the most lucrative option. When such a "counterfactual loss" occurred, they were more likely to jump to the bond (thus making a risk-aversion mistake). It should have been apparent to the subjects that, given the odds, the "good" stock would occasionally pay less than the "bad" stock. Nonetheless, subjects had difficulty sticking with the "good" stock after a counter-factual loss.

Some subjects who had performed well in the first portion of an experimental block became more conservative toward the end, apparently fearful that they might "give back" some of their winnings. This is a type of risk-aversion mistake (called "cutting winners short") that is discussed in Chapters 14 and 15. Experiencing a counterfactual loss (in the first example) or accumulating large profits (in the second) predicted subjects would choose the safety of the bond, thus making a risk-aversion mistake. The subjects' anterior insulas became activated just before they made the switch to a more conservative, risk-averse strategy.

Investors who sell their long-term investments after a brief period of underperformance are demonstrating risk aversion. Additionally, investors who sell a rising stock, effectively "cutting a winner short," may similarly be displaying insula-driven risk aversion.

THE NUCLEUS ACCUMBENS

In the BIAS task, when subjects invested in one of the stocks before they were 70 percent sure that it was the "good" stock, they committed what is called a risk-seeking mistake. Kuhnen and Knutson found that the NAcc of the reward system was activated before subjects made risk-seeking mistakes, thus predicting the mistake that subjects were about to make (see Figure 7.2).

The nucleus accumbens is well known among neuroscientists due to several interesting characteristics:

1. The Pleasure Center. Neurosurgeons found that people undergoing surgery reported intense sensations of well-being (and some had orgasms) when electrically stimulated in the NAcc.16 More recently, scientists demonstrated that NAcc activation is correlated with subjective reports of positive emotionality.17 While pleasure is undoubtedly one function of the NAcc, there are other functions such as motivation and learning that are also of interest to neuroscientists.

2. Drug Abuse. All drugs of abuse activate dopamine neurons in the reward system, which has terminals in the NAcc. Thus, the NAcc is thought to be the brain center responsible for drug craving.

3. Reward Anticipation. The NAcc is activated on fMRI scans when people are anticipating or expecting to make money.18 Other rewards can

FIGURE 7.2 These are images of nucleus accumbens (NAcc) activation. Activity of the NAcc is associated with the experience of positive excitement and predicts risk-seeking mistakes in the BIAS task.

activate the NAcc, such as chocolate, luxury items, and pornographic pictures.

Activation of the NAcc does not in itself predict risk-taking mistakes. Rather, it is excessive activation, as compared to baseline, that correlates with investment decision errors. "On average, the participants in the study made rational choices 75 percent of the time and made mistakes 25 percent of the time," according to Knutson in the article's accompanying press release, "and the brain areas lit up even when rational choices were being made, just not as much."

Some businesses use cues or triggers in order to activate customers' risk-taking brain regions to induce them to take more financial risk. Per Knutson in the press release, his findings "may also explain why casinos employ 'reward cues' such as free drinks and surprise gifts as anticipation of other rewards that may activate the NAcc and lead to changes in behavior. ... Insurance companies might employ the opposite strategy, using strategies that would activate the anterior insula." From the previous discussion of brokerage advertising during the late 1990s, it is clear that such cues have been used widely in the financial industry to encourage investment risk taking.

Investors are experiencing NAcc activation when they feel excited about "hot" stock investment opportunities. Stocks in new or high-growth industries and those with lucrative-sounding stories trigger NAcc activation and the experience of greed for gain.

EXCITED ABOUT A GOOD DEAL

The BIAS task demonstrated how "irrational" risk-taking decisions could be predicted by watching changes in brain activation. Researchers then turned their attention to the mechanics of the "buy" decision in a retail environment. Professor Knutson, Professor George Loewenstein (at Carnegie Mellon University), and others designed an experiment to measure whether there is a "buy signal" in the brain. Specifically, are there brain areas that drive purchases of consumer items?

In the experimental task, the researchers displayed a number of routine consumer products (such as a box of Godiva chocolates, an MP3 player, or a Dodgeball DVD). Alongside the items they posted the prices at which subjects could buy them from the researchers. Interestingly, the prices of the items had been discounted approximately 70 percent from their retail prices. The discount was necessary because subjects had been unwilling to buy the items near the full retail price.

Knutson found that activity in three brain regions predicted purchasing decisions. Activity in the NAcc was associated with a preference for a product (a desire to possess it), and predicted that the participant would buy the item. The participants' MPFC was activated when prices were very cheap, and its activation also predicted that the subjects would buy. Decreased activity in the brain's pain center, the insula, occurred during this experiment, and this decreased activity also predicted buying. In conclusion, it appears there are three neural predictors of buying consumer items—desire for the product (increased NAcc), a cheap price for the product (increased MPFC), and little perceived risk (decreased anterior insula).15

There are several speculative applications of these findings to investment practitioners. The satisfaction value investors feel as a result of hunting for bargain-priced stocks may be due to MPFC activation. It's possible that value investors such as Warren Buffett, David Dreman, and Bill Miller are tuned in to "bargain" signals from their MPFCs.

Stock investors who look for an exciting or desirable story may be buying stocks based on NAcc activation. These are the investors who buy stock in a "good company" that they like, forgetting that a good company does not equal a good stock.

Investors who see little risk in an investment are driven to buy by the absence of a perceived "downside" (decreased anterior insula activation). Because they don't see how they could lose, they are more willing to take a risk and buy. The MPFC, NAcc, and insula are all part of the neural circuitry with which investments are evaluated. Interestingly, patterns in their activation also predict purchase decisions.

IMPROVING BIASED DECISION MAKING

Emotions are part of both rational and irrational choice behavior. It's the extremes of emotion that lead to excess. Intense emotions, such as greed and fear, are indicators that one is susceptible to the risk-aversion and risk-seeking mistakes seen in the Kuhnen and Knutson study.

People can use the physical signs of emotion (feelings) as signals for when they are likely to make errors in their investment decision making. Using feelings as predictive signals requires a high degree of self-awareness. Self-awareness of feelings and consciously monitoring recent decisions for emotional influences can significantly improve decision making. Deliberate action to interrupt emotional decision making, even something as simple as taking a deep breath, may be the most efficient means for reducing excessively emotional decision making. The real message may be a common-sense one: Whenever you're facing a big decision, and you feel excited, step back a moment and think it over.

For example, if an investor has experienced a recent loss and notes that he is either feeling nervous or exhibiting signs of irrational risk avoidance behavior such as (1) hesitating in entering new positions, (2) deliberating about further potential losses, or (3) seeing more financial threats than usual, then he is experiencing excess anxiety. He should identify that anxiety is the origin of his decision problems and take action to either reduce the anxiety or bolster his self-discipline.

Conversely, if an investor has recently made large gains and is feeling (1) celebratory, (2) infallible, and (3) like taking more risk, then he ought to take a step back. Is he focusing solely on potential returns while ignoring prudent risk control? If so, then steps should be taken to reinforce investment discipline.

GREED IN THE MARKETS

"I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful."

—Warren Buffett, lecturing to a group of students at Columbia University (he was 21 years old)

One proxy for excessive emotionality is the language that investors use to describe their investments and the current market conditions—their verbal framing of the investment climate. If investors express themselves in a negative emotional tone, then they are likely to be feeling risk averse. However, when investors use positive words to express their market sentiments, they are more likely to be taking excessive risk. A simple way to test this hypothesis is to count the number of negative and positive words in the media.

In May 2005, I counted such words using the online transcripts of the television business news programs Nightly Business Report with Paul Kangas and CNN's Moneyline with Lou Dobbs. Moneyline's transcripts ran from January 3, 2000, to June 12, 2003, while NBR's are available from January 3, 2000, up until this writing. When the number of positively and negatively toned words are summed, one can get a pretty consistent idea of the amount of negativity and positivity in the business news during any given broadcast.

I ran a simple linear regression to see if there is a correlation between the number of positive or negative words and the future market direction.

It turns out that when there is a high frequency of positive words, the stock market (S&P 500) is more likely to decline over the following week. The reverse pattern is true using negative words—a high frequency of negative words precedes market advances. While interesting, these patterns do not lead to investment profits due to transaction costs.

Based on this informal language study, the "sentiment" of the media appears to reflect the risk perceptions of the average investor. During highly negativistic business news broadcasts, the average investor will feel the emotional inclination to be risk averse, but in fact would have greater longrun profitability if she were buying stocks during those times. The opposite pattern is true during excessively positive newscasts.

These findings seem to support advice Warren Buffett wrote to a hypothetical market timer in the 2004 Berkshire Hathaway annual newsletter: "And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful."

The next chapter looks at the effects of overconfidence and hubris on investor decision quality.

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