R is for Representative Heuristic

The Representative Heuristic is our trick of comparing whatever happens to be under consideration to whatever we can bring to mind. It's an effect of availability, but we can be primed into triggering the heuristic by clever manipulators or not-so-clever psychologists.

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Low Risk, High Rewards: The Low Volatility Anomaly

Axiomatic Memes

It’s an axiom of standard economics that you don’t get above average returns without taking above average risks. No risk, no reward.  It’s an appealing idea, an extension of the entrepreneur's creed: you don't become successful without taking chances.  It’s a meme that’s gone viral, an idea that permeates discussions about investment, drives hard headed analysis and leads us to celebrate the risk taking achievers in society.

And of course it’s a bucketload of hogwash. In fact, lower risk portfolios will tend to outperform higher risk ones.  High risk stocks are dangerous rubbish, and offer not excess returns but excess losses.  They’re a one way ticket to the seedy side of the market.

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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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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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Idiot Noise Traders

Who's Noisy Now?

In 1985 Fischer Black published a paper entitled “Noise”.  In this he argued that much of the irrationality in financial markets could be explained by people trading without information: essentially using various spurious signals to decide when to buy or sell. In fact there’s an argument that without such people markets couldn’t work at all. The downside of this is that it’s difficult to separate the noise from the information.

Black predicted that there would be people who spend their lives trading on noise – so-called “noise traders”; people that Paul Krugman calls "idiots". Unfortunately these idiots generate so much noise that it’s very hard to determine the real information, which would suggest that if we're not careful, at root, we’re all idiots.

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Sharpshooting the Investment Gurus

Hitting a Barn Door

Take a rifle and randomly spray bullets at the side of a barn. Invite some gun-toting friends around to see your handiwork and accept their lavish praise as a dead-eyed sharpshooter, knowing all the while it’s an illusion. The trick is to paint the targets after you’ve made the bullet holes.

This, the Sharpshooter Effect, is essentially how many business gurus and investment analysts make their living. Worse, the effect affects statistical analysis of data that are genuinely important, like clusters of birth defects. The problem is that we’re not very good at distinguishing randomness from order and this causes us no end of grief as we pursue illusory patterns in the belief that we’re being smart.

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Behavioural Finance’s Smoking Gun

Linda

Here’s a classic demonstration of behavioural finance in action, proving the irrationality of humankind. It’s the (in)famous Linda problem:

Linda is 31 years old, single, outspoken and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in antinuclear demonstrations. Which of these two alternatives is more probable?

(a) Linda is a bank teller.
(b) Linda is a bank teller and is active in the feminist movement.

Most subjects choose (b) and are informed that they’re irrational because the conjunction of two events – Linda is a bank teller and active in the feminist movement – is less likely than her just being a bank teller, regardless of her leisure interests. This is known as the conjunction fallacy. Unfortunately there’s a teensy little problem with this finding.

It’s wrong and it’s the smoking gun of behavioral finance.

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