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JOHN ALLEN PAULOS Bestselling author of A MATHEMATICIAM READS THE NEWSPAPER and MATHEMATICIAN PLAYS T H E w - STOCK M A R K E T A Mathematician Plays the Stock Market Also by John Allen Paulos Mathematics and Humor (1 980) I Think Therefore I Laugh (1 985) Innumeracy: Mathematical Illiteracy and its Consequences (19 88) Beyond Numeracy: Ruminations of a Numbers Man (1 991) A Mathematician Reads the Newspaper (19 95) Once Upon a Number: The Hidden Mathematical Logic of Stories (1 998) A M a t h e m a t i c i a n Plays the Stock Market John Allen PauIos BOOKS A Member of the Perseus Books Group Copyright O 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 1 John Allen Paulos. p. cm. Includes bibliographical references and index. ISBN 0465-05480-3 (alk. paper) 1. Investments-Psychological aspects. 2. Stock exchanges-Psychological aspects. 3. Stock exchanges-Mathematical models. 4. Investment analysis. 5. Stocks. I. Title. 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." Contents 1 Anticipating Others'A nticipations 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 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 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 . PIE 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 e e 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 Index I I Anticipating Others'A nticipations I t was early 2000, the market was booming, and my invest- ments 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 port- folios. 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 2 John Allen Paulos successful devourer of high-tech telecommunications compa- nies. Bernie Ebbers, the founder and former CEO, is now viewed by many as a pirate, but then he was seen as a swash- buckler. I had read about the company, knew that high-tech guru George Gilder had been long and fervently singing its praises, and was aware that among its holdings were MCI, the huge long-distance telephone company, and UUNet, the "backbone" of the Internet. I spend a lot of time on the net (home is where you hang your @) so I found Gilder's lyrical writings on the "telecosm7' and the glories of unlimited band- width particularly seductive. I also knew that, unlike most dot-com companies with no money coming in and few customers, WorldCom had more than $25 billion in revenues and almost 25 million customers, and so when several people I knew told me that WorldCom was a "strong buy," I was receptive to their suggestion. Al- though the stock had recently fallen a little in price, it was, I was assured, likely to soon surpass its previous high of $64. If this was all there was to it, there would have been no im- portant financial consequences for me, and I wouldn't be writ- ing about the investment now, Alas, there was something else, or rather a whole series of "something elses." After buying the shares, I found myself idly wondering, why not buy more? I don't think of myself as a gambler, but I willed myself not to think, willed myself simply to act, willed myself to buy more shares of WCOM, shares that cost considerably more than the few I'd already bought. Nor were these the last shares I would buy. Usually a hardheaded fellow, I was nevertheless falling disastrously in love. Although my particular heartthrob was WCOM, almost all of what I will say about my experience is unfortunately appli- cable to many other stocks and many other investors. Wher- ever WCOM appears, you may wish to substitute the symbols
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