Table Of Content

A Mathematician Plays the Stock Market Also by John Allen Paulos Mathematics and Humor (1980) I Think Therefore I Laugh (1985) Innumeracy: Mathematical Illiteracy and its Consequences (1988) Beyond Numeracy: Ruminations of a Numbers Man (1991) A Mathematician Reads the Newspaper (1995) Once Upon a Number: The Hidden Mathematical Logic of Stories (1998) A Mathematician Plays the Playst heS tock Market John Allen Paulos BASIC B BOOKS A Member of the Perseus Books Group Copyright © 2003 by John Allen Paulos Published by Basic Books, A Member of the Perseus Books Group All rights reserved. Printed in the United States of America. No part of this book may be reproduced in any manner whatsoever without written permission except in the case of brief quotations embodied in critical articles and reviews. For information, address Basic Books, 387 Park Avenue South, New York, NY 10016-8810. Designed by Trish Wilkinson Set in 11-point Sabon by the Perseus Books Group Library of Congress Cataloging-in-Publication Data Paulos, John Allen. A mathematician plays the stock market / John Allen Paulos. p. cm. Includes bibliographical references and index. ISBN 0-465-05480-3 (alk. paper) 1. Investments—Psychological aspects. 2. Stock exchanges—Psychological aspects. 3. Stock exchanges—Mathematical models. 4. Investment analysis. 5. Stocks. I. Title. HG4515.15.P38 2003 332.63'2042—dc21 2002156215 03 04 05 /10 9 8 7 6 5 4 3 2 1 To my father, who never played the market and knew little about probability, yet understood one of the prime lessons of both. "Uncertainty," he would say, "is the only certainty there is, and knowing how to live with insecurity is the only security." This page intentionally left blank Contents 1 Anticipating Others' Anticipations 1 Falling in Love with WorldCom • Being Right Versus Being Right About the Market • My Pedagogical Cruelty • Common Knowledge, Jealousy, and Mar- ket Sell-Offs 2 Fear, Greed, and Cognitive Illusions 13 Averaging Down or Catching a Falling Knife? • Emo- tional Overreactions and Homo Economicus • Be- havioral Finance • Psychological Foibles, A List • Self-Fulfilling Beliefs and Data Mining • Rumors and Online Chatrooms • Pump and Dump, Short and Distort 3 Trends, Crowds, and Waves 37 Technical Analysis: Following the Followers • The Euro and the Golden Ratio • Moving Averages, Big Picture • Resistance and Support and All That • Pre- dictability and Trends • Technical Strategies and Blackjack • Winning Through Losing? 4 Chance and Efficient Markets 57 Geniuses, Idiots, or Neither • Efficiency and Random Walks • Pennies and the Perception of Pattern • A Stock-Newsletter Scam • Decimals and Other Changes • Benford's Law and Looking Out for Num- ber One • The Numbers Man—A Screen Treatment vii viii Contents 5 Value Investing and Fundamental Analysis 85 e is the Root of All Money • The Fundamentalists' Creed: You Get What You Pay For • Ponzi and the Irrational Discounting of the Future • Average Riches, Likely Poverty • Fat Stocks, Fat People, and P/E • Contrarian Investing and the Sports Illustrated Cover Jinx • Accounting Practices, WorldCom's Problems 6 Options, Risk, and Volatility 117 Options and the Calls of the Wild • The Lure of Ille- gal Leverage • Short-Selling, Margin Buying, and Fa- milial Finances • Are Insider Trading and Stock Manipulation So Bad? • Expected Value, Not Value Expected • What's Normal? Not Six Sigma 7 Diversifying Stock Portfolios 141 A Reminiscence and a Parable • Are Stocks Less Risky Than Bonds? • The St. Petersburg Paradox and Utility • Portfolios: Benefiting from the Hatfields and McCoys • Diversification and Politically Incor- rect Funds • Beta—Is It Better? 8 Connectedness and Chaotic Price Movements 163 Insider Trading and Subterranean Information Pro- cessing • Trading Strategies, Whim, and Ant Behav- ior • Chaos and Unpredictability • Extreme Price Movements, Power Laws, and the Web • Economic Disparities and Media Disproportions 9 From Paradox to Complexity 187 The Paradoxical Efficient Market Hypothesis • The Prisoner's Dilemma and the Market • Pushing the Complexity Horizon • Game Theory and Super- natural Investor/Psychologists • Absurd Emails and the WorldCom Denouement Bibliography 203 Index 205 Anticipating Others' Anticipations It was early 2000, the market was booming, and my investments in various index funds were doing well but not gener- ating much excitement. Why investments should generate excitement is another issue, but it seemed that many people were genuinely enjoying the active management of their portfolios. So when I received a small and totally unexpected chunk of money, I placed it into what Richard Thaler, a be- havioral economist I'll return to later, calls a separate mental account. I considered it, in effect, "mad money." Nothing distinguished the money from other assets of mine except this private designation, but being so classified made my modest windfall more vulnerable to whim. In this case it entrained a series of ill-fated investment decisions that, even now, are excruciating to recall. The psychological ease with which such funds tend to be spent was no doubt a factor in my using the unexpected money to buy some shares of WorldCom (abbreviated WCOM), "the pre-eminent global communica- tions company for the digital generation," as its ads boasted, at $47 per share. (Hereafter I'll generally use WCOM to refer to the stock and WorldCom to refer to the company.) Today, of course, WorldCom is synonymous with business fraud, but in the halcyon late 1990s it seemed an irrepressibly