Since Princeton psychologist Daniel Kahneman won the 2002 Nobel Prize in economic sciences much attention has been given to studying behavioral finance, behavioral economics, the psychology of investing,
and other neurosciences, including neuro-marketing and the new science
of irrationality. Though new and often kept hidden as proprietary
secrets in the case of quants, it is now clear that Wall Street is
using these tools to manipulate and control Main Street investors in
subtle and sophisticated ways—structuring fund portfolios, making
buy/sell/trade decisions, designing new funds, developing marketing
campaigns, training brokers and other clever ways to manipulate Main
Street investors. Here’s how the new psych-ops strategies play out in
the mind of one major Wall Street banker.

A few years ago, as the mutual funds scandals were peaking, with dozens of fund companies implicated in illegal activities, Andrew Spencer, chief investment officer of J.P. Morgan Chase’s Fleming asset
management arm, was interviewed in a Forbes article, “Madness
of Crowds.” So what did this senior Wall Street banker think about the
American investor? Spencer said: “Investors are stupid.” Today most
Wall Street insiders are a bit more circumspect in their choice of
words, but yes, he clearly said that “investors are stupid.” Spencer is
unquestionably one of the new breed of behavioral finance experts now
running Wall Street, guys who believe investors constantly make
irrational decisions when buying, selling and trading their hard-earned
money for securities. But before you get angry at guys like him, you
need to understand the equally “stupid” mindset of the Spencers and the
J.P. Morgan Chase Flemings out there.

Wall Street’s goal: Rationally predict irrational behavior

Like all Wall Street behaviorists, Spencer believes that even though investors are irrational, their irrational behavior can be predicted by portfolio managers using rational technologies! Let me restate that for
emphasis: These behavioral finance quant hot-shots are convinced
they’re so far ahead of you and me that they can “rationally” predict our “irrational” behavior and the irrational behavior of America’s 95 million investors.Yes I know, that sounds circular, tautological, like an oxymoron, an obviously self-contradictory phrase.

But the truth is, that’s exactly what the behaviorists are doing with their high-tech math algorithms: They are rationally predicting the irrational behavior of the markets and its irrational investors.
For example, for years Spencer observed that investors hang onto stocks
long after any rational person should—long after it is obvious that
those losers should be dumped. But instead, investors tend to hang on,
and on, and on …. And the same goes for the upside. Investors don’t buy
until stocks are way overvalued, near a peak. Like hanging onto tech
stocks from the manic days of the nineties well into the bear years,
not willing to take their losses and admit they made a mistake, praying
they’d come back.

Wall Street’s taking advantage of America’s “stupidity”

Thanks to their perceived ability to predict irrational behavior, Spencer and other behaviorists make money by trading on the “anomalies” created by the irrational behavior of investors. Their strategy is
simple. In blunt terms, their goal is to take advantage of the inherent
“stupidity” of the vast majority of American investors. But the
“problem” for most investors is that they’d need a million bucks to buy
into one of his funds. There are a few other problems: For one thing,
turnover and capital gains are high, so his funds work best for
tax-free retirement accounts and high-net worth individuals, which
protects and leaves out most of America’s “stupid” investors. Secondly,
management expenses are high, in the range of 1.5 percent. Then there’s
this clincher: Spencer’s funds were performing just a little ahead of
the S&P 500, which suggests that maybe a simple garden-variety
no-hassle index fund would do just as well for most passive investors.

Behavioral finance—new wine in old bottles?

Something else caught my eye: The way Spencer, an avowed behaviorist, picks which stocks to track, analyze and pick using momentum trading. He may have been doing well, but it reveals even more
about how stupid he thinks investors are. He said “earning surprises”—changes in analysts estimates either up or down—are
a big factor in his stock-picking strategy. He sells when a company
downgrades estimates, buys when estimates are revised up. 

His reasoning is simple. Research analysts are no different than average investors, they have their own quirky “stupid” behaviors too. These pros are supposed to be super-savvy about the stock market … but
like us, they’re “too often overly optimistic” and slow to downgrade
because they’re human and hate to admit they’ve made mistakes, which is
also a “stupid” and irrational behavior And, of course, we know that
securities analysts have an huge bullish bias, so strong they’ll have a
panic attack before uttering the word “sell.”

Warning, the blind are leading the blind

Spencer’s reliance on earnings suprises reminded me of the Zacks Investment Research team and the importance they’ve always placed on earnings surprises. And while market timing and day trading are not
strategies I’d recommend to passive investors, successful traders are
familiar with Zacks excellent research.

Here’s why. First, you begin with the same basic premises as a behaviorist that investors are irrational, or “stupid” if you prefer Spencer’s blunt profile. Next, add in the fact that even though
analysts have their own irrational blind spots and biases, a lot of
institutions, banks, brokers, pension plans, and money managers also
buy and rely heavily on the research generated by these analysts, and
therefore, all this irrationality is constantly recycled over and over
throughout the markets, with Wall Street’s hot-shots behaving as
equally blind as Main Street’s investors, except with more
sophisticated weaponry. In fact, in Ahead of the Market,
Mitch Zacks writes that Wall Street’s geniuses pay over a billion every
year for the research generated by all these irrational analysts. They
pay because they know that all the irrational investors will follow the
irrational analysts’ estimates—like lemmings over the cliff!

Yes, you can beat ‘em at their own game

So if you want to win in this particular game of market timing and short-term trading, you really need expert folks like the Zacks team working for you. Much in the same vein that Spencer says
he is rationally analyzing the irrational behavior of stupid Main
Street investors, the Zacks team is analyzing the irrational behavior
of Wall Street’s irrational stock analysts.

Zacks research tells them that stocks highly recommended by analysts tend to outperform in a rising market and under-perform in a declining market. “This has as much to do with the behavior of investors as it
does with the stock-picking ability of the analysts.” Translation: The
herd instinct is at work at all levels of America’s irrational
markets—because irrational investors tend to buy whatever irrational
analysts are recommending to irrational brokers working for irrational
Wall Street bankers.

One way traders get ahead of all the “irrational investors”

So Zacks is “ahead of the market,” that is, able to predict which stocks are likely to move up or down by tracking the revised estimates analysts are making in the months leading up to the actual earnings reports. That’s right: From the 1980’s through 2003, Zacks research
concluded that returns did in fact increase an average of 20.1 percent
whenever a consensus estimate was raised by analysts. And when analysts
estimates were slashed returns dropped an average of 4.2 percent.

In short, the herd plays follow-the-leader, up and down. And Zacks is using analyst behavior in much the same way as the higher-priced Spencer is doing with investor behavior, as a signal and measurement of future irrational behavior. Zacks Research ranks stocks relative to their probably performance in
the coming months. Their rankings are based on four criteria that make
up analysts’ consensus earnings estimates. Using these four criteria,
Zacks ranks a stock from a “strong buy” to a “strong sell.” Moreover,
the numbers speak for themselves, an equal number at both ends of the
spectrum, the system is unbiased: “In many cases,” says Mitch, “the
Zacks Rank is the earliest possible signal you will receive about the
future potential of a stock,” up or down.

Works for passive long-term investors too

Now here’s the best part, the system works for long-term investors: “We have discovered that many companies experience extended cycles of positive earnings momentum that lead to multiple
quarters with a high Zacks Rank,” which will help investors “uncover
profitable long-term holdings as well as short-term trading
opportunities.” Anyone who reads my stuff on a regular basis knows it
takes a lot to get me to say something favorable about anything that
resembles market timing and day trading. But if an investor insists on
trading stocks, you should know about Zacks. Read Mitch’s book, it is
probably the simplest and easiest-to-read explanation you’ll ever get
about adding a little of rationality to the irrational business of
market timing, trading—in order to compete against the Spencers, the
J.P. Morgan Chase Flemings and other behavioral finance guurs who are
convinced that all investors are both stupid and irrational.