Be Humble, Become Wealthy

Thrusting, Decisive and Frequently Wrong

We are both by design and by culture inclined to be anything but humble in our approach to investing. We usually invest on the basis that we're certain that we've picked winners, we sell in the certainty that we can re-invest our capital to make more money elsewhere. We are usually wrong, often extremely wrong.

These tendencies come partially from hard wired biases and partly from emotional responses to the situations we perceive ourselves to be in. But they also arise out of cultural requirements to show ourselves to be decisive and thrusting; we rarely reward those who show caution in the face of uncertainty. But we're private investors, we have limited capital and appetite for risk. A little humility – or even a lot – wouldn't go amiss.

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Dirty Money: There IS Accounting For Taste

Unfungible People

The link between emotions and decision making, particularly financial decision making, has been recognized for years.  This is a tricky area because the connection between emotions and rationality is difficult to unpick, which is why making investment decisions while in an emotional state is usually not recommended.

To complicate matters, though, it now appears that we associate certain types of money with certain types of emotion, and will only spend such money on certain things.  Which is odd, because the last time I looked money doesn’t seem to be especially emotional: it rarely breaks down and starts sobbing when you try and spend it.  Money is fungible, but people aren’t.

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Happy People Make Terrible Traders

Optimistic Fools

People who are happy are more confident and expect to make more money by trading, and anticipate taking lower risks in doing so. This result ought to be enough to depress most people, but most people are optimistic and don’t depress easily. This is especially true if they make money on their random trades, because that makes them happier, more optimistic and more prone to trading.

Even better, over-optimistic people are more socially popular and therefore more likely to be imitated. Whether any of this will really make anyone happier is doubtful, but we can but hope. It certainly won’t make for better investors.

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Backfiring Investment Theories

Holy Theory

We’ve met the nasty nature of confirmation bias on several occasions. This is the twisted trait that sees us in thrall to the views of others around us, and helps us encourage them to maintain those views, regardless of anything resembling reality. But this is only the half of it.

No, we also have to cope with the impact of information that blows huge great holes in our world views and which undermines our most devoutly held beliefs. When faced with unequivocal evidence that shows that our favourite investment ideas are wrong we do what you really ought to expect by now: we don’t so much ignore it as twist it to our own predetermined ends. Folks, meet the wonderfully counter-intuitive backfire effect.

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Love Your Kids, Not Your Stocks

That Love Thing

Psychologists have about as many theories about love as economists have about investing, and they have about the same success in making predictions based on their ideas. Still, both sets of social scientists plod on regardless, presumably on the basis that if there’s a market for oddball ideas they might as well try and serve it. Or maybe they’re just hoping for a date.

There are plenty of cases, though, in which it appears that investors fall in love with their investments and regardless of how fickle or downright untrustworthy their squeeze's behaviour is they’ll stick with them through thick and thin. Mostly thin. So maybe the psychology of love can tell us something about the psychology of investors?

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Risk, Stone Age Economics and the Affect Heuristic

Real Risk Management

Meet Grunt, a Stone Age economist. Grunt spends his time assessing risks. Usually these involve delicate decisions that may end up having quite important consequences – like whether he’s alive at the end of the day or not. Whether it’s attempting to impress a potential mate or ingratiating himself with the alpha males or simply choosing not to eat that odd smelling fruit he’s constantly having to weight risks and probabilities.

Grunt, however, isn’t blessed with modern economic theory and probability analysis is unknown to him. Although his grasp of number theory that doesn’t run much beyond one, two, err … a whole load he has a mechanism that’s been honed over hundreds of generations. Rather than rationality Grunt relies on the Affect Heuristic.

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Value in Mean Reversion?

Many shall be restored that are now fallen; and many shall fall that are now in honour (Horace, Ars Poetica)

From Horace to Graham and Doddsville

The quote above is now a couple of thousand years old but was used by Ben Graham and David Dodds in their seminal book on value investing, Security Analysis, a term invented by the book's title. At root it’s a simple plea for understanding that current market conditions, no matter how placid or tempestuous, will pass. The job of the conscientious investor is, at worst, to ignore the short-term forecasts or, at best, to take advantage of them.

Some psychological quirk means that a small subset of humanity latches onto this concept instantaneously and holds to it, like an investing life preserver, through thick and thin. The rest of us either learn the slow, hard and painful way or, more likely, continue to be storm-tossed. Occasionally someone gets washed up on a tropical paradise and is accounted a genius but mostly we drown, quietly, where no one can see us waving.

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Get An Emotional Margin of Safety

Businesslike Investment

Warren Buffett states, quite frequently, that the most important investment statement ever made was that of his mentor, the father of value investing, Ben Graham:

“Investment is at its most intelligent when it is most businesslike”

Now if you’ve ever wondered exactly what that means you’re not alone. But it’s really one of the most important business lessons any of us can ever learn. It encapsulates the idea that investment isn’t about individual subjective feelings but about general objective rationale. To be good investors we need to learn to control our emotions. Unfortunately it’s got a bit more difficult since Graham first wrote those words.

Unemotional Investment

We find Graham’s statement difficult to understand because we don’t understand Graham’s – or Buffett’s – viewpoint. Although both men are amongst the best communicators the world of top-class investment has ever thrown up they still sit in the rarefied atmosphere of that elite group of investors who are able to step away from their own emotions when they come to investing.

By “businesslike” Graham meant “unemotional”. At the root of all good investment, he believed, was a focus on the underlying numbers. Graham, far more so than Buffett, was focused on the investment ratios and balance sheets of his investments. To be “businesslike” the individual investor needs to ruthlessly focused on the numbers, not the stories associated with them. Thus Graham and Buffett aim to remove the behavioural biases that affect most investors.

Of course, there’s no doubt that there are a select group of people who are more easily able to ignore the impact of group psychology than the rest of us. It’s possible – even probable – that the great investors of the world are simply psychologically unusual people who are capable of ignoring the impact of normal behavioural biases. These people are so rare that it would be interesting to take one of them and wire up their brain to a computer to see whether their responses are different from that of normal humans. Only trouble is they’re so rich that they can employ really big bodyguards and generally reckon their brains are their own concern.

Emotionless Delusions

Antonio Damasio has conducted lots of research on the effects on reasoning of damage to the areas of the brain implicated in emotion – probably best encapsulated in his book Descartes’ Error: Emotion, Reason, and the Human Brain. The results are largely counterintuitive. What he shows is that emotion and reasoning seem to be linked at the hip, or at least at the prefrontal cortex. Emotion doesn’t make us irrational, rather it seems that it’s part and parcel of whatever rationality we actually possess.

In essence emotions are heavily tied into the business of decision making: you probably wouldn’t want to entrust your safety to someone whose emotional reactions were damaged. For instance there are a range of rather nasty syndromes associated with the loss of emotional arousal including Cotard’s syndrome where the person thinks they’re dead and the Capgras delusion which causes the sufferer to think that a person or persons close to them have been replaced by an identical clone. Although these may sound odd or even amusing they’re not: Capgras sufferers have been known to behead their nearest and dearest to prove that they’ve been replaced by machines and been found burrowing in the remains looking for the batteries.

Emotions and Decision Making

Human decision making is one of the main puzzles facing psychology. How do we decide what considerations to take into account and what to leave out? This is hard enough at the best of times but is especially difficult under conditions of ambiguity or uncertainty. Technically the problem of deciding what to take into account when making a decision is known as the philosopher’s frame problem – given limited time and limited intelligence how do we manage to do anything other than stare at our navels?

The philosopher Ronald de Sousa (who provides a good introduction to theories of emotion at the Stanford Encyclopedia of Philosophy) has argued that rational decision making is critically dependent on emotions – emotions are the way evolution has fitted us to focus on the important issues involved in any decision. Emotions are a rapid response mechanism to filtering out the unimportant features of any situation. When you’re about to be eaten by a tiger then the colour of your kimono shouldn’t really matter.

If de Sousa’s ideas are even roughly correct then we can’t simply become unemotional by choice, because emotions are implicit in who we are. However, we can learn to control our emotions in specific situations in order to restrict our behaviour: we can learn practical rationality. So, implementation of Graham’s mantra requires a real determination to ignore all the churned up feelings of the primordial ape within us and resolution to focus on the few certainties that we can latch onto in the investment world.

Brain Damaged Investors

Some research we’ve looked at before by Baba Shiv and others, including Damasio, into the impact of emotional centre brain damage on investor decisions suggests that a lack of emotion is actually a benefit to investors. While such damaged people might not be able to judge the danger of walking into a Hell’s Angel’s convention and disrespecting facial hair they are remarkably good at making sensible investment decisions. So while in real life a failure to take contextual information into account may be exceptionally dangerous it seems to be a benefit when investing.

Lest all of this seem to suggest that the great investors of the world are simply people who’ve been hit on the head one too many times let’s be clear that what we’re ultimately talking about is the ability to inhibit emotional reactions to investing situations, rather than advocating some process of self-induced brain trauma. So, it would seem that these emotional responses are getting triggered inappropriately in investing situations, leading to decisions that are simply stupid. Which suggests that learning to control these responses should make us better investors or, as Ben Graham would put it, would make us more businesslike.

Beyond Asset Value – Back to Rent Seeking

In Graham’s heyday this was simpler than today: his mechanical strategy looked for clear mispricing of stocks in terms of discount to net asset value. Most, if not all companies, were valued based on their assets. What Warren Buffett realised, earlier than most, is that this has changed. The corporations of today are valuable more for their future earnings streams than their assets. The most valuable companies are those successfully engaged in rent seeking – gaining value by extracting fees without making any contribution to productivity. It’s those companies who can make money simply by existing that are most valuable.

The trouble with this is that it’s far harder to value rent seeking corporations like American Express and Coca Cola than the traditional Graham-type discount to net asset value opportunities. Which brings us back to the messy business of emotions: we can’t simply put aside our emotions by running a spreadsheet. We have to engage in the difficult job of identifying the must-have rent seekers and then waiting for the price to fall to a level at which we can rationally judge it rational to invest.

Businesslike Under Uncertainty

Only when this point comes it’s most likely that it’s on the back of some dramatic and stomach churning market event. Most people can’t ignore their emotions at these points – the overwhelming evidence of mutual fund investment flows is that people buy at the top and sell at the bottom. Short of beating ourselves around the head regularly we have to learn to stop listening to our in-built emotional warning systems and embrace the uncertainty. Only then will be truly businesslike in our investment habits.


Related Articles: Investing Like Berkshire Hathaway, Is Intrinsic Value Real?, Unemotional Investing is Best

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 Psychology of Scams

Gullible Brits, Smart Scammers

The UK’s Office of Fair Trading (OFT), an arm of government concerned with stopping consumers being ripped off, has just published a study into The Psychology of Scams looking at why 3.2 million adult Brits manage to lose £3.5 billon ($5.4 billion) to scammers each year. The fact that they’re looking into the psychological reasons that the victims throw their money away, with a view to stopping them from doing so, suggests an enlightened view in the British civil service that hadn’t been previously noticeable.

Some of the results are really interesting. It seems you’re more likely to fall victim to a scam if you think about it or, if you’ve previous knowledge in the area that the scam’s targeting, you’re likely to suffer from overconfidence in your ability to detect a problem. So are we all potential victims?

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The Media, Fear and Stockmarket Manias

Breast Cancer

If I were to ask you at what age are women most at risk from breast cancer, what would you answer? Write down what you think. Or, at least remember carefully. We don’t trust our memories around here.

I’ll come back to that later.

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Unemotional Investing is Best

Emotionally Braindamaged People Make Better Judgement Calls on Money

Behavioral economists see humans exhibiting irrationality when it comes to dealing with money all the time. The suspicion is that this behaviour is adaptive – out in the jungle it pays to be risk adverse when approaching a snake if the last time you did so you got bit. In the stockmarket this is potentially exactly the wrong thing to do, as the stocks that did less well last year are more likely to do better this one.

Proving this isn’t easy but a remarkable experiment using emotionally braindamaged people has provided further evidence that the hypothesis may well be correct.

Trying to untangle cause and effect is difficult, but if emotions are key to this maladaptive investing approach then at least one experiment suggested itself: find yourself some people who don’t experience emotions and see how they perform in a risky environment. This is exactly what Baba Shiv and colleagues (1) tried out but rather than sticking their subjects in a room with a bunch of snakes – psychology generally frowns on experiments that lead to participants dying these days – they went for a more traditional approach involving coin tossing.

Gambling on a Favourably Rigged Game

There is an unfortunate class of people who have suffered a type of brain damage which causes them to exhibit no emotions whatsoever. These people are pretty much unable to operate in the world around them as, lacking any understanding of social cues, they’re unable to interact with other people. What the experiment tested out was whether or not a group of such people would behave differently to more emotional investors in the light of investment success or failure.

The experiment was pretty simple – each subject was given $20 and a coin. On each toss of the coin they risked $1 with a $2.50 reward for guessing correctly but they had the option of not gambling and keeping the dollar. They walked away with their winnings.

So over twenty rounds if you chose not to gamble at all you would walk away with $20. However, this would be profoundly irrational because the win-loss ratio was weighted in the former’s favour. With average luck by gambling on every round you would have walked away with $25 with only a 13% chance of getting less than the starting value.

Unemotional Gambling Wins

The researchers speculated that normal investors would become more risk adverse if they lost on a previous round while, if their hypothesis was correct, the emotionless subjects would continue to gamble, being unaffected by the previous snake bite. This was exactly the finding – “normal” participants were significantly less likely to take a risk having just been burned while it made no difference to the emotionless participants. The latter group walked away with the average $25 that probability would predict while the emotionally handicapped ones got less.

So it seems that the emotional group were unable to ignore their feelings of loss after each failure and became more risk adverse while the unemotional group simply carried on playing the odds. Hence those people with a full grip on their feelings failed to capitalise on a game clearly rigged in their fashion – a description, many of us would argue, equally applicable to the stockmarket over long enough periods.

Inexperience Loses, Once More

Added to John List’s experiments suggesting that experience in markets can help people overcome trading biases, this suggests that less experienced stockmarket investors need to find ways of leaving their feelings at home before risking their capital in a jungle where snakes are all too common. As usual, the emotional and inexperienced investor is at most risk from stockmarkets.

I guess learning to embrace your inner snakes isn’t easy.


(1) Investment Behavior and the Negative Side of Emotion
Baba Shiv, George Loewenstein, Antoine Bechara, Hanna Damasio, and Antonio R. Damasio
Psychological Science, Vol. 16, No. 6, 2005