Less Is More

Error, Human

Much market analysis operates on the assumption that more data is better – more data leads to more accurate results. More data may require more complex processing, leading to greater and greater requirements for computing power but, in principle, the idea is that more is better.

Out in the real world, however, we don’t have the luxury of this kind of analysis. This leads to errors which sometimes we call biases. But surprisingly it also, often, leads to better results. It may just be that the reason we make so many mistakes is because we’re trying to process too much information, not because we’re naturally error prone.

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A Load of Bull

Sporadic Bull 

In a recent (very nice) review the writer described me as a “sporadic blogger” which is, I suppose, nothing more than a statement of fact.  It’s nicely circular, though, as the one of the reasons for the infrequent posting was the subject of the review … 

The book, Investing Psychology: The Effects of Behavioral Finance on Investment Choice and Bias (Wiley Finance), is a review of the current state of behavioral finance for the non-expert – a task born out of hope as much as expectation, I should add, as the subject moves almost as fast as you can research it – and a plea for investors to take care, to avoid the less-than-well-signposted traps.  Finance is a world dominated by people whose relationship with the truth isn't so much tenuous as trivialized.  And a bull market attracts bull merchants like no other.

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The Curse Of Seven

I’d like you to memorise a number for me. The number is 111011101001101010010. Easy, huh? Now, read on.

Shouting at the Plastic

We humans have many unusual traits. We’re the only mammal that can’t swim when it's born, the only mammal whose male can’t tell when its female is fertile, we have large brains which we habitually attack with fermented grains, we walk upright other than in ongoing fermented grain situations, and, perhaps most importantly, we use language to communicate (even when fermented grains are involved).

Now language, of course, is a curious thing. Given the huge amount of brain space and energy it consumes it was clearly very important to our survival as a species. So it’s odd that many of us then use this gift to shout inanely at mobile phones in public spaces. That’s what we call an “unintended consequence” and it helps lead to a big investing problem, the issue of information overload.

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Robert Cialdini and the Weapons of Influence

“Well here, again, Cialdini does a magnificent job at this, and you’re all going to be given a copy of Cialdini’s book. And if you have half as much sense as I think you do, you will immediately order copies for all of your children and several of your friends. You will never make a better investment.”; Charlie Munger on The Psychology of Human Misjudgement.

A World Too Complex

One of the recurring themes in behavioral economics is the concept of bounded rationality: the idea that we’re perfectly rational up to the point at which our limited brainpower stops out. Cialdini’s Influence turns this idea on its head, and argues that it’s our brainpower that’s created a world that’s too complex for us to understand: and that the result of this is that we take mental shortcuts, which then open us up to exploitation at the hands of any unscrupulous third-party. Which is pretty much everyone, these days.

We'd argue that these weaknesses are exposed directly in stockmarket investing when we're not so much fooled by other people as dumbfounded by our own brains.  Influence is not about investing, but about psychology: which makes it essential reading for everyone, but especially investors.

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Economics & Psychology: Reconciliation?

Continued From Economics & Psychology: The Divorce …

By the early 1970’s, as the long bull market of the post war years collapsed in a welter of unforeseen problems, financial professionals confronted the real meaning of risk on a systemic basis. As markets crumbled in the face of economic uncertainty trading companies turned to economists in academia in the hope of finding a way through the mess, or at least some excuse to get people to buy stocks.

What they discovered was a way of measuring risk that appeared to offer the option of quantitatively managing investments in a rational way, rather than relying on the intuitions of individuals. This approach has come to dominate the securities industry ever since. At the same time, though, a small revolution was brewing in psychology. And it's been fermenting revolution ever since.

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Satisficing Stockpicking

Logical Lab Rats

When we make decisions we nearly always do so in the context of something or other. In fact about the only time we’re asked to make contextless choices is in academic exams and laboratory based psychology experiments. As these are the two most familiar situations faced by the academics generating the theories that underpin most of modern finance we shouldn’t be awfully surprised if their great ideas are somewhat lacking in any understanding of … well, anything, really.

Being trained to think logically and probabilistically is a necessary part of being a modern economist, but it’s hardly a requirement for most people in most professions most of the time. You don’t find many baristas trying to make Bayesian inferences about which particular coffee to pour next. We clearly don’t rationalise most decisions, we make them quickly and effortlessly. We don’t optimise, we satisfice.

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Metaphors of Mind and Money

Theories of Mind

The question of how psychologists come up with their theories of how the mind works is one that’s long troubled philosophers. Now this might not seem like a very serious concern, especially to those of us more worried about whether our stocks are going up or down, but this is misleading: how our minds work is part and parcel of how financial systems operate and our theories about this process are important in developing sensible approaches to safe and profitable investment.

Unfortunately psychologists and cognitive scientists who study such things are as likely to suffer from the pain of the availability heuristic as anyone else. The general approach to theory of mind that is now most commonly used is simply based the latest set of tools available to the researchers, who view the mind as a computer. It has ever been thus because we need metaphors to think about things and without metaphors we have nowhere to start from. This brings with it a long legacy of hard to remove but wrong ideas about financial systems.

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Behavioural Finance’s Smoking Gun

Linda

Here’s a classic demonstration of behavioural finance in action, proving the irrationality of humankind. It’s the (in)famous Linda problem:

Linda is 31 years old, single, outspoken and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in antinuclear demonstrations. Which of these two alternatives is more probable?

(a) Linda is a bank teller.
(b) Linda is a bank teller and is active in the feminist movement.

Most subjects choose (b) and are informed that they’re irrational because the conjunction of two events – Linda is a bank teller and active in the feminist movement – is less likely than her just being a bank teller, regardless of her leisure interests. This is known as the conjunction fallacy. Unfortunately there’s a teensy little problem with this finding.

It’s wrong and it’s the smoking gun of behavioral finance.

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Investor Decisions – Experience is Not Enough

Economic Paradoxes

At the heart of Prospect Theory, the seminal approach behind behavioural finance, lies a puzzling paradox. Although the theory argues that people overweight the chances of unlikely events occurring – so, of instance, we worry much more than we ought to that our children will be kidnapped – the evidence from the field suggests exactly the opposite.

So, it seems we have a dilemma at the centre of the behavioural universe. Either way traditional economics gets it wrong but so, it seems, does the newfangled psychological kind. Given that we start the analysis with only three choices – that people correctly weight rare events, underweight them or overweight them – then it’s a bit disappointing that the two main branches of economics manage to slightly miss the correct answer.

That’s “slightly” in the sense of “completely and utterly”, of course.

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