Meme Reversion

500 and Counting

I’m now about 500 posts and a million words into the back-to-front world of financial psychology and you might think I'd have learned something useful by now. Well, it turns out there are only a couple of things you need to bear in mind: that mean reversion is the only certain thing about markets and that (almost) no one is interested.

The reason that no one is interested is that everyone is convinced that they can identify the narrative, the story, the meme that will find the next wonder stock that defies the law of mean reversion. And you might, but the chances are you still won't become filthy rich on the back of it, because only in hindsight is success inevitable. 

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Behavioral Bias 101: #3 Curse of Knowledge

Know What?

We're often told that knowledge is power. However, in reality, knowledge may be unexploitable leading to the paradoxical situation that high quality goods get overpriced and low quality ones underpriced. Insiders, it turns out, are often burdened by the curse of knowing too much.

Part 3 of 101 Ways To Lose Money

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Can You Forecast Better than a Dart Throwing Chimp?

The fox knows many little things, but the hedgehog knows one big thing - Archilochus

Cover Story

Philip Tetlock has spent many years studying the ability of experts to predict important events in their sphere of interest and come to the not entirely astonishing conclusion that they aren't much good at it. Soviet experts, for instance, missed the possibility that the Soviet Union might stop existing. On the other hand, they're exceptionally good at promoting themselves: being wrong is no impediment to fame, it seems.

Tetlock has discovered that people fall into two groups that he labels 'hedgehogs' and 'foxes', Hedgehogs have one big idea and tend to interpret the world in terms of it. Foxes have lots of ideas and are more flexible in the face of change. Unsurprisingly foxes are better at predicting stuff; but does that make them better investors?

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Mr Popper’s Predictions

In My Experience

In my experience whenever you hear someone saying "in my experience" you're about to get an earful of incoherent nonsense justified by the observer's single perspective. It's nearly always dangerous nonsense, justified by specific examples taken from a single snapshot in time.

Well, in my experience, personal observations are typified by overconfidence, colored by hindsight bias and impervious to evidence suggesting that they're wrong. They're flung about with gay abandon, but have as much in common with objective truth as a report from an analyst.  The future is unknowable, anyone who claims special knowledge is either lying or mad. And possibly both.

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H is for Hindsight Bias

Hindsight Bias is the tricky problem that in the past we think we predicted the present, so here in the present we think we can predict the future. Only we didn't predict the present, we only think we did, and we can't predict the future because we don't have the gift of foresight. Nobody does (that only happens in movies and magic shows and it's not real).

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Clueless: Meet the Overprecise Pundits

Bedside Punditry

Most short-term opinions on markets or any system that includes human beings as part of the machinery are generally worthless in a financial sense.  Mostly we can’t predict what side of the bed our children will emerge from in the morning so why anyone should expect to be able to accurately forecast the outcome of the interactions of millions of people remains an abiding mystery.

Despite this reams of words are written each day by pundits safe in the knowledge that today’s news is forgotten tomorrow and that expressing unwarranted certainty is the way to succeed.  They’ve learned that extreme, albeit incorrect, precision will fool most of the people most of the time, and no one ever checks.

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HONTI #2: Hindsight’s Not So Wonderful

Rule #2: Don't forget the past, get yourself some feedback.

Feedback

"Those who cannot remember the past are doomed to repeat it"; George Santayana, The Life of Reason

The second most dangerous trap any investor can fall into is the “I knew it was going to happen” syndrome: the remarkable ability of people to decide that they can predict the future, but only after that future has already happened: an exercise in futility were it not so damaging to investment prospects. This isn’t just a problem for amateur investors either: studies of investment bankers, for instance, show that those bankers least affected get the best returns: and vice versa¹. Overcoming this wilful amnesia is critical to improving investment results.

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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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Financial Memory Syndrome

False Memory Syndrome

There continues to be serious debate over the concept of false memory syndrome, where allegedly innocent people have been accused of serious crimes on the basis of memories which may have little basis in reality. Whatever really lies behind these cases it seems that planting fake memories in people’s brains is rather too easy to make the truth easy to ascertain.

The problem is that our memories are rather more malleable than we’re brought up to believe and it’s easy to create imaginary ones if you know what you’re doing – and often if you don't. Even worse, we can plant fake memories in our own minds and these are implicated in many of the behavioural issues that dog investors. Financial memory syndrome is at the heart of many a financial crisis.

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What’s the Shape of Your Recession?

Clueless Commentators

Over the past few years we’ve had endless economic experts opining on the nature of the recession. From initial hopes of a bouncy V shaped recovery we moved onto a sluggish U and then a very droopy looking L before a dose of government pump-primed financial Viagra re-erected the idea of the V. More pessimistic predictors – mainly those who originally plumped for a U or an L – are now hopefully suggesting that we’ll get a double-dip W or a triple-dip VW in an attempt to save their remaining credibility.

Of course, the reality is that none of them have the faintest clue because none them possibly can have the faintest clue. We are, as always, in the uncharted waters of the future. The only letter that needs apply is the X that marks the spot where we bury the commentators and their useless predictions.

Blithe Ignorance

As we’ve sailed on through the treacherous shoals of economic uncertainty people have naturally looked to the world’s experts for advice. Occasional suggestions by central bankers, who actually have the real data to analyse, that they don’t have a clue what’s going to happen have resulted in shudders across world markets. Meanwhile commentators have happily carried on making essentially random predictions based on their thirty years or so experience of largely benign economic times. It’s like watching a weather forecaster from Hawaii trying to make predictions for the Mid-West: amusing, but not terribly helpful.

In fact, as economies have uncertainly recovered we’ve seen the standard reactions by experts who’ve been caught out (see You Can’t Trust The Experts With Your Investments). Many have simply ignored the fact that they were wrong and have blithely continued to make further predictions; presumably on the grounds that yesterday’s media makes tomorrow’s lining for kitty litter trays. Others have opted for the standard “I was right, but not yet” or “I was wrong, but for the right reason” responses as though getting your timing wrong about the world economy and causing people to flee into overpriced government bonds just as the biggest stockmarket rally in history kicked off is a normal sized mistake.

The highly respected John Authers of the Financial Times is one of the few who’s come out and admitted he got it wrong (which is one of the reasons he’s respected). However, the one point he should have made, but didn’t, in “OK I called the rally wrong” is that picking the trends that were important is easy with hindsight but was impossible to do with certainty at the time.

The Two Rules of Ignorance

Still, a few rare experts called it right, at least temporarily, and their opinions are increasingly and eagerly sought. The problem is that simply being right last time is no proof that they can get it right next time. In investment, of course, next time is the only time that matters – hindsight is a perfectly useless investment tool.

Unfortunately we’re at least partially programmed to look for advice from experts. In an increasingly complex world we know, as a proportion of total knowledge, less and less. We’re four hundred years past the time when one person could hope to know everything yet many of the decisions we’re called upon to make are horribly complicated and not having a guide to help us is impossible much of the time.

There are, roughly, two loose rules humans follow when called upon to make decisions that lie outside of our area of expertise. One is to follow the crowd, the other is to follow the expert. Both are decent shortcuts much of the time, both are highly dangerous in investment.

Herding

Following the crowd, although much derided, is a perfectly good strategy in lots of circumstances. Doing what everyone else is doing in an unfamiliar setting is as good an approach as any. If everyone else is eating the dodgy looking purple mush then it’s a safe bet it’s not poisonous – although there’s no guarantee it’s not disgusting (trust me, it was really disgusting). Herd following has a long and honourable history, and is certainly evolutionarily adaptive – children habitually copy their parents and other adults in order to learn more advanced behaviours. You know, stuff like getting drunk, betting on lame horses, buying overpriced property and reading magazine articles on talentless micro-celebrities who’ve the star quality of a dead skunk.

Of course, in individual investing, herding is often the wrong thing to do assuming that we’re trying to maximise our wealth. Although, it should be noted, the momentum effect – where shares that have gained continue to do so and losers continue to fail – is extremely persistent. The problem with this is that shares do, eventually, tend to mean revert and that usually catches the crowd unawares.

Ask The Expert

The alternative, to ask the expert, is also a method with a decent pedigree. In science based areas where there’s a dispute it’s a reasonable rule of thumb to go with the side that has the most experts, although not everyone completely agrees as David Coady sets out in When Experts Disagree. For most of us this has the most direct impact in medical matters. So, for instance, in the recent debates over whether the MMR jab could cause autism the vast weight of the establishment came down in favour of children having the inoculation. The dangers of not having it were real, the dangers of taking it uncertain and the risks, as usual, were exaggerated by the headline obsessed media.

Unfortunately experts aren’t always right. The advice of the child-rearing expert Dr. Spock to lay babies on their stomachs is now the exact obvious of the expert opinion in regards to cot-death. As Ben Goldacre has repeatedly written about on his Bad Science blog, pharmaceutical funded research consistently shows a bias in favour of positive results that isn’t seen in independently funded studies. This isn’t evidence of deliberate bias by the researchers, however, since we’ve seen before how unconscious psychological drivers can lead to this type of reporting.

Investment Advice

In non-scientific areas of research, like investment, the problem is much harder. The issue is that we’re not dealing with matters of fact but with matters of opinion. Mostly there is simply no consensus to base a decision on and we tend to gravitate to the expert who’s been most recently right. Unfortunately, if expert opinion is truly random then the most recently correct experts are probably those least likely to be right in future. But in truth, we don’t know.

So in financial matters our two most favoured short-cuts in areas of specialist expertise are almost bound to leave us in the lurch. Of course, mostly we follow these routes so automatically that we’ll go ahead and use them anyway, like a driver following a sat-nav over a cliff edge. The alternative is to try and acquire sufficient knowledge to do the job ourselves and here we tend to fall victim to a different bias – the idea that because it’s easy to do something it’s easy to do it well.

Simply being able to log on to a sharedealing site, purchase a few shares and see them roar is no evidence at all of investment expertise. In fact, there’s a good case for arguing that the easier it is to get access to a means of making money the harder it actually is to do so. Consider blogging, an activity engaged in by everyone from five year old toy collectors to octogenarian needle workers. Anyone can do it, which means making money from it is virtually impossible for new entrants: that’s the nature of basic economics.

Good Enough Expertise

As so often the best advice in this area comes from Charlie Munger who observes that in order to make difficult technical decisions you need to employ an expert and then gain sufficient knowledge personally to at least cross-check that they know what they’re doing. In investment that roughly equates to them not chasing every trend, not trusting research done by others and having a clear understanding of the fundamentals of valuation techniques and competitive advantage.

For the most part, though, you don’t want an expert who spends their time opining on the shape of nebulous concepts like recessions. Better find one that actually spends some time thinking.


Related Articles: Technical Analysis, Killed By Popularity, Ambiguity Aversion: Investing Under Conditions of Uncertainty, You Can’t Trust The Experts With Your Investments

Hindsight Bias

Behavioural Biases (2): Hindsight Bias

The CIA reports that hindsight biases are:

attributable to the nature of human mental processes, not just to self-interest and lack of objectivity, and that they are, therefore, exceedingly difficult to overcome.

And, after some years searching for weapons of mass destruction in the wrong country, as the North Koreans have demonstrated by actually exploding nuclear weapons, the CIA really ought to know about this.

In fact, if you replace “exceedingly difficult” with “impossible” you’ve basically got the point – hindsight bias, the tendency to believe that events that have already occurred were more predictable than they were before they took place, is endemic and a built-in part of the human psyche. It’s one of a multitude of factors that leads to investor overconfidence and underperformance.

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