Leadership insight

Essential Skills and Strategies for Managers of Growth Companies

by Kirby Cochran

Unlocking the mysteries of human behavior can be your ticket to driving shareholder value.

TABLE OF CONTENTS
The Psychology of Investing 1. Stock Price Shepherds 2. Why Investors Buy Stock 3. Investors Are Emotional 4. Drum Roll Please . . . I’m About to Buy Stock 5. One Point in Time 6. The Rubber Band of Volatility 7. Should I Stay Or Should I Go? 8. Culling the Herd 9. Emotional Twin Powers: Fear and Greed 10. Fear: First Loss, Best Loss? 11. Greed: Pigs Get Slaughtered 12. Discipline 13. What is “Fair Value?” 14. The Efficient Market Hypothesis and Other Distractions 15. Supply and Demand 16. Taking Charge of Your Future 17. Conclusion 1 2 3 5 6 8 11 13 15 16 18 19 20 22 24 24 26

COPYRIGHT © 2008 KIRBY COCHRAN. ALL RIGHTS RESERVED

1. Stock Price Shepherds
It starts with the shareholders. Shareholders drive the value of the company. However, it is my observation that most Senior Management teams fail to understand how their shareholders can affect the stock price of their companies. Some managers are even contemptuous toward shareholders, looking at their responsibilities to the shareholders as an unnecessary burden, an annoyance that interferes with the running of the business. When management teams do understand how shareholders drive the value of the company1 (after all this isn’t something they could pick up in business school or from traditional consulting firms) they want to know more about their shareholders. They have spent years learning their business—the specifics of their industry and the competitive landscape. They go to great lengths to understand the customers who buy their products and services and how to manage their production and sales organizations. In contrast, they may have been only passively involved in getting and retaining their shareholders. Unfortunately these management teams often look at equity financing

as just another fundraising effort to fuel their goals for the business and give little thought to the obligations and responsibility which comes with having a base of shareholders.

As Senior Management work to fulfill their mandate to increase shareholder value, they ought to realize that they have become stewards of two sides of the business (generating sales/earnings and increasing their shareholder value through raising the stock price). These two sides are just like a Yin and Yang of growth and success–two inseparable halves that require equal nurturing for the company to flourish. Senior Management teams look to better understand their shareholders; the under-served and neglected side of their business. They need to know what threatens and what encourages investors to buy and sell their stock. One absolute necessity for management teams is to understand the psychology of their investors.

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The psychology of investing looks at how people think and behave. It offers insights into the ranks of investors who are sometimes driven by powerful emotions rather than logic and reason. These emotions are easy to identify with; we all have them. But, that same empathy makes these emotions difficult to see in others without first understanding some guiding principles. Over the years, I have consulted with Senior Management teams in dozens of growth companies and have seen firsthand how gaining access to the skills and strategies outlined in this article empowers managers to become leaders in their industries and to build and sustain an enduring

competitive advantage. These are principles which should guide Senior Management teams as they endeavor to understand shareholder’s behavior. Prepared with these skills and strategies, management should be able to prevent being sucker punched by a sudden (yet predictable and preventable) drop in the stock price— because they will understand the psychology of investing. 2. Why Investors Buy Stock The psychology of investing starts at the beginning—the purchase of shares of stock. One signature, one phone call, one click of a mouse and—voila—an individual turns from a prospect into a shareholder. What is the thought process that motivates someone to take a hard-earned dollar and cast their lot with a company by purchasing its stock? What makes owning that little piece of a business so attractive? Why do they do it? We know that a lot of people are doing it. More people are investing in the stock market today than ever before. We even hear of the working class being renamed the “investor class”. In fact, over half of Americans now own stock in some shape or form.2 Why?

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The main reason investors buy stock is because they think its value will go up. They buy because they think they will make money. Oh, they may not think it will deliver a return today or even tomorrow, but it is nearly universal that individual investors are driven to make the purchase because they expect to gain value on the money they invest. They are looking for that “R” in ROI (return on investment). Investors don’t just think, they expect to make money when they invest. Not every investment makes money. Some investments make money and some lose money. Investors know this, so it is not an easy decision to part with those dollars. In fact, the decision to purchase is often highly emotionally charged. The rush of emotions can cause this moment to become an anchor point in the investor’s mind and forms a reference point, a baseline, against which all other points in time are measured over the lifetime of the investment. They know at what price they bought; now they want to see if they will end up selling high or low. Investors are always looking back at that decision to buy and weighing their feelings against that original

expectation—that the value of this stock will rise. 3. Investors Are Emotional We would like to think that financial decisions, especially big ones, are made rationally. There is a place inside us that says when it really counts, we will weigh all the facts, seek out all the information available and, using our grand powers of reason, make an educated and informed decision which should yield strong results. The truth, however, is that we don’t. In fact, the investing behaviors of human beings do not make much sense at all. On top of that, they do not typically perform very well— considering that most individual

investors generate returns lower than a good mutual fund. One study compared investors within the fund to the overall performance of the fund itself. The results: “…the data show

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that investor returns have generally lagged those of the funds’ published total returns… In fact, in every diversified stock-fund category and all but a handful of sector categories, funds’ 10-year investor returns lagged their total returns.”3 In fact, one study claims that our emotions make us bad investors and went so far as to compare investing results from a group of individuals who had brain-damage affecting the emotional areas of their brain, with a control group who had emotions intact. The results? “Emotionally impaired participants outperformed the non brain-damaged participants...”4 Investor behavior only starts to make sense when viewed through the lens of psychology. That’s because investors make decisions from the gut rather than from the head. It is just the way we humans are put together. Decisions

to buy stocks or tradable securities can be as fickle as decisions to buy groceries. In order to understand the buying and selling behavior of investors, you need to gain an understanding of the emotional thought process, the essential psychology that drives it. I love what Robert Armstrong and Jacob Ward said in February of 2008. “You’re stupid with your money. You may fancy yourself a shrewd investor, but if you have normal human instincts—if you stand up and cheer at sporting events, if you follow the crowd toward the exit at the theater— then you have the instincts that make investors alternate between delirious greed and inconsolable fear. Like most of your peers, you are wired to buy high and sell low…”5 Another example comes from Terrance Odean at U.C. Berkeley. Several of his studies show that

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“when people have the choice of two stocks to sell, more often than not, they sold the stock that did better in the future and held on to the one that did worse. And, when they bought something new, they tended to buy a stock that did worse than the stock they just sold.” His mentor, Daniel Kahneman told him, “It’s expensive for these people to have ideas.”6 For better or worse, most investors are at the mercy of their humanity. Investor behavior is often emotional, irrational and illogical, and for that reason this behavior is best understood in emotional terms, not rational terms.

4. Drum Roll Please… I’m About to Buy Stock Where does it start? As I mentioned earlier, the first hurdle, the first commitment, the decision to ride the roller coaster happens when the decision is made to make that initial purchase.

An entire discipline, called “Behavioral Economics” has sprung up as scientists and investors alike try to understand the impact of psychology in the market. Many of the concepts that I have been teaching students over the past decade are now being more widely discussed and published. Even though it is intellectually possible to understand that our emotions are not great teachers when it comes to investing, I have found that it is nearly impossible to be an investor and be dispassionate in approaching the market. That is why I teach companies that they need to understand the psychological picture instead of simply advising them to encourage their shareholders to be less emotional. Richard Thaler, from the University of Chicago, said about the emotions that drive investors, “I don’t think you can fix what’s in your head.”7 In other words, investors aren’t going to change, but they can be understood. I am speaking from experience. Over the past 30 years I have been one of those investors. I have felt every exquisite dip and turn in the emotional roller coaster of investing. I have invested in public companies; I have invested in private companies. I have traded in all kinds of stocks, from

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small and micro caps to large caps; I’ve traded in most major currencies, traded commodities, traded options— you name it. Through it all, I have been blessed to taste that sweet feeling of exhilaration and triumph as a trade becomes a windfall. And, I have also felt like kneeling over the toilet and vomiting my guts out over a trade that just buried me (or worse, one that I was still in). Think about times when you have felt this way. You agonize over your business and the far-reaching impact of the leadership decisions you make. Your shareholders go through the same agony and ecstasy of investing every time they make a decision to buy or sell your stock. Another factor that drives the emotional intensity of a stock purchase is the scarcity of information. Your investors must peer into a very murky crystal ball and make the decision. Investors often believe they have enough information, or that the little bit of information they have is sufficient for them to “outwit” the market. As Daniel Kahneman puts it (Kahneman won the Nobel Prize for essentially birthing the field of Behavioral Economics), “In fact, in most situations what you don’t know is so overwhelmingly more important

than what you do know that you have no business acting on what you know.”8 So, with this huge emotional mountain to climb why do investors buy? Because they don’t read Kahneman, they run on emotion, and they want to make money. Finance professionals often describe the act of making a trade as “pulling the trigger” on the deal. Just like the firearm metaphor suggests, making a purchase creates a commitment from the buyer—and just like a bullet leaving the muzzle of a gun, there’s no calling it back. It’s a little bit of fact and a lot of faith—remember, nobody buys a stock wanting or expecting to lose money. 5. One Point in Time After becoming a shareholder, how does an investor evaluate whether or not he or she made a good investment? After all, there is a lot of emotional turmoil riding on the outcome of this decision. Simple, they look and see if the stock is trading for more or less than they paid. The question is, what does the price they paid have to do with what the stock is currently worth? Answer:

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nothing, nada, zippo. Did I make money? Did I lose money? These are the same criteria people use at the casino! Investing is theoretically about an exchange that creates greater value. Companies raise money by selling stock. The money they raise should allow them to accelerate or increase the magnitude of their execution, thereby creating more value for the customer and the shareholder alike. So why do investors act like they dropped money on a tip at Churchill Downs? In order to really understand what your investors are thinking, you have to get inside their heads. You have to listen in on that conversation they are having with themselves. Put yourself in their shoes. Here’s a scenario: You have diligently saved $10,000 to invest. After extensive research, you have found a stock that is trading for $1 per share. The company looks very good. It has developed an exciting new technology and appears to be on the fast track with a bright and promising future ahead. On top of that, you have heard through the grapevine—a friend of a friend, named George, who is both very successful and experienced— that, the way this company is going, the stock could hit $100 per share in

the next two years. To yourself you are saying, this could be the luckiest find of my life! Boy, am I good. Here I am with an opportunity to get in on the “ground floor,” before this company is even on most people’s radar. This is just too good to pass up. You make the purchase and are now the proud owner of 10,000 shares of stock in the company. Hey, if this deal pans out I might even be able to retire early. In fact, with the money from this deal, I can look for other deals and make a ton of money. If I did that, I could quit my job. I’d never have to deal with my boss again! A month later the stock is trading at $2 per share. You can hardly contain yourself. In a month you just doubled the money it took you most of a year to save up. Think how long it would have taken to earn a return like that from your savings account at the bank! You are thinking that you have outsmarted just about everyone. Think of the other investments you could have made: the money could have been sitting in a certificate of deposit (CD) earning 5% annually. It could have been invested across the market and earned an average of 7.8%. Instead, you just earned 100% in a single month!

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Then the doubt starts setting in; you get concerned that you might lose what you have just gained. Surely this can’t keep going up. Sooner or later, it’s going to come back down. What if I lose everything I have in this deal? You know, I probably will never see returns like this again. These are once in a lifetime opportunities. The smart thing to do would be to sell now and lock-in my profits. I’ve already made $10,000. That’s enough to cover the kids braces and get my wife that new camera she’s been wanting—maybe we could even go on that second honeymoon. Besides, once I sell, I don’t have to endure the stress of the uncertainty I feel wondering what will happen. Okay, that’s it. I’ve decided. I have to sell. And then, but… was it the right decision to sell? What if I had held on a little longer? In part, because the decision is such a big deal, investors are often powerless to resist the temptation to compare the price of the stocks they own to that single point in time—the time they purchased the stock. The logical approach, of course, would be to “calculate whether a stock is worth its current price.”9 But, whether or not it is worth its current price does not tell us whether we made money or lost

it. It does not stroke our pride and tell us we are wise and gifted and have the Midas touch. 6. The Rubber Band of Volatility Once investors have purchased the stock, two principles start working on them in combination. First, the faster a stock accelerates beyond the original purchase price the greater the volatility that is created. Second, as volatility grows, so does the psychological impact and the likelihood of poor decision-making when it comes to their buying and selling behavior. I like to use the example of a rubber band to illustrate this point. Imagine one end of the rubber band is looped around a peg posted at that “one point in time,” the time at which the stock was purchased. As the stock price accelerates, the rubber band stretches out. As it stretches, it gets tighter and tighter. The tension grows more and more intense. And the more tension there is, the more volatility there tends to be in the stock. The price swings are larger and more pronounced. Eventually the tension gets so great that it breaks. Put yourself back in the shoes of the investor in our example. The pressure to sell was previously too great for you after gaining 100% in

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a month. But what if you had stayed in? Let’s say you made the same purchase, but instead of selling once the stock got to $2 per share, you held on. By the end of the second month, the stock is at $3.50 per share. Not only can you afford the braces, the vacation, and the camera, but you are thinking a new snowmobile would look great in your garage and your car suddenly seems like its ready to be updated. This is getting exciting! I knew I was smart to pick this stock. You are thrilled. You start chatting to your friends about how you have been studying the market and just

Within four months, the stock is trading at around $5 per share. That’s $40,000 in profits only four months—which is like making $120,000 a year! I only get paid $80,000 at my job now. I just earned half a year’s salary. Maybe I’m foolish to even be working a regular job. I really am smart—I could make a lot of money trading. I seem to really have a knack for investing. If I invest full time in deals like this, I could really boost my income. A few good years and I could retire. Maybe pull in several times what I do now. I think I owe it to myself to at least consider it. And, it was so easy… You ponder just how astute you

made a great buy that went from $1 to $3.50 in two months. Of course, your friends lay on the compliments and wonder at your great insight. If only they could be equally gifted. Life is looking pretty good.

have been. Your head fills with thoughts of vacations, a larger house, new cars, prep school for the kids. And then the doubts settle in and the rubber band starts twisting…

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Well, the market has been acting strange lately. What if the stock goes down? Now that you have dreamt up all the stuff that your earnings represent, you have heart palpitations at the thought of losing it all. In order to protect yourself from this loss, you develop a game plan: you will watch the stock daily and if it drops by even a dollar you will immediately sell. But, the stock doesn’t drop. It goes up… way up. It hits $7 per share, then $8. The game plan takes on a different dimension. Now you are saying to yourself, quitting my job may not be just a pipe dream. It might be the smart thing to do. Okay, if the stock hits $16 per share, sayonara angry boss, hello wonderful world of investing (with a new lifestyle to boot). Within the first year, the stock is trading between $12 and $13. The $16 goal seems within reach and your

overall net worth has grown by over $100,000. Just think of what I could do investing the big money, you think. Then, the growing pattern shifts. The stock price begins to retreat. It drops by $1 per share… then $2. Do you sell like you had earlier promised yourself? Of course not. You rationalize that the stock has grown this far, it is likely only a momentary hiccup, a temporary downturn that is sure to recover. You think, if the price just gets back to $13, then I’ll sell. I’m not asking for too much. Besides, that would realistically put me in a position to quit my job. The stock opens the next morning at $7 per share. Your plans are on very shaky and precarious ground. Unbelievable. But, I still have faith that the stock will recover. I’ve heard other investors talk about riding out the storms of the market. I just need to weather this fluctuation. I’m sure it will go back up. I can just feel it. It should easily make it back to the $12 or $13 neighborhood, maybe better. Remember, George said it could hit $100. At $100 per share, my 10,000 shares would be worth $1 million. But, hey, I don’t need $100 per share right now. I just need $13. I’m not being greedy. All I need is enough

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to quit my day job and that will be sufficient. The market must have got this wrong. It’s sure to straighten out. I made that money and now I just need to get it back. You go to work ignoring the market and willing the stock price to recover. Within the next month, the news is out. The revolutionary technology at the center of the company’s business has become obsolete due to a competitor’s product. Devastated, you think to yourself, I have a mind to call the company’s CEO right now and tell him what a fool he’s been. How could he have allowed this to happen? But before you make any other calls; you realize that you had better sell quickly if you hope to recover even your initial investment. Ironically, you fire off the sell order as the price hovers at just over $1 per share. What we see in this example is the rubber band principle at work. As the investor in the example, you made all the classic mistakes. You anchored your opinion on the date of your purchase. Perhaps you compared your returns with other “safe” investments (CDs, Money Market accounts, T-Bills,10 etc.), or maybe you looked at the market in general. You knew your returns were outpacing what was

common and as that distance grew, the rubber band just got tighter and tighter. The same studies that show that investors earn poorer returns individually than a fund does collectively, also indicate that there is a link between poor investor decisionmaking and volatility.11 This makes some sense as we consider that the psychological pressure increases as the tension in the rubber band grows toward its snapping point. 7. Should I Stay Or Should I Go? One problem is that investors do not know when to sell. They aren’t typically disciplined enough to know how or when to sell. It really boils down to buying and selling on emotion rather than on fundamentals. In the case where you imagined you were the investor, all along the roller coaster ride you would throw out benchmarks for your decisions. If I could only get this much, I will sell. If the stock just gets to a certain point, I will sell (I don’t need much—just one more dollar). When the stock starts to fall, these investors are always thinking it will recover. They typically do not put stop-loss orders in, they hold on… and ride it all the way down, hoping it will go back up. We have a saying:

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even a cow will bounce if you drop it from high enough. These guys are not looking at fundamentals. They are not looking to see if there is a reason for the stock to recover, they are just shooting from the hip. With every little peak, they get their hopes up and say to themselves, see I knew I was right and that it would go back up. But, without the underlying fundamentals, the stock just plummets again. When the company fails to produce earnings and revenues, these investors ride it all the way down. This is part of the reason the shares owned by these investors could be considered overhang. Overhang is cheap stock—cheaply purchased relative to the current price, which threatens to unpredictably drop into the market in sufficient volume to impact the price. Managers want to do whatever they can to patriate the overhang stock into the float (the freetrading shares in the market) to keep the price intact. In other words, they need to find buyers for the cheaply gotten stock that earlier investors are going to sell. They need to increase demand in order to absorb the increase in supply, which should help keep the price intact and hopefully on the uptick as the overhang is patriated into the market. If these shares ramp up

supply in the open market without an equal ramping in demand, the stock price is usually going to fall. This effort by management is about moving stock from weak hands to strong hands; strong hands being new investors who have a whole new investment horizon and new return expectations. The only research our investor did was before making the initial purchase (and even that was lukewarm.) After becoming a shareholder, we never saw a comparison of the selling price of the stock with some objective valuation metrics. Fundamentals are out the window. Instead, the thought process was all about feeding his mood vis-à-vis an internal conversation riddled with the emotional content that makes for bad investing. In both my teaching and consulting, I outline the role of investors as a company migrates through the value-changing events in its growth. Almost universally, people tell me that they want to sell when the company hits one of these events. This perspective is particularly troublesome for the younger company because if it is not protected by lock-up agreements or has not sold its investors on the vision of the company over the long haul, then the

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stock becomes susceptible to rampant selling and the company’s value tanks because everyone dumps their stock and the price blows off. This illustrates the critical point that investors don’t know when to sell. Senior Management needs to know that investors don’t typically know when they should be selling. I have often met with CEOs who are frustrated by a shareholder who has sold unexpectedly or as soon as possible after a value-changing event. Upon further investigation, I find that more often than not, the investor would have stayed in the stock if someone had reached out to them with a reason to. Senior Management teams should be prepared to help investors understand why they should hold from selling and wait for a more opportune time to liquidate their shares into the market. 8. Culling the Herd 10,000 lemmings can’t be wrong. At least that’s the theory employed by investors who buy or sell under

the collective peer pressure of “herd” mentality. One of the hallmarks of growth companies is that shareholders have limited resources for information about them. Scant information reinforces emotional investment decisions and without a more principle-based decision criteria, investors often fall victim to herd mentality. An investor thinks, since I don’t know what I’m doing, I’ll watch for others who must have access to more information than I do. My fellow shareholders undoubtedly pay closer attention and do more homework than I do, so I can make the right decision by closely watching them instead of doing all that work for myself. I should make out all right if I just follow their lead. The problem is that it is often a mistake to pull cues from the herd. The herd may not know what it is doing at all. Here is why: if you hear that a stock is hot from your friend around the water cooler, or your neighbor who really “knows his stuff,” it’s probably too late. You hear, “This stock has already climbed over 200%, for crying out loud. You don’t want to miss this opportunity.”

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(Nothing encourages emotional buying behavior like a good story.) And, you are thinking you better buy now and strike while the iron is hot. Well, what are you doing if everyone else is already buying or has already bought in sufficient volume to drive that 200% growth? You are probably buying high—after the 200% has already been realized. Conversely, when you own a stock and it starts to drop. You hold on for a little bit hoping for a recovery, but eventually it drops enough that you cannot take it anymore. So, what do you do? You sell… low. The pattern of buying high and selling low is not a recipe for making money, but it is a favorite practice of the herd. Institutions also create a herd effect. I often hear entrepreneurs coming to me who want to court the institutions to invest in their companies. My advice is always the same: “you live by the institutions, you die by the institutions”—and what I mean is that, as shareholders, the institutions play by different rules and are motivated differently. Part of knowing who makes up your shareholder base is knowing whether you have institutions that own your stock. If you do, you need to be ready to play by their rules. You need

to communicate with them and craft your story in a way that is tailored to them. Institutional purchases are not made by the same criteria used by individual investors. Institutional buying and selling is done at the behest of a professional manager. This is not usually a guy who is looking for a big opportunity; it is typically someone who is looking for justification for his or her actions. When it comes down to that justification, he or she wants to be able to show that they moved with the herd, but in this case it is a herd of analysts and other institutions. He or she wants to show that the decision was in line with others in the field. If the decision is in keeping with other colleagues, the justification for the position to purchase or sell is there. The bosses ask why a bad trade was made and out comes the justification: well our research showed that this company would increase earnings by 44 cents per share and furthermore we have fifteen analysts that gave us a general consensus within one standard deviation of the mean that they would hit their earnings. Last year they did hit 38 cents and we believed they would hit their target this year. Anyway, I wasn’t the only one that got it wrong.

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Everybody else got it wrong too. What do you expect from me? If the best analysts in the world can’t figure it out, how do you expect me to? And on it goes, as they often manage to mediocrity. The institutional investor is playing by different rules and his or her pains will be altogether different from the individual investor, as will his or her reasons for buying or selling. An analyst report could indicate that someone is going to miss their earnings by a penny a share and the institution sells. Earnings could be too high for the institution to consider sustainable, and they sell. What makes this so essential to understand is that institutional purchases are usually made in much greater volume than individual buys— these guys have the capability of moving the market for a stock in one fell swoop. I tell people, however big you get; you still want the individual investor. And, I do not mean day traders; I am talking about investors who believe in your company. Day traders generally just create a distraction from what is really going on because they do not hold for long periods of time. In other words, the more day traders you have in your shareholder base, the more volatility there is.

9. Emotional Twin Powers: Fear and Greed You get these emotions working in tandem: the fear of losing and the greed of not getting more. I remember an episode of Leno shortly after the Enron and WorldCom debacles, where Wanda Sykes cracked a joke that Wall Street was now the tough area in town, because at least on the streets nobody was mugging you for your future. That comparison–trading stocks and being robbed on the street– is one that brings home the reality of just how deep the fear and greed run in the human psyche. I recall watching the market 15 minutes before the closing bell. Five minutes earlier I had called in an order to buy 10 S&P full contracts. I had gone long (which means I was anticipating that the market would go up). I was already up a full point. I had just made over $10,000. The palms of my hands were sweating; sweat was beading up on my forehead and I felt like I had just injected a full syringe of adrenaline. My body had a physiological “fight or flight” reaction every bit as real is if someone had pulled a gun on me and demanded my wallet. The emotions driving investors are real and intense. As that tension grows in

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the rubber band, the intensity of these emotions grows ever-more acute.

The thing about the market is that “greed gets you in, and fear scares you out.”12 It is human nature to compare investment returns with what a safe and secure investment would yield. When a stock starts to climb quickly, investors start panting and getting the jitters thinking that this growth is not sustainable. Because it is outdoing most everything else, investors feel like they are cheating. The fear of losing what has been gained makes investors think and act like they just got caught with their hands in the cookie jar. But, then the greed kicks in. They hear a story or a tip about how great the stock is going to do and they hold on. They believe the story—they want to believe it—but their fear is making them sweat bullets. These two emotions are driving them to a very emotionally precarious place.

According to Wendy HackettDominguez, “Pride is the pleasurable feeling investors have when investments do well. Remorse is the painful feeling investors have when their investments do poorly and they second guess themselves. Remorse tends to be felt more deeply than pride. Remorse compels people to avoid situations in which the chances of their feeling remorseful are perceived to be high.” In other words, investors are afraid of losing money. So afraid that they sell at the wrong time, minimizing their returns, in order to avoid the chance of losing more money. Pride cometh before the fall. Remorse? It looks like that cometh after. 10. Fear: First Loss, Best Loss? Fear is a big motivator for a lot of human behavior. It is no surprise then that fear is one of the emotions that causes investors to sell at the wrong time. I often hear companies use the axiom, “first loss, best loss” in terms of their operational management. While this may be an excellent heuristic when it comes to your assembly line or making the decision to terminate a supply relationship, it does not correlate to stock ownership.

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With stocks, this is simply running with the “devil you know” to staunch your emotional bleeding, but ignores any real valuation or valid decision criteria. In truth, without more insight than simply looking at the stock price, there is no way to know whether “cutting your losses” is also cutting your returns. Consider this scenario. You buy a stock at $20 per share, which immediately retreats to $15 per share. Are you likely to sell? Most investors will hold. Why? Because, they didn’t buy expecting to lose money and selling confirms to them that they made a bad decision to purchase. People do not want to lose money. They do not want to sell a stock for below what they bought it for. When the stock goes down, they ride it out hoping to get their money back before they get out. What if you have been in this stock for a while? You have gained quite a bit of stock value since you first bought it, but all that value is sitting out there, at the mercy of the market—at risk. What if you lose it? You might have been counting on that money for any number of things and it is hanging out there in the market where any nasty downturn could take it away from you.

You start chiding yourself saying, okay, maybe this wasn’t a good decision, but if I sell now my chances of making my money back are zero. I’ll hold for now and wait for the stock to recover. Once it gets back to $20, I’m out. I’ll sell… if I can just get my money back. One of the hardest things for investors to do is to take a loss. Yet fear often causes them to do worse with their portfolio than they otherwise would have. More than that, however, when someone sells for a loss, it confirms that they made a bad decision and they think that they must be flawed or that something is bad about them. Deep down, however, they do not want to believe that they are bad or flawed, so they don’t sell. More than just feeling remorse at losing money, selling at a loss would assail their self-perception; it would attack their very identity. And while this war rages inside them, the stock continues to decline. Fear also provides the motivation behind what is called the “December

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Effect.” In order to ease the blow that they bought a bad stock or to eliminate the uncertainty of not knowing whether or not they did, investors will look for an alternative way or reason to sell. One alternative to selling and getting nothing for the transaction is selling at a loss, but using that loss to offset taxes. At least they get something out of the deal, right? Sometimes the plan is to sell the stock at a loss, and turn around and buy it back in the New Year, but take the write off. An investor may have another investment, maybe they transacted a real estate deal and after capital gains they still need an offset. Or, maybe he or she is simply acting on the advice of a tax accountant. They may use the end of the tax year as an artificial line in the sand, saying, if this stock does not do something before the end of the year, I will sell. Another possibility is that they have been in the stock for a couple of years and it has not done anything and is still trading close to where they bought it. In the end, sometimes they buy back and sometimes they don’t, but the increased volume can wreak havoc with your stock price and this is another example of behavior that (with a few exceptions) is very predictable. Senior Management

teams need to be aware of the December Effect. It is all part of understanding who your investor is and how they are going to react. Odean, performed a study on trading behavior of investors while he was a professor at University of California at Davis, His study concluded that investors do not want to take additional risks with stocks in which they have already made money. However, they will tend to hold on and risk additional losses with stocks they are currently losing money on.”13 11. Greed: Pigs Get Slaughtered Greed can be described in its extremity as a horrific trait. I’m talking about extreme greed; the type of immoral behavior rooted in greed that qualifies this vice as one of the seven deadly sins. The proud, avaricious, insatiable desire to obtain and consume that boils down to an unbridled want for more. This type of greed certainly exists in the market, but more common, and perhaps more insidious because of its subtlety is that mild greed that is just enough to keep investors from trusting their better judgment. This type of greed is just enough to tip the scales in the privacy of the investor’s mind. These investors may not think of their behavior as greedy at all. But,

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to the extent that their desire for more overpowers their sense of reason, they have allowed emotion to dictate their behavior and surrendered the outcome of their buying and selling to their own greed. Wise investors learn what money really is available to them and what is not. They learn to walk away from money that is not theirs. As the saying goes, “Bulls make money. Bears make money. And, pigs get slaughtered.” Greed gets people into the market. They see an opportunity to make money, and greed gives them “rose colored glasses” when they evaluate the purchase. Then greed keeps them in the deal when they should get out, or when the company is doing well, they feel guilty because they know they made the trade on greedy motives and this sets them up to become victims of fear. “Human nature is a coin that flips between greed on one side and fear on the other side. Unfortunately this coin for most investors lands on the edge… and the edge is stupidity.”14 Senior Management teams need to watch for greed and for situations in their stock where greed may play a role. They can start to see the emotions develop. With experience, you can actually see greed take hold of these investors and at that moment,

you can say to yourself, alright, I know how these people are going to behave. Then management teams can be prepared to take some action to protect their company from the result of that behavior. (A side note: Senior Managers need to be able to recognize greed in themselves and those around as well. It’s funny, but I’ve seen how greed sometimes makes people “forget” their promises.) Perhaps nowhere is the frantic pressure point of the twisting rubber band felt as much as with companies that are young. They may be pre-earnings, or even preproduct. Investors in these companies are looking for big gains as early shareholders, and that is fertile soil for greed to get out of hand. Conversely, telling the right story about the company and its progress could be just what Senior Management teams need to be doing in order to get these investors to hang in there while they get the company off the ground. 12. Discipline Warren Buffet is quoted as saying, “Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”15

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If it is not reasonable to expect that investors are going to discipline themselves when it comes to their buying and selling behavior, then how can you assert a reasonable and disciplined approach for them? Maybe the first thing to do is ask why undisciplined trading is such a fundamental problem. Senior Management teams looking to grow their stock price do not want a sell-off motivated by one of the fickle emotional triggers that are at the core of the psychology of investing. The reason this is a problem, is that it drives investors to focus on the wrong thing. They may be focused on analysts, their friends, the “herd” or any number of other sullied and unreliable sources of information. If there is no message coming from the company, no long-term vision or strategy being communicated by the CEO to counteract the flawed one, then the company is at the mercy of whatever story is being told in the market. Companies are not helpless in this regard. If investors were rational and disciplined, they would be focused on things like the real intrinsic value of the stock. Senior Management teams need to communicate the real value of their companies in order to inoculate

their shareholders from flawed beliefs and perceptions of the market. The great thing about this approach is that it tempers both extremes. It counteracts the emotional buyer and the over-analytical one. The buyer who breaks down every aspect of the company and its performance to number crunching is missing out on the art of investing. Strong communication from the company about its vision and strategy as well as how it looks at valuing itself can go a long way to evening out the erratic behavior of investors and keeping the company’s stock price on an even keel. Business and particularly investing is an art, not a science. 13. What is “Fair Value?” The discussion of all the metrics and data points to establish fair value is not within the scope of this article. However, the principle of looking at the fair value of a stock based on fundamentals is essential for Senior Managers who wish to combat emotional buying and selling that

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hurts the stock price of their company. Here’s an example of someone trying to get to the bottom of whether a stock’s price is based in its intrinsic value: “Take a profit-making biotech company [biotech’s are notoriously difficult to value].… Its market capitalization is over 90 billion dollars and yet its annual profit is about one billion dollars. If one had 90 billion dollars to spare and put it in … 30 year US treasury bonds at 4.5%, it would yield an annual return of 4.05 billion dollars. Assume for a moment that sales… would grow at 50% per year and the profit margins would be 50%. Assume that its profit margins would grow at 50% too and possibly slightly more. Thus its earnings in five years would be over 8 billion dollars or nearly $8 per share. It’s highly unlikely that this would happen and far more unlikely that this astronomical growth rate would continue further on. At today’s market price of the company, the 90 billion dollars compounded at 4.5% for five years in treasury bonds without change in interest rates would yield on nearly 22 billion dollars in return. Yet foolish investors buy the stock.”16 This example illustrates the point that sometimes a “common sense” check is needed when it comes to

stock price and intrinsic value. Buyers often intuitively know that they need to do this, but are blinded because they are operating out of fear and greed. I’m no exception. Early in my career; I had just graduated with my MBA and I really knew my stuff (I thought!) I was buying based on P/E (price/earnings) ratio. I found a stock and bought 8,000 shares of it based on P/E ratio alone. The price was around $7 or $8. I did not even consider the volume… until I completed the trade and my purchase had moved the stock $1 per share! I ended up selling my stock for around $5 per share. That’s what I call, “dumb tax.” The point is, the psychology of investing will generally influence investors to buy or sell based on emotion. Senior Management teams, however, should know whether their company’s stock is fairly valued based on the fundamentals. They can then communicate those details to shareholders in an effort to mitigate the uncertainty and volatility in their stock price that often comes as a result of letting the shareholder’s emotions go unchecked. The ordinary individual investor does not understand that. Like I teach my graduate students, the ability to finance your company is a function of

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the price and volume of your stock, as long as the market cap and intrinsic value are within reasonable terms (and the company continues to execute on its growth plan, showing they can grow earnings, of course). Management takes a fine line keeping their market cap in line with the stock’s intrinsic value because they are working to drive the price up. While it is possible to create a momentum-based stock, where stock price is outpacing earnings for a period of time, management needs to stay cognizant that, over the longterm, their stock will eventually trade on its historical performance, the company’s fundamentals, and their industry’s earning average. 14. The Efficient Market Hypothesis and Other Distractions Now, there is a lot of discussion and debate about what I call “Market Distractions.” This boils down to any program, theory, or software that is designed around the idea that the market functions in a purely scientific way. Prominent among these is the Efficient Market Hypothesis (EMH). The primary critics of Behavioral Economics and its use of psychology for investment management are proponents of EMH. EMH is based

on the idea that the price of a stock (or other investments that are traded) inherently contains all the information that is known about the investment—that the financial markets are “informationally efficient.” It therefore claims that it is impossible to outperform the market on a consistent basis using information available to the market. Chicago finance professor Eugene Fama, for example, argues that ‘the empirical evidence is weak (for behavioral economics), they don’t have a coherent theory and without that, there is no behavioral finance.”17 Do not misunderstand; I am a fan of technology. I think technology is great for uncovering stocks that meet certain analytical criteria, or analyzing the management of stocks, but you need to reconfirm your entry position based on fundamentals. How much cash does the company have, how much revenue, what is the content of their latest 8k, 10k, or 10q reports, are insiders buying or selling, etc. Instead of trading strictly on technicals, you want to be able to say there is a basis for you to make your position. At one point in my career, I was trading in the S&P 500. I had a computer programmer working with me full time and we developed a strategy that our computer program was built around. It returned accurate

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predictions 79% of the time on the S&P stocks we were tracking. We had a very sophisticated model essentially based on these principles. One of the things I learned from tackling the stock market with all the technological tools at my disposal is that the markets are not random. History and experience have shown me that the markets are not efficient. I first ran into this when I saw a press release for a company that really impressed me. I was getting the news in real time, so I new this information was hot off the press. I bought the stock. And, it went down. Then I looked back at the chart and two or three days before the press release, the stock had jumped up a dollar or two. I was troubled. This was not fair. Somebody knew something I did not know. Since then, I have seen it time and again; from the “insider’s” view the markets are inefficient and always will be. Why? Because people have access to news you do not have. No matter what the SEC does, it cannot police every transaction, every employee, supplier, or customer conversation. It is impossible for all information to be incorporated instantly into the market and then determine what the reaction by investors will be to those events.

Think of the butterfly effect or the bullwhip effect where seemingly insignificant changes (in other words, not newsworthy) can have farreaching effects. You cannot foresee the impact of a hurricane in Brazil, or a stolen laptop in New York City. The dearth of information and the unpredictability of the market are

the Achilles heel of the EMH. With growth companies this impact is even more exaggerated because the impact of the unexpected and the inability of getting accurate information is greater. As Gunduz Caginalp puts it, “The Efficient Market Hypothesis depends upon a mechanism of arbitrage that is an idealization that assumes the existence of many different agents with diverse interests. When the participants belong to a few distinct groups [think insiders] each with its own interests, the basic assumption is far from valid.”18 In the end, I believe that you can run all the analysis you want, you can

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back test and crunch numbers and run simulations, but you can never simulate the emotion that is involved in a trade. Which means essentially that markets are decidedly inefficient. 15. Supply and Demand What makes the value, the stock price, go up? I often pose this question to my classes of graduate students. I hear answers like “good news,” “earnings increases,” “operational improvements,” “lower costs,” “positive analyst coverage,” “rating upgrades,” “growth perception of the industry group,” and the like. While all of these are reasons that influence buyers’ belief in the aforementioned motivator for buying stock, there is still only one reason the price of a stock goes up. It’s the simple lesson on supply and demand that they were taught in their first economics class. The price of a stock goes up because… there are more buyers than sellers. For Senior Management teams, getting the stock price to go up is a matter of always making sure there are more buyers than sellers. If there is not a home for every share of stock at the end of every day, the price is going to go down. If the company is not prepared for more stock to hit the market (for any of the myriad reasons

it might), the price is going to go down. On the other hand, getting the price to go up is also as simple as creating demand—getting the word out and appealing to more buyers than you have sellers. 16. Taking Charge of Your Future So, how do you go about building your shareholder base? Management needs to do a lot of very proactive work, but before anything, you need to understand the profile of the perfect shareholder and know that you are marketing your stock to them. I see many companies where their shareholder base springs up by accident. By the time companies start to get strategic about their shareholders, they have overhang all over the place and a lot of work ahead of them to get that overhang patriated without taking a hit to the stock price. It is much better to start with a profile and a plan, however “better late than never” holds true when it comes to getting strategic about your shareholder base. Part of that profile is the understanding of what appeals to the target investor and part of it is alignment with the vision Senior Management has for the company. Nobody will have a more grand

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vision for the company than its leadership. The problem is that it is not uncommon for either none of that vision or a watered down version to make it to the shareholders. Companies need to be working at building relationships with their shareholders. Instead they often get short shrift or neglect. Never let someone forget that they own your stock. Consider the psychological impact of the mushroom treatment—being kept in the dark and constantly fed manure. Lack of information increases volatility and the probability that investors will make bad decisions. Shareholders just need some TLC. Communication with your shareholders and potential shareholders is critical. I am dumbfounded at how many companies do not understand this, but shareholders can be “news junkies.” Strong companies make their messages more frequent and relevant than the messages their shareholders are getting elsewhere; be they from analysts, the media, word of mouth, etc. Shareholders need that reassurance, and they need the critical information that only management can give them—that the stock is fairly valued and the company is on

a winning course. These messages counteract their natural tendency (exacerbated by a lack of information) to sell at the wrong time. Actively pursuing the type of shareholders that are a good fit for the company while transitioning out those that are not (because they increase volatility or exert influence in harmful ways, etc.) is essentially a matter of communication. Senior Management can proactively hit all the watering holes for their industry: put out news releases, go to conferences, work on getting analyst coverage, do webinars, podcasts, blogs, whatever it takes to get the word out. First and foremost, management needs to communicate the big picture for the company. They need to exert their leadership and show that they have a vision for the company and that it is compelling. Then this story needs to be backed up with substance and authenticity, which builds trust among the shareholder base. Good shareholder relations are built on trust just like any relationship, and among this group you want to guard your credibility and reputation at all costs. Things like goals and milestones which are met through repeated performance, integrity and openness when tough decisions are made, education about the market and the

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company’s true intrinsic value. Being a good corporate citizen can also help. People like to associate with likeable companies. Remember that your existing base contains your best evangelists. Especially in growth companies, the way to get the word out is through word of mouth. This makes your communications to shareholders even more essential, because the message you deliver to them is the same message they will deliver to the potential shareholders—their friends and neighbors. The saying goes: investors “buy on rumors, sell on news”—Senior Management needs an Investor Relations and Public Relations department that understands that it can create both. Where possible, the messages put out by your IR and PR departments should tie in to current events (in today’s world that might include “green” initiatives for example). You need to understand how they work and what motivates

them. Investors buy the story of your company, but there has to be substance to it. In other words, the story is as important as the facts, but it must be authentic–there has to be something behind it. Attracting these new shareholders mitigates the risk that overhang somewhere in your shareholder base will unexpectedly hit the market and cause a stock price catastrophe for you. As you steadily increase your volume, what you find is that volume begets more volume. As management, it is your responsibility to make sure that when people buy your stock that it is not a one or two day trade; that these people understand the vision that you have communicated and are executing on. 17. Conclusion Most people are simply not aware of these principles. Senior Management teams need to understand their shareholders and that means they need to understand the psychology of investing. The psychological perspective shows them that even though the behaviors of investors are irrational, they are in a large measure, predictable. Can you put a numerical probability to these predictable events? I do not believe you can. Business, and particularly

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investing, is an art and understanding human behavior is generally a qualitative, rather than a quantitative analysis. However, by understanding the principles of the psychology of investing, management teams can be prepared to protect and grow the price of the company’s stock. Senior Management can catch a glimpse into the minds of investors and draw information from their observations which can inform their business decisions and push them toward best practices. What this boils down to is that understanding the shareholders is critical for Senior Management teams in understanding their obligations to increase shareholder value. Understanding that people are not rational, that psychology does matter, the market is not random or efficient, and that, while irrational, the behavior of people is predictable because it is motivated by greed and fear, in essence, that understanding the psychology of investing is essential to understanding shareholders. 

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Kirby Cochran is an educator, speaker and thought leader in the field of management and

finance and is a leading expert on capital structure and shareholder value. He has been teaching new venture financing and entrepreneurship to graduate students for over a decade. Kirby currently serves as an adjunct professor in the Finance department of the David Eccles School of Business at the University of Utah. A veteran of the venture capital industry and a pioneer of emerging approaches to raising capital, Mr. Cochran has been at the forefront of the growth company financing and management trends for over twenty-five years. In his new series of articles entitled Leadership Insight, Mr. Cochran reveals secrets used by entrepreneurs and CEOs to drive growth in their companies. This information has always been difficult and painful for Senior Managers to acquire, found only in the ruthless university of experience and obtained through costly tuition at the school of hard knocks. North Point Advisors, the firm founded by Mr. Cochran, advises growth companies on the implementation of the best practices discussed in Leadership Insight for increasing shareholder value.

ACKNOWLEDGEMENTS
Chad Jardine, my close associate and friend, was responsible for much of the leg work and physical writing of this article. His contribution allowed the principles and practices of my consulting process to come to life in written form and bring my insights, personal experiences and unique “voice” to a new audience via the printed page.

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Cochran, Kirby. 2008. What About Those Pesky Shareholders. (Another article in the Leadership Insight series.) 2 Norquist, Grover. 2008. Tax Issues Front and Center in 2008. Real Clear Politics (March 9), http://www. realclearpolitics.com/articles/2008/03/tax_issue_front_and_center_in.html (accessed July 15, 2008). 3 Benz, Christine. 2006. How Did Investors Really Do?: Investor Returns Help Capture Shareholder Experience. Morningstar Fund Spy (November 13, 2006), http://news.morningstar.com/articlenet/ article.aspx?id=178504 (accessed July 15, 2008). 4 Spencer, Jane. 2005. Lessons From the Brain-Damaged Investor: Unusual Study Explores Links Between Emotion and Results; ‘Neuroeconomics’ on Wall Street. The Wall Street Journal Online (July 21, 2005), http://online.wsj.com/public/article/SB112190164023291519-rvYW40ZbTjek4HWC DUyijBCigY8_20060720.html?mod=tff_main_tff_top (accessed July 15, 2008). 5 r strong, Robert, and Jacob Ward. 2008. Money Minded: How to Psychoanalyze the Stock Market. Am Popular Science, February. 6 o enwald, Michael S. 2008. How Thinking Costs You: Behavioral Economics Shows That When It R s Comes to Investing, People Aren’t That Smart. Washingtonpost.com (May 25, 2008) http://www. washingtonpost.com/wp-dyn/content/article/2008/05/24/AR2008052400002_pf.html (accessed July 15, 2008). 7 Ibid. 8 Ibid. 9 Ibid. 10 Investopedia. 2008: Five Chart Patterns You Need to Know: Treasury Bill–T Bill. http://www. investopedia.com/terms/t/treasurybill.asp (accessed July 15, 2008). Note: A short-term debt obligation backed by the U.S. government with a maturity of less than one year. T-bills are sold in denominations of $1,000 up to a maximum purchase of $5 million and commonly have maturities of one month (four weeks), three months (13 weeks) or six months (26 weeks). T-bills are issued through a competitive bidding process at a discount from par, which means that rather than paying fixed interest payments like conventional bonds, the appreciation of the bond provides the return to the holder. 11 Benz, Christine. 2006. How Did Investors Really Do?: Investor Returns Help Capture Shareholder Experience. Morningstar Fund Spy (November 13, 2006), http://news.morningstar.com/articlenet/ article.aspx?id=178504 (accessed July 15, 2008). 12 Gold, Donald H. 2007. Don’t Let Emotion Ruin Investing Choices. Investor’s Business Daily. (January 4, 2007) http://www.investors.com/editorial/editorialcontent.asp?secid=1100&status=article&id=252 803370965116 (accessed July 15, 2008). 13 Hackett-Dominguez, Wendy J. The Psychology of Investing: Understand the Emotions That Underlie Your Investment Decisions. National Association of Residents and Interns. http://www.nari-assn.com/ news/psychology_of_investing.html (accessed July 15, 2008). 14 h tt, Gaurang. 2005. Greed, Stupidity and Market Follies. Boloji. (August 21, 2005) http://www.boloji. B a com/rt2/rt186.htm. (accessed July 15, 2008). 15 Mo ningstar. Investing Classroom: Stocks 400. 2005. http://news.morningstar.com/classroom2/course. r asp?docId=145104&page=1&CN=COM 16 h tt, Gaurang. 2005. Greed, Stupidity and Market Follies. Boloji. (August 21, 2005) http://www.boloji. B a com/rt2/rt186.htm. (accessed July 15, 2008). 17 Investor Psycholoyg. 1999. http://www.deanlebaron.com/book/ultimate/chapters/invpsy.html (accessed July 15, 2008) 18 Caginalp, Gunduz. 2001. The Real Year 2000 Problem: Investor Psychology. The Journal of Psychology and Financial Markets. 2 No. 1: 2-5. 1

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