Behavioral Portfolios

Beer Balancing Behavioralism

Perusing the literature on behavioural finance you might be inclined to the thought that although this stuff is all very interesting and even occasionally amusing it’s not much use when you come to actually investing. It’s a bit like posture – it’s easy enough to point out to someone that they slouch like a sloth with a dose of haemorrhoids, it’s entirely another to explain to them how to retrain their muscles to start balancing pitchers of beer on their head on the way back from the bar.

Digging deeper, though, what becomes apparent is not that we're especially bad at understanding investing but that the way we go about constructing our portfolios is radically different to what theorists expect. Whether it's the theorists who are wrong or the investors is entirely dependent on your perspective. Either way recognising what's going on is an important step on the way to getting a beer balancing musculature.

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Irrational Numbers: Price Clustering & Stop Losses

Universal Number Theory

One of the odder things about the universe is that the small set of numbers that define its structure, the so-called universal constants, don’t seem to have any structure of their own. You’d have thought that whatever immortal deity breathed life into the whole shebang would have at least have bothered to make sure that reality was defined in simple integer values your average gameshow contestant could remember. Yet someone’s just calculated Pi to more decimal places than you can read in a lifetime. The universe is strangely irrational, it would seem.

More likely, however, is that the irrationality lies in our heads. If you look at the way we treat numbers for investment purposes it’s probably a good job the infinite cosmos is specified in irrational numbers, because if it were otherwise we’d probably have sold it to the lowest bidder eons ago. Humans, it seems, treat numbers as an approximation to reality, unlike reality; which treats humans as an approximation to nothing.

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The Case Against Re-Emerging Markets

Brave Punditry

If you’re of a contrarian viewpoint you might cast your eyes across the pundit’s tips for the best performing sectors of 2010 – or, indeed, any year – with a slightly jaundiced eye. This year’s favourite flavour of investment is emerging markets. There are strong and powerful arguments in support of this particular long-term trend but you’ll rarely find the short-term value counterargument.

Counterarguments are critical for sensible value investors, because they force us to consider what could go wrong despite what our deceitful and biased brains are telling us. Any idiot can see what can go right – and, indeed, they spend a lot of time telling us about it – but putting a purely positive spin on any investing situation doesn’t come close to providing a sensible basis for allocating our valuable and scarce capital.

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Financial Lessons in Mass Deception

Deceit, Incorporated

One of the things you may have noticed as we’ve parlayed our way around the world of finance is how much of what goes on seems to be hidden beneath the surface. It’s almost as though most of the people involved were out to deceive us in an attempt to part us from the limited savings we’ve managed to keep out of the clutches of the taxman.

In fact, at one level, that’s probably exactly what’s going on. Market participants are engaging in an escalating war of deception to persuade people to give them their money. Taken to extremes this even goes so far as to encourage the citizen in the street to lie in order to boost the coffers of the securites industry. All of which is what you get when you replace the natural processes of social trust with actuarial projections.

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To Predict the Next Bust, Ask An Austrian

Revising The Mantra

It’s long been the mantra of the Psy-Fi Blog that no one can successfully predict anything about anything to do with finance; or anything much else, to be honest. To this, though, we probably ought to add a corollary – no one can successfully predict anything about anything to do with finance except when they do, but when they do everyone will ignore them. Tough business, this crystal ball gazing lark.

Although the history of the recent crash is too close to analyse, it is possible to look at what happened in the turn of the century debacle. It turns out that there are two groups of people who successfully predicted the market collapse – a bunch of value based investors and an obscure group of economists hailing originally from central Europe. In difficult times we must take our heroes where we can find them.

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Be A Sceptical Economist

Small Furry Animals

It’s unsurprising that behavioural finance is gaining ground in economic circles, as the wanton failures of more traditional versions have become all too clear over the last decade. However, just because psychology can provide us with valuable insights into the workings of finance there’s no need for us to drop our defences. Like any new subject there’s plenty to be sceptical of.

One of the biggest problems is one that psychology has faced since it began, to do with the authenticity of its experiments. If you take a bunch of people, shut them in a darkened room and make them do odd things, out of context, you might expect them to behave a bit peculiarly. Psychologists, on the other hand, tend to live in darkened rooms and regard doing odd things in them, often involving small, furry animals, as quite normal. So they see nothing wrong in this and are quite happy to write up the results of these experiments in order to help deepen our knowledge of human behaviour.

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The Neuroeconomics Revolution

A Marriage Made in Heaven – or Hell?

A recent development in economics sees the combining of neurology, psychology and economics in an attempt to reduce economic behaviour to brain function and to predict market behaviour from observable brain patterns. Its aim is to glue together a subject that can’t predict human behaviour from analysis of the brain with a subject that can’t predict human behaviour from analysis of people to a subject that can’t predict human behaviour from analysis of economic data.

Welcome to the Neuroeconomics Revolution.

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From the Railroad to the Internet … and Back Again

The Death of The Death of Distance?

Although our digitally networked world has seen some remarkable changes in the last two decades the need to physically move goods around the world has remained unchanged. I can communicate my thoughts to you without leaving my desk, but sending you this banana requires considerably more effort on my part. Anyway, I’m hungry, so keep your thieving minds off it.

Most research shows that the death of distance – the collapse in transportation and communication costs – first prophesised back in the nineteen nineties has failed to materialise. Although it’s certainly the case that the internet has caused some costs to fall others haven’t. This matters because the idea that global growth is mainly driven by technological innovations is almost certainly wrong: technology matters but what governments and people do matters more. And so it turns out that it’s the railroad, not the internet, that’s more important for our future prosperity.

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Buy and Hold, the Least Worst Option?

Trigger Happy Traders?

The arguments over market timing versus buy and hold are likely to continue until the end of time. Often these debates aren’t really over the actual merits of one approach or the other but centre on the philosophy of the methods.

Proponents of timing strategies can’t understand why anyone would ever adopt buy and hold as it’s “obviously” a worse method of investing. Meanwhile supporters of buy and hold regard market timers as a bunch of hopeless goons with itchy trigger fingers. As ever, the truth is sitting about one inch behind your eyes.

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