December 9th, 2009

Far From Random

I don’t usually do book reviews but decided to make an exception for this one I just ran across. I strongly recommend it if you’re interested in getting a better understanding of how and why you, as an investor, make the decisions you do and why stock charts perform the way they do. The book, “Far From Random” by Richard Lehman, was published by Bloomberg Press earlier this year.

The book is organized in three parts: the first part is an excellent critique of fundamental analysis and including its shortcomings. In the same way that the advocates of fundamental analysis ridicule and attempt to debunk technical analysis, Lehman dissects the academic concepts of Efficient Market Theory and Random Walk and why the various techniques fundamental analysts use to assemble their fair market valuations of individual stocks just don’t work.

Lehman then turns his attention to the question of market timing. He underscores the inconsistency of Wall Street professionals (of which he was one for 30 years before switching to academia himself) who instruct individual investors to sell stocks when they become overvalued but never apply the same discipline to markets (time the market, sell stocks and move into cash) when they become overvalued as was the case at the end of 2007 and beginning of 2008, the beginning of the Financial Crises melt down.

The next part of the book, its guts and essence and the part I think is the best, deals with a form of stock market research that few individual investors are aware of: the study of behavioral finance, a discipline that began thirty years ago among behavioral psychologists and now includes countless research reports and findings. “Many aspects of human behavior, when aggregated over a large number of people, can be indeed be quantified”, writes Lehman. He then proceeds to define many (investor) behaviors impacting stock prices and trends:

  • Ambiguity Aversion: people will give something up in order to have something more certain….people underweight outcomes that are merely probable compared with outcomes that are certain.
  • Anchoring: people put mental stakes in the ground on a reference point that forms the basis of quantitative estimates such as stock prices…for example, anchoring purchase price when considering what we are willing to sell for.
  • Disposition Effect: causes people to be heavily biased in favor of disposing (selling) a stock or other asset to realize a gain and against disposing to realize a loss.
  • Mental Accounting: people mentally categorize their money differently according to time horizon, levels of wealth, life changes, family changes.
  • Gambler’s Fallacy: wagering that after seeing a streak, that the gambler (investor) assumes there’s a high probability that the streak (of black/up days) will end and reverse (to red/down days).

These are just five of 23 psychological factors impact investors’ buying and selling decisions. If I’m honest to myself, I can find many in my own trading history. I realize that many of the rules and disciplines I’d created to guide my trading are aimed to neutralize the most damaging of these behavioral phenomenon.

The final part, what Lehman calls “Trend Channel Analysis”, is the weakest and most narrow (no pun intended). He focuses on trading channels (movement between parallel trendlines) to track momentum in one direction to the exclusion of other tools that, I believe, better identify turns in momentum direction. As readers know, I use moving averages (simultaneously four different time horizons to confim each other) in conjunction with trendlines (support and resistance variety over channels).

The book is just over 200 pages and is a relatively easy read. It will improve your investing experience by helping you understand how and why you currently make the decisions you do.