Building An IKEA Portfolio

Cartoon Capers

If you get someone to build an IKEA sideboard – you know, one of those flat-pack conundrums that involves trying to work out what a cartoon character is doing with a hammer, a drill and forty three assorted metal dowels – they immediately place a higher value on it than anyone else would, even if it goes on to develop an alarming 45 degree tilt.  This is the IKEA effect.

It’s associated, sort of, with a more general behavior that’s been known about for years, the endowment effect, in which possession of an item immediately causes us to value it more highly. Just imagine what the impact might be if you build your own portfolio, no matter how wonky it might be.

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7 Investing Lessons from Behavioral Psychology

Click … bait

You could start by not wasting your time clicking on stupid clickbait articles, I suppose. But since you’re here you might as well learn something.

Investing should be mainly about hard work, slogging through accounts and trying to figure out where or why a company has a defendable competitive advantage. But that’s not much help if you have the self control of an octogenarian with prostate trouble.  Investing is 90% hard work and 10% mental discipline – but don’t even bother if you haven’t got the 10%.

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Be Prepared, Be Resilient

Are You Ready?

So, markets are down, the oil price is seemingly in terminal decline, the (alleged) Ponzi scheme that is the Chinese economy is collapsing and interest rates are on the way up. A crisis? Well, for anyone who’s been around the markets for more than two minutes it’s déjà vu, all over again.

Of course, the wise investor is prepared for this; not merely in the sense of having a trading strategy in place, but in terms of psychological resilience. There’s no point being the best darned stockpicker in the known universe if you flee for the hills at the first sign of trouble – or, even worse, at the last.

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Uber Irrational

Wet and Irrational

A few weeks ago a group of French taxi drivers attacked the US singer Courtney Love's car as she tried to get to Charles de Gaulle airport in Paris. As it turned out this wasn't a Franco-American cultural argument over the relative merits of Ms Love's brand of alternative rock, but a side-effect of an industrial dispute that has its origins in the complexity of behavioral economics.

In fact, at root, it's about whether you'd like to be able to find a cab in the rain in New York. 

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L is for Loss Aversion

Loss Aversion is the name given to our aversion to losses (duh). We're twice as unhappy at a loss as we're happy at an equivalent gain, which leads us into keeping rubbish investments (to avoid realizing a loss) and into selling good ones (because then we can never take a loss). Under loss aversion selling or buying has no relationship to the actual investment merits of the asset, it's all about our emotional attachment to an arbitrary number.

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Your Self-Inflicted 6% Trading Tax

How Not To Make Money

Making a turn from the markets is hard, we all know that.  Unfortunately we tend to make it a lot harder for ourselves than we need to, and if we don’t then the investment industry is always there to lend a helping hand.  For an extortionate fee, of course.

We’ve already looked at the gross amount of money we conspire to lose each year – something in the region of $160 billion a year in the US alone (see: The 160 Billion Dollar Bezzle).  Now a UK writer has looked at what this means for us as individuals.  The answer is, very roughly, a cost of 6% a year.  Which, when the average return from the stockmarket is probably no more than 5%, makes for a not very good way of making money.

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Do Stocks Always Outperform (in the Long Run)?

Funny Futures

The equity premium puzzle is one of the longest standing anomalies in finance: the finding that stockmarket investing outperforms other types of investment by a significant amount. Generally you’d expect the price of shares to rise until this advantage was cancelled out, but this hasn’t happened and has made quite a lot of futurologists look rather silly.

It turns out, though, that the equity premium puzzle may be even more puzzling than it first appears. Basically researchers aren’t exactly sure how large it is, or even if it exists at all. So is the idea that stocks always outperform other investments in the long run just another market myth used to cajole unwary investors into parting with their hard-earned cash?

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It’s How Big, Not How Often, That Counts

Soros' Batting Record

George Soros, one of the greatest investors of the last fifty years, has a fairly poor batting record when you look at the total number of strikeouts he’s had over his career. By his own account he’s been wrong about investments more than he’s been right. However, when he’s been right he’s been right BIG time:

"It's not whether you're right or wrong that's important, but how much money you make when you're right and how much you lose when you're wrong"; 

Unfortunately human behavioral biases make most of us shy away from taking lots of losses and trick us into giving up the potential big winners. Our problem is that our biased brains punish us much more for failure than they reward us for success: so we prefer frequent small wins and few losses to frequent small losses and few wins. And, as Soros proves, our brains are wrong.  Fortunately there are a few simple techniques that guide us right.

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Profit From Self Knowledge

Gnôthi seauton! and is this the prime
And heaven-sprung adage of the olden time!
Say, canst thou make thyself? Learn first that trade;
Haply thou mayst know what thyself had made.

(Samuel Coleridge – Self Knowledge)

Behavioral Moneymaking

It’s easy to talk about the fundamental errors people make in investment but, in truth, we rarely get to see this in action. To judge from the terabytes of trading derring-do published daily you’d be hard pressed to find anyone who actually loses money on the stockmarket. Most people seem to adopt the attitude that, if these behavioral biases make a difference, it’s to other people and never themselves. And often, they believe their own rhetoric.

We can’t usually look inside individuals’ trading histories to point out the mistakes they’ve made, most research is based on gross, anonymised data. However, occasionally some anomaly allows us shed some light on the actual practice of real investors and such an opportunity arose with the trial and conviction of Martha Stewart for obstructing justice in an insider dealing case. Stewart may be a fine host, but she’s no better – or worse – at investing than most of us.

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Moral Hazard, But Thanks For All The Fish

Vanishing Regulators

Regulators spend a lot of time worrying out loud about moral hazard, the problem that occurs when people don’t have to take risks commensurate with their potential rewards. This sort of ignores the point that if moral hazard didn’t exist most of the need for regulators would disappear overnight.

Still, there’s a sneaking suspicion that a lot of the problems investors face are less to do with moral hazard and more to do with the problems caused by behavioural biases that cause organizations to fail to manage information successfully. This so-called intellectual hazard, it’s suggested, lies behind some of the securities industries biggest boo-boos.

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Eat Your Stocks

Much Ado About Nothing?

Scientists study stuff which exist: physicists the physical laws of nature, biologists the nature of life and psychologists the human mind. Economists, on the other hand, study money: which is surely a figment of the human imagination.

Given the ephemeral nature of the subject it’s a wonder that there’s any mileage in spending any effort on the subject at all, but huge amounts of time and money are expended in doing so. So if money is fundamentally unreal, what the hell is economics all about?

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Loss Aversion Affects Tiger Woods, Too

Behavioral Biases (3): Loss Aversion

Loss aversion, the tendency for people to be more risk adverse when protecting a gain than when chasing a loss, is a pervasive psychological bias. Indeed, it appears not even Tiger Woods is immune:

“Although the very best golfers are slightly less biased than their peers, even the best golfers—including Tiger Woods—exhibit loss aversion. This is a costly mistake. If any one of the top 20 golfers in 2008 was able to overcome this bias, his expected annual tournament earnings would have increased by $1.2 million dollars (a 22% increase).”

Put simply golfers play better when attempting to avoid dropping a shot than when trying to gain one, when they consistently leave their shots short. Yet this doesn’t make any sense – “bogey”/loss” and “birdie”/“gain” are purely relative concepts – all that should matter is the overall score or portfolio value.

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