Rock On, January Effect

Born Lucky

Calendar related effects are amongst the most obvious manifestations of the way that collective human mental misbehaviour can impact stockmarket returns. Anomalies like the much observed January Effect, the outperformance of small cap stocks in the US markets during January, point to some kind of systematic bias in the structure of markets.

In fact there’s little doubt that the calendar does impact upon human behaviour but what’s in question is how it does so. Consider, for instance, the odd fact that people born between May and July consistently rate themselves as luckier than those who enter life’s great adventure between October and December. Nothing strange in that, you might think, until you discover that summer babies really are luckier than their winter siblings.

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Investment Forecasts: Known Unknowns

End of Year Epiphanies

At the end of every calendar year we experience a rush of forecasts on the likely direction of various markets and stocks for the next year. You can find thousands of such forecasts on the internet and you can’t pick up a paper without someone or other opining on the subject. In fact, no matter what your preference, you’ll doubtless find someone out there predicting whatever you want.

The uselessness of these predictions was carefully explained by the Ancient Greek philosopher Socrates, two and half thousand years ago. Not letting death, the lack of Ancient Greek stockmarkets or the fact he lived in an economy based on slavery get in the way of a good analogy, Socrates noted that he, at least, knew what he didn’t know. Which in investment analysis terms is about as close to an epiphany as you’re likely to get.

From Socrates to Rumsfeld

Socrates seems, as far as we can tell, to have spent his life in philosophical musings, preferring to spend his time asking the supposed wise men of Athens for their insights rather than doing anything more economically useful. His conclusion was, largely, that they didn’t know very much – an insight that echoes down the ages. They, on the other hand, decided that they didn’t like a smartass and the result is a lesson to would-be gadflies the world over.

In particular he seems to have annoyed the powerful by informing them that he knew something they didn’t. Having already upset them by showing up exactly how dim they were he then compounded his crimes by revealing his secret: “I know what I do not know”. If this sounds familiar, you’d be right:

“There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don’t know. But there are also unknown unknowns. There are things we don’t know we don’t know.”

It’s long way from Socrates to investment analysis via Donald Rumsfeld but I think we’ve just managed it.

The Known Unknowns of the Market

Socrates’ known unknowns are important for markets, because each of us can know – with something approaching certainty – that one of these is that there are people out there who know more about investing than we do. If different participants have different abilities when it comes to analysing and interpreting information then, by definition, the markets can’t be strongly efficient. Even if we’re all rational we aren’t all equally gifted.

However, if we are all rational then, if we recognise that other people know more than we do, we ought to stop investing actively. After all, if investment analysts and institutions have this much of an edge on us it makes no sense for anyone without demonstrably superior investing skills to try and compete with them. So if we’re rational maximisers then we ought to buy index trackers and content ourselves with sitting on the sidelines watching the heavyweights slugging it out.

Extending this argument, as the least good investors stop competing, the remaining participants will themselves divide into the best and worst groups with the winners taking the spoils. Once again members of the worst group should, rationally, stop investing actively and this process of winnowing should carry on until there is only one investor left. Who then has no one to invest with, leading to the heat death of efficient markets.

The Unknown Unknowns of the Market

Now, obviously, this isn’t what’s happening. Millions of people continue to dabble in active stockmarket investment in spite of having no obvious ability to outperform markets. Even better, they carry on investing even when they’re losing money, failing to learn from their mistakes. These people, who clearly don’t know what they don’t know, are the inefficient grit in the gears of the efficient market. Bless them, because without them value investing couldn’t work.

The behavioural weaknesses of market participants – certainly their overconfidence and lack of insight into the reasons for past underperformance – are clear and powerful drivers of market inefficiencies. Exploiting these inefficiencies should be the goal of all right thinking investors, which means that we need to be constantly looking for where people are behaving most irrationally.

These manifest inefficiencies mean that making anything approaching a detailed forecast is almost impossible. The end-of-year forecasting bonanza, which is largely driven by the need to fill column inches, is one of the odder and more pointless activities humans engage in, somewhere up there with bog-snorkelling and cheese rolling.

Random Forecasts

There’s so much data out there it’s possible to find evidence to support any theory you might like. Someone, somewhere, will be right – which is nice for them, but not much use for the rest of us trying to avoid losing money. Of course, the people who ought to be best at predicting the motion of the stockmarket ocean are those that are paid for the experience: security analysts.

Going all the way back to the original work of Alfred Cowles’ Can Stock Market Forecasters Forecast? in 1932 the evidence for analysts outperforming the market is ambiguous, to say the least. Possibly the best gloss on the situation comes from this paper by Ericsson, Anderson and Cokely who identify that the best analysts do seem to have an edge in making predictions but that seems to be linked to extremely constrained areas of expertise, is not generalisable to wider markets and is too small to be exploitable when costs are taken into account:

“With the possible exception of the advantage of trading by insiders, the advantage offered by expert investors is too small to allow profitable transactions, yet sufficiently large to show reliable gross abnormal returns, before the costs of the transaction are subtracted. From the point of view of expertise research we find that there are consistent individual differences among experts, with experts exhibiting specialization, and demonstrating superior and reproducible investment and forecasting performance”.

So as it stands even the best brains in the business don’t have the ability to outperform the markets so, naturally, the rest of the world – which has next to no experience of market behaviour – expects to outperform the analysts, heaven help us. The only thing that the mass of return seeking mavens has to offer as an advantage over the analysts, who, as we discussed in Rise of the Machines, have the most powerful computer systems, the best researchers and the cleverest algorithms around, is their willingness to outwait the latest trend. Obviously this is, generally, the only attribute they’re not willing to use to their advantage.

Hemlock for the Pundits

The end-of-year forecast frenzy is simply a bit of temporally induced fun which shouldn’t be taken seriously. Recognising not just that we don’t know very much but that most of the people telling us what to do don’t know very much either is an important step towards freeing ourselves from the straitjacket of our social conformity and becoming intelligent investors.

Socrates, of course, ended up drinking hemlock and committing suicide after annoying too many powerful people. That seems like a step too far in search of a perfect investing strategy but being willing to go against the trends and to ignore opinion is absolutely critical. So if you must read the pundits’ predictions at least do so usefully: write them down and then compare them with what actually happens.


Related Articles: Contrarianism, Regression To The Mean: Of Nazis and Investment Analysts, Technical Analysis, Killed By Popularity

A Sideways Look At … Behavioral Bias

Behavioural Bias on the Psy-Fi Blog

It’s pretty much a given that investors, analysts, regulators, executives, tipsters, brokers, dealers and the bloke next door with a day trading account and a nervous twitch are all affected by behavioural biases which cause them to do irrational things when investing, especially in open markets with near instantaneous price feedback. Although most economic models are still based around the concept of efficient markets you’d be hard pressed to find a economist capable of fogging a mirror that doesn’t agree that human psychology plays a major factor in major market movements.

Unfortunately academic approaches which aim to replicate market behavior by tweaking efficient market models often don’t translate well to the harsh, Darwinian world of real finance where people need to use these ideas to make money. Typically the models work right up to the point they don’t, when they fail catastrophically. Integrating behavioural finance into the models is a work in progress but, as individuals, we need to start by recognising the problems in ourselves before we can start to benefit from our insight.

Anyway, here’s a brief summary of the Psy-Fi Blog’s thoughts on behavioral biases …

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A Christmas Cavil

The Return of Marley's Ghost

If it could be said that a chain rattled apologetically then this one did, a feeble jingle, one hardly worthy of the name. Scrooge opened one eye and glared balefully out from under his night covers.

“Hi there,” said his dead ex-partner, Jacob Marley, exuding a blatantly false cheer while once more clinking the chains that bound him in a manner which suggested that he was embarrassed by the whole affair. “How you hanging?”

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Zombies in the City of London

Attention Deficit Disorder

Often, as I wend my way around the City of London, I find my way blocked by some slow, shuffling, seemingly moronic creature staggering along, head loosely hanging to one side, as it meanders across the sidewalk in a way calculated to force me into the gutter where I’m assailed by tricycling sandwich trolleys, homicidal hackney carriages and a mulch of yesterday’s free newspapers. Yet when I finally get past these drooling monsters it invariably turns out that they’re not zombies at all, merely highly paid financial executives who can’t walk and use their cellphones simultaneously.

In fact they’re suffering from the human inability to multi-task, being unable to attend to two tasks simultaneously – in this case walking and typing. Such minor cases of attention deficit disorder are quite normal but can become a major cause of concern for drivers of automobiles, manufacturers of aeroplanes and all investors – because attention anomalies are at the heart of many flawed investment processes and are, inevitably, used to manipulate investors something rotten.

Don’t Multi-Task in the Driving Seat

The idea that women, or people generally, can multi-task is a myth. Our parallel processing capability is designed for unconscious processing of multiple tasks, not conscious ones. Trying to consciously attend to multiple things simultaneously comes at a price, as we shift our attention backwards and forwards. In essence we have limited cognitive resources and spending these in switching rather than attending reduces our overall performance on all tasks under consideration.

This is increasingly a concern in the cockpits of aeroplanes. Providing too much information to pilots is dangerous, because the more they have to attend to the less likely they are to focus on the really salient issues like the fact that the ground is getting very large very quickly. A similar problem befalls drivers and the increasing range of in-car entertainment and navigation equipment is exacerbating the problem – if a driver stops directly attending to the road for much more than two seconds the risk of an accident increases dramatically.

Incidentally, you might think that if people can’t walk and use their cellphones at the same time then driving and using them might be even less safe. You’d be absolutely right. A mobile phone in the hands of an inattentive driver is one of the most significant dangers facing pedestrians and other road users. For more scary facts like this read Tom Vanderbilt’s excellent Traffic.

More Data, Less Information

In investment the limitations of attention have some different and rather peculiar results. Mainly what seems to happen is that investors, presented with too much data, focus on the wrong bits and make important decisions based on irrelevant information. The problem of figuring out what information to worry about and what to discard gets worse the more we’re presented with. This is a situation where more is definitely less.

In general, though, this poses a puzzle. Markets should get more efficient with more information, not less. One possible answer to this is that the real information is hidden in the excess data, so that as more information is presented it becomes harder and harder to see the wood for the trees. In essence, although information may be available in the public domain the harder it is to extract from the underlying data the less likely it is that it will be.

Potentially this is a rational solution to the failures of efficient market theories. If it’s too expensive to extract the data, because the rewards are ultimately less than the cost, then some information will remain undiscovered by the markets. The inverse is also true, however – if information is easy to extract from the data then it will be and markets will react to it. Which leads us to an interesting observation – that if one or more parties involved in the preparation of the data has a vested interest in keeping some information hidden then they’re likely to do so, as long as regulations permit this.

The Incomplete Revelations Hypothesis

One simple example of this are the headlines which accompany most results statements. Most experienced investors know to look for the dog that didn’t bark – things missing, like a profit statement or a dividend rise. This, of course, is a trivial example but it makes the point: managers of companies may choose to massage their public statements in a legally permissible way to obscure the really important information beneath a mountain of irrelevant data.

Robert Bloomfield points to a range of ways in which managers seek to make information extraction more difficult for investors, all of them strangely biased towards supporting higher stock prices. In his words:

• Managers choose and lobby for accounting methods that improve highly visible data, such as earnings-per-share and debt-equity ratios, and conceal expenses and liabilities in less-visible footnote disclosures.
• Managers classify arguably ongoing expenses as non-recurring or extraordinary items, while reporting arguably unusual gains as part of operating income.
• Managers develop “cookie jar” reserves to maintain the capacity for positive accruals to boost earnings in the future (Nelson, Elliott and Tarpley, 2002).
• Managers announce “pro forma” earnings numbers that emphasize improvements relative to their own strategically-chosen benchmarks, while making it more difficult for investors to observe other measures of performance (Schrand and Walther 2000, Krische 2001)

Underlying Bloomfield’s observations is his “Incomplete Revelations Hypothesis” which provides a way of addressing the problem we discussed in the Special Theory of Behavioural Finance; namely how do you marry the Efficient Markets Hypothesis – which describes how investors should behave – with Behavioural Finance – which describes what they actually do. So an investor may rationally choose not to spend their time extracting difficult to analyse information from otherwise obscure data while simultaneously being viewed behaviourally as showing limited attentional capacity.

Presentation, Not Content

The idea that our limited capability for attention is being manipulated by market participants who’d like us to behave one way rather than another, and that this manipulation can be carried out through the use of public information, shouldn’t come as a big surprise to anyone versed in the ways of the markets. However, what’s more interesting is to view this through the lens of metaphor: results statements are the gadget festooned displays of modern vehicles and while we’re busily attending to the obvious we’re being misdirected away from the important. My word, Mr. Pilot, the ground looks really big outside.

More evidence for this was provided by Maines and McDaniel who showed that the format of income statements affected the evaluation of the information by investors. This research was directed only at non-professionals so perhaps you might not find this too surprising. However, as usual with behavioral finance, what applies to amateurs also applies to professionals so when Hirst and Hopkins did the same sort of research on the latter group they found that financial analysts also had difficulty in identifying artificially inflated earnings statements. As they put it:

“…we believe this result is not surprising given the variety of possible ways a company can manage its earnings, the non-trivial effort required in detecting any of these activities, and the difficulty in distinguishing earnings management from other events”.

Quite.

Leave Our Zombies Alone

This type of underlying cognitive limitation comes with the territory of being human and gives the lie to more is better when it comes to data. The truly great investors develop their own analysis methods to cut through the chaff rather than relying on discovery by others, while the oft-quoted advice that people should only invest in what they understand also arises out of this limitation.

From all of this we can gain a few useful rules. Firstly, if you must invest in individual companies do your own research, read the footnotes and make sure you know what they mean. Secondly, avoid using any gadget in a car that requires dividing attention between it and the road. Finally, leave our zombies alone, because interacting with them may cause a significant overload in their liquefying brains. The world of high-finance has enough trouble already without losing its brightest and best under the wheels of a sandwich trolley tricycle.


Related Articles: Buyback Brouhaha, The Halo Effect: What’s In A Company Name?, Gaming The System

Stocks Aren’t Snakes

Rational or Emotional?

How do humans make decisions? Are we careful, rational processors of information or emotional, rapid – but possibly illogical – decision makers?

Well, the easy answer is that we’re both. Sometimes we take our time over decisions and sometimes we don’t. Some of us make more decisions one way rather than the other but we all use both methods some of the time. The question is, why do we do this? Why have two decision making processes, the results of which must inevitably lead to different outcomes on occasion? To answer this let's don our outdoor gear and go for a ramble in the wild.

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A Sideways Look At … The Randomness of Markets

Surviving Randomness on The Psy-Fi Blog

There are hundreds if not thousands of sites on the internet offering would-be investors self-help guides on how to become rich through investing in stocks. These cover the technical mechanics of investing, but generally fail to address the true art of the great investor, the management of one’s own state of mind.

Of course, here we swing to the beat of a different tune, holding fast to the syncopated rhythms of the mental processes within and between people which drive them to make investment decisions that seem often to ignore the basic logic of time and space. When examined closely it usually turns out that behaviour developed and honed to maximise our survival chances out in the real jungle is ill-adapted for the investment one. We’re frequently led astray by our instincts and unfortunately the markets trigger our reflexes all too often.

Here, then, is a selection of the Psy-Fi Blog’s thoughts on surviving the randomness of markets …

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Mental Accounting: Not All Money Is Equal

Coherent Holes

Now listen carefully, because this is where the bizarre, byzantine and seemingly disparate behavioural biases that afflict our every monetary movement start to coalesce into a single, coherent whole. Or at least a set of coherent wholes. Or is that coherent holes?

Mental accounting isn’t about the madness of the dark denizens of accounting departments, although that’d be as good a subject as any. No, in fact it’s the strange way that we humans turn the perfectly designed medium of exchange we call “money” into an irrational, segregated and non-transferrable set of silos to which we then apply all the normal battery of biased behaviours, thus gearing up our irrationality to a marvellously unhinged degree.

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Springing the Liquidity Trap

Bad Omens

We’re in the middle of one of the most dramatic experiments financial markets have ever seen. Central banks, across the world, have bet your house and mine on a gamble of extreme proportions yet, such is the unpredictability of markets, we’ll only know the outcome of this with hindsight, a notoriously unhelpful bedfellow.

The problem is that changes in monetary and market liquidity can trigger outbreaks of investor insanity and by pumping the world full of cheap money central bankers are gambling that they can manipulate markets to beat behavioural biases. The omens are not especially good for them getting this right.

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The Lottery of Stock Picking

Risk Seekers, Risk Fearers

On average stock traders lose money. So do people who play the lottery. Yet both sets of people will often buy insurance as well. On one hand people are risk takers, engaging in risky and usually unprofitable activities, yet on the other they’re risk adverse, looking to protect themselves against possible, although often unlikely, losses.

Mostly we don’t find this particularly odd. Yet it poses a particular problem for economists and psychologists trying to disentangle the various threads that make up the skein of the human condition. They feel we should either be risk seekers or risk fearers: to be simultaneously both suggests something strange is going on. Stock pickers take note: sell insurers, buy lotteries. Or is it the other way around?

Markowitz’s Lottery Puzzle

One of the earliest researchers to note this gambling/insurance peculiarity was Harry Markowitz who we’ve met before in Markowitz’s Portfolio Theory and the Efficient Frontier. In the same year he published the paper that eventually led to modern Portfolio Theory, the efficient markets mayhem and a Nobel Prize he also wrote The Utility of Wealth in which he both described this confused risk model and sought to explain it.

It’s a bit of surprise to find the father of rational investing theories elaborating on a subject which describes how irrational people really are. However his two 1952 papers are linked. While The Utility of Wealth describes how people really behave Portfolio Selection describes how they should behave to maximise their wealth. We can’t blame Markowitz for the investment industry using his ideas with all the subtlety of a Mob family collecting a debt from the man who wasted their mother with a cheesegrater.

Models which really aim to describe the way humans deal with risk are deluded and denuded if they exclude the risk-seeking part of the human experience. Deluded because they ignore the evidence of everyday life and denuded because they strip away the essence of human experience. Humanity would still be trolling around on its knuckles in East Africa if curiosity about what was on the other side of the forest canopy hadn’t got the better of our ancestors.

Utility and Gambling

Yet we can’t ignore the fact that we’re also risk adverse under many conditions. Buying insurance is sometimes an intensely rational thing to do – to pay a small premium to protect against the loss of a large asset such as our home makes a lot of sense. As commonsense people rather than academic economists, we don’t see the problem in a combination of risk seeking and risk aversion. After all, a small flutter on the horses or a bit of bungee jumping adds to the spice of life.

The classical economic explanation of these contradictory behaviours is full of complex equations and inflecting graphs which worry about the nature of something called the utility function. Utility is, roughly speaking, the value that a person gets out of an activity. Utility can be considered, roughly (OK, very roughly), as ‘happiness’ and many people have pointed out that the apparent inconsistency between risk seeking and risk aversion can be explained if you view the positive utility of pleasure people get from gambling as exceeding the utility they lose through the monetary expense.

Utility and Stock Trading

However, there are other sorts of gambling of which, for our purposes, the business of stock trading is the most important. When the same trigger that makes minor gambling on lotteries and horses enjoyable also encourages major risk taking in stock investment this supposedly harmless pastime suddenly becomes a deadly serious problem. As Meir Statman puts it in Lottery Traders:

“People confuse the stock-holding game with the stock-trading game. The stock-holding game is a positive sum game : buyers of stocks can expect to receive, on average, more than they spend. However, the stock trading game is a negative-sum game. In the absence of trading costs, management fees and expenses, stock traders can expect to match the return of an index of all stocks. But they can expect to lag that index once trading costs are considered. “

The problem with utility based models is that they rather ignore the fact that people process information very inefficiently. We can, and often are, fooled into thinking that the utility of a thing is different from what it actually is. So buying a long-term warranty on a fridge is usually a waste of money and so is buying a lottery ticket or actively trading stocks, no matter how much pleasure we get out of these activities. We miscalculate – and sometimes it’s a good job we do, otherwise life would be a drab procession of accountancy courses.

The Utility of Social Class

The problems lie deeper than this. Studies of lottery gamblers show that the people who spend the most money are those who can least afford it. Conversely those who spend the most on insurance are those who can most afford the losses they’re insuring against. Markowitz’s paper points to a possible explanation for this: people aspire to move up from their current social class and to avoid dropping down to a lower one.

Developments of this by Coelho and McClure also offer a hint of an explanation for the old aphorism that there’s nothing more damaging to a man’s happiness than his brother-in-law becoming rich. If our happiness is determined relatively – by assessing our wealth against our peers – then our peers getting richer than us will make us unhappy. Or, in the jargon, our utility reduces. And, the researchers predict, we’re likely to gamble more in the short-term to try to make up the defecit until our expectations about our peer group change.

The Illusion of Control

The sheer range of ways to invest gives investors every chance to delude themselves that they’re in charge. Ellen Langer pointed out as long ago as 1975 that illusion of control, the idea that people will behave as though they’re in control in situations where every outcome is actually determined by chance, seems to be part of human nature. As she puts it:

“…the more similar the chance situation is to a skill situation … the greater will be the illusion of control. This illusion may be induced by introducing competition, choice, stimulus or response familiarity, or passive or active involvement into a chance situation. When these factors are present, people are more confident and are more likely to take risks”.

Given that the vast majority of active funds and active traders do worse than simply buying and holding a basic index tracker you’d have thought the message would have got through by now. Illusion of control may cause more than financial risks. People still prefer to drive themselves for the same reason, despite the evidence that cars are the most dangerous way to travel any significant distance.

The only safe way of investing is to be constantly risk averse. There’s no contradiction in stock market investment and risk aversion – it simply means you need to insure yourself against the worst that can happen. Investing as though something is about to go badly wrong is the only safe option. After all, something is always about to go badly wrong, somewhere.

Avoiding Capital Mistakes

What most people can’t do is trade their way safely to riches – that’s to take on the risk seeking side of the equation. To do so at all is one thing, to do it without recognising it as an extension to natural risk seeking behaviour is entirely another.

There’s a part of us which embraces risk in order to better ourselves – to find the next fertile pasture, to seek a better world, to enrich our families and to remove ourselves from the monotony of the everyday grind. Without the drive to explore and take risks we’d still be wrestling chimps for food and using gravel as dental floss.

Risk taking is part of the human condition, to be embraced and cherished. But all things in their time and everything in its place – mistaking the stock market for a real world adventure playground is to make a capital mistake, in every possible sense.


Related Articles: Momentum Trading Madness, Markowitz’s Portfolio Theory and The Efficient Frontier, The Psychology of Scams