Behavioral Bias 101: #2 Wishful Thinking

Permanently High

Famously the economist Irving Fisher predicted that stocks had reached a "permanently high plateau", just before the Wall Street Crash. He was talking his own book, having loaded up heavily in stocks. Fisher was engaged in wishful thinking, a cognitive bias that's rife among investors, a notoriously optimistic bunch when it comes to expecting the downright improbable.

Part 2 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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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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O is for Overconfidence

Overconfidence is highly underrated as a cause of poor investing behavior. You see, almost no one believes that they, themselves, are overconfident. Generally we're very confident about the fact we're not overconfident. Generally we're wrong.

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CEOs: The More You Pay Them, The Worse They Perform

The Peter Principle

"Every new member in a hierarchical organization climbs the hierarchy until he/she reaches his/her level of maximum incompetence"

The Peter Principle states that everyone gets promoted to a level at which they're incompetent. More generally Lawrence Peter observed that anything that works gets used to do other things until it fails. This is true even of ideas, and sometimes even failure doesn't stop them being promulgated. Consider, for instance, economics as the primary example of an idea stretched beyond its elastic limit.

But at the top of the corporate tree are those executives who've somehow avoided becoming victims of the Peter Principle. Of course, simply becoming a CEO doesn't disprove the idea, it just makes it more likely that we'll have lots of incompetent business leaders who've become really good at blaming other people. And a survey of CEOs suggests that this is exactly true: they're overrated, they're overpaid and they don't deliver for anyone apart from themselves. Why am I not surprised?

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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.

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Where Two Strangers Never Meet: Self-Serving Bias

"If you can meet with Triumph and Disaster, and treat those two strangers just the same"

IF … Rudyard Kipling

Problematic Pronouns

We all probably know someone who believes that their successes are entirely down to their own levels of skill and whose failures are someone else’s fault.  To some extent most of us will meet them in the mirror each morning.  This is self-serving bias in action.  As Donelson Forsyth explains it:

“Those told they failed attribute performance to such external factors as bad luck, task difficulty, or the interference of others, and those told they succeeded point to the causal significance of such internal factors as ability and effort.”

Now, what do you think will happen to a corporation if you put someone with a bad case of self-serving bias in charge?  Beware the CEO with a bad case of the personal pronouns, that’s what I say. And let's not talk about global warming.

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Risky Shifts

Female Underwear (Not)

No doubt some will be disappointed to learn that a risky shift is not a slightly daring article of female underwear, but an outcome of the counterintuitive process of group polarization. This says that if you take a group of roughly like-minded people they will gravitate to a more extreme position than that of the average team member. 

Mostly people would expect the opposite, that the average would hold sway, but the fact that this doesn’t seem to happen is a concern in many spheres, some of them more important than investing.  However, as financial markets often seem to be populated by like-minded groups of wildly overoptimistic people, they’re excellent breeding groups for risky shifts.

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A Woman’s Place is in the Money

Money Maketh Woman

The research showing that women are better investors than men has been around for a while.  This is linked to the evidence that women are more risk averse than men – they tend to take less chances in general and with their money in particular.

This leads to a simple idea; that we should encourage more women to get involved in trading, both in the professional world and in the home.  The reasoning is that if women are more cautious, and therefore more successful, investors then their stabilizing influence will lead to a safer and less volatile financial world.  Which is a nice idea, but is probably wrong, although you’ll need balls to admit it.

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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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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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Crowdfunding Heroic Entrepreneurs

Ask Not 

The crowdfunding provisions in the JOBS Act have provided a rich source of material for commentators both for and against the concept. Providing bright eyed innovators with seed capital seems like a good idea, but pushing small investors into dubious schemes with little chance of success is less obviously smart.

In fact the crowdfunding regulations are still being created, so we don’t really know how much investors will be protected from themselves but we know one affected group who do need some help. Step forward the heroically biased entrepreneurs of America. Your country needs you, although you probably need your country more.

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Your Self-Inflicted 6% Trading Tax

How Not To Make Money

Making a turn from the markets is hard, we all know that.  Unfortunately we tend to make it a lot harder for ourselves than we need to, and if we don’t then the investment industry is always there to lend a helping hand.  For an extortionate fee, of course.

We’ve already looked at the gross amount of money we conspire to lose each year – something in the region of $160 billion a year in the US alone (see: The 160 Billion Dollar Bezzle).  Now a UK writer has looked at what this means for us as individuals.  The answer is, very roughly, a cost of 6% a year.  Which, when the average return from the stockmarket is probably no more than 5%, makes for a not very good way of making money.

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Limit Orders, on the Crumbling Edge of Behavioral Finance

Crumbling Limits

Although behavioral psychology has helped explain some of the odder effects around investment there remain many sceptics. The reason for this isn’t hard to find, because if you start out assuming that peculiar features of investment markets are caused by rampant misbehavior then you’re quite likely to find evidence to support that assumption.

Some of this is down to irrational behavior, no doubt, but perhaps not in the way that the academics first thought. So, for instance, consider the use of the humble limit order. Used unwisely – which is to say, nearly always – it doesn’t just lose investors money but ruins the researchers’ results into the bargain. Just watch those behavioral biases crumble away.

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The 160 Billion Dollar Bezzle

Bezzled by Their Blind Spot

It’s sort of common knowledge that private investors generally lose by over-trading; invariably individuals think this only applies to other people and not to themselves, but you're just Bamboozled by Your Bias Blind Spot. The question remains, however, just how much do private investors lose by this behaviorally challenged frenzy of trading?

Figures are hard to come by, but one rule of thumb estimate suggests that US investors gave up $160 billion dollars in 2010 through this hyperactivity. Which is a nice boost for the denizens of the underpaid and underappreciated securities industry, struggling to keep their superyachts afloat.

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Bamboozled By Your Bias Blind Spot

No UFOs Here

It has come to our attention that there are amongst you those who are quite happy to accept that behavioral biases affect the way that other investors act but refuse to agree that you, yourself are so afflicted. Of course, most UFO abductees reckon everyone else is a faker, so we shouldn’t be too surprised at this.

There’s a term for this wilful foolishness: it’s called the bias blind spot. We recognise it in others, so why don’t we see it in ourselves?

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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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Sexism and the City

Hair-Trigger Traders

It’s long been known that women make better investors than men, although frankly that’s not a particularly difficult thing to do as most of us males have the patience of a small child with a full bladder and a tendency to hair-trigger trading for all sorts of behaviourally induced reasons. However, what’s a bit more surprising is that this difference is seen in professional investment circles as well while at the same time biases against female fund managers ensure they have less money to manage more wisely.

Behind all of this appears to be a basic bit of brain processing evolved to make sure we bond tightly to our social groups and to regard outsiders, en-masse, as strange and potentially dangerous. As so often in investment, though, if we stick to our basic stereotypes we blind ourselves to opportunity.

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Depressed Investors Don’t Need Feedback. Everyone Else Does.

Depressed Yet Clearsighted

Although it’s easy enough to show that overconfidence is a blight on investment performance we need to be careful that we don’t blind ourselves to an important reality. Overconfidence is not simply a problem for investing, it’s an issue that applies to most of us, most of the time in most of the things that we do. It’s not something we can simply stop because we wish it so.

In fact it turns out that there are only one group of people who are not habitually overconfident. Unfortunately these people are, instead, habitually miserable. It turns out that to invest sensibly you need to be depressed.

Overconfident or Depressed

That most people are overconfident is a finding that’s been replicated scores of times on a wide variety of tasks. However, the research showing the so-called depressive realism effect indicating that depressives are almost alone in not exhibiting overconfidence at least suggests a reason – that feeling confident about ourselves is a necessary antidote to real life and that if we saw our lives and the world we live in as the ghastly messes they truly are we’d be unable to function properly.

Trading off our mental health and general happiness in order to improve our investing returns, however, seems a bit of a bad bargain – although, we could equally well argue that if most people properly analysed their real returns they’d probably feel pretty depressed anyway. Of course, it’s quite possible that when an overconfident investor runs into the brick wall of a real bear market the cognitive car crash this causes can lead them to develop an aversion for all types of investing activities. Anything rather than face the grim reality of life as an average stock picker.

Feedback’s the Key

Fortunately there is an alternative to taking the anti-happy pills but it does require investors to force themselves to face their decisions, something the evidence suggests that many investors are reluctant to do. The problem is that unless we analyse what we’ve actually done we won’t change our behaviour, even when it’s obviously not in our interests, until we have no choice. Which will usually be when the repo merchant knocks on the door. Alternatively we need to calibrate ourselves against our actual performance and learn to adjust what we do.

Calibration’s a pretty simple affair, nothing more than the process of receiving and using feedback. The trouble with stockmarket investing is that there’s no simple, instantaneous feedback process to allow us to calibrate ourselves – often it takes months or years before we know whether any given decision was a good one or not. However, the evidence across many areas suggests that when people force themselves into calibrating their performance their success rate improves – often dramatically.

Geology, Accountancy and Weather Forecasting
 
Schoemaker and Russo’s 1992 paper on Managing Overconfidence is essential reading for investors. They give three examples of groups who don’t exhibit overconfidence – geologists, weather forecasters and accountants. In all three cases these groups receive rapid and effective feedback by design. In their own words:

“Being well calibrated is a teachable, learnable skill”

The beauty of this accelerated feedback is that it attacks overconfidence without needing to address the underlying psychological biases that cause it. And, of course, it’s something every investor can do if they’re motivated to do so.

Don’t Rely on Memory

In adding accelerated feedback to the armoury it’s crucially important not to rely on memory nor to tie ourselves down to definite statements. No investment is ever a 100% certainty and neither is any memory. Memories are too often simply reconstructions of what we want to believe. Investing decisions must be written down and then analysed at various points. This needs to cover both the positive and negative decisions – a decision not to invest is as important as a decision to invest, both can – with hindsight – turn out to be mistakes. The critical thing is to analyse the decisions in the light of the information used at the time and that generated by hindsight.

Yet it’s impossible to get every decision right so coming up with a probability judgement is important. Retrospectively analysing decisions where we thought there was a very high probability of success yet which have failed tells us something important about our inner states. Indeed conducting this analysis can be eye-opening: companies can suffer poor performance for any number of reasons many of which would have been completely unpredictable at the time. You may have covered every possible foreseeable risk and still be left with losses when the Finance Director runs off with the CEO’s spouse. And your shock would be nothing to that of their wives’.

The Harder You Practice …

Despite this, a fair percentage of investing results will turn out – with hindsight – to have been perfectly predictable. Calibrating your decisions is the start of the process of turning hindsight into foresight. At a qualitative level a simple list of pros and cons with regard to any given investment is an important start. It’s really important to force yourself to face the possible negatives of any decision at the time you make it. It’s even more important to look back at these judgements in the light of experience to decide whether or not you were being realistic in your judgements.

Shining the hard light of reality on our decisions doesn’t come naturally. We’re in danger of violating our own overconfident preconceptions about ourselves. Who wants to come face to face with the reality that we’re not very good at something we pride ourselves on? Yet the numerical evidence suggests that this is exactly the situation pertaining to a large proportion of investors.

… The Better You Get

The alternative is to continue to stumble blindly around in the hope that everything will turn out to be OK. If people insist on becoming active investors rather than passively letting the markets take their course, then they need to concentrate on improving their abilities. Experts get to be expert by practicing, not by simply wishing it to be so. Of course, if you accept the arguments of the more extreme proponents of efficient market theories then you’d conclude that this is a waste of time. However, that argument was roundly demolished many years ago some geezer called Warren Buffett in The Superinvestors of Graham and Doddsville which demonstrated that certain pre-selected investors were able to outperform the markets over many, many years.

Of course, it’s unlikely that simply by more carefully analysing your investment decisions that you’ll end up joining the exalted ranks of the super investors. However, if you’re going to invest actively it would be highly irrational to not try. Alternatively, of course, you could just try and make yourself really depressed before making any investment decisions.


Related articles: Overconfidence and Over Optimism, Pascal’s Wager – For Richer, For Poorer, O Investor, Why Art Thou Rational?