You ever notice—
That some memories tend to be stronger than others?
What sort of things do you remember?
You remember events in your life that had a lot of feelings associated with them.
You remember the death of your pet like it was yesterday. All the nights spent sitting on the couch watching Wheel Of Fortune—it’s just a blur.
Researchers have studied this in rats. They found that rats remembered things better if they experienced a rush of adrenaline.
In those moments with strong memories, it feels like time slows down. Time doesn’t actually slow down—time is linear. But human beings experience time as flexible. Time also speeds up when things are boring.
I’m fond of saying that all of finance, or at least the interesting part, is about human behavior. I find the daily fluctuations of stocks and credit spreads less interesting the older I get. And I think finance is more depraved the older I get. But the human behavior part fascinates me.
The fact that time stretches and compresses isn’t news to anyone who’s traded options.
In the world of options, time and volatility work in opposite directions. As time passes, options decay. As volatility increases, options increase in value. All stuff you learned in class.
But if you think about it, volatility increasing is another way of saying that there’s a lot of s— going on. Things are crazy. Options increase in value—which is really like saying that time is slowing down.
Which is exactly how we experience it. Of all my days trading on Wall Street, what are the times that I remember most? The financial crisis, naturally. There was a lot of adrenaline associated with that.
We all have strong memories of it. And while we experienced it, it seemed like time was slowing down—which was reflected in options prices. They were the highest in recorded history.
If I think back over the last 10 years, what do I remember?
- The European crisis
- The US debt downgrade
- The Ebola scare
- The yuan devaluation
- The vol-splosion
All the crazy times. Nobody remembers the stuff in between. Old-timers like me remember all the way back to 1997 and 1998, with the Asian Financial Crisis and LTCM and the Russian debt default. It’s the accidents that help us mark our time in the markets.
We all perceive things differently. As I just demonstrated, we all perceive time differently.
We also might perceive color differently—we just don’t know. There is no way to know that the red I see is the red you see.
We all have different perspectives, especially when it comes to financial markets. I might find a stock attractive that you find unattractive. Happens all the time.
A lot of financial analysis is searching for some objective truth in the markets. This is what the value people try to do. They try to identify the correct value of a security and then buy it if it’s underpriced.
But there really is no objective truth in finance—just a set of ever-changing perspectives. Some examples:
Target is up over 90%, year to date:
Is Target’s business 90% better? Is it earning 90% more revenue? Of course not—more people find the stock attractive and fewer find it unattractive.
Pharmaceutical giant Bristol-Myers is up 48% in the last couple of months:
Again, is their business 50% better? No.
People have created several models to explain stock market behavior. Keynes’s beauty pageant is at the top of the list. I will always catch a beauty pageant if it’s on TV. The goal isn’t picking the most attractive contestant. It’s picking the contestant that the judges will find most attractive. It’s a great exercise.
But I don’t think that’s the right model.
I came up with my own model and gave it to the world on the Bloomberg Opinion page. You can read about it here. But I feel like it’s incomplete, too.
Sentiment also plays a role—big turning points are always at sentiment extremes.
I’m not sure what the answer is—or if there even is an answer. I think about it all the time. People smarter than me spend even more time thinking about it.
Maybe there is no Grand Unified Theory—maybe there are regimes in the financial markets, and sometimes some things work and sometimes other things work.
Maybe the rules change all the time and there is nothing we can do about it.
I am not even sure buy-and-hold and dollar-cost averaging will work going forward.
And that’s what you learn when you have 20 years of experience—that you actually know nothing.
That said, one thing I do know is that the adrenaline rush reckless traders get throwing money at “hot stocks” is not something to aspire to. It’s much better to even out your odds with a diversified, balanced portfolio and a long-term view.