The Anxious Investor

Building Wealth in Uncertain Times

Scott Nations

• Publisher: William Morrow
• Year: 2022
• ISBN:
  9780063067622
• Topic: Développement personnel
• Subtopic: Finances personnelles

A revelatory new guide to becoming a smarter investor, drawing upon behavioral psychology, economic modeling, and market history to offer practical advice for reaching your financial goals

"With the equity and fixed-income markets off to a rough start in 2022, investors might do well to review the lessons shared in Mr. Nations's book." — Wall Street Journal

The human brain is ill-suited to making wise investment decisions. We are overconfident in our own knowledge and hunches, terrible at assessing risk, and prone to chasing financial thrills rather than measured long-term goals. Making matters worse, periods of severe market turbulence—whether the dotcom bubble of the late 90's, the Great Recession a decade later, or the brief, vertiginous COVID crash of 2020—bring out our most irrational selves, at the exact moment when the consequences for investment mistakes are most severe.

Scott Nations has spent his career studying market volatility. His firm, Nations Indexes, is the world's leading independent developer of volatility and option-enhanced indexes. In The Anxious Investor, he teaches readers how to understand markets, master their own fear, and make the most of their money. Drawing upon cutting-edge research in behavioral psychology, Nations shows that the secrets to excellent investing lie in mastering the quirks of human psychology. How are some investors able to make prudent decisions under pressure, while others rely on gut instinct to disastrous effect? How can we prepare for a market crash before it happens? And what can help us stay the course when the waters get choppy? Using the stories of three infamous market bubbles as his backdrop, Nations offers readers history's hard-earned lessons about greed, volatility, and value.

Whether you're saving for retirement, a home, or a child's college education, The Anxious Investor offers a blueprint for achieving your goals. While we can never know exactly which financial surprises may loom ahead, here is an indispensable resource for investors to make sense of them.

Chapter 1

Fear

He was an old man now. He had never been tall—he was so small and underweight at birth that he was not expected to live out the day—and at seventy-eight, he was stooped with age. His unusually small head did not add to his stature, but the silver-gray hair that fell to his shoulders concealed a formidable intellect.

His first name was almost certainly Isaac, although some say it may have been Lawrence, and a few say without much evidence that his last name was James. We know he lived in London in considerable prosperity, having accumulated a sizeable fortune for himself after turning from academia to finance twenty-five years before our story begins in 1720, a transition many have made since. In 1696 he had been named Warden of the Royal Mint, where one responsibility was investigating and prosecuting counterfeiters—at least two dozen were executed for the crime during his tenure. In 1699 he was promoted to Master of the Royal Mint and was paid £2,000 annually in salary and commission, equivalent to about $2 million today and about twenty times more than he had earned while teaching at university. He had no children—he never married—but maintained a comfortable household supervised by his half-niece.

After more than two decades as Master of the Mint, Isaac in 1720 had a net worth of about £30,000. Like many wealthy men his age, he invested conservatively. Most of his holdings were government bonds and shares of the few large, stable joint stock companies that were offered to the public. These included the Bank of England, which was founded as a private concern in 1694 to act as banker for the British government, and the South Sea Company.

Despite its fanciful name, the South Sea Company conducted a humdrum but immense and necessary business. In 1711, the British government had been groaning under approximately £10 million of debt (the precise amount was unknown) owed to creditors and contractors (the precise number was unknowable) who had supplied the British military during the War of Spanish Succession. The conflict had commenced when King Charles II of Spain died in 1700 without an heir. France and Great Britain maneuvered to fold Spain into their respective empires, battling for more than a decade at sites sprinkled across Western Europe. It was an enormously costly war.

The British government’s financing of its various wars had always been haphazard because it lacked a unified budget and central treasury despite the scale of disbursements foreign war required. Each department would borrow and spend as it saw fit and the exigencies of a foreign war fought on multiple fronts which were separated by hundreds of miles, resulted in military quartermasters buying whatever materiel was needed to support the army in the field—on credit—at whatever prices were demanded and whenever it could be found. When the war limped to a close, four hundred thousand had been killed and Great Britain had spent £30 million, one-third of which was still owed to creditors a decade later.

The South Sea Company was formed as a private company in 1711 to help the government deal with the growing problem. The plan was for holders of government debt to swap their debt for shares in the company which would receive payment of interest from the government and pass it along to shareholders after keeping a small portion for itself. Each full share of stock would represent £100 in converted debt, and the shareholder would collect £6 in interest each year. Fractional shares were given to those who converted smaller amounts of debt. The share price would fluctuate around £100 as interest rates changed and as the £6 annual interest payment became relatively more or less valuable, but during the years immediately after conversion, the price of one South Sea share never strayed very far from £100.

The conversion of illiquid individual IOUs into readily tradeable shares was immensely attractive to investors despite the small percentage the company kept. The deal also promised to be a boon for the British government which would now deal with a single large creditor, the South Sea Company, rather than thousands of tiny ones. The government expected the arrangement would be so advantageous that it was anxious to get as many debt holders to go along as possible so it agreed to sweeten the deal; the company would be granted a monopoly on the potentially lucrative trade with South America—hence the name South Sea Company—and any profits from that trade would augment the interest payments made to shareholders.

Daniel Defoe, a well-known English journalist who published on a variety of topics including money and finance (despite having gone bankrupt in 1692 and spending at least two stints in debtors’ prison), was typical of the many who were enthusiastic about the prospects for the company in light of the monopoly on trade with South America. In 1711 he wrote that the South Sea trade would “open such a Vein of Riches, will return such Wealth, as, in a few years, will make us more than sufficient Amends for the vast Expenses [sic].” Despite his previous financial misadventures, Defoe’s hope, and the hope of all shareholders, was that eventually ships belonging to the company would deliver British manufactured goods to South American shores and return heaped with gold and silver from Bolivia, Mexico, and Peru, transforming the plodding business of collecting interest from the government and forwarding it to shareholders into a dynamic one focused on its monopoly on trade.

Unfortunately, the company’s overseas trading was never very lucrative. The same treaty that ended the war also limited British trade with South America to a single shipload each year—and even then, the profit had to be shared with the new king of Spain. The only portion of trade with South America that the company could conduct without interference was the asiento, the right to import slaves from Africa. In addition to being grotesque, even that was never very profitable. Defoe would ultimately make out better in the South Sea. In 1719, he used the northeast coast of South America as a setting for his acclaimed novel Robinson Crusoe.

Its promise of great riches thwarted, the South Sea Company lumbered along, spending nearly a decade focused pleasantly on the business of collecting interest payments from the Crown and forwarding them to shareholders. It was profitable, if quiet, and since the British government had plenty of debt and little discipline in paying it back or avoiding the wars that spawned more of it, there was always additional raw material for the company to convert into shares.

More of that raw material was ripe for conversion in 1719. Even before the War of Spanish Succession, the Nine Years War with France, which had commenced in 1688, predictably drained the Exchequer and left it in debt. In 1694, Thomas Neale, the royal retainer responsible for organizing and supervising gambling in the court of King William III, hit on the idea of a “lottery loan” to cover the shortfall. Tickets cost £10 and winning numbers were drawn by chance. Every ticket holder got at least a £1 annuity for sixteen years and the luckier players would receive an additional annuity totaling between £10 and £1,000—an immense windfall in a time when a common laborer might earn £20 a year. That initial lottery raised £1 million through ticket sales, so Britain naturally did it again, and again. Between 1703 and 1715, another £10 million had been borrowed through lottery loans with similar terms.

Of course, Neale had not invented the lottery as a means of raising revenue. The Old Testament describes distributing land according to a random drawing and municipal governments in the coastal region of northwestern Europe, including modern-day Belgium, Luxembourg, and the Netherlands, had instituted lotteries to finance civic investment more than two centuries earlier. But Neale, who through his gambling post may have understood some of the general public’s more degenerate impulses, would take it further than anyone had before.

It is likely easy to remember a moment when you were not completely rational about money. Nonetheless, the theoretical construct that economists latched onto in the 1950s, and which many still embrace stridently today, assumes that we remain rational. This concept conveniently does away with much of the computational messiness of economics, as qualitative issues such as idiosyncratic consumer preferences and John Maynard Keynes’s “animal spirits” gave way to a purely quantitative, inhuman approach.

Prior to the 1950s, human emotion and frailty had been part of the canon of economics for hundreds of years. In the eighteenth century, Adam Smith, the Scottish economist sometimes called the father of modern economics, wrote not of capitalism but of “commercial society” which contained a healthy portion of human altruism. One hundred and sixty years later Keynes was the first to apply the old concept of animal spirits to economics. Acknowledging that financial speculation itself results in “instability,” he went on to posit that there is also “instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits.” Keynes defined animal spirits as “a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.”

Thomas Neale, the royal pit boss, understood this well. He created the lottery loan because it relied on sensation seeking, emotions, hope, and animal spirits—the urge to do something rather than nothing—to separate investors from their money.

When our minds are focused on some new, intense sensation, such as a bet or speculation that has the potential for profit, our brain releases a swirl of chemicals bringing about a blissful feeling. One of these chemicals is adrenaline which increases the heart rate which in turn increases the amount of oxygen reaching the brain. This enhances energy levels and mental focus. Another chemical released as a result of new sensations is dopamine, sometimes called the “feel-good” neurotransmitter, which contributes to a general feeling of happiness and pleasure. Others include the endorphins which ease physical pain and are responsible for the feeling of euphoria some feel after exercising.

We naturally want more of this feeling. Some of the activities that produce it, such as roller coasters, exotic travel, and horror movies, are harmless, while others, including illicit drug use, clearly are not harmless. Still others fall somewhere in between. These include drinking alcohol and trading on the stock market.

Economists have been confounded for decades by the volume of stock trading that takes place each day. In theory, the market reflects the equilibrium price for any stock at each moment in time. That equilibrium price should change, and trading should occur, only when something fundamental has changed for the company. This might be the announcement of an uptick in sales or the release of a new product—but those events are infrequent. Even if more frequent changes in interest rates drive some investors to change their opinions regarding the valuation of a stock, it should, in theory, experience trading activity maybe a couple dozen times a year. It would occur around quarterly earnings announcements, other corporate news, Federal Reserve meetings, and the release of macroeconomic data such as the unemployment rate. Instead, investors trade millions of times each day in volumes surpassing billions of shares. This trading cannot be explained by the economists who believe humans are purely rational. But it is logical if it is driven by “a spontaneous urge to action” or animal spirits.

One academic theory for this spontaneous urge is sensation seeking which is the tendency to pursue novel, intense, and varied feelings and experiences that are generally associated with real or imagined physical and financial risks. The quintessential examples beyond roller coasters, scary movies, and drugs are driving too fast and casino gambling. Given that the odds of winning are firmly in the casino’s favor, the only logical rationale for gambling, euphemistically called “entertainment,” is sensation seeking. We generally don’t think of investing as a source of entertainment or thrills. But is it?

A study titled “Sensation-Seeking and Hedge Funds” examined the automobiles purchased by hedge fund managers and discovered many managers were sparked by sensation seeking when buying a car. According to the authors, hedge fund managers who owned high-performance sports cars took on more investment risk than their colleagues but did not generate commensurately higher returns. Even worse, funds managed by owners of high-performance sports cars were more likely to fail. These managers preferred unusual investment strategies such as investing in high-risk stocks that had a low probability of appreciation, appropriately called “lottery-like” stocks, and they traded more often. To be specific, hedge fund managers who drove sports cars took 11 percent more risk than hedge fund managers who drove minivans. These decisions make sense if you’re looking for a thrill but not if you are striving for the best possible investment returns.

A study of driving patterns among individual investors in Finland from 1995 through 2002 demonstrated that those who incurred more speeding tickets were more likely to make stock trades. For each speeding ticket received by a subject of the study, the number of trades they executed increased by nearly 10 percent.

Maybe the best proof of the link between trading and sensation seeking comes from Asia. In January 2002, Taiwan introduced three new “Public Interest” lotteries with scratch-off cards, twice-weekly computerized games, and a bimonthly traditional lottery. They were seen as harmless fun in a country that loves gambling yet still outlaws casinos. Stock market trading in Taiwan declined by 25 percent when these lotteries were launched.

Trading stocks for entertainment naturally makes a game out of it. Investing shouldn’t be an ordeal, but individual investors who do it for the thrill are likely to be less successful. Sensation-seeking traders aren’t crazy; they’re just playing a different game than the deliberate, thoughtful investor who’s trying to fund a child’s education or their own retirement. Sensation-seeking traders are after the thrill, the shot of specific chemicals released by the brain, not the long-term accumulation of wealth.

Investors should ask themselves if they have a tendency to make a gamble of the market and trade for the sensation of it. If they do, they should remember this quote from Keynes: “The game of investing is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll.”

Thomas Neale’s lottery loans were cloaked in the legitimacy of investing, but they raised so much money because of the titillation of the gamble. The thrill of a lottery loan, and hopes for one of the larger prizes, resulted in some individuals overextending themselves. But the lotteries at least paid high interest rates to ticket holders—compensation for the fact that the loans were paid out as an illiquid annuity rather than a lump sum.

With the thrill just a distant memory and the money spent by the government long ago, the lingering debt from Neale’s lottery loans was another problem that could be rolled into the South Sea Company.

The 1719 conversion of lottery loans was even more successful than earlier efforts, including the original conversion of debt from the War of Spanish Succession. By converting the annuities into readily tradeable shares, the government was able to lower the interest rate it was obliged to pay. Meanwhile, debt holders received the flexibility of being able to sell their shares and cash out, rather than wait on the annuity payments.

These improvements did not go unnoticed. When stock traders were evicted from London’s Royal Exchange for rowdiness, they started to gather at nearby public coffeehouses such as Jonathan’s and Garraway’s, both on Exchange Alley, a maze of walkways that opened across from the Exchange building and connected Cornhill Street, Lombard Street, and Birchin Lane. The three streets defined a lopsided triangle full of brokerages and banks that offered a ready clientele for the coffeehouse traders, adding a new social aspect to investing. One Londoner observed, “they that live in London, may, every noon and night on working days, go to Garraway’s coffee house, and see what prices the actions bear of most companies trading in joynt-stocks.” Investing, suddenly, was both salient and a social activity. Average investors (at least, those with the not-unreasonable sum of £10 and friends who frequented the coffeehouses), started hearing about the successful conversion of debt to equity in the South Sea Company and about the company’s sparkling prospects.

Investors did not have to venture down to Exchange Alley and its coffeehouses to get the latest market news. They could instead turn to a new phenomenon: an independent press. By 1719, hundreds of newspapers and semi-regular pamphlets were fighting for readership, and those who did not subscribe could hear them read aloud in coffeehouses far from Exchange Alley. Several newspapers focused on financial news and published the latest prices each day with those for South Sea Company the most important.

The ability of investors to always know the value of their now-liquid shares was a new and profound contrast to the time when it had been impossible to know the exact value of their illiquid lottery loan annuities. Similarly, today it is easy to know the precise value of a stock portfolio—all an investor has to do is log into their brokerage account—while, in contrast, it is impossible to know the value of your home beyond some rough estimate. Precision in valuing one’s holdings—and watching that value change from day to day—injected emotion and immediacy into investing in a manner that had never existed before. This precision also made individual investors overconfident regarding their understanding of the market, the profit they could expect, and their individual ability to realize it.

Prior to the creation of the South Sea Company and the ability of investors to convert their debt into shares, investors were never certain of the present value of their holdings but that was unimportant just as the current...

Table of contents

• Cover
• Title Page
• Dedication
• Contents
• Preface: The Anxious Investor
• Chapter 1: Fear
• Chapter 2: Irrationality
• Chapter 3: Complexity
• Chapter 4: A Checklist for Better Investing
• Acknowledgments
• Source Notes
• Index
• About the Author
• Also by Scott Nations
• Copyright
• About the Publisher