Smart Money: A Psychologist's Guide to Overcoming Self-Defeating Patterns in Stock Market Investing

By Stanley H. Teitelbaum Ph.D.

In Smart Money, Dr. Teitelbaum conveys how to identify and overcome our emotional roadblocks that interfere with successful investing, and he explores ways for people to develop greater trust in their ability to navigate their own investment decisions and to reduce their reliance on financial advisors. We all have personality issues that can become impediments to successful investing in the stock market and lead us into pitfalls, like buying high and selling low, following the herd, and searching for the next guru.

Dr. Teitelbaum explains how addressing and overcoming our personal obstacles and implementing a set of guidelines such as distinguishing luck from skill, leaving your ego out of investment decisions, recognizing the value of self-discipline, avoiding self-deception, taming your inner con man and inner critic, and tuning out the media “noise” will enable investors to achieve a greater degree of success.

Praise for Smart Money

“In this painstakingly researched and well-written book, the clinical psychologist Stan Teitelbaum has applied his craft to something all investors know too well—our emotions, and human foibles often diminish our portfolio results. He takes you through countless cases of common mistakes using markets and the heroes of the past. As you read it, you will personally identify with some of his examples and find yourself saying, “That’s me!” As a result, you are likely to learn some important money-management lessons along the way.”

Byron Wien, vice chairman of Blackstone Private Wealth Solutions Group

“Stanley Teitelbaum’s disciplined approach to investing is a wise path for individual investors to build wealth over time. His understanding of the stock market’s volatility, its cyclicality, its inherent risks, and its history of performance informs that approach. Dr. Teitelbaum illustrates clearly how our own behavior and our very human impulses often lie at the bottom of our disappointing investment results and how recognizing and controlling our behavior can lead to successful investing.”

Al Messina, managing director, Silvercrest Asset Management Group

“This is quite an engaging book about psychological perceptions of risk and its relation to stock investing. It should appeal to both financial types and a general audience.”

Edward N. Wolff, professor of economics, New York University

• Language: English
• Publisher: Page Publishing, Inc.
• Release date: Sep 7, 2021
• ISBN: 9781662439087

Book preview

Chapter 1

The Cassandra Syndrome

You have to be willingly ignorant of the past not to know where all this leads.

—Paul Krugman, the New York Times

Successful investing in the stock market is an imperfect enterprise. We all make strategic mistakes related to stock or fund selections, especially on the timing of when we buy or sell. Our susceptibility to the euphoria accompanying market advances and despair during market declines can color our judgment and lead us to make impulsive and unsound decisions. All too often, we respond to huge price swings by being lured into buying at a top and, conversely, into panic selling at a market bottom. The important takeaway in this realm is that we can learn from our investment errors and that not learning from them predisposes people to repeat those mistakes and to engage in a blind repetition of self-sabotaging patterns.

The overall long-term history of the financial market reveals an upward bias for equities. Over time, this bias takes many zigs and zags into bull market and bear market territories, and usually, there are warning signals that augur for direction reversals. These warning signals can be particularly useful in gauging our strategies and comprise what I refer to as the Cassandra syndrome. I am identifying the Cassandra syndrome, a term that originates from Greek mythology, to refer to the tendency of investors who disbelieve or dismiss valid warning signals about the direction of the stock market or of a particular equity.

The term is intended to describe investors who blithely and arrogantly ignore the history of the stock market, which tells us that inevitably there will be bull and bear market cycles in the future. During a roaring bull market, there is often a suspension of disbelief that the advancing trend will continue and that the reality of market corrections is outstripped by the illusion of endless gains.

In the Greek myth, Cassandra was the beautiful daughter of the king and queen of Troy. It was alleged that her beauty was so great that the god Apollo fell deeply in love with her and imbued her with the ultimate power to foretell the future. Cassandra, however, did not love Apollo in return, which deeply wounded him; and he inflicted his revenge upon her by decreeing that no one should ever believe her prophecies. Although Cassandra repeatedly warned her countrymen of the lurking danger of keeping Helen of Troy as captive, she was consistently ignored, and the dire consequences of the Trojan War ensued. Her prophecies were accurate, but they were routinely ignored. Ultimately, she was taken away as a slave during the Trojan War, and subsequently, she was murdered.

The historical data of the stock market tells us that since 1926, the average annual gain (as measured by the DJIA, or Dow Jones Industrial Average) has been 9.6%. This is a significant statistic that points to the overall upward bias in the appreciation of equities. It is interesting to note, however, that it is extremely rare for a 9% to 11% gain or loss to occur in any given year. Instead, the advance or decline tends to overshoot or undershoot this level. Hence, when the market becomes frothy and rises far above its 200-day moving average, it creates a sense of euphoria, a state too heady to last. History tells us that such an advance is unlikely to continue unabated (a reversion to the mean is probable) and that one might consider lightening up, to a partial degree, on his or her investment allocations. This can be an emotionally challenging action to take, especially when others are still enjoying the late-night party. Trying to time precisely when to get in and when to get out of the market can be a fool’s mission, but following the path of selectively trimming may give you the last laugh, as declines in a bear market can be sudden and vicious and profits can evaporate astonishingly fast. Similarly, selectively adding to a portfolio when the market has declined excessively into negative territory can enhance profits.

Arrogance as a Major Self-Defeating Pattern

The arrogant defiance toward the stock-market Cassandra is among the most common and pernicious self-defeating patterns. The stock-market Cassandra informs us that stock prices do not move in a straight line and that bull and bear market trends are inherent to the long-term cycle. Uptrends and downtrends have a tendency to overstretch themselves, and it is these phases that are most dangerous for the investor. When these trends become excessive, it is a certainty that eventually they will correct to realistic levels. It is helpful to maintain a mental image of this and what we might think of as the rubber-band effect. When our portfolio is soaring, it becomes hard to remember that stock prices will sooner or later, like a ticking time bomb, correct to the mean; and we are prone to lapse into a this-time-will-be-different mentality. It is easy to allow ourselves to be seduced into such a frame of mind when our portfolio gains seem magical. At such times, it is a natural tendency to become increasingly ebullient and want to ride the bull mercilessly. Conversely, on the other end of the spectrum, when we are in the throes of a correction or a serious bear market (as in 2008), our fear mentality takes over as the downtrend overextends itself, and we suppress the knowledge and wisdom that every bear market is followed by a recovery and subsequent bull market. Cassandra tells us this, but our greed and fear instincts tune her out.

To a degree, the stock market’s historical performance is its own Cassandra. On a long-term basis, since 1871, the earliest year on record, there has never been a twenty-year rolling period in which the DJIA has shown a negative return. A rolling period is defined as twenty consecutive years—for example, January 1, 1970, through December 31, 1989; January 1, 1990, through December 31, 2009; etc. The best twenty-year period shows an average annual return of 16.88%, and the worst twenty-year period shows a gain of 2.77% on average; and the median for all twenty-year periods is an 8.09% gain. What this means is that the market is foretelling that despite some vicious bear market periods, the long-term upward bias has invariably, without exception, remained intact during a twenty-year span.

While, as has been pointed out above, the moderate trimming of one’s portfolio during a significant downtrend can enhance profits, there are times that total inaction has worked out more favorably. For example, in the prolonged 2007–2008 bear market (ending on March 9, 2009, with the Dow at 6,627), those investors who stayed pat during the debacle fared better in the recovery wherein the DJIA climbed more than 100% by August 2013 than those investors who fled in panic in early 2009, when the consensus of the so-called experts was that stocks would continue to decline. In retrospect, it would have been very difficult for those who fully sold out of their positions to have had the courage to come back in at the low point in March 2009, and few investors did so as investor sentiment remained deeply negative. As a result, those who remained on the sidelines missed out on the large gains acquired in the early stage of the bounce-back bull market. What is essential here is for investors to maintain a disciplined strategy so that they do not panic during a correction or a bear market plunge, such that they are out of the market in disbelief when the market inevitably resumes its long-term upward bias.

Being disciplined means that you expect corrections. A correction is generally defined as a pullback of between 10% and 20% in a benchmark like the DJIA, even as the trend marches upward. Declines greater than 20% are considered to be bear markets. Since 2000, stocks have experienced several corrections, and there have been two powerful bear markets. During the 2009–2013 bull market, which advanced more than 100%, there was a correction of 16.2% from July to October 2011. There again, those who largely remained fully invested fared better than those who tried to exquisitely time their points of entry and exit. The Dalbar research studies underscore this point. Their findings consistently indicate that a large segment of the investor population succumb to the tendency to buy stocks in response to excessive euphoria—when the market averages are overstretched on the upside—and to sell stocks after they have been trashed in response to excessive fear and despair. Thus the human tendency is to enter and exit the stock market during price overreactions, which lead people to buy and sell at precisely the wrong time. The market itself tends to self-correct from extreme valuations with the rubber-band effect, which snaps prices back to more realistic levels after they have become overstretched in either direction. Sometimes there can be a substantial lag time before an overextended direction makes the necessary correction. What is required during such periods is for you to remain patient and disciplined while maintaining your rationale-based decisions.

The takeaway is for you to be and stay mindful of this inherent cyclical process and to resist getting swept up in the mania of a huge upturn or the terror of a severe downturn. Over time, the market, as Cassandra tells us, will perform with gains that are superior to most other investments in response to the prevailing market environment. In essence, Cassandra cautions us that mania and panic are the twin enemies of a sound portfolio strategy.

Using a financial advisor, by no means, insulates you from making poor investment decisions since FAs, fearful of losing their clients during choppy stock market conditions, are prone to make the same mistakes in their recommendations. One prominent study found that during the period from 1996 to 2004, investors who relied on advisors harnessed a weighted average return of 2.9% annually, while investors who self-directed their portfolios reaped annual gains of 6.6%.¹

This period includes the major bear market related to the bursting of the tech bubble (2001–2002) and suggests that relying on a financial advisor to navigate us through a stormy period is less effective compared to relying on our own decision-making ability. By following a small cluster of basic principles, a do-it-yourself approach can be more successful than working with an FA. Thus, these researchers (Bergstresser, Chalmers, and Tufano) found that advisors’ asset allocations did worse than allocations investors made on their own, that advisors chased market trends, and that the investors whom they advised paid higher upfront charges.

It is common knowledge that 60%–75% of equity fund managers typically trail their benchmarks like the S&P 500 Index, and a 2013 study by J. P. Morgan indicated that 32% of such managers underperformed their benchmarks by 2.5% or more. This is further evidence that you can do better on your own by simply investing in benchmark indexes.

While performance history cannot reliably tell us which successful mutual funds will continue to be winners (most of them won’t), the history of the stock market can tell us with certainty that the general market trend will ebb and flow with peaks and valleys and that over time, like an incoming tide, the gains will exceed the losses. For example, in the thirty years from 1982 to 2012, despite several steep bear markets along the way, the DJIA climbed from 1,000 to 13,610.

Many investors were financially devastated by the stock market debacle of 2008, especially those who panicked toward the end of the relentless and vicious bear market and did not reenter the market at an opportune time in 2009. As a result, a disenchantment with stock market investing has prevailed in many quarters, as reflected in a 2013 Gallup poll that revealed that 52% of Americans owned stocks compared with a high of 65% in 2007, before the crash. A once-burned-twice-shy mentality may account for the decline in popularity of stock market investing, despite the consistent data that shows that the 9.6% average annual gains make the stock market an appealing place to invest. The reality is that the equity market, compared to other arenas of investing, has been generously rewarding to investors for nearly a century, but it is our self-sabotaging behavior that has limited the average return for many individual investors.

The stock market benchmarks, like the DJIA and the S&P 500 Index, have advanced more than 400% since the 2009 bear market lows, so those investors who stayed pat during the crash fared better than those who fled. However, they may have been successful for the wrong reasons. Instead of holding firm based on their belief in the long-term appreciation of equities, many were overwhelmed by a deer-in-the-headlights paralysis, wherein in the midst of the precipitous decline, they did not know what to do or where else to invest their assets. In effect, this group of investors feel lucky ultimately to have emerged unscathed rather than feeling wise for having made an active rather than passive decision based on a knowledge of bear market recoveries.

We are familiar with the John Templeton famous quote—this time it’s different are the four most expensive words in the English language. This reminder is often associated with investors who, during a bull market, fail to see the warning signs of an impending decline. However, this reminder can equally apply to the despair often felt during bear markets when investors fail to see that stocks do and will recover over time.

For example, the DJIA after peaking at 12,811 on April 29, 2011, trended downward for seven consecutive weeks, through June 26, 2011. This was a serious warning signal that all was not well in the stock market and presaged the collapse in early August with a 531-point DJIA drop on August 4, 2011, and another 635-point decline two trading days later (August 8, 2011). The latter was the sixth largest one-day decline in the history of the New York Stock Exchange (NYSE) on a huge volume of 2.5 billion shares. Nevertheless, Cassandra listeners would have taken comfort in knowing that downtrends clear up and resume an upward trend over time. This is precisely what happened, and by February 3, 2012, the Dow had set a new all-time record high of 12,862.

Selective Amnesia

Economist George C. Church has noted that "every generation has its characteristic folly, but the basic cause is the same: people persist in believing that what happened in the recent past will go on happening into the indefinite future, even when the ground is shifting under their feet" (italics mine). This tendency toward myopia is a form of selective amnesia, which many investors succumb to.

The philosopher Santayana has stated that those who cannot remember the past are condemned to repeat it. In stock market investing, unbridled euphoria during a bull market or doom-and-gloom despair during a bear market are examples of failing to remember the history of cyclical trends in the market and of falling prey to the pull of greed or fear in your decisions. At such times, our emotional reactions can color our judgment and undermine our ability to access our memory of historical sequences. Learning from past mistakes involves recognizing and remembering the role of self-defeating factors such as denial, unrealistic expectations about financial advisors’ talent and skill, rationalizations fueled by greed, being married to a stock, listening to fear-inducing noise, and the irrational exuberance of portfolio managers.

Selective amnesia is most often apparent during a roaring bull market when investors, in the grip of unbridled euphoria, distance themselves from the awareness of the devastating financial impact of a bear market. In the cyclical nature of the stock market, traders earn large returns during a powerful bull market phase, when stocks become overvalued and the benchmark S&P 500 Index rises excessively. Traders then suffer huge losses when the market periodically crashes. When you are immersed in the euphoria or despair of one side of the cycle, you tend to tune out on the rest of the spectrum, and the broader scenario becomes blurred. The once-burned-twice-shy mentality doesn’t work here because being on a winning streak is so emotionally intoxicating that it usually requires at least two scaldings before investors allow themselves to recognize and appreciate the rumbles of an imminent stock market bubble. When we are flying high, imbued with the power and thrill of stock-picking successes, it is seductively easy to underplay, minimize, or even forget about the lessons learned from the vicious crash of 1929 and, more recently, in 2000–2002 and 2008–2009. Similarly, selective amnesia during a downturn precludes having confidence that a reversion to the mean and a recovery will occur along with a resumption of the long-term upward bias.

Sometimes, we remember past stock market calamities but ignore the causes that led up to producing them. The public flocking to buy shares of worthless companies in 2000 because of their internet-sounding names and the role of indiscriminate mortgage-lending policies by banks in creating the housing bubble, which contributed to the crashes of 2001–2002 and 2008–2009 respectively, are cases in point. Such examples serve to repeat the mindset of selective inattention and thereby set the stage for the next round of misfortune.

The political history of the world is replete with this phenomenon. A stunning illustration is described in Erik Larson’s bestseller, In the Garden of Beasts. Larson highlights the Cassandra-like impact of William E. Dodd who served as the U.S. ambassador to Germany prior to the beginning of World War II. Upon returning to the U.S. in January 1938 after spending four and a half years in Berlin, Dodd warned about the dangers of Germany’s repressive totalitarian regime. In a well-attended speech, Dodd proclaimed, Mankind is in grave danger, but democratic governments seem not to know what to do. If they do nothing, Western civilization and religious, personal, and economic freedoms are in grave danger.² Larson maintains that Dodd embarked on a campaign to raise the alarm about Hitler and his plans, but he was not taken very seriously. Later, he would be referred to as the Cassandra of American diplomats.

Dodd foresaw that Hitler would annex Austria and then seek to seize Czechoslovakia and Poland. He also accurately predicted that Hitler would be free to pursue his territorial conquests without military resistance from neighboring European countries, which would choose concessions and appeasement over going to war. Dodd’s warnings predominantly were disregarded, and until the U.S. was pushed into World War II by the attack on Pearl Harbor, the isolationist rhetoric of Joseph Kennedy and Charles Lindbergh was widely embraced in America.

Selective Inattention

Selective inattention is a variable within the spectrum of selective amnesia. Michael Covel in his book Trend Following cites research by Ronald Rensink who states that a large fraction of traffic accidents are of the type ‘driver looked but failed to see.’ Here drivers collide with pedestrians in plain view, with cars directly in front of them and even run into trains. That’s right—run into trains, not the other way around. In such cases, information from the world is entering the driver’s eyes. But at some point along the way, this information is lost, causing the driver to lose connection with reality. They are looking, but they are not seeing.³

This type of inattention is often at play in the tuning out of warning signals about significant changes in the direction of the stock market. In the back of our mind, we know that corrections and even bear market downturns are inevitable, but in the throes of euphoria as our portfolios continue to rise, we suppress that awareness under the more powerful sway of greed and arrogance. The rubber-band effect tells us that when the market is overextended on the upside, the probability of a pause or correction increases. (Overextended can be measured by such factors as the distance of the DJIA from its six-month moving average or the length of time without a correction.) From the bear market low of 6,547 in March 2009 until the last day of December 2013, when the DJIA closed at a record high of 16,577, the benchmark average had appreciated 150%!

A correction of 16.6% in 2011 had temporarily slowed the stampede, but the bull regrouped, charged ahead, and by year-end 2013, it was once again overextended. Some respected observers began to sound a clarion call for danger. Jeff Sommer, a New York Times financial strategist, pointed out that the huge gain in 2013 prompted investors to feel like a genius as they watched their portfolios soar, but that stormier times are coming, probably fairly soon. Sommer noted that throughout the rise in 2012 and 2013, there was not a single day of a decline of 3%, a very unusual pattern; and in sounding the alarm, he concluded, What we’ve been experiencing is outside the typical range of market behavior over the last one hundred years.⁴ In a March 28, 2014 report, the Vanguard Group issued a warning that in view of the 30% run-up in 2013, History teaches us that it’s wise to anticipate a pullback in stocks after an extended winning streak.

But it is hard to listen to the cautionary message from our inner Cassandra, especially when we are on a winning streak. At such times, it is easier to operate with denial and to develop the illusion that the uptrend will continue. Historically, the crash of 1929 can be viewed as a prominent self-defeating episode for investors. The debacle was preceded by an era of unbridled optimism and enthusiasm for stocks and was characterized by the lack of attention to hovering storm clouds and warning signals. This climate was chronicled by Frederick Lewis Allen in his book Only Yesterday: An Informal History of the 1920s. In looking at the antecedents of the crash, Allen highlights the mindset of arrogance as the culprit that led people to ignore significant warning signals. He points out that as early as January 25, 1928, Moody’s Investor Service had stated that stock prices were far exceeding their companies’ anticipated values. "But the voices of skeptics were drowned out by general enthusiasm. This was a market that promised