Bias In Action

Myopic Urges

The recent sharp correction in markets has clearly surprised a lot of investors. No doubt this is partly due to the standard myopia people seem to exhibit as soon as the last crash is out of sight, but it also seems to be connected to the fact that the seemingly inexorable rise in share prices and the continuing low interest rates on deposits has tempted new people into stocks. Faced, for the first time, with nasty losses they’re casting about for some kind of strategy to deal with the situation.

In truth if you need to find a strategy after markets have started falling it’s too late. For most of us the only sensible approach is to only buy things we’re comfortable holding through any kind of downturn and to then do nothing when volatility strikes. But even experienced investors face the urge to do something – anything – in the face of mounting losses. This is action bias, in action.

Read Full Post >>

A Catalog of Investing Errors

Love Lists

We're attracted to lists like moths to flames and netheads to clickbait. The Big List of Behavioral Biases is by some way the most popular page on this website, but it actually provides very little insight into investing successfully.

Behind this, though, lies a deeper truth. Lists are processed more easily by the brain, and they're perfectly optimized for the click and go environment that is the Internet. Here I explain why. In a list. Obviously.

Read Full Post >>

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.

Read Full Post >>

I is for Illusion of Control

Illusion of Control refers to our convoluted efforts to retain the belief that we're in control in situations where we really aren't. In fact, having some level of autonomy seems to be important for our psychic health but there are times where we take this to extremes. Like when we think we can predict anything about stockmarkets.

Read Full Post >>

Brains, Bulls and Lucky Tossers

The Wile E. Coyote Moment

With the great post-Armageddon bull market party in full swing suddenly everyone's an investment genius again. Back in 2008, when stocks were languishing at lows not seen since talking movies were invented, no one wanted to know. And, as usual when the bull is running, logic is taking a quiet break and considering early retirement.

Well, logic needn't bother. At some point people are going to look down and realize that they've run over the cliff edge again. The question is not if, but when, the Wile E. Coy moment will happen.  The trouble is that bull markets get people thinking they’ve got brains when mostly what they’ve got is hope.

Read Full Post >>

Stories, Control, Fundamentals and Panic

Nerve, Lost

There’s an ongoing, long term argument about the nature of financial crises.  Many believe that they’re caused by the underlying fundamentals of the economy, imbalances of various kinds, leading to failure.  Others argue that the only fundamental is the inevitable hopelessness of human nature in the face of uncertainty: panic.

Of course, panic itself is a bit of a vague term, although it clearly refers to some kind of failure of collective nerve in the market.  For a panic based model of financial crises to have any validity we’d need to link it to some of the more pervasive failure modes of human rationality.  And, as it turns out, it's our need to feel in control and our urge to tell stories that leads us into the pit of financial damnation.

Read Full Post >>

Mindless With Money

Non-conscious Numbskulls

We all know the feeling of mindlessness. You get it when you drive the same roads as usual and get out at the end not remembering anything about the journey, or when you eat a meal without tasting it, or leave a meeting without the faintest idea what just happened. Yet to everyone around us we’ve behaved just the same way we always do.

There’s something really odd about this, because it suggests that we don’t need to be conscious of what we’re doing to achieve what we want to do. Whether that’s a good thing or not is debateable, because being mindless with money is likely to cause results that might be best described as “unfortunate”.

Read Full Post >>

Monty Hall Economics

God and the Economists

Apparently the Monty Hall test is one that Wall Street firms commonly use to see if potential applicants are suitable material for the madness that is a trading desk in the heartlands of financeland. In so using the test these corporations are, knowingly or not, addressing some of the most hard to overcome behavioural biases that often defeat legions of unprepared investors.

In fact, this particular test has been a source of delight for grant seeking academics of all persuasions. The thing is that the Monty Hall test can be explained in many different ways, most of them simultaneously contradictory. However, it does increasingly look like this blatantly irrational behaviour is hard-wired into our neurons. It seems God really doesn’t like economists.

Read Full Post >>

The Lottery of Stock Picking

Risk Seekers, Risk Fearers

On average stock traders lose money. So do people who play the lottery. Yet both sets of people will often buy insurance as well. On one hand people are risk takers, engaging in risky and usually unprofitable activities, yet on the other they’re risk adverse, looking to protect themselves against possible, although often unlikely, losses.

Mostly we don’t find this particularly odd. Yet it poses a particular problem for economists and psychologists trying to disentangle the various threads that make up the skein of the human condition. They feel we should either be risk seekers or risk fearers: to be simultaneously both suggests something strange is going on. Stock pickers take note: sell insurers, buy lotteries. Or is it the other way around?

Markowitz’s Lottery Puzzle

One of the earliest researchers to note this gambling/insurance peculiarity was Harry Markowitz who we’ve met before in Markowitz’s Portfolio Theory and the Efficient Frontier. In the same year he published the paper that eventually led to modern Portfolio Theory, the efficient markets mayhem and a Nobel Prize he also wrote The Utility of Wealth in which he both described this confused risk model and sought to explain it.

It’s a bit of surprise to find the father of rational investing theories elaborating on a subject which describes how irrational people really are. However his two 1952 papers are linked. While The Utility of Wealth describes how people really behave Portfolio Selection describes how they should behave to maximise their wealth. We can’t blame Markowitz for the investment industry using his ideas with all the subtlety of a Mob family collecting a debt from the man who wasted their mother with a cheesegrater.

Models which really aim to describe the way humans deal with risk are deluded and denuded if they exclude the risk-seeking part of the human experience. Deluded because they ignore the evidence of everyday life and denuded because they strip away the essence of human experience. Humanity would still be trolling around on its knuckles in East Africa if curiosity about what was on the other side of the forest canopy hadn’t got the better of our ancestors.

Utility and Gambling

Yet we can’t ignore the fact that we’re also risk adverse under many conditions. Buying insurance is sometimes an intensely rational thing to do – to pay a small premium to protect against the loss of a large asset such as our home makes a lot of sense. As commonsense people rather than academic economists, we don’t see the problem in a combination of risk seeking and risk aversion. After all, a small flutter on the horses or a bit of bungee jumping adds to the spice of life.

The classical economic explanation of these contradictory behaviours is full of complex equations and inflecting graphs which worry about the nature of something called the utility function. Utility is, roughly speaking, the value that a person gets out of an activity. Utility can be considered, roughly (OK, very roughly), as ‘happiness’ and many people have pointed out that the apparent inconsistency between risk seeking and risk aversion can be explained if you view the positive utility of pleasure people get from gambling as exceeding the utility they lose through the monetary expense.

Utility and Stock Trading

However, there are other sorts of gambling of which, for our purposes, the business of stock trading is the most important. When the same trigger that makes minor gambling on lotteries and horses enjoyable also encourages major risk taking in stock investment this supposedly harmless pastime suddenly becomes a deadly serious problem. As Meir Statman puts it in Lottery Traders:

“People confuse the stock-holding game with the stock-trading game. The stock-holding game is a positive sum game : buyers of stocks can expect to receive, on average, more than they spend. However, the stock trading game is a negative-sum game. In the absence of trading costs, management fees and expenses, stock traders can expect to match the return of an index of all stocks. But they can expect to lag that index once trading costs are considered. “

The problem with utility based models is that they rather ignore the fact that people process information very inefficiently. We can, and often are, fooled into thinking that the utility of a thing is different from what it actually is. So buying a long-term warranty on a fridge is usually a waste of money and so is buying a lottery ticket or actively trading stocks, no matter how much pleasure we get out of these activities. We miscalculate – and sometimes it’s a good job we do, otherwise life would be a drab procession of accountancy courses.

The Utility of Social Class

The problems lie deeper than this. Studies of lottery gamblers show that the people who spend the most money are those who can least afford it. Conversely those who spend the most on insurance are those who can most afford the losses they’re insuring against. Markowitz’s paper points to a possible explanation for this: people aspire to move up from their current social class and to avoid dropping down to a lower one.

Developments of this by Coelho and McClure also offer a hint of an explanation for the old aphorism that there’s nothing more damaging to a man’s happiness than his brother-in-law becoming rich. If our happiness is determined relatively – by assessing our wealth against our peers – then our peers getting richer than us will make us unhappy. Or, in the jargon, our utility reduces. And, the researchers predict, we’re likely to gamble more in the short-term to try to make up the defecit until our expectations about our peer group change.

The Illusion of Control

The sheer range of ways to invest gives investors every chance to delude themselves that they’re in charge. Ellen Langer pointed out as long ago as 1975 that illusion of control, the idea that people will behave as though they’re in control in situations where every outcome is actually determined by chance, seems to be part of human nature. As she puts it:

“…the more similar the chance situation is to a skill situation … the greater will be the illusion of control. This illusion may be induced by introducing competition, choice, stimulus or response familiarity, or passive or active involvement into a chance situation. When these factors are present, people are more confident and are more likely to take risks”.

Given that the vast majority of active funds and active traders do worse than simply buying and holding a basic index tracker you’d have thought the message would have got through by now. Illusion of control may cause more than financial risks. People still prefer to drive themselves for the same reason, despite the evidence that cars are the most dangerous way to travel any significant distance.

The only safe way of investing is to be constantly risk averse. There’s no contradiction in stock market investment and risk aversion – it simply means you need to insure yourself against the worst that can happen. Investing as though something is about to go badly wrong is the only safe option. After all, something is always about to go badly wrong, somewhere.

Avoiding Capital Mistakes

What most people can’t do is trade their way safely to riches – that’s to take on the risk seeking side of the equation. To do so at all is one thing, to do it without recognising it as an extension to natural risk seeking behaviour is entirely another.

There’s a part of us which embraces risk in order to better ourselves – to find the next fertile pasture, to seek a better world, to enrich our families and to remove ourselves from the monotony of the everyday grind. Without the drive to explore and take risks we’d still be wrestling chimps for food and using gravel as dental floss.

Risk taking is part of the human condition, to be embraced and cherished. But all things in their time and everything in its place – mistaking the stock market for a real world adventure playground is to make a capital mistake, in every possible sense.


Related Articles: Momentum Trading Madness, Markowitz’s Portfolio Theory and The Efficient Frontier, The Psychology of Scams

Your Financial Horoscope

Using the latest in IP address geo-detection and profiling technology we’re delighted to bring you your personalized horoscope:

You have a great need for other people to like and admire you. You have a tendency to be critical of yourself. You have a great deal of unused capacity which you have not turned to your advantage. While you have some personality weaknesses you are generally able to compensate for them. Your sexual adjustment has presented problems for you. Disciplined and self-controlled on the outside, you tend to be worrisome and insecure on the inside. At times you have serious doubts as to whether you have made the right decision or done the right thing. You prefer a certain amount of change and variety and become dissatisfied when hemmed in by restrictions and limitations. You pride yourself as an independent thinker and do not accept others’ statements without satisfactory proof. You have found it unwise to be too frank in revealing yourself to others. At times you are extroverted, affable, sociable, while at other times you are introverted, wary, and reserved. Some of your aspirations tend to be pretty unrealistic. Security is one of your major goals in life.

Trick or treat?

Cargo Cults

In the Second World War many remote Pacific islands found themselves occupied by warring forces. This often led to an unexpected windfall for the primitive islanders as the troops were supplied from the air with unimaginable luxuries like corned beef, custard powder and anti-aircraft guns. When the war ended and the troops went home the planes stopped coming so, naturally, the islanders hatched a cunning plan to make them come back again.

They created the rudiments of the apparatus that the ground crew had used – paddles to welcome the aircraft, fake headsets for the radio operator, fake landing lights – and engaged in the same strange ritual ceremonies, behaviour generally known as a cargo cult. Yet no matter how they adjusted the ceremony they couldn’t get it quite right and the planes never came back. It would be crass simplicity to suggest that the same kind of magical thinking pervades the world of investment. Only it does, of course.

Paranormal Beliefs

The curiously enduring nature of belief in the paranormal is one of the mysteries of the modern age. Less than 50% of the world’s population believes in evolution despite copious evidence in its favour, much of it propping up the nearest bar, yet a majority happily accept the probable existence of invisible, incorporeal and undetectable entities of which science can find not the slightest trace. This isn’t explicable under the normal definition of “rational”.

Many practitioners of magic argue that this widespread belief in things that go bump in the night is de-facto evidence that there must be something “out there”. Only almost certainly there isn’t, but there’s definitely something going on inside our heads: we’re infinitely suggestable. This factor, combined with our desire to seek forms of control in situations of extreme uncertainty is a powerful driver of behaviours that we’re apt to label as “irrational” when, in fact, they’re nothing of the sort.

When the Irrational Isn’t

The smoking gun that leads to the redefinition of “rational thinking” was discovered in the Trobriand Islands. The anthropologist Bronislaw Malinowski noticed that the islanders engaged in elaborate rituals when they went deep sea fishing but not when they were fishing inshore. He surmised that the open seas superstitions were an attempt to protect themselves from danger in a fundamentally uncertain environment.

This tendency to attempt to exert some form of control, no matter how illusory, in the face of great uncertainty, seems to be part of the human condition. Various studies, including this one on the superstitious behaviour of baseball players, back the theory up. The evidence is that people attempt, always, to put themselves in a position where they feel they have control of the situation, regardless of the reality: the so-called “illusion of control”.

Magical Investment Thinking

Now, boys and girls, can we think of another situation where people are essentially at the mercy of random and unpredictable events and spend a lot of time developing ritual behaviours to make them feel as though they have control of the unfolding events? Admittedly, the stockmarket is an extreme example of the genre – a global manifestation of a belief in magical forces leading to the mass delusion that we can predict the movements of individual stocks, markets and economies.

While primitive tribesmen have mystical seers, priests and soothsayers we have investment analysts; while they have chicken entrails, hallucinogenic drugs and animal sacrifice we have multi-year earnings forecasts, better hallucinogenic drugs and occasional executive bloodlettings. Simply clothing the magical rituals in a smart suit and a well formatted report doesn’t make the outcome any more predictable and the rituals any less pointless, but it does make us feel better when things go pear shaped and we go looking for reassurance.

Logical or Astrological?

In fact if this theory is correct we should see an increase in such magical behaviour during conditions of extreme market movements; a greater reliance on divining the future using essentially random techniques, and indeed we do. In times of uncertainty many people abandon any pretence of higher cognitive functioning and head off in search of their nearest soothsayer.

For instance, if you type “investment astrology” into Google you’ll get over 2 million hits. The survival of astrology into the modern age is itself remarkable but huge swathes of the world’s population still conduct their lives according to the prophetic divinings of invisible, undetectable and unmeasurable forces that enmesh us at birth and mark us for life. Apparently.

Yet, as has been repeatedly demonstrated, the evidence for astrology actually working is decidedly thin away from areas of human suggestability. So, for instance, those people who believe in astrology tend to have personalities that conform to their astrological signs while people who don’t, don’t. Belief is a powerful weapon in human systems but it sadly doesn’t mean that magical thinking can actually have an effect on the physical world around us.

Supernatural Stockmarkets

Only, of course, the stockmarket isn’t the real world. It’s an artefact of human construction and is therefore open to manipulation through all of the kinds of things that we let affect us. In theory the performance of stocks on the market is determined by fundamental factors like earnings, competitive advantage and marketing. In the long-run this is generally true, but in the short-term magical modes of thinking can easily overwhelm more fundamental factors.

Still, you’d assume that if astrology, charting and other magical modes of prediction were completely useless then their repeated failure would eventually persuade people to give them up in favour of something more rational like chain-saw juggling or duck weaving. However, it’s far from being that simple because we’re all subject to being fooled by a behavioural trick called the Barnum Effect.

Roll Up, Roll Up, Get Things Wrong

This was first demonstrated in 1949 by Bertram Forer who constructed the fake horoscope at the head of this article using the most general astrological statements he could find. He presented this to his students, explaining that it had been customised for each of them when, in fact, he gave everyone the same reading. When he asked them if it accurately represented them they virtually all agreed that it did. This trait – to see insightful information in the most general rubbish – is the stock in trade of all magicians, astrologers and other sayers of soothes:

“It was pointed out to them that the experiment had been performed as an object lesson to demonstrate the tendency to be overly impressed by vague statements and to endow the diagnostician with an unwarrantedly high degree of insight. Similarities between the demonstration and the activities of charlatans were pointed out”.

Everyone is prone to the Barnum Effect and it works because we think the same way. We read into things whatever we want to: again, it’s not that there’s anything “out there”, it’s all inside our heads.

Stocks that go Bump in the Night

The idea that most investment is driven by magical thinking underpinned by psychological tricks like the Barnum Effect is disquieting, but once you start looking for examples it becomes all too easy to find them. Astrology is simply the most obvious outward sign of this, but sneering at astrological investment techniques while continuing to faithfully follow more orthodox but equally magical processes ignores that this is the way most of us deal with uncertainty.

For children Halloween comes once a year but many investors spend their entire lives trick or treating. Sadly most treats are just tricks and most tricks are just illusions that we fool ourselves into believing. Trouble is we can only see this with hindsight – and that’s if we ever figure it out at all.


Related articles: Science, Stocks and Superstition, O Investor, Why Art Thou Rational?, Don’t Lose Money In The Stupid Corner

Overconfidence and Over Optimism

Behavioural Biases (1): Overconfidence and Over Optimism

Most of us are way too confident about our ability to foresee the future and overwhelmingly too optimistic in our forecasts. This finding holds across all disciplines, for both professionals and non-professionals with the exceptions of weather forecasters and horse handicappers.

To add the problems it also turns out that the executives running the companies we invest in so hopefully suffer from the same problems. Overconfident, over optimistic investors investing in companies run by overconfident, over optimistic executives. What could possibly go wrong?

Read Full Post >>