Idiots in Investing Echo Chambers

Investing in the Dead

Some people like to wander round graveyards. I get the same sort of ghoulish pleasure out of frequenting investment discussion boards. They're full of Pollyannas, forever only able to see the good in the stocks they invest in.

Sadly they're almost always wrong. But it's kind of fun watching them keeping the reanimated corpses of zombie stocks moving about through the power of sheer stupidity.

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Scamming Journalists with Counterfactuals

Skim and Pump

Every so often there’s a story in the press about contactless payment cards being skimmed and money being extracted from them. Basically someone goes around tapping hapless commuters on the ass with a contactless card reader. Which given the state of the UK’s stupid prosecution service probably puts them more at risk of a charge of sexual assault than being arrested for theft.

This story is a recurring meme, and exemplifies what’s wrong with the state of financial journalism today. And on the way we get to look at real-world conspiracy theories and a bit of behavioral economics. What fun.

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The Emergent Rationality of Markets

Frogs and Philosophers

In Games People Play we alighted upon the germ of an idea that bears further investigation – that although individual investors may themselves be as mad as a box of frogs on mescaline their combined behavior can somehow result in relatively rational markets.  The idea is that, somehow, rational markets arise out of irrational traders doing stupid things.

Odd though this may seem as an idea the possibility of new properties emerging from systems made up of complex component parts isn’t new, although it does serve to make a lot of scientists and philosophers extremely annoyed.  Which is a good reason for pursuing the idea, is it not?

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Parsimonious, Big Picture Behavioral Bias

107 Ways of Being Wrong

As we’ve seen in The Big List of Behavioral Biases, there are 101 (well, 107 at the time of writing) ways in which people exhibit irrational biases. The basic idea, that we’re affected by these biases in predictable ways, is now well accepted. The problem is that there are simply too many biases for this to be the be-all and end-all of the explanation of market irrationality.

So while the basic concepts of behavioral finance are understood, in the sense that irrationality is a driving force of market misbehavior, the underlying mechanisms by which they operate are not.  There's not much point in claiming that these behaviors are predictable if you can't use them to predict anything, So what's the big picture of behavioral bias: how does it all fit together?

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One Long Argument: A Big List of Behavioural Biases

Over the hundreds of articles published on the Psy-Fi Blog we’ve generated a long list of examples of behavioral biases, which is now collated in The Big List of Behavioral Biases.  It’s an extraordinary compendium of irrationality, an imperfect register of the various strange ways in which rational economics goes astray.  Ultimately, though, what we have here is really just one long argument.

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100 Ways To Leave Your Lucre

Irrationality, The Enemy Within, by Stuart Sutherland

For those of us interested in how people manage to behave oddly in the face of anything to do with finance, these recent years have been good, as a range of intelligent books have been published on the topic. From Freakonomics and Predictably Irrational to The Undercover Economist and Nudge, plus a whole host of imitative single word follow-ons, we’ve been treated to real economists demonstrating a hitherto unforeseen talent for communicating with the unwashed masses. Nonetheless, despite this, there is still no better introduction to the subject of behavioral psychology than Irrationality, by Stuart Sutherland, even though it originally dates from 1992. 

Unsurpisingly, although the world has moved on, people haven’t; and the mistakes they made twenty years ago they still make today. We are still the enemy within.

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Jam Today – Tyranny Tomorrow?

Tyranny of Choice

One of the most famous experiments in social science published this century was on jam, or at least the impact of having more or less types of jam to choose from. This research, by Sheena Iyengar and Mark Lepper, in When Choice is Demotivating: Can One Desire Too Much of a Good Thing, suggested that consumers are often paralysed by choice.

By extrapolating from what was originally a pretty limited study researchers have created a whole new industry out of reducing the number of options for people to select from. Of course, that leads to the next tricky question – which is who decides what should be available, and to whom?

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Death of the Accrual Anomaly

Surprise, Surprise

Company earnings are, you’d have thought, a pretty straightforward measure of a company’s health. After all, earnings are a statement of profits, are they not? Of course this is finance and, therefore, nothing is quite as it seems.

You see earnings are not necessarily cash and contain a mysterious component called accruals, the calculation of which keeps accountants the world over gainfully employed. Companies that rely heavily on accrual based earnings tend to have more earnings surprises and this anomaly is exploitable by investors: or at least it was, until it mysteriously vanished.

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Recency: Hot-Hands and the Gambler’s Fallacy

Behavioural Biases (6): Recency

Recency is a great trouble to us, being a particularly tricky sort of behavioural bias that’s rather difficult to overcome. It works thus: you overfocus on the most recent events you’ve experienced and neglect to worry about older information. We don’t so much integrate new information with the old as use it to overwrite our memories.

For investors recency may have a couple of different effects. Positive recency makes you a momentum trader, a sort of living incarnation of a goldfish, forever surprised by the same piece of seaweed. Negative recency makes you a contrarian investor, solidly heading away from anything exciting, looking for where the action isn’t. Either way you’d better be damn sure you know what you’re doing because both approaches more or less guarantee under-diversification.

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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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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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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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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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Investors, You’ve Been Framed

Lakoff's Political Frames

Suddenly politicians are all excited about a psychological trick that’s been known about for years. This is in no small part due to George Lakoff who’s popularised the idea of ‘framing’ in political circles. In the simple terms that politicians will understand, framing is about using the right loaded phrases and words to position yourself.

So, for instance, the American Army engaged in a ‘surge’ in Iraq: a short-term, rapid build up and assault is what comes to mind, rather than a long-term commitment. Or consider the renaming of the aggressive British Ministry of War to the protective Ministry of Defence. Or the various euphemisms for firing people: “sorry we have to let you go”. Such phrases create frames and these cause underlying behavioural biases to trigger in certain ways. As usual with psychological tricks the effect of this on individuals’ investing habits is largely bad.

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Anchoring, The Mother of Behavioral Biases

Behavioural Biases (5): Anchoring

Just as an anchored ship rarely strays too far away from its tethering point a human being prefers to stick close to the references with which they feel most comfortable. Anchoring is an easy-to-demonstrate, hard-to-eradicate behavioural bias that has all sorts of nasty implications for investors, many of them not obvious. In fact, along with availability, it has the claim to be the mother of all biases.

The fundamental investment problem lies in the difficulty in deciding what something is intrinsically worth. A skilled negotiator will start from an extreme position, such as a very high price, in order to frame the subsequent discussions. Anywhere and anytime someone presents us with a number in order to start negotiations we’re being anchored. So if it really matters then you need to start from your own number or walk away.

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So What’s Behavioural Finance Ever Done For Us?

“7 Ways To Profit From Other People’s Folly” has been posted over on Monevator with thanks to the Investor. For anyone interested in some background here are the relevant links …

1. That there’s always a crisis just around the corner was covered in Panic!
2. Everyone’s affected by behavioural biases is a repeating meme, but see You Can’t Trust The Experts With Your Investments and Overconfidence and Over-Optimism for some examples
3. That stocks tend to under and over-react to news due was touched on in Regret, a fact that generally because …
4. Everyone’s risk adverse, at everything, as discussed in Loss Aversion Affects Tiger Woods, Too
5. Investor gullibility was addressed in The Halo Effect: What’s In A Company Name? although there are countless examples elsewhere
6. The importance of either getting good feedback or simply being miserable was reflected on in Depressed Investors Don’t Need Feedback, Everyone Else Does and that
7. Anecdotes are not evidence was pointed out in Fairy Tales For Investors

Happy researching!

Investing With a Time Machine

An Obvious Approach?

Always and everywhere the market timing argument resurfaces in multifarious forms. The idea is simple: sell high and buy low: what could be more obvious? Well, there’s a problem. It’s not necessarily insurmountable but it’s definitely a bit tricky.

You may need a time machine to implement the concept successfully.

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Regret

Behavioural Biases (4): Regret

If you’ve ever done something and then regretted it you’re in the fine company of the rest of the human race. If you’ve never regretted anything then you’re probably a sociopath and need to stop attacking people with spatulas and get a nice quiet hobby instead. Something like misdirecting people into buying stupid stocks on internet bulletin boards should do nicely.

If you are fairly normal, however, you’ll be aware that regret is an unpleasant and queasy feeling which you’d generally rather avoid if at all possible. As ever, when it comes to finance, obeying the urgings of your intestines comes at a cost. In investment it pays it to pays to regret nothing: although it’s certainly true that pride comes before a fall in your portfolio value.

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The Halo Effect: What’s in a Company Name?

Angels and Demons

The halo effect is a simple, pervasive and powerful psychological bias which sees us anchor onto a single positive feature of a person and then indiscriminately apply it to all of their other traits. So if we perceive someone as physically desirable we’re likely to assume that they’re attractive in all other ways as well. Which is highly fortunate for those beautiful but bad tempered, foul mouthed and cerebrally challenged personalities who commonly grace our multi-media world.

Companies will often attempt to use the halo effect by getting celebrity endorsements from completely unrelated but popular celebrities. Still, trading on such a simple psychological trait would be unlikely to fool savvy investors, you’d think. Wrongly, of course.

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