Retirees, Procrastinate At Your Peril

Fun or Future Famine

Given a choice between doing something light-hearted and fun which brings immediate gratification or something boring and difficult that won’t pay off for decades – if ever – most of us wouldn’t find it very difficult to make a choice. In fact we’re probably designed to operate this way, since the probability of surviving long enough to enjoy our future wasn’t very great for most of human history.

Now, however, things are different. In the developed world most of us are going to live long past our sell-by dates. Which means our in-built tendency to prevaricate over the tricky, boring and very long-term problem of preparing for retirement is an issue that most of us can’t afford to put off a day longer. If we’re to avoid eking out our dwindling days in destitution we need to stop procrastinating, pronto.

Hyperbolic Discounting

Procrastination is the technical term for the preference of pleasure today over pleasure tomorrow. It’s been the subject of considerable research because the failure of tomorrow’s pensioners to plan for their old-age is a major concern for governments. They’d rather not have to deal at all with old people who don’t pay any taxes and who are a burden on healthcare services, but when they haven’t got any savings they’re worse than a nuisance as they tend to moan a lot and generally vote the wrong way.

One of the odder impacts of procrastination is the effect of time as captured by something called hyperbolic discounting utility. Generally people will take $100 today over $110 tomorrow but would rather have $110 in twenty one days over $100 in twenty. Of course, when the days count down and day 20 becomes today they reverse their preferences. This is profoundly irrational because over such short periods the risk of not being paid is minimal.

Paying Through The Nose

Our desire for short-term gratification and our inability to properly calculate the cost of money allows companies to make heaps of profits out of us. Pretty well anything that enables us to get what we want today without paying for it until tomorrow is enough to get us hooked. So offers of instant credit by stores gets people buying on the never-never like there’s no tomorrow. Only there is, and when it comes we pay through the nose.

Of course, the counter argument is that people should show more self-restraint and that our consumer oriented economy is at fault. The evidence, sadly, is that self-restraint is the exception, not the norm, and people like consuming: it stimulates the limbic centres of the brain and makes them feel happy. Extreme shopaholics have to be treated by drugs targeting these areas, such is the addiction issue.

Hedonism Versus Inertia

Stores aren’t the only beneficiaries of our short-term hedonistic ways. Credit card companies are well known for offering low or zero teaser interest rates to get people to switch, only to rack up the fees later on. The huge impact of the short-term is shown again by research which demonstrates that people will go for the lowest possible initial rate even if offered a better deal with a slightly higher starting rate.

The credit card transfer effect is, in fact, a war between two competing tendencies – short-term pleasure seeking and basic inertia. The rates have to be so good because otherwise we just can’t be bothered to change our ways. Banks habitually take advantage of this by offering zero interest on checking accounts and higher interest savings accounts. No matter how easy it is to transfer funds we generally don’t bother doing so, presumably because we’re out shopping and filling in credit card applications.

The list goes on: preferential insurance rates for new customers, payday loans, mortgage protection policies and extended warranties for instance. The latter two products capitalise on another psychological trait, by the way: the tendency to not worry about small add-on costs when you’ve just made a large purchase. That’s why a salesperson will always sell you a suit first and the accessories afterwards – when compared to the large upfront cost of the expensive suit it’s relatively easy to sell other items afterwards because we anchor on the big number. Suits you, sir.

Retirement Planning Isn’t Pleasant

However, the problem of procrastination goes way beyond the simple issue of instant gratification versus delayed pleasure. Whenever we decide to do something we implicitly decide not to do other things. Even more, we need to decide which tasks to devote time to and which to simply skim over. More difficult and less pleasurable tasks – such as planning how to save money for retirement – are likely to find themselves at the bottom of the list. If they get done at all procrastination will tend to ensure that they’re done inadequately: so retirement planning defaults to what someone who knows a friend who’s consulted an advisor is doing.

Anyway, it’s doubtful if most people can figure out how much they need to retire on. Take Harry Markowitz, the inventor of modern portfolio theory. Did he analyse the co-variances of the various asset classes available to him to figure out an efficient frontier in order to design a portfolio optimised to give him the best return for the lowest risk?

Did he heck.

He did what most people do and split up his contributions equally between the available asset classes. However, there’s a lesson here as well. Better a roughly right decision made quickly than a perfect solution that takes a decade to implement. The time to act is now. Always.

Dumb, Dumber and Poor

As ever in finance financial biases are most damaging to those people with less understanding of the problem area. Procrastination is no different. So reasonably aware and switched on investors are less likely to delay sorting out their finances. As O’Donaghue and Rabin have shown, even relatively low levels of problems with self-control can cause naive investors to avoid the issue completely. It falls in the class of “too hard” so they never get round to dealing with it.

But it gets worse (of course it does, this is the Psy-Fi Blog). Understandably people are more likely to procrastinate over important issues than minor ones. So, for instance, someone may decide to sort out their retirement savings issue but then be unable to complete the task because they’re presented with too many options. Fear of getting things wrong may mean that they end up doing nothing.

The researchers argue that three factors interact to determine whether or not procrastination takes place – self control or lack thereof, domain knowledge or a similar lack thereof and the range of possible options. Even people with good knowledge and exemplary self control may end up dithering if presented with too large a range of options. And, to cap the issue, the more important an issue is, the more procrastination is likely. So investing $100,000 is likely to prove harder than investing $10,000. Although presumably spending it wouldn’t provoke the same level of cognitive dissonance.

Paralysis By Analysis

The odd, but inevitable conclusion, from this research is that when figuring out what to do about the tricky business of retirement investing people may never get around to doing it because it’s too important. It’s hard to know what’s worse – a mass of pleasure seeking, live for the moment hedonists ignoring their retirement problems because of lack of self-control or the responsible and thoughtful folks who are paralysed by analysis.

The answer to this appears to be one that sits uncomfortably with democratic, free market ideals – to use our behavioural biases to coerce people into doing what’s best for themselves. Whether you agree with it or not the evidence is clear: if we don’t help people help themselves then we’re looking at a grim future for millions of dumpster diving pensioners. The alternative may be waking up to find a granny in your garbage.


Related Articles: It’s Not Different This Time, The End of the Age of Retirement, Don’t Lose Money in the Stupid Corner

Cyclical Growth, Form and Fibonacci

Ancient Ideas, Modern Setting

As an up-to-date in-your face sort of blog we like to make sure our readers are well informed about the financial world as we see it. So, starting back in Ancient India in 200BC and taking in medieval Italy and some early twentieth century anti-Darwinian evolutionary thinking let’s take a look at plant growth and snail shells, how twentieth century humanity’s inclination to see the Man in the Moon translates into modern financial theory and why physics may simply be wishful thinking.

At the root of this journey is a simple mathematical progression named after a man who never discovered it and was more concerned with accountancy than trading. Still, he’s still remembered a millennium after his death, which is more than most of us can ever aspire to.

The Golden Ratio

In 1202 the Italian mathematician Leonardo of Pisa, aka Fibonacci, wrote Liber Abaci, a book which has three claims to fame in financial circles. Firstly it was one of the first books to introduce the Arabic numbering system to the West. Secondly it laid out the foundations of modern bookkeeping. Thirdly it presented the number pattern known as the Fibonacci sequence, although this had been known long before by Indian mathematicians. Only the latter has little significance in the development of science and business but, naturally, it’s the one that’s received the most attention.

The Fibonacci sequence is that that which starts with 0 and 1 and proceeds by adding the previous two numbers in the sequence to create the next one. So you get: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, etc, etc. Divide any Fibonacci number by the one below it and, as you get higher up the sequence, you get closer and closer approximations to the so-called golden ratio of 1:1.618.

Fibonacci in Living Form

As a piece of pure mathematics the sequence is unremarkable until you start digging around in the real world and find it appears regularly in nature. It can be found in many forms – in the arrangements of leaves around a stem, in the structure of sunflowers and pine cones and the shape of snail shells. The appearance of the golden ratio in nature has led many people to suspect that it embodies some kind of mystical significance. These people are idiots, of course, but idiocy has never been a bar to success in this world.

The true explanation for the presence of the Fibonacci sequence in nature was provided by D’Arcy Thompson back at the beginning of the twentieth century. In an age where evolution was accepted but the genetic code underlying it was not widely known Thompson was not alone in trying to find alternative explanations for natural selection. In the unique and beautifully written On Growth and Form he showed how many of nature’s creatures were adaptations of simple geometry rather than difficult evolutionary changes.

Essentially, Thompson argued that there were a few geometric forms suitable to life on Earth and by changing the morphology of these you could explain the majority of physical animal shapes. As an example, he showed how changing a few physical parameters could generate the whole range of different crab shapes found in nature. On a similar note, he showed how the golden ratio is the best physical adaptation to the shape of snail shells.

Order Out of Chaos

The existence of Fibonacci sequences and the golden ratio in nature is therefore not the result of some divinely inspired meddling but the process of natural selection figuring out the best forms for survival. It so happens that Fibonacci numbers offer the most optimal form of growth or packing for certain creatures and that natural selection has, though its normal process of trial and error, figured this out. It’s not that the golden ratio is “out” there, it’s simply that nature finds an efficient way of managing its resources to best effect.

Indeed the golden ratio is a trend rather than a fixed rule. Many flowers, for instance, don’t use Fibonacci numbers and the oft-quoted “fact” that the golden ratio defines the proportions of a human is simply wrong. In fact, judging by the preference of artists down the ages, it’s not even the preferred ratio of human beauty. Statements alleging that the golden ratio is everywhere and unavoidable are, simply, nonsense propagated by mystics and financial theoreticians. Not that there’s much difference between the two, usually.

Elliot Waving Not Drowning

The appearance of this mathematical sequence in nature, however, convinced many people that there was something special about it. As we’ve seen in recent times there’s no industry more attracted to mathematical solutions to complex problems than the financial sector and this isn’t simply a recent trend. The search for the magic formula for making money with no risk and less brainpower has been around for about as long as money has.

Back in the 1930’s Ralph Nelson Elliot developed a technique for forecasting market price movements which he, at some point, decided was based on the Fibonacci sequence. The principle of the Elliot Wave is that collective human psychology drives moves from mass optimism to mass pessimism and then back again. In Elliot’s reconstruction the ebb and flow of the markets is done in an eight step process, five up and three down, ranging over timescales from minutes to a grand supercycle of multiple centuries. According to Elliot the Fibonacci numbers simply appeared out of his theory, although there’s no known underlying principle to explain this. It’s just the way the world works, presumably: shake your chakra, baby.

For reasons we don’t quite understand humanity seems to have a drive to see cyclical behaviour in nature. Going all the way back to Ancient Greece the circle was viewed as the symbol of perfection and a whole model of physics was generated out of this, complete with circular orbits around the Earth. When the universe failed to play ball with the theory, by making planets seen from the Earth go backwards the scientists naturally refused to change their theory and instead developed an elaborate and wondrous system of epicycles, circles within circles.

Epicycles in Finance

Of course, the model was wrong, being based on a false premise, just as models of stockmarket behaviour based on Fibonacci sequences are wrong. The golden ratio exists in nature because it’s the optimal solution to specific problems, not because the universe is designed that way. Our projection of pure mathematics onto the universe’s haphazard geometric best fit engineering solution seems like as good a metaphor as any for the way that modern physics is trying to understand how our universe is put together. Instead, maybe it’s just the only way of making the damn thing work.

In Elliot’s work and the development of multiple other stockmarket cycles – Kitchin, Kuznets, Kondratieff – we see humanity trying to impose order onto chaos. It’s in our nature to try to find patterns, because we’re pattern matching creatures: it’s our way of structuring the world around us. Sadly this often plays us wrong, causing us to see a Man in the Moon, castles in the clouds and cycles in stockmarkets.

Spurious Stockmarket Structures

Many of the more recent market failures have been caused by attempts to model stockmarkets on the assumption that there’s structure underlying them. This spurious quest for structure and precision where none really exists is dangerous for investors. From time to time any theory will work – possibly because enough people believe it, possibly by chance. Inevitably, however, all theories will melt into oblivion in the crucible of market madness.

Those ancient Indian mathematicians knew a thing or two, but they didn’t know about stockmarkets. Remember – the truth isn’t out there, it’s inside us. Trusting in invisible sequences in random systems won’t always be successful, even if those sequences genuinely appear in nature. Systems including humanity will never obey nature’s simple physical laws.


Related Articles: Technical Analysis, Killed By Popularity, Correlation Is Not Causality (And Is Often Spurious), Gaming The System

So What’s Behavioural Finance Ever Done For Us?

“7 Ways To Profit From Other People’s Folly” has been posted over on Monevator with thanks to the Investor. For anyone interested in some background here are the relevant links …

1. That there’s always a crisis just around the corner was covered in Panic!
2. Everyone’s affected by behavioural biases is a repeating meme, but see You Can’t Trust The Experts With Your Investments and Overconfidence and Over-Optimism for some examples
3. That stocks tend to under and over-react to news due was touched on in Regret, a fact that generally because …
4. Everyone’s risk adverse, at everything, as discussed in Loss Aversion Affects Tiger Woods, Too
5. Investor gullibility was addressed in The Halo Effect: What’s In A Company Name? although there are countless examples elsewhere
6. The importance of either getting good feedback or simply being miserable was reflected on in Depressed Investors Don’t Need Feedback, Everyone Else Does and that
7. Anecdotes are not evidence was pointed out in Fairy Tales For Investors

Happy researching!

Sexual Trading

Contagion in Markets

It’s often remarked that stockmarket manias and panics are contagious, as though there’s some virus spreading through the markets, infecting the participants and causing their irrational behaviour. Of course, this is usually meant as a metaphor rather than something to be taken literally – it’s a nice conceit that there’s a disease “out there” causing us to all do stupid things all together.

However, humans are social animals, we live in social networks and networks are prone to attack at their weakest points. Models of how real and virtual diseases spread – the study of epidemiology – can give us clues as to what’s really happening when everything goes screwy. And it turns out that the more connected we are the more danger we’re in.

Rod Steiger’s Network

Most people are aware of the Kevin Bacon game which measures actors by how close they’ve come to acting with the prolific star of Flashdance. Someone who’s acted in the same film with Kevin has a Bacon number of 1, someone who’s acted with someone who’s acted in the same film as him has a number of 2, and so on. By tracing out this network researchers have been able to piece together the network of social connectedness amongst Hollywood actors. In fact it turns out that Mr Bacon isn’t anywhere near the most connected actor, and the thesps should actually be linked by the Rod Steiger number.

What’s really interesting, however, is what happened when the researchers looked at how the actors were connected. It turned out that the average actor has an average number of connections but that a few, key, thespians held the network together. These critical “nodes” had far, far more connections than most of their fellow luvvies. If you think of this as a network, then if you could somehow remove the key players then suddenly the whole thing would fall apart.

Scale Free Networks

It turns out that this is a decent model for the way most social networks link and, in particular, for the way diseases spread. Epidemiologists have a real interest in understanding this because they’re interested in figuring out how to prevent the spread of diseases like AIDS. When a bunch of researchers from Stockholm and Boston studied the Web of Human Sexual Contacts they discovered a network that looks an awful lot like that of the actors. Preventing the spread of sexually transmitted diseases turns out to be difficult because not all of the people have the same importance within the network: the especially promiscuous individuals – the critical nodes – were the key. Targeting these people successfully could stop the disease transmission, but a failure to do so would see re-infection occur again and again.

Networks like these are known as scale free, because there’s no pattern to how connected each node can be – to be precise, the distribution of connections follows a power law. It seems that the worldwide web has the same pattern. A few, very popular websites, are linked to with a frequency that’s way in advance of the average site. These sites are our critical points for disease transmission when some problem sweeps the information highway. And herein lies the next clue to the epidemiological model of stockmarket madness.

Markets Are Social Networks

Markets are inherently comprised of traders, agents communicating with each other, doing deals. Some of these agents are our supernodes, the critical people holding the vast majority of the network together. If these nodes get infected then we can surmise that all of their unimmunised contacts also get the virus. Which is why we have nothing to fear but fear itself.

Interestingly this research suggests an amendment to efficient markets theory rather than an alternative to it – a reminder that econophysics research like this comes from a background of rational theory rather than empirical observation. The development of scale-free networks from models of interacting traders has been observed by Tseng, Chen, Wang and Li, who posit a concept of zero intelligence traders in their models. This, of course, may be rather closer to the truth than they imagine, but the argument is that the scale-free nature of the network emerges from market structure, not trader interaction – aka, the Efficient Market Hypothesis.

On the other hand a paper from Rossitsa Yalamova suggests that extreme market events are a result of the coordination of trader activities due to synchronisation of trading rules through a relatively small number of highly connected individuals. As she states:

“I argue that stock price correlations actually reflect coordination of traders activity that might be initiated by different factors related to news or noise. At the end what determines price changes are trading orders. Therefore, I propose that price changes actually measure the interaction strength among traders especially in extreme events situation.”

Infection and Connectedness

So, if the key market nodes get infected then all we need to assume is that other people will copy their behaviour. From this it’s easy to deduce the spread of waves of buying and selling or, at extremes, manias and panics: the contagion that can spread through networks of this type is greatly exaggerated by these critical points getting infected. The same is true of the internet where computer viruses can survive long after they should have been destroyed – the ability of any critical node to re-infect swathes of the internet is the problem. It’s like one of our promiscuous lovers refusing to use any protection despite the clear evidence that they’re a danger to their partners.

So it is in markets, and modern technology makes it worse. The days when the average non-professional trader, working from home, was disconnected from the critical nodes has long gone. The critical nodes are out there on the internet, like giant spiders, spinning their webs, entrapping their clients and claiming their victims.

Immunise Yourself or Perish

Of course, there’s no getting away from the promiscuous purveyors of popular trading ideas, and the ever present global media, which likes nothing more than to feed off the extremes of human reaction: there’s no exciting copy in news that the stockmarket isn’t crashing or booming. So each of us has to take action ourselves, to seek out and immunise ourselves.

Worse, we need to desensitise ourselves to the opinions of those we work with or discuss ideas with. Danger lurks in listening to the authoritative ideas of anyone, but especially in social situations where herd like behaviour can develop: internet bulletin boards are a particular danger, although even simple investment clubs may be risky.

Developing a sceptical frame of mind when it comes to do with anything about investing is probably a good idea. As the old adage has it, you’ve got to buy when the blood is running in the street, even when it’s your own. You can’t bet against the market when all you’re doing is listening to what the market’s telling you: as anyone who sold stocks in early 2009 can tell you.


Related Articles: Newton’s Financial Crisis, The Limits of Quantification, Capitalism Evolving, Be a Cockroach Not a Dinosaur, Bacteria, Boids and Market Instability

Disclosure Won’t Stop A Conflicted Advisor

Monetary Conflicts

Nowhere are conflicts of interest quite so common as in the financial industry. Accountancy firms want to provide consulting services, credit rating agency employees want to work for security analysis firms, independent security analysts need to ensure their recommendations don’t lose their employers important mandates, financial advisors want to get commissions for recommending products … the list is almost endless.

The popular answer to these problems is almost always the same – disclosure of the conflict of interest so that the purchaser is fully aware of the potential problem. Unfortunately the reason that disclosure is so popular is that it doesn’t work. Even worse, it may actually make the problem worse.

Corruption’s Not The Problem

Let’s start this sad catalogue of problems with an important caveat. In almost all instances the problems caused by conflicts of interest between personal interests and professional ones are not cases of corruption. Of course there are some advisors who are blatantly dishonest and who deliberately oversell their products but these are relatively few and far between and besides aren’t the topic of our investigation. No, our bunch of conflicted advisors are driven by internal demons that are far more difficult to pin down. These are unconscious side-effects of various psychological biases rather than deliberate acts of criminal intent.

In the end most corrupt advisors get rumbled – although as Bernie Madoff has shown, this may take an awfully long time. The problem with the honest ones is that they’re still chiselling us yet would be able to fool a lie detector or, worse, their wives, without the slightest difficulty. Meanwhile the methods used to protect us from these practices may actually make things worse.

Disclosure or Regulation?

The most popular remedy to conflicts of interest is disclosure. The idea is that if the advisors, of whatever hue, declare their conflicts then we, the purchasers, can make a clear sighted call about whether the advice we’re being given is in our best interests. However, we can almost immediately identify two problems with this. Firstly, if we were really able to make such decisions then we wouldn’t need to consult an expert anyway. Secondly, even if we do adjust our behaviour to take account of the conflict we have no guarantee that the advisor won’t adjust theirs to take account of the fact we know about the conflict.

And if you didn’t get that don’t worry. We’ll get back to it soon enough.

The alternative to disclosure is often regulation, making the disclosed behaviour illegal. Mostly the affected parties prefer disclosure since this avoids them having to give up whatever they’re disclosing and also means that all parties don’t have to adjust to a difficult new reality. However, the idea behind disclosure is actually pretty dubious: it shifts the responsibility for making informed decisions from the (supposedly) knowledgeable advisor to the (usually) uninformed client.

The Dirt on Coming Clean

Cain, Loewenstein and Moore investigated this whole area in The Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest and anyone really interested in this topic should peruse the source material as it’s impossible to do it justice in a short article. It’s a very fine piece of research.

They took the basic idea of disclosure into a laboratory setting and set about developing an experiment to investigate its effects on advisors and clients. By comparing advisors’ own personal estimates with the advice they actually gave under different conflicted situations they found that:

1. If advisors don’t have any conflicts of interest their advice is unbiased;
2. If advisors do have conflicts of interest but don’t disclose them then their advice is biased;
3. If advisors do have conflicts of interest and do reveal them then their advice is even more biased.

Trying to disentangle the various threads involved in this is tricky but two possible explanations have been proposed. The first is simply that the disclosure of conflicts of interest leads advisors to assume that clients will discount their advice, so they increase the bias in their advice to compensate. The second is that the disclosure frees the advisor from guilty feelings about violating professional norms and this so-called “moral licensing” leads to more bias.

There was another problem, though. Although clients discounted their advisors’ opinions when the conflict was disclosed this was insufficient to offset the bias. Which led to even less accurate decisions than when the conflict was undisclosed.

Clients Are Also Conflicted

So this is a two-way street: clients are also affected by advisor disclosure, only not necessarily in the way you might expect. Other research has found that disclosure doesn’t necessarily deter clients from accepting advisors’ advice and may actually have the opposite effect. Two underlying biases seem to be implicated in this. Firstly we have a tendency to delegate difficult decisions to experts – so, for instance, we generally accept the opinions of our doctors without ever asking for a second opinion (a mistake, by the way). So the fact that we’re being told that the expert has a conflict of interest often doesn’t make much difference – the expert is the one in charge.

Secondly, the disclosure inadvertently seems to trigger a response that works along the lines of “if they’re told me about this conflict then that shows that they’re honest and if they’re honest then I should trust them more”. The fact that the honesty has been forced upon the advisor by a legal requirement to make the disclosure is irrelevant, it seems. It’s the disclosure that triggers the response.

Expert Evaluation of Expert Disclosure

Possibly the biggest problem, however, is that a disclosure of a conflict of interest by an expert often requires an expert to evaluate it. If you go to a doctor about a difficult medical problem and the physician tells you that you need an expensive drug but that she’s being paid by the pharmaceutical industry to plug it how do you respond? Does this disclosure help you make the decision or not?

Well, not, as it happens.

If you can’t trust the expert giving you advice then possibly your only option is to get another expert opinion. However, the evidence from medical research is that people don’t bother. This is possibly more worrying in finance than medicine. As Bill Bernstein has said:

“The depressing fact of the matter is that the federal and state governments do not protect investors in the same way that they do the clients of other professions. Amazingly, stockbrokers are not considered fiduciaries at all, as are practitioners of all other learned professions. This state of affairs is, in some respect, a historical accident.

All the professions I’ve mentioned, except finance, have long since recognized that regulation of minimal standards of training and practice is a necessity. It happened, for example, to the medical profession a century ago with the publication of the Flexner Report. Bluntly put, there’s no chance that your doctor, dentist, or attorney is a high-school dropout. Your stockbroker, however, just might be.”

After all, what is a financial expert anyway?

You Get What You Pay For – One Way Or Another

Disclosure’s a lousy way of fixing the kind of problems caused by conflicts of interest. It seems that business models that rely on promoting such conflicts are fundamentally flawed because they’re bound to trigger this type of behavioural confusion. In fact, wherever you find a situation where disclosure is mandated you should automatically assume that you’re at risk from these types of unconcious bias. As my grandmother used to say: you get what you pay for. Even if you don’t know you’re doing so.

The research says, that when it comes to advice, especially in financial matters, it’s always safest to pay directly rather than indirectly. Alternatively, get a second opinion.


Related Articles: You Can’t Trust The Experts With Your Investments, Bulletin Boards Are Bad For Your Wealth, Survivorship Bias In Magical Mutual Funds

Index Tracking At The Omega Point

Stick or Twist?

We’re hearing the clarion call of market timing ever more loudly. It’s unsurprising that this is the case – in times of almost unprecedented market volatility many people have suffered a horrible rude awakening about the true nature of stockmarket risk. By some measures markets have now returned the square root of bugger all for the best part of four decades.

Despite this we need to be careful that the alluring song of the naysaying sirens doesn’t blind us to the real meaning of risk. While passive investment can clearly be outperformed by people with time and money it’s not necessarily the safest way of proceeding if you don’t know what you’re doing.

And, to be frank, that’s most of us.

Read Full Post >>

Depressed Investors Don’t Need Feedback. Everyone Else Does.

Depressed Yet Clearsighted

Although it’s easy enough to show that overconfidence is a blight on investment performance we need to be careful that we don’t blind ourselves to an important reality. Overconfidence is not simply a problem for investing, it’s an issue that applies to most of us, most of the time in most of the things that we do. It’s not something we can simply stop because we wish it so.

In fact it turns out that there are only one group of people who are not habitually overconfident. Unfortunately these people are, instead, habitually miserable. It turns out that to invest sensibly you need to be depressed.

Overconfident or Depressed

That most people are overconfident is a finding that’s been replicated scores of times on a wide variety of tasks. However, the research showing the so-called depressive realism effect indicating that depressives are almost alone in not exhibiting overconfidence at least suggests a reason – that feeling confident about ourselves is a necessary antidote to real life and that if we saw our lives and the world we live in as the ghastly messes they truly are we’d be unable to function properly.

Trading off our mental health and general happiness in order to improve our investing returns, however, seems a bit of a bad bargain – although, we could equally well argue that if most people properly analysed their real returns they’d probably feel pretty depressed anyway. Of course, it’s quite possible that when an overconfident investor runs into the brick wall of a real bear market the cognitive car crash this causes can lead them to develop an aversion for all types of investing activities. Anything rather than face the grim reality of life as an average stock picker.

Feedback’s the Key

Fortunately there is an alternative to taking the anti-happy pills but it does require investors to force themselves to face their decisions, something the evidence suggests that many investors are reluctant to do. The problem is that unless we analyse what we’ve actually done we won’t change our behaviour, even when it’s obviously not in our interests, until we have no choice. Which will usually be when the repo merchant knocks on the door. Alternatively we need to calibrate ourselves against our actual performance and learn to adjust what we do.

Calibration’s a pretty simple affair, nothing more than the process of receiving and using feedback. The trouble with stockmarket investing is that there’s no simple, instantaneous feedback process to allow us to calibrate ourselves – often it takes months or years before we know whether any given decision was a good one or not. However, the evidence across many areas suggests that when people force themselves into calibrating their performance their success rate improves – often dramatically.

Geology, Accountancy and Weather Forecasting
 
Schoemaker and Russo’s 1992 paper on Managing Overconfidence is essential reading for investors. They give three examples of groups who don’t exhibit overconfidence – geologists, weather forecasters and accountants. In all three cases these groups receive rapid and effective feedback by design. In their own words:

“Being well calibrated is a teachable, learnable skill”

The beauty of this accelerated feedback is that it attacks overconfidence without needing to address the underlying psychological biases that cause it. And, of course, it’s something every investor can do if they’re motivated to do so.

Don’t Rely on Memory

In adding accelerated feedback to the armoury it’s crucially important not to rely on memory nor to tie ourselves down to definite statements. No investment is ever a 100% certainty and neither is any memory. Memories are too often simply reconstructions of what we want to believe. Investing decisions must be written down and then analysed at various points. This needs to cover both the positive and negative decisions – a decision not to invest is as important as a decision to invest, both can – with hindsight – turn out to be mistakes. The critical thing is to analyse the decisions in the light of the information used at the time and that generated by hindsight.

Yet it’s impossible to get every decision right so coming up with a probability judgement is important. Retrospectively analysing decisions where we thought there was a very high probability of success yet which have failed tells us something important about our inner states. Indeed conducting this analysis can be eye-opening: companies can suffer poor performance for any number of reasons many of which would have been completely unpredictable at the time. You may have covered every possible foreseeable risk and still be left with losses when the Finance Director runs off with the CEO’s spouse. And your shock would be nothing to that of their wives’.

The Harder You Practice …

Despite this, a fair percentage of investing results will turn out – with hindsight – to have been perfectly predictable. Calibrating your decisions is the start of the process of turning hindsight into foresight. At a qualitative level a simple list of pros and cons with regard to any given investment is an important start. It’s really important to force yourself to face the possible negatives of any decision at the time you make it. It’s even more important to look back at these judgements in the light of experience to decide whether or not you were being realistic in your judgements.

Shining the hard light of reality on our decisions doesn’t come naturally. We’re in danger of violating our own overconfident preconceptions about ourselves. Who wants to come face to face with the reality that we’re not very good at something we pride ourselves on? Yet the numerical evidence suggests that this is exactly the situation pertaining to a large proportion of investors.

… The Better You Get

The alternative is to continue to stumble blindly around in the hope that everything will turn out to be OK. If people insist on becoming active investors rather than passively letting the markets take their course, then they need to concentrate on improving their abilities. Experts get to be expert by practicing, not by simply wishing it to be so. Of course, if you accept the arguments of the more extreme proponents of efficient market theories then you’d conclude that this is a waste of time. However, that argument was roundly demolished many years ago some geezer called Warren Buffett in The Superinvestors of Graham and Doddsville which demonstrated that certain pre-selected investors were able to outperform the markets over many, many years.

Of course, it’s unlikely that simply by more carefully analysing your investment decisions that you’ll end up joining the exalted ranks of the super investors. However, if you’re going to invest actively it would be highly irrational to not try. Alternatively, of course, you could just try and make yourself really depressed before making any investment decisions.


Related articles: Overconfidence and Over Optimism, Pascal’s Wager – For Richer, For Poorer, O Investor, Why Art Thou Rational?

Investing With a Time Machine

An Obvious Approach?

Always and everywhere the market timing argument resurfaces in multifarious forms. The idea is simple: sell high and buy low: what could be more obvious? Well, there’s a problem. It’s not necessarily insurmountable but it’s definitely a bit tricky.

You may need a time machine to implement the concept successfully.

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Moral Corporations: An Oxymoron?

Ethical Management

In the wake of the fin de siècle scandals involving Enron and Worldcom came a new focus on business ethics. Most MBA courses these days routinely run courses where bored wannabe rich, thrusting junior executives are preached to about how money is not the most important thing. This situation is rich in comic potential, but one can’t help suspecting that the students are, if they’re paying any attention at all, simply constructing a checklist of how not to get caught.

The problem is that the unconstrained free market seems to encourage behaviour that in the normal context of human life would be regarded as completely unacceptable. Many of the ethical problems of corporations occur when their managers are unable to apply the morality of normal human interaction to that of business life.

Maximising Profits, Setting Incentives

Back in 1970 Milton Friedman argued in “The Social Responsibility of Business is to Increase its Profits” that … well, you can probably guess. His argument was based on the premise that executive officers have no right to spend company money on anything other than maximising profits because to do so is to defraud the rightful owners of the money – that’ll be us, the shareholders. He sets the limit of lawful action at the boundary of corporate law – whatever is permissible in law is permissible in business.

A related argument is that business people will only behave ethically if their incentives – their financial recompense and the strictures of the law – are set so as to ensure that they do so. There’s no need for any concept of ethics in this view – people behave as they’re incentivised to do and if they behave immorally then that’s because the framework they operate in is incorrect.

We’ve had a taste of what happens if these approaches to ethics are allowed to run amok, back in mid-nineteenth century Britain when the free market was allowed to flourish, almost unimpeded by regulation of any kind. By the normal human standards of morality it wasn’t a pleasant experience, albeit one that allowed the dark satanic mill owners to maximise their returns at the expense of a decrease in the average workers lifespan even as economic growth was exploding.

The point is, of course, that we can’t just rely on the argument from incentives or even the attenuated ethical model advanced by Friedman. These systems have obviously never stopped any determined shyster from pillaging the system, from Charlie Ponzi through to Bernie Madoff, nor dubious investments in dodgy regimes or ethically reprehensible policies like selling dried baby food to Third-World countries without clean water supplies. We simply can’t turn the debate about right and wrong over to remuneration committees and legislators.

Immorality is Behavioural

The reason we can make this call on ethical behaviour is that personal and business morality are closely related: we frequently behave unethically outside a business environment so it should be no surprise that we do so inside one. All that’s different is the context – although, as we’ll see, that can make a big difference. You’ll be unsurprised to know that at the root of these problems is a behavioural issue. Simply, we don’t recognise or accept when we’re being unethical. In the encouraging words of Tenbrunsel (1998):

“People believe they will behave ethically in a given situation, but they don’t. They then believe they behaved ethically when they didn’t. It is no surprise, then, that most individuals erroneously believe they are more ethical than the majority of their peers.”

We have multiple strategies for dealing with the nasty reality that we aren’t as honest as we’d like to think. My favourite is our use of euphemism to avoid facing up to unpleasant truths. So “right-sizing” means people getting fired and “downsizing” means people getting fired and “rationalizing” means … Yeah, well, you get the idea.

Travelling Hopefully Not Ethically

In all probability there’s an underlying evolutionary reason for self-deception. People who see the world in a less self-centred manner are given to more frequent bouts of depression: we may simply need to view ourselves through rose coloured glasses in order to survive. The theory is that we’re born liars because we need to be able to convince other people that we’re truthful – and to do that the person we most need to convince with our lies is ourselves.

Regardless, most people’s self-predictions generally reflect their hopes rather than any realistic self-understanding. The more socially desirable the behaviour that’s being predicted the less realistic tends to be the prediction – behaving ethically is, of course, socially extremely desirable. And, of course, people tend to be completely unaware of these biases.

In a business situation we’ll frequently be given a reason to cast our morals aside. Here our natural inclination to self-deception can collide with business imperatives to create the kind of ethical scandal that gets onto the front pages of the gutter press. To prevent this many businesses have introduced ethical monitoring systems to check up on our behaviour. As you’d obviously expect the introduction of such systems has a noticeable effect on ethical behaviour: people start behaving less ethically.

Much, much less ethically.

Framing the Situation

The monitoring systems seem to cause us to “frame” the situation differently. We no longer have to judge for ourselves what constitutes ethical behaviour. We frame the situation as a business one: the cost of misbehaving isn’t an ethical issue but simply a question of price.

A practical example of this was shown by Gneezy and Rustichini (2000) who studied day care providers. The nurseries introduced a fine to encourage more timely behaviour in parents who were persistently late to pick up their children. Naturally this resulted in a dramatic change in parent timeliness. As you’ve probably guessed – many, many more parents arrived late.

The introduction of the fine had changed the frame from a moral one “it’s not right to be late” to a business one “if I’m late it’s OK because I’m paying for it”. So much for financial incentives.

When we take together our ability – even our need – to engage in self-deception along with the tendency to frame business situations in a different way from those of our personal lives it’s not hard to see how business morality can be eroded. In particular when ethical degradation occurs in small steps we’re more likely to accept it – the road to Hell is paved with small transgressions.

Moral Ambiguity Rules, OK?

When corporate leaders fail the ethical test it’s almost always when they get muddled up between business morals and personal ones. Business morality and that of everyday life mustn’t be separated. We should respect the reality that many business decisions are sunk in moral ambiguity without demanding that executives leave their morals at home. Is it right for western clothing companies to pay third-world children a pittance for their labour? Or is it OK that they pay those children an above average wage for their society and ensure they receive a schooling that would otherwise be impossible? And where do we stand when both these situations are the same situation?

Corporations tread a difficult path between profit maximisation and an ethical quagmire. However, a company that encourages its employees to abandon their limited personal morals at the entrance can’t be trusted to tell the truth to its shareholders. Remember that “creative accounting” is a business euphemism, for “we’re lying to our shareholders”.


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