Wednesday, January 07, 2009

You can learn a lot about market psychology at the craps table

You think I'm kidding, right? Let me tell you a story.

My friend Tom and I took the occasional trip to Las Vegas in our single days, and after I got tired of trying to count cards in blackjack, he convinced me to try craps.

In craps, you can bet with the shooter ("pass" and "come" bets) or against ("don't pass" and "don't come"). The same bets are possible, and the payoffs are proportional to the odds of each occurrence. In other words, it's the same game either way.

Given all that, you'd imagine that as many people would bet the don't pass and don't come as the pass and come lines. But they don't. My unscientific observation is that 90% of craps players play with the shooter, not against.

I noticed something else. When I played "don't pass" and "don't come," people gave me dirty looks. They completely forgot that the dice have no emotion; they come up seven or eleven or eight or whatever and the game pays out or takes your money accordingly. After a while, it just seemed easier to play with the shooter. I could then be part of the crowd.

I sense a similar psychology at work in the markets. Shorting stocks is more complicated than playing the "don't pass" line, but there's no significant impediment to doing so. But not only is shorting much less common than going long, there's also a stigma against doing so.

Companies whose stocks are shorted scream that the short-sellers are generating and amplifying negative news to influence the direction of prices. You'll never see even the world's most successful short-seller compared to Warren Buffett or Peter Lynch. Analysts (perhaps till recently) rarely trotted out "sell" recommendations.

This wouldn't be a problem except the goal of an efficient market is to price a security properly. This requires downward pressure when things aren't as they should be. If there aren't enough short sellers, there won't be a counterbalance to ebullient buying. Momentum kicks in, and a bubble ensues.

I don't know how much this had to do with our current problems, but I bet it was a contributor.

(For those wanting to read interesting perspectives on the financial crisis, I'd recommend Felix Salmon's blog on Portfolio, James Surowiecki's blog, and the Economist's Free Exchange blog.)

Photo by runneralan2004 via Flickr Creative Commons

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