Confirmation Bias, The Investor’s Curse

Behavioral Biases (7): Confirmation Bias

The problem of confirmation bias – the tendency of people to seek evidence confirming an already held opinion and to avoid looking for that which might upset their carefully constructed mental models has attracted a lot of attention from researchers. It occurs across all domains of human endeavour and triggers all sorts of implausible behaviour, yet investors and institutions remain in its thrall.

We find examples in law courts and doctor’s surgeries, in scientist’s laboratories and the lairs of legislators. So we shouldn’t be surprised to find it coursing through the veins of economists and investors, colouring their every thought and structuring their every idea. Of course a rational market participant, faced with a theory built on a crumbling cornerstone will abandon their ideas and look for some new ones. As you’d expect, therefore, we do no such thing, clinging irrationally to the wreckage of our dreams as they collapse around us.

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Gambling, From Iowa to Soochow

Bodies and Brains

One of the more convoluted and, to the majority of the world, boring arguments among psychologists is around the extent to which we use our brains to learn. Of course a commonsense view has it that brains are fairly essential things for learning type activities but there’s also a view that bodies have a part to play as well.

Through a series of convoluted jumps this takes us from William James' research on phantom limbs, through the Somatic Marker Hypothesis and onto the odd findings of the Soochow Gambling Task. On the other, less invisible, hand it might be better for all of us if I simply skip to the nub of the problem: investors are addicted to gains, so much so that they’ll happily make overall losses just as long as they make lots and lots of small wins along the way.

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Freedom Of Financial Choice Is A Myth

Finance Isn’t Child’s Play

As we’ve navigated the nether regions of investing folklore like a drunken Frankenstein’s monster in search of a late night high cholesterol snack you may have formed the opinion that this author is somewhat sceptical of all investment processes that don’t explicitly guard against human psychological perversity and highly doubtful that those that do can overcome ingrained biases and an industry dedicated to causing us to do exactly the wrong thing at exactly the wrong time. Still, scepticism isn’t cynicism, and along the way we’ve found one small chink of light in the gloom; the finding that if you give people a financial education early enough in life it improves their money management.

Well, for all you folks out there preparing to send little Jimmy and Jemima to financial summer school don’t bother, because you’d be better off giving them your credit cards and dropping them at the nearest mall for a day. Sadly educating our kids about money doesn’t improve their investing decision making. In fact there’s a pretty strong argument that nothing does and it’s time to stop blaming people for allowing themselves to be exploited: the idea that everyone can be a financial expert is a myth. Time for a different approach?

Does Educating the Under 16’s Help?

Back in Financial Education Doesn’t Work we looked at the research showing that training in financial matters doesn’t improve peoples’ money management. Indeed, sometimes it makes things worse. However, some of the research in this area suggested that if you can give under 16’s some economics education the long-term effects of this are strikingly beneficial.

The key research in this area was from Bernheim, Garrett and Maki who showed that mandates requiring schools to provide personal finance education were correlated with higher levels of savings later in life. Teasing this information out wasn’t easy because we’re talking about periods of decades between the education being provided and the savings being accumulated. Such long term research, known as a longitudinal study, is notoriously difficult to run simply due to the elongated periods over which it must be conducted and the likelihood of the participants doing odd and unreasonable things like dying or developing an obsession about the end of the world and hiding out in a mountain cave with enough baked beans to float a balloon.

Education Doesn’t Help Financial Literacy

In contrast to the Bernheim, Garrett and Maki findings the Jump$tart Coalition for Personal Financial Literacy has run surveys of US high school seniors since 1997 and have shown a distressing fall in financial literacy. In essence, the financial education which is supposedly fresh in the minds of those groups of young people about to launch themselves into adulthood doesn’t seem to have stuck. This is a replication of a finding seen in other contexts – most notably that the financial understanding of economics students declines following financial training. The summation of the findings is provided in this report by Lewis Mandell, who also provides a much more detailed review of the work in this area than I have space for.

Now the Jump$tart findings clearly matter because if we can’t find a way of educating people about financial matters then we’re pretty much stuck when it comes to improving the financial services industry. If humans can’t understand the basics of compound interest, credit card costs, index tracker fees and variable rate mortgages then they’ve absolutely no chance of grasping the essence of mean reversion, stock valuation and exotic derivatives. Although, to be frank, it’s not actually clear that anyone really understands the latter: the suspicion is that many of these acronymic weapons of wealth destruction are generated by a computer programmed to spit out random numbers and are fronted by actors with weird hair who specialise in misdirection. Seems to have worked so far.

Financial Education Can’t Work

In fact there’s worse to come, because if we can’t find a way to educate people and we can’t overcome the implicit biases within the financial advisory industry then we’re more or less forced to go back to the drawing board and start redesigning financial products so that people can’t make mistakes. Lauren Willis in Against Financial Literacy Education puts it thus:

“The gulf between the literacy levels of most Americans and that required to assess the plethora of credit, insurance, and investment products sold today—and new products as they are invented tomorrow—cannot realistically be bridged. Educators would need to impart a sophisticated understanding of finance because rules of thumb are not useful for decisions about complex products in a volatile market. Further, high financial literacy can be necessary for good financial decision making, but is not sufficient; heuristics, biases, and emotional coping mechanisms that interfere with welfare-enhancing personal finance behaviors are unlikely to be eradicated through education, particularly in a dynamic market. To the contrary, the advantage in resources with which to reach consumers that financial services firms enjoy puts firms in a better position to capitalize on decision making biases than educators who seek to train consumers out of them.”

Bascially, the average human being doesn’t stand a chance in today’s complex financial markets and financial education isn’t going to solve the problem. Willis’ paper is brutal about the financial education model believing that it enshrines a myth about consumer self-reliance that then allows those self-same consumers to be blamed for their greed when everything goes wrong. If this model is fatally flawed because people can’t learn this stuff then the whole idea of consumer self-sufficiency in financial markets needs to be rethought, which ultimately leads to some pretty serious questions about the nature of those markets and their regulation. Perhaps most cuttingly Willis observes:

“That [the financial] industry supports financial literacy education is, while indirect, perhaps the strongest evidence that this education is not effective in improving consumer financial decisions”

Factors in the Failure of Financial Education

Four main factors preventing the success of financial education programs are identified:

1. Information Asymmetries and Chasing Moving Targets. Put bluntly, there’s simply too much choice in the marketplace, and the development of niche targeted products worsens the problem as they’re marketed to people outside of their original niches. No one can possibly cope with the complexity of the range of financial products in the market.
2. Insurmountable Knowledge, Comprehension and Numeric Skill Limitations. People simply don’t have the basic skills needed to even begin to understand the nature of the products that they’re being offered. For example, Willis quotes the research showing that after 40 years of use only 10% of consumers have any understanding of what an APR is.
3. Poor Conditions for Debiasing. Cognitive biases, as we’ve repeatedly seen, drive people into wealth destroying behaviours and the nature of financial markets provides a poor environment for overcoming these. Indeed, financial education can create an illusion of control and lead to unwarranted overconfidence in financial decisions, with predictable results.
   
4. Reaching Consumers at Teachable and Vulnerable Moments. A “teachable moment” is one at which a person is particularly receptive to the education on offer. For financial education this would normally be when an important decision is being made – buying your first house, acquiring your first credit card, etc. Willis argues that these moments are the points at which lifelong preferences are generated and then that they’re more likely to be set by the deep pockets of the financial services industry than by educators.

Don’t Bother With Financial Education

The conclusion is depressing:

“Given the foregoing, the failure to find any empirical evidence that the financial literacy education model works is not surprising. In light of the velocity of change in the consumer credit, insurance, and investment marketplace, the innumeracy of much of the population, the prevalence of decision making biases, and the financial advantage held by sellers of financial products, financial literacy education should not be expected to work.”

Given all of this what should we do? Well that’s a question for another day, but if interested parties want to avoid blaming the financial industry for the screwing up of pretty much everything then their only route out is through financial education – because only then can they continue to censure individuals for their mistakes, rather than acknowledging the widespread deceit that lies at the heart of the problem. Fact is, swamping people who have low levels of financial literacy – which is the majority of us – with a vast array of over-complicated products designed to feed their innate biases is just a cast iron way of ensuring another financial crisis is lurking just around the corner.


Related Articles: The Lottery of Stockpicking, Financial Education Doesn’t Work, Save More … Tomorrow

Pulling Up The Intellectual Property Ladder

Tragedy of the Anti-Commons

Human ingenuity has been behind much of the economic boom that the world’s undergone since the late eighteenth century. Sparked by the rise of reason in the form of deepening scientific knowledge and backed by increasingly large flows of capital there’s been an ever increasing range of ideas and inventions, some of which have even added to the sum of human happiness. I was particularly taken by the motorised ice-cream cone.

Behind this sparkling cascade of cleverness lies the ability of inventors to temporarily protect their inventions from competition by use of intellectual property rights – patents, copyrights and so on. Unfortunately, as we move forward, these monopoly rights may, in some cases, actually result in a slowing of progress as we increasingly face the Tragedy of the Anti-Commons.

From Monopolies to Patents

The development and evolution of patent laws stretches back hundreds, if not thousands, of years. We know that the Ancient Greeks granted temporally limited monopoly rights on particularly tasty recipes which seems to suggest that the modern cult of the celebrity chef isn’t so modern after all. By 1331 we find Henry VI of England granting John Kempe and his Company a patent in respect of the textiles industry. In fact this appears to have been an early attempt to attract skilled foreign workers to England rather than a reward for genuine innovation. Nearly seven hundred years on we’re still bribing scarce overseas workers to come here rather than fixing our education system.

Something like the first proper patent was granted in 1422 in Florence to the architect, genius and key Renaissance figure Filippo Brunelleschi for a barge with hoisting gear. In 1449, in England, John of Utynam received a 20 year monopoly to make stained glass and in the following year the Republic of Venice created the modern patent, mainly to protect its native glassblowing industry, presumably to stop England pinching all of its skilled workers, another continuing trend.

Patents were systematically abused by money-grabbing monarchs, particularly in England where the rulers were always short of money, granting monopolies for even commonly used stuff like salt and coal. Eventually the English, as is their wont, revolted and forced the introduction of the Statute of Monopolies in 1601, which is really the start of the modern patent system, as it enshrined the novel concept that the idea had to be new, rather than simply purloined, in order to be awarded a patent.

Monopoly Rewards

That patents and other intellectual property rights have had a beneficial impact on economic growth is beyond dispute. By ensuring that an inventor has a limited time to exploit their idea the system rewards innovation, encourages exploitation and eventually gives the rest of the world free access to the accumulated wisdom of the ages. However, as we can see, patents are closely entwined with monopolies and anti-trust issues, which means that these rights need to be carefully managed if we’re all to benefit properly.

Underlying the awarding of patents is the idea that they’re a public good – the benefit of the temporary monopoly outweighs the downside of monopolist price gouging. This isn’t always an easy coupling – particularly as we’ve seen with large pharmaceutical companies demanding first world prices of third world countries for treatments for diseases like AIDS. On one hand, without the excess profits that come from patent exploitation these corporations have no reason to invest the billions of dollars that they do. On the other, denying millions of sick people drugs that could usefully extend their lives is morally objectionable.

There isn’t an easy solution to the problem and the resulting mess where governments have effectively forced the drugs companies to sell to them cheaply will almost certainly result in less investment in treatments for diseases targeted at those countries. It’s not a happy situation.

The Tragedy of the Anti-Commons

However, there’s another more insidious problem with patents and the ever-increasing pace of innovation. This was first pointed out by Michael Heller, who’d been puzzling over why there were so many empty stores in ex-communist countries despite the fact there was obviously huge demand for retail space. Drawing on Hardin’s idea of the Tragedy of the Commons, where property owned by no one is ruthlessly exploited to the detriment of all – think overfishing of deep sea stocks or pollution of the air we breathe – he postulated the idea of the Tragedy of the Anti-Commons.

The problem in Moscow and other Eastern European cities, it turned out, was that the ownership of the property rights for the stores was widely distributed between lots of different groups each with different agendas. The sheer difficulty of getting these disparate parties to agree on something that would have been beneficial to all of them meant that the stores stayed empty while open air booths sprung up in front of them.

Technology Patent Anti-Commons

Since Heller postulated this idea it’s been suggested that a similar problem exists for modern corporations attempting to develop new technologies. The issue comes because, increasingly, any new device requires the use of hundreds and possibly thousands of patented inventions: even the humble CD player requires at least a dozen licences, a microprocessor needs thousands. It only takes a single hold-out to prevent the possibility of a useful advance in technology.

As the pace of technological innovation has increased the sheer impossibility of avoiding patent infringement has increased. The dispute that nearly shut the Blackberry network down is caused by a single disputed patent in a device which uses thousands. Nokia is now suing Apple over ten patents on the iPhone – no doubt they’ve been trawling their patent library for months to find these and, doubtless, there are many more to be found around the world.

Biomedical Patent Anti-Commons

Another area where the spectre of anti-competitive problems arise due to anti-commons issues is in biomedical research, particularly where commercial organisations are patenting human gene fragments and other fundamental biological intellectual property. This is likely to prevent further useful exploitation of these discoveries because in order to test the effectiveness of any treatment it may be necessary to test the whole spectrum of the human genome. By splitting it up into ever greater groups of patents owned by differing parties it may become impossible to effectively conduct medical research.

While we might expect that the market would find a way of solving these issues – say as the music industry has by developing groups holding copyright for lots of artists – simple behavioural biases may restrict their development. Hewson and Eisenberg suggest that the problem we have estimating the likelihood of low probability events of high importance to us and the associated issue of tending to overvalue stuff we’re committed to – essentially facets of the availability heuristic and commitment bias – may prevent the effective resolution of anti-commons intellectual property disputes.

Basically the problem is that any patent which leads to a new treatment for something important – cancer or AIDS, say – will obviously be immensely valuable and the patent holder won’t want to give this up cheaply. Unfortunately no one can know in advance which patents will be valuable and which won’t so you end up with asymmetric valuations on the part of patent holders and potential licencees. The result being deadlock.

The Growth of Patents

The pace of patent creation is increasing – it took 18 years for the first 250,000 patents to be filed under the global Patent Co-operation Treaty, a further four years to double that and a further four years to double it again. Anti-commons issues are only going to grow and as patents and other intellectual property are central to the economic progress of the planet anything that can impede it is a cause for concern.

However, using patent disputes to disrupt parts of the global telecommunications network that people rely on, or to control access to parts of the human genome, may bring the system into disrepute if not handled carefully – a case of the owners pulling up the Intellectual Property Ladder behind them to the detriment of all. It’s often suggested that we’re in an age in which information is power and certainly the ownership of critical patents is going to be increasingly valuable to corporations and individuals. Learning to exploit that power wisely may be the biggest challenge of the Information Age.


Related Articles: The Tragedy of the Financial Commons, Black Swans, Tsunamis and Cardiac Arrests, Akerlof’s Lemons: Risk Asymmetry Dangers for Investors

Basel, Faulty?

Containment, Not Cure

The international banking regulations known as the Basel II Accord have come in for some stick, given the fallout from the banking crisis of 2008. This is, on the face of it, a bit unfair given that Basel II hasn’t yet been fully implemented in most countries and anyway was designed to try to head off some of the problems that have occurred.

Still, most observers reckon that Basel II wouldn’t have prevented the crisis and the tendency of regulators, like generals, to fight the last war means that proposed changes won’t help. Whatever causes the next crisis it won’t be the same as the last one and while regulators are busily building a Maginot Line to stop one kind of problem they’re unlikely to notice that they’re also incentivising banks to invade Belgium, or at least find a way to go around the new regulations. We need a new kind of regulation, one that recognises we can’t stop the disease, but that it can be contained if we act quickly enough.

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Adam Smith’s Monkey Business

The Theory of Moral Sentiments

Before Adam Smith got round to inventing economics in The Wealth of Nations he invented social psychology in The Theory of Moral Sentiments. Under Smith’s synthesis it’s sympathy that’s the glue that brings people together, underpins human morality and drives the engine of economic progress. Without fellow feeling there’s no basis for any kind of exchange, whether of simple gifts, bodily fluids or physical goods.

Smith, of course, was a man way ahead of his time. However, it’s still rather remarkable to discover it’s taken to the twenty first century to uncover the evidence that his intuition was not just correct as a theory of economics but is actually built into the structure of our brains. If you’ve ever bounced out of a feel-good film, full of effervescent vim you’ll know exactly what Smith was on about: we’re designed for sympathy and thus built for trade.

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The Psychology of Dividends

Dividends Can’t Matter – Rationally

One of the more amusing failures of classical economics is its inability to explain why companies pay dividends. The Miller and Modigliani (1958, 1961) synthesis shows that rationally dividends are irrelevant to a corporation’s valuation: after all, if you give investors some of the company’s earnings then the company should be less wealthy to the same degree that investors are more, so there’s no net gain for shareholders.

Which is all nice and theoretically sound in the hermetically sealed world of rational economics but, unfortunately, when companies cut dividends their valuation usually drops, often quite dramatically, and when they raise them significantly the opposite happens. As usual, out in the real-world, it’s what people do, not what economics dictates, which rules.

Give and Take

The rational analysis of the irrelevance of dividends is perfectly grounded in straightforward economics. If I own a share which gives me access to $2 of a company’s earnings and the company gives me $1 directly then the company’s share price should drop by $1 and I will be $1 personally better off (minus taxes). So all things being equal a dividend should be irrelevant.

In fact dividends may well be damaging to a company’s prospects. If instead of giving me $1 the company invested it in product innovation, or marketing or an earnings enhancing acquisition (no laughing, please) it will be able to grow its earnings more quickly. I, the shareholder, benefit with a more rapidly increasing share price. If I want some of this for my own personal consumption I sell some stock.

Of course, large and mature companies may not be able to find sufficient earnings enhancing opportunities and so, all things still being equal, may decide that returning excess earnings to shareholders is the best thing. Again dividends aren’t the only way of doing this, although as we discussed in Buyback Brouhaha the main alternative – stock buybacks – is shrouded in managerial deceit and accounting opaqueness in a way that dividends aren’t. Although buybacks may be more tax efficient, depending on your taxation jurisdiction.

Dividend Signalling

So there are valid reasons for dividends, even if the classical view states that this won’t benefit shareholders directly. At least returning cash to shareholders allows us to redeploy these into other opportunities with better earnings prospects – although, as has often been pointed out, we can do that by selling one company’s shares and buying another’s.

Overall, then, it’s not at all obvious why companies should be overly concerned about dividends. However, they are, because they spend a great deal of effort manipulating dividends and giving indications about future dividend policy. And they’re right to do this because surprises in terms of dividends tend to cause significant share price movements in spite of what classical economics tells us should be the case. One of the possible explanations about why dividends persist in spite of economists saying they shouldn’t is their signalling effect.

So, a change in dividend policy may often indicate a change in the company’s fortunes. A cut in dividends will often signal reduced earnings – although it sometimes indicates that there are better earnings enhancing opportunities around. Similarly an unexpectedly raised dividend will often see a share price surge – even though this often indicates that the management have run out of ideas about how to deploy their spare cash, which isn’t exactly a positive sign.

Desperate Dividends

However, to argue that the only reason dividends exist is to give managements a way of showing their confidence or lack of seems, well, desperate. After all management could rather more simply tell us directly that they have low visibility of future earnings – they’ve been doing that rather a lot recently. No, the real explanation seems to be that investors often prefer dividends: so why might investors have a preference for higher taxed dividends over internally reinvested earnings?

Well, firstly, returning free cash to shareholders removes from management the temptation to waste it on pet projects. It also has the rather odd effect of disciplining managements because they will more often have to raise additional capital in the market. Strange though it is, companies that pay out dividends are often simultaneously tapping the markets for additional capital. That additional capital costs the company money in fees, dividends cost the shareholders money in taxes and the total result is a significant reduction in earnings available to the company’s owners.

We live in a strange world.

The Psychology of Dividends

There are also multiple behavioural reasons why investors might prefer dividend paying stocks over non-dividends. Firstly, receiving an income stream means that investors don’t need to sell stock to receive an income, which can often be a source of regret (which we discussed in … err … Regret) if the company subsequently does well. Of course, investors could have reinvested their dividends in the stock but this is a sin of omission, as opposed to a sin of commission, and is far more easily ignored, as suggested by Shefrin and Statman.

Secondly, the problem of self-control that we discussed in Retirees, Procrastinate at Your Peril is far easier to manage if investors decide to spend only their dividends. Although the research suggests quite strongly that the only stock market growth available for long periods is through dividend reinvestment investors will often spend the “interest” on their dividends anyway. By avoiding any sale of capital it’s easier to control the urge to spend the lot. This is Mental Accounting again, of course.

Finally there’s a case that a stock paying a high dividend today is perceived as a better bet than one that may provide greater earnings and price increases in future. This is known as the “bird-in-the-hand” fallacy.

Residual Dividend Policies

One of the odder findings in research on dividend paying stocks is that those companies which follow a so-called residual dividend policy – essentially paying out their entire free cashflow to investors as dividends – are generally more financially sound than companies paying out less of their earnings. Explaining this isn’t easy, but it’s possibly worth noting that these higher dividend payers tend to be larger and find it easier to raise external capital.

It’s certainly a counter-intuitive idea for investors to look for larger companies with lower free cashflow, but those companies with residual dividend policies tend to have longer term outlooks than others. In essence these companies don’t actually aim to run with low free cashflow but instead set dividend policy based on expected long-term earnings, rather than adjusting based on the short-term winds of fortune. So perhaps this finding is simply stating that those companies whose managements take a long term view and want to maintain a stable shareholder base are likely to be better aligned with their long-term owners than others.

Note, though, that “alignment” means understanding shareholder psychology and playing to it, attending to the lessons of behavioural finance. This isn’t necessarily the same as maximising shareholder value as promoted by more orthodox economic theories. We’ll revisit this issue, soon.

Dividends Are Not Enough

However, it’s fairly clear that deciding on an investment policy purely on the basis of dividends without regard to the nature of the underlying corporation is a pretty stupid idea and one that’s founded in behavioural fallacies. The behavioural tricks and twitches that make people adopt this kind of approach regardless of the underlying robustness of the institutions involved is simply another facet of the psychological blindness that many investors have with regards to stockmarket investment.

In the end, there’s none so foolish as those that are blinded by their own behavioural failings. Most of us can recognise the psychological problems of stockmarket investing in others yet the majority of people will still fail to acknowledge their own issues. Dividends are simply the tip of a very a large problem. Still, on the positive side, well managed dividend payers are amongst the best bets in the market. Just don’t forget to reinvest the dividends while you can, otherwise you’re spending the majority of your future wealth.


Related Articles: Real Fortune Telling, Buyback Brouhaha, Debt Matters, Don’t Overpay for Growth

When a Dollar’s Not Just a Dollar

Reciprocity Rules

If you have nothing and someone offers you a dollar you’d take it, right? But what if you’ve just seen your aunt give your cousin $100 and told to share it between the two of you? After all, a dollar is still a dollar more than you had a moment ago.

What studies of so-called reciprocity in humans show, time and again, that while we’ll accept the dollar in the first situation we’ll refuse it in the second. Our sense of fairness is offended and, it turns out, that given half a chance half the population will seek revenge on the perpetrators of this swizz and take pleasure in it. So, sometimes, a dollar is not just a dollar.

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Money Can’t Buy Happiness

Wish Carefully For You May Receive

Often the quest for the illusory bird of happiness is equated with the accumulation of ever increasing amounts of money. If only we had more wonga, moula, spondoolies we’d be so much more cheerful. Only when we get the extra dough our partners find that we’re still the same miserable gits that we were before and elope with the gardener, most of our money and the garden gnome collection.

Worse, not only does money not equal happiness, it seems that offering people money for doing things that they would otherwise do out of the goodness of their hearts can destroy their generosity. Money may not make you happy but it can sure as hell make you a miserable son of a bitch.

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