A Sideways Look At … Behavioral Bias

Behavioural Bias on the Psy-Fi Blog

It’s pretty much a given that investors, analysts, regulators, executives, tipsters, brokers, dealers and the bloke next door with a day trading account and a nervous twitch are all affected by behavioural biases which cause them to do irrational things when investing, especially in open markets with near instantaneous price feedback. Although most economic models are still based around the concept of efficient markets you’d be hard pressed to find a economist capable of fogging a mirror that doesn’t agree that human psychology plays a major factor in major market movements.

Unfortunately academic approaches which aim to replicate market behavior by tweaking efficient market models often don’t translate well to the harsh, Darwinian world of real finance where people need to use these ideas to make money. Typically the models work right up to the point they don’t, when they fail catastrophically. Integrating behavioural finance into the models is a work in progress but, as individuals, we need to start by recognising the problems in ourselves before we can start to benefit from our insight.

Anyway, here’s a brief summary of the Psy-Fi Blog’s thoughts on behavioral biases …

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A Sideways Look At … The Randomness of Markets

Surviving Randomness on The Psy-Fi Blog

There are hundreds if not thousands of sites on the internet offering would-be investors self-help guides on how to become rich through investing in stocks. These cover the technical mechanics of investing, but generally fail to address the true art of the great investor, the management of one’s own state of mind.

Of course, here we swing to the beat of a different tune, holding fast to the syncopated rhythms of the mental processes within and between people which drive them to make investment decisions that seem often to ignore the basic logic of time and space. When examined closely it usually turns out that behaviour developed and honed to maximise our survival chances out in the real jungle is ill-adapted for the investment one. We’re frequently led astray by our instincts and unfortunately the markets trigger our reflexes all too often.

Here, then, is a selection of the Psy-Fi Blog’s thoughts on surviving the randomness of markets …

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A Sideways Look At … Economic Models

Economic Models on the Psy-Fi Blog

Almost inevitably economic models keep on appearing on this blog, an annoying but inevitable occurrence. These models underpin so much of what happens in finance that it’s impossible to ignore them. In fact they’re now so important that the models themselves can change markets, although usually only because they’ve screwed everything up again.

All models are simplifications of the real-world – a model that described everything would have to be bigger than the universe, so until we can figure out how to start consuming other dimensions we’ll have to make do with approximations. Of course, when we do break out of this cosmos we’ll end up with a bunch of do-gooders complaining about the effects of dimensional change as vast chunks of the space-time continuum break off and strand the pan-dimensional equivalent of the polar bear.

Anyway, here’s a brief summary of the Psy-Fi Blog’s thoughts on economic models …

Newton’s Financial Crisis: The Limits of Quantification

It all started nearly three centuries ago when a bewigged philosopher-scholar named Issac Newton went and invented calculus in order to model planetary motion. Soon if you weren’t using maths to do your modelling other physicists were calling you a sissy. It wasn’t long before generating mathematical models became the gold standard for everyone and that’s where the trouble started. The next thing you know we have the Efficient Markets Hypothesis:

“The Efficient Market Hypothesis is one of the great blights of modern investment analysis. What it says is that markets price efficiently, all the time. So all known information is already in the price of stocks or bonds or whatever which means that unless you know something that’s not in the public domain you can’t, on average, profit by trading. The corollary of this is that you can develop mathematical models to describe – and predict – market movements.

Charlie Munger, the octogenarian billionaire Vice-Chair of Berkshire Hathaway has a name for the Efficient Market Hypothesis. He calls it “bonkers”.” >> Read More

Markowitz’s Portfolio Theory and the Efficient Frontier

In investment circles math was, for a very long time, something done by rocket scientists. In the wake of the Second World War the climb and climb of the stockmarket led many to think that there was something inevitable about the perpetual rise of stocks. Then the seventies hit, the Arabs decided that the oil in their countries was, well, theirs and the markets went into a dizzying tailspin.

Belatedly recognising the existence of risk, and casting about for some way of managing it, fund managers happened upon some twenty year old research which equated risk with volatility and meant that everything could be boiled down to a few simple numbers. The Efficient Market Hypothesis and models that go with it were born.

“What Markowitz did was put a number on risk to allow it to be managed. The first danger for investors is in not understanding the importance of Portfolio Theory for risk management of stockmarket investments. The second is in believing that it can explain everything. People don’t get programmed linearly – we come with randomness built in, not as an optional extra. Thank goodness.” >> Read More

Of course, no one understood the downside of what rapidly turned into a quest for spurious precision.

Alpha and Beta – Beware Gift Bearing Greeks

Markowitz’s ideas led eventually to something called the Capital Asset Pricing Model (CAPM). CAPM assumes that returns from a market lie on a Bell Curve or, in the jargon, are distributed normally. Sometimes you get very bad returns, sometimes you get very good returns but mainly you get something in the middle. Only this turns out to be dead wrong.

“The markets can behave normally for long periods of time but when they go wrong it can be spectacular. Long Term Capital Management (LTCM) a hedge fund run by Nobel laureates found this out to their cost in 1998 when their normally distributed model collapsed when they were unable to sell assets at any price due to the collapse in the Russian bond market. Only concerted government intervention prevented a massive financial crisis.” >> Read More

The search for spurious mathematical precision was to lead to all sorts of problems.

Holes in Black Scholes

The LTCM Noble Laureates had made the basic assumption that the world they knew was the only world that there was to know and constructed their models accordingly. Unfortunately a human lifetime isn’t time enough to get to know even a fraction of the possibilities. What’s odd, not to say worrying, is that the inefficient Black-Scholes option pricing model that underpinned LTCM (which itself depends on the distribution of returns on a Bell Curve, aka the Gaussian distribution) is still in use today.

“Peer under the covers of Black-Scholes and you find our old friend, the Gaussian distribution, assuming that extreme events are impossible instead of just rather unlikely. The unlikely happens all the time in markets, usually because of human behavioural biases which kick in at extreme moments and lead to sustained overshoots in valuations and liquidity.” >> Read More

Of course, any hope that the lessons of the past would be learned by the financiers of the future was forlorn.

Risky Bankers Need Swiss Cheese Not VaR

Underpinning many of the risk models being used by financial institutions is something called Value at Risk (VaR) which attempts to measure the likelihood of an unlikely event under everyday conditions. Unfortunately, like many models, it’s open to abuse if the people overseeing it don’t know what they’re doing or are too distracted by large bonuses to bother. Guess what?

“To summarise a vast range of problems in simple terms, the people running the banks, the credit rating agencies and the regulatory bodies didn’t have a clue about the limitations of the risk management models they were all using. They were all looking at the same data and using the same models. And all drawing the same conclusions. Which were wrong. >> Read More

Which eventually led to the almost inevitable problems the world started reluctantly facing up to in late 2007.

Quibbles with Quants

The rise of all of these quantitative models, based on the spurious precision accompanying analogies with Isaac Newton’s models of gravitation, have resulted in continual market failures culminating in the crash of 2007-2008, which was by far the most spectacular implosion of math based financial models yet.

“The sheer nuttiness of the credit rating agencies changing their risk models purely because a quantitative model existed that indicated that the risk of these securities collapsing like dominoes in the event of isolated defaults was remote is still hard to believe. It’s not that the models didn’t indicate exactly that. … You’ve got to ask – did none of the overpaid executives running the world’s financial corporations and regulators actually stop to wonder whether someone might have, just possibly, failed to predict everything that might happen in the real world? Did none of them look at the collapse of LTCM and wonder?” >> Read More

The Death of Homo economicus

Dig hard enough into these models and you’ll uncover the idea of the perfectly rational human being, weighing up decisions in the light of perfect information. Yet the brain is, at best, an imperfect rationalising machine making all sorts of shortcuts in an increasingly desperate attempt to make sense of our information saturated world. In 1979 Kahneman and Tversky came up with a different model, behavioural finance, based on human psychology which suggest that …

“…investors – were more risk adverse when it came to protecting a profit than they were in trying to recover a loss.

So, in effect, if something went wrong with a stock they were holding the theory stated that they would be more likely to sell it if they were in profit than if they were making a loss. This is, indeed, illogical since it’s the same company with the same prospects. If investors were truly rational they would decide whether to sell or not based on the current information – stock history is irrelevant to whether a stock is currently a good investment or not. Yet the evidence suggests that this decision is, in fact, heavily biased by their personal history and, therefore, that the decision is not really a rational one.” >> Read More

Exit homo economicus, leaving a mathematical vacuum just dying to be filled.

The Special Theory of Behavioural Economics

The death of Homo economicus is required by behavioural finance, which looks at how intelligent human beings behave irrationally for the most rational of reasons. Increasingly it looks like the Efficient Markets Hypothesis is just what happens when we don’t all have some particular bee in our collective bonnets.

“A hypothesis, then, is that behavioural biases effect investors all of the time but while there’s a reasonable balance between different types of investors in the market any deviation in valuation is corrected, leading to a market that exhibits the hallmarks of a standard efficient model. However, this is only correct at the gross level – look under the covers and you’ll find a whole bunch of behavioural biases twitching away but doing so fairly randomly, cancelling each other out.” >> Read More

To Infinity and Beyond

If rational man is dead and the rational models they go with him are similarly extinct you’d hope that these adventures in stupidity are over. Unfortunately the quest for spurious precision through mathematical models that can be programmed to make institutions easy money isn’t likely to end any time soon. Whether any of these models can successfully integrate human behaviour is questionable but, on the other hand, perhaps we should hope that they don’t.

At least we can be reasonably sure that people will continue to do exactly what these models expect until they don’t. That’s the thing about people, we’re unpredictable. Which, fortunately, is still about the only predictable thing about us.

A Sideways Look At … Retirement

Retirement on the Psy-Fi Blog

For one reason or another retirement has figured large on PSB over the past few months. It’s probably my fixation about retirement being the main objective of stockmarket investing for most people. The idea of getting old is bad enough without the thought of being poor as well. Although on the bright side you can pretend to be deaf and then be rude to people all you like.

Anyway, here’s a brief summary of the Psy-Fi Blog’s thoughts on retirement …

Old? Prudent? You’ve Been Bilked!

The sheer scale and effrontery of the banks’ reactions to government bail-outs are enough to drive anyone to outright sarcasm …

“In fact it’s only non-working savers who will lose out and let’s face it, they don’t have much say in the matter anyway. It’s a small price to pay that we’re taking from the prudent to bail out the profligate but frankly most of these people are quite old and would probably have died quite soon anyway.” >> Read More

Of course, providing you don’t eat very much, don’t require heating or shelter and can avoid healthcare costs you’ll probably be OK. Here in the UK we’re preparing to legalise euthanasia. This is almost certainly a coincidence. Probably.

The basic demographics of developed nations virtually guarantees that some nasty decisions lie ahead. Of course we can always agree to allow more immigration to pick up the slack of absent taxpayers. That’s always popular with electorates.

The End of the Age of Retirement

When Otto von Bismark introduced pensions it was on the understanding that most people would die before they got one. Unfortunately people promptly decided that if they were going to be paid to be old then they’d hang about to do so. That’s not quite so stupid as it sounds – there’s good evidence that people manage to delay their deaths to benefit from taxation changes.

Anyway, the average lifespan of a male in London in 1900 was only about 40, now it’s nearly double that. State pension schemes paying out today’s taxes to today’s pensioners are bust if you look at future liabilities. Future pension and healthcare benefits can’t possibly match the expectations of the middle aged and may not even see the already retired through safely. Pension ages are already increasing …

“For those of us in middle age there’s at least some time to take note of the demographic trends and prepare ourselves. Assuming that we’ll retire at Bismarck’s 65, pick up inflation protected benefits and be able to sell our houses for enough money to fund a golden age of cruises, holiday homes and golf club memberships isn’t very wise. Doing some sensible paying down of debt and investing in the stockmarket in a way that will guarantee capturing the maximum returns for the minimum risk is a better bet. ” >> Read More

The only problem with this being that most people are more likely to chase the latest investing trend and lose their savings in hopeless gambles than they are to invest safely. In fact most people will simply fail to make a decision at all because it’s all too difficult. Usually they’ll go off and spend their retirement savings on some new clothes and a nice holiday rather than thinking about retirement.

Retirees, Procrastinate At Your Peril

The art of not making a decision, choosing short-term pleasure over long term gains and generally operating on the basis of tomorrow never coming is pretty much the status quo when it comes to retirement planning. Most people simply don’t get around to doing it because it’s not fun. Those who do often fail because they can’t decide what to do for the best, give up and go bowling instead:

“The odd, but inevitable conclusion, from this research is that when figuring out what to do about the tricky business of retirement investing people may never get around to doing it because it’s too important. It’s hard to know what’s worse – a mass of pleasure seeking, live for the moment hedonists ignoring their retirement problems because of lack of self-control or the responsible and thoughtful folks who are paralysed by analysis.” >> Read More

Time to call for an expert advisor?

Disclosure Won’t Stop A Conflicted Advisor

Well, sadly not. Advisors only give unbiased advice if you pay them directly and most people don’t want to pay them at all. Advisors paid by commission on the products they sell will sell you the wrong thing. If they tell you that they get commission on the products they’ll do even worse stuff.

“Possibly the biggest problem, however, is that a disclosure of a conflict of interest by an expert often requires an expert to evaluate it. If you go to a doctor about a difficult medical problem and the physician tells you that you need an expensive drug but that she’s being paid by the pharmaceutical industry to plug it how do you respond? Does this disclosure help you make the decision or not?

Well, not, as it happens.” >> Read More

So trusting advisors isn’t usually a good option, either. Perhaps we should learn how to invest for ourselves – better get some training.

Financial Education Doesn’t Work

Only, it turns out, we’re awful at learning about finance. When we do learn anything we usually end up drawing the wrong conclusions:
 

There is one type of training that does seem to improve the situation – the so-called stockmarket game in which students actively participate in their learning approach. This produces a 6 to 8% improvement. Researchers seem to be puzzled by why this might be the case but there’s plenty of psychological research around that shows how active involvement in learning situations improves student ability to use the training afterwards.

Regardless, the stockmarket game success turns out to be a pyrrhic victory because the successful students then go on to save less  than their peers. The (unsubstantiated) hypothesis is that they learn that they can make up for failing to save by taking additional risks on the markets. Which is of course, what happens when you treat people like lab rats – they figure out how to get the cheese for as little effort as possible: proponents of ‘Nudge’ techniques beware. >> Read More

In fact the only thing that does seem to work is abandoning your sense of responsibility by opting out of the decision altogether.

Save More … Tomorrow

Yes, it’s been shown that the people who save most are the people who make a decision up front and then refuse to think about it. Being inherently lazy and utterly bored by the topic if we decide to invest an ever-increasing percentage of our salary in our pensions, increasing as our salaries increase, then we end up saving more than pretty much anyone else. It’s a rare case of behavioural finance actually helping us rather than pointing out exactly how stupid we are. Unfortunately there are likely to be downsides:
 

“As the same article points out, however, there is a problem in using these methods. We know that they work but we don’t know exactly why. And therein lies an issue, because when we nudge people in one direction we’re likely to find that although we may get the desired outcome, we may also cause them to do other things we don’t expect: consumers who save more for retirement in automatic schemes will be consuming less and buying fewer financial products, for instance.” >> Read More

It Ain’t What You Save, It’s What You Do With It

Of course, many people will argue it’s what you do with your savings that matters, rather than the amount you save. Sadly the evidence is not on their side. The vast majority of people who try to think their way through the thicket of the investment jungle end up doing worse than a cross-eyed monkey armed with a set of darts and a copy of the Wall Street Journal.

Although, of course, the monkey’s more likely to use the paper for other purposes than investment. Still, that’s true intrinsic value for you …