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THE PSYCHOLOGY OF CORRECTIONS (Author Unknown)
Homer's epic story of Odysseus' wanderings in the west, as he tries to find his way home after victory in Troy, is a book every investor should read (the Robert Fagles translation is the best). For it captures metaphorically the long-term struggle of investors as they navigate their ships through "the twists and turns" of uncharted waters, with all its bewitching temptations, magical successes, and monstrous losses.

Many cities of men he saw and learned their minds, many pains he suffered, heartsick on the open sea, fighting to save his life and bring his comrades home. But he could not save them from disaster, hard as he strove-- the recklessness of their own ways destroyed them all, the blind fools, they devoured the castle of the Sun and the Sungod blotted out the day of their return.

Reading the Odyssey one learns how fragments of an individual's experience are woven together, either supporting our long term goals and ambitions or unconsciously undermining our efforts and needlessly complicating our journeys. Even a resourceful veteran of a ten-year war, Odysseus was "driven time and again off course, once he had plundered the hallowed heights of Troy."

What drives most investors off course is the sudden onset of a correction. This significant decline in a bull market (or significant advance in a bear market) evokes a myriad of emotional reactions: anxiety, panic, euphoria, relief, hope, despair, self-blame, anger. What underlies these ephemeral psychological states is usually an intense feeling of uncertainty stimulated by one's own inability to organize what is happening in the market into some coherent idea to guide our actions. Investors fear holding their position because a correction in a bull market may turn out to be the beginning of a bear market; and they fear selling because of capital losses, transaction costs, and concern about missing the resumption of the bullish tend.

Corrections

Corrections (in a bull market) are generally defined as market declines which retreat 30%-60% of the advance from the last correction bottom. In general this retreat typically means a 5%-15% decline from the market's recent high. Corrections can occur over a 2-8 month period, although most corrections last 3 weeks to 3 months. Such retreats occur because of a combination of psychological and cyclical factors. Vic Sparandeo, in his book, Trader Vic--Methods of a Wall Street Master (worth reading) quotes Robert Rhea, from his now famous book on Dow Theory, suggesting that corrections are analogous to release valves on a boiler system. In other words, they allow the excess build up of hopes and expectations an escape route so that severe internal pressures do not destroy the market.

The primary question in all such corrections, however, is whether the drop in prices is the first leg down in a bear market or whether it is merely a short interruption in a major upward trend. Hindsight is always very accurate. If the market drops 5%-15% and resumes its upward momentum, we look back and call it a correction; if the market attempts to rally and fails, then retreats a total of 25%-30%, we call it a cyclical bear market; and if the market continues its free fall 45%-50% over a prolonged period, we call it a secular bear market.

Corrections, as opposed to most bear markets, tend to occur as steep and sudden declines in market averages and individual stocks; but the volume levels in correction phases tend to decrease as the market drops. Bear markets, in general, are slower to develop and have increasing volume as the decline continues. Bear markets usually produce fear; corrections typically evoke anxiety.

Predicting Corrections

To my knowledge, no investor has predicted ahead of time, with any accuracy over a ten-year period, whether a correction is in fact the first leg of a bear market. Most advisors keep track of a plethora of statistics, which encompass technical indicators (price and volume measures, advance/decline line), monetary policy (changes in interest rates, money supply, free reserves), fundamentals (P/E ratios, dividend yields, stock offerings and buy backs), smart money trades (insider trading, short selling), contrary indicators (news comments, investor sentiment poles, put/call ratios), the state of the economy, political factors, and the psychology of market participants. This data is available to all market participants. Most of it can be found in weekly or daily publications such as Barron's, Investor's Business Daily, and the Wall Street Journal. The fact that all information is so readily available with computer like speed means that market events unfold more quickly than formerly. But even computers are not yet sophisticated enough to accurately account for the correct weighting of all the variables. In addition, the fact that all this data must eventually be interpreted by human beings, who are influenced by their own beliefs and psychology, means that most advisors will appear prescient and omnipotent on occasion and dead wrong the remainder of the time.

What are we to make of this phenomenon? Those advisors and media pundits who continually predict corrections and bear markets know that if they make outrageous statements and happen to be correct, they will be remembered for a long time. If they turn out to be wrong, their predictions will be quickly forgotten. So there is a psychological motivation in issuing public pronouncements. Warren Buffet, perhaps the most successful investor of this century, offers an historical antidote to these attempts to predict corrections. In his 1994 Berkshire Hathaway annual report, Buffet writes that "Coke went public in 1919 at $40 per share. By the end of 1920 the market, coldly reevaluating Coke's future prospects, had battered the stock down by more than 50%, to $19.50. At year end 1993, that single share, with dividends reinvested, was worth more than $2.1 million." Buffet goes on to quote Ben Graham as saying: "In the short-run, the market is a voting machine--reflecting a voter-registration test that requires only money, not intelligence or emotional stability--but in the long-run, the market is a weighing machine."

Psychological Factors

Emotional stability is the primary force, which prevents disaster during a correction. Such stability means not yielding to the characteristic psychological reactions during this period. While there are numerous psychological traps for investors during any correction, the following three are perhaps the most common ones.

Scapegoating

Every correction engenders a psychological need to blame someone. Both the suddenness of onset, and the anxiety experienced, leaves the investor temporarily feeling like the small child who, while running into the kitchen, bumps into a table and is furious at either the table for being there or the parent who put it there. "My broker should have told me," or "The CEO knew this was going to happen," or "The analyst's timing was dead wrong,"or "It was only a stock promotion." As Zeus stated in the Odyssey,

Ah how shameless--the way these mortals blame the gods.
From us alone, they say, come all their miseries, yes,
But they themselves, with there own reckless ways,
Compound their pains beyond their proper share.

The psychological scapegoating of others absorbs that time and energy which should be directed at understanding the fundamentals of one's own stocks and the monetary, valuation, and psychology legs of the market

The Primacy of Negative News

It is a psychological axiom that human beings pay much more attention to negative than positive news. There is a human fascination with suffering, loss, catastrophe, and the ills of others. Sometimes this pre-occupation is merely out of guilt, as when we stare at a handicapped person, not wanting to admit "better you than me." Sometimes the pre-occupation is related to complex feelings of jealousy and fear. In either case, our fascination with the negative is the reason the media emphasizes disaster and often feature those market gurus who are fond of predicting gloom and doom.

The proclivity toward believing negative news, when combined with the human tendency to place the highest value on most recent information generally creates undue pessimism in the investment community. Not only is this true with regard to broad market corrections, it is even more relevant to corrections in individual stocks.

Rumors and Gossip

Because any correction is perceived as a crisis by most investors, there is a natural tendency for individuals to retreat to herds for protection, just as our evolutionary history teaches. As the goddess Athena suggested, within herds,

Someone may tell you something
Or you may catch a rumor straight from Zeus,
Rumor that carries news to men like nothing else.

__________________
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