Don't Frag Yourself ...

...or, How To Take Lemons and Turn Them Into a Large Pitcher of Margaritas.

Watching the flow of money has always fascinated me. It is astonishing how often money flows in predictable directions, even when the situation calls for the polar opposite movement. Whenever there is a crisis in a certain area, there is an inevitable abandonment of that sector and a sudden investment in "safety." But crisis always brings opportunity, if one spends a little time investigating the larger picture. The "safe" investment can vary, but it is almost always not anywhere near where the opportunity is, and often is a poor stand-alone investment. Following the crowd works when you need to go to the bathroom, but rarely is effective during an investment upheaval, because the crowd turns into lemmings and marches straight off a cliff, leaving the rewards to a small band of opportunistic traders who stay behind and sift through the wreckage looking for the opportunities.

Professor Robert Shiller of Yale University is at the forefront of a field of finance called behavioral finance, which examines how human emotions affect the process of making investment decisions. He has done a great deal of work to try to explain why the vast majority of investors will panic and sell at the bottom, or jump in and buy at the peak (after their hair stylist and landscaper have jumped in). 100+ years of market volatility have not changed the behavior of investors one lick; therefore there is something hardwired in many people that lead them to make poor decisions time and time again. The efficient markets hypothesis has as one of its core assumptions that humans are rational beings, and will act rationally in a variety of situations. Nothing could be further from the truth. The human race is lucky to still exist at all, given its abysmal history of rational decision making.

I don't think you can change the behavior of humans, but you sure can model it scientifically. It is possible to make accurate predictions of where money might flow in almost any situation. In the future, you will see us taking advantage of people's innate desire to self-destruct, although we are a few years away from that. Professor Shiller's work is still mostly in the theoretical stage; there are very few hedge funds taking full advantage of human irrationality. That is why there are winners and losers. If every poker player had the same style and same risk tolerance, then no one would make any money in the long run, they would just swap money around in the short term and break even in the long term. Therefore, poker would not exist.

It is important to know that because the vast majority of people get it wrong most of the time, there are investment opportunities created by this behavior alone. What companies are doing is also important, but not as important as knowing where the money will likely flow next. I've stopped wishing that people will behave rationally. We as a species are not capable of it. We don't need to be faster than the proverbial bear to get ahead, just faster than the guy next to us.