A Mathematician Plays The Stock Market

225 Pages·2003·9.1 MB·English

by  John Allen Paulos

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."
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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 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