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.

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U is for Uncertainty

Uncertainty is the reality of the unknown unknowns. We don't know what we don't know: we can't even measure it. And we don't like it, not at all. In fact we don't like it so much we're prepared to ignore it, which is unfortunate as it's an 800 pound gorilla sitting in the corner. Painted blue, wearing a tutu and playing a bassoon.

We really hate uncertainty.

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Five Commandments for Investors (Or Why Dogs Can’t Catch Frisbees)

Dogs and Complexity 

One of the more thoughtful regulators around is Andrew Haldane of the Bank of England whose speech “The Dog and the Frisbee” from 2012 remains the touchstone for anyone wanting to appreciate the reasons that modern economics has made a mess out of understanding the real world.  To boil the whole thing down to a single statement: you can’t control a complex system with complex rules, complex systems require simple rules.

Applied to regulation this is revolutionary, applied to investing it adds to reams of evidence suggesting that most investors need to avoid overcomplicating their analyses, that simple rules of thumb outperform detailed analysis and that mostly we’d be better off going off to the beach with a Frisbee rather than pouring over the latest numbers. It’s all guesswork anyway, best take the easy option.

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Curiouser and Curiouser: Incentives Through the Looking Glass

Demotivated by Design

The world is full of schemes aiming to incentivize us; we’re spurred on to achieve new targets and scale new heights by the carrot of lucre-based incentivization schemes designed to appeal to our selfish natures.  Which is not surprising because we live in a society characterised by a belief that we’re all out for what we can get, wheeling and dealing in our own self-interest, forever trying to get the maximum reward for the minimum effort.

Which is like determining that 5 is the square root of 17.  Anyone who truly believes that money is the main motivation for most of our behavior is someone whose belief system needs to be carefully inspected with one of those devices used for stirring septic tanks.  Worse still, financial incentive schemes may actually miss the point by undermining our most cherishable quality: curiosity makes the man, even if it flattens the feline.

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Experience, Rare Events and Risky Choice

Choice, Education and Experience

Decision making, the challenge of choice, is often discussed as though it’s a single, invariant type of event.  Perhaps this is most strongly presented in the idea of stable preferences, the idea that if we choose to eat the fish at a restaurant one day then we should choose it the next day as well, always assuming we liked it.  People don’t actually behave like this, and decision making is much more complex than economics often makes out.

However, we can roughly divide our choice processes into two – decisions we make from personal experience and decisions we make from education.  We may invest in banks because we've had a good experience doing so, but we may choose to limit our investments based on third-party knowledge that financial institutions are inherently risky.  But how we decide which model to follow can change the course of our lives; and certainly determine the health of our wealth.

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A Yen For Yield: Redux

Uncertainty On the Brink

Following on from A Yen For Yield we’re left with the rather odd position that a quest for yield through investing in higher yielding, but risky, assets seems quite at odds with the possibility of a deflationary environment where risky assets are likely to valued downwards. This is what comes of looking at behaviour as well as economics.

The underlying problem is uncertainty. No matter what anyone tells you, no one knows exactly what tomorrow will bring. And, in particular, if you stand on the brink of retirement that means no second chances if you get things wrong.

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Crash 2012: The Sunspots Are Coming …

Spurious Predictions

Next year (or, more probably, the year after) will, scientists predict, be the peak of the current sunspot cycle, when the Earth will be blasted by electromagnetic waves emanating from the Sun, disrupting communications networks, destabilising power grids and causing an almighty market crash as panicked investors head for the hills.  Although presumably they'll leave their battery powered cars at home.

Of course, if that turns out to be true I’ll claim I’m prescient and if it doesn’t, well, then it’s a deft attempt at irony. The effects of sunspots, however, are very real indeed and, for reasons we shall now analyse, the worst affected people appear to be economists.

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Are Traders Dumber than Drooling Dogs?

Salivating Spaniels

Given the ebb and flow of investor sentiment, often for no other apparent reason than the ring of the opening and closing bells of the market, it’s terribly tempting to compare traders to the salivating dogs from Pavlov’s famous experiment.  The dogs, of course, were trained to salivate at the ring of a bell in the expectation of a good meal.

Naturally, this would be demeaning, a gross insult to the intelligence of our canine friends.  Because it turns out that there’s quite a lot of good evidence that humans investors are, despite their superior intellectual capabilities, dumber than drooling dogs.

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Dread Risk: Investing Outside the Goldfish Bowl

Goldfish Don't Have Defensive Moats

To argue that many investors and all markets are like goldfish, continually forgetting the recent past as soon as they swim around the corner of their cute seaweed festooned castle, is to do our piscine friends a disservice: goldfish have a memory span of up to three months. Investors sometimes struggle to be consistent for three hours consecutively.

It often seems like people have a switch in their heads marked “Risk”. While this is in the “OFF” position they’ll happily fill their boots with any old rubbish stock as long as enough other people are buying it. Yet as soon as life’s rich uncertainty rears its ugly head the switch gets set to “ON” and they head for cover behind the seaweed in the hope that their tiny castle can protect them. Memo to markets: risk is always with us, no matter how bad your memory – and castles in goldfish bowls don't have defensive moats.

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Investing at the Edge of Reality

Relief from the Bizarre

Mostly we expect scientists to make the world a more understandable place – or at least a more comfortable one. After all, science has helped us move from a state in which we prayed to invisible deities for deliverance from natural disasters to one in which we rely on functionally illiterate politicians to direct relief operations. So, perhaps prayer isn’t entirely irrational…

Unfortunately, as we’ve dug deeper into the mysteries of the multiverse, increasingly we’ve been forced to face the fact that reality is more bizarre than we can possibly imagine and that our senses offer us only a limited window on the world. Oddly, though, it also hints as to why we make investing mistakes.

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MIA: The Invisible Hand

Fantasy Finance

Here’s a thought. What if all of modern finance is an elaborate hoax, a fantasy perpetrated on an unsuspecting world by an unscrupulous coalition of evil power brokers, determined to ensure that free market agendas are secured in their own interests?

Exaggeration this certainly is, but it contains the nub of an idea that’s been around for over a century. This is that modern finance is built on foundations that aren’t really secure. Laissez faire may be many things but it isn’t necessarily fair, and this isn’t an inevitable consequence of economics but a decision made by people. Perhaps the invisible hand is invisible because it doesn’t exist.

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Metaphors of Mind and Money

Theories of Mind

The question of how psychologists come up with their theories of how the mind works is one that’s long troubled philosophers. Now this might not seem like a very serious concern, especially to those of us more worried about whether our stocks are going up or down, but this is misleading: how our minds work is part and parcel of how financial systems operate and our theories about this process are important in developing sensible approaches to safe and profitable investment.

Unfortunately psychologists and cognitive scientists who study such things are as likely to suffer from the pain of the availability heuristic as anyone else. The general approach to theory of mind that is now most commonly used is simply based the latest set of tools available to the researchers, who view the mind as a computer. It has ever been thus because we need metaphors to think about things and without metaphors we have nowhere to start from. This brings with it a long legacy of hard to remove but wrong ideas about financial systems.

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Physics Risk Isn’t Market Uncertainty

Physics Envy

The idea that economics should be modelled on the concepts of physics has been prevalent for the best part of a century. It’s a deliciously engaging idea, that the steadfast and unbending rules of science should be the template for the queen of the social sciences. The only trouble is that in economics human beings are part of the system and don’t tend to behave as economists would wish them to.

On the other hand the ideas generated by analogies between physics and economics have generated a whole bunch of truly great economic ideas and are the basis of the whole of microeconomics. Although it’s tempting to argue that these ideas don’t truly make sense it’s actually quite hard to make this accusation stick. Economics and physics are connected – only just not quite the way economists like to imagine.

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No Need For A Drawdown Drama

Get Out Less

Whenever markets go into free-fall we see a certain drama play out: participants firstly refuse to believe things are going wrong, then gradually subside into confusion before eventually capitulating and demanding that something needs to be done and that someone’s to blame. Generally, of course, the people most to blame are the ones in the mirror in the morning who’ve either let greed get in the way of good sense or fear in the way of opportunity.

Sadly these people are obviously getting out too much and not spending their evenings studying the statistical lessons of stockmarket history. What these tell us is that although we can have no idea how markets will next go loopy we can guarantee that they will. And every year that they don’t just makes the slippery slope that much steeper.

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In Markets Bad Stuff Happens – Frequently

Numbers and Stories

We’ve seen before that investors are generally attracted to a good story and tend to shy away from the hard problems associated with analysing numbers. Worse, even if people do look at the numbers they tend to be swamped by information to the extent of not knowing what’s important and what’s not. Although generally this is only obvious in retrospect, anyway.

However, there are strong suggestions that our inclination to follow a good and particularly interesting story isn’t simply stuff that happens. It looks as though this is built into our processing centres and is a driving force behind a lot of what we do on an everyday basis. We’re simply misapplying the lessons of life.

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Ambiguity Aversion: Investing Under Conditions of Uncertainty

Uncertainty Is Not Risk

A huge amount of effort in financial circles is spent trying to measure and manage risk. Basically risk that can’t be quantified isn’t really risk, because unless you can put a number on it, it doesn’t really exist. Perhaps we should apply the same idea to budget deficits.

Way back in 1921 the economist Frank Knight dismissed such ideas as deluded. As far as he was concerned any system involving humans was far too unpredictable to be hedged and hemmed by numbers. What Knight identified was the difference between measurable risk and unmeasurable uncertainty. However it took a man with a bunch of balls and couple of jars to shown exactly how deeply ingrained into the human psyche the fundamental nature of uncertainty is.

Extrapolate If You Dare

By all accounts Knight was deeply cynical about human nature, to the point where he dismissed the attempts of most economists to develop forecasting techniques on the basis of historic data as futile. Extrapolating from the past to the future was always bound to end in failure, he believed, because some things – especially those involving people – are inherently unpredictable. Specifically Knight distinguished between risk – which you can measure – and uncertainty – which you can’t.

For the most part investors ignore uncertainty. Which isn’t surprising, because so does most of the investment industry. Generally people operate on the basis that there’s a measurable risk in investment but that if you’re reasonably careful in how you invest you can mitigate against this. Tomorrow’s conditions will be the same as yesterday’s so we can operate on the basis that what worked yesterday will also work tomorrow.

When this all changes, however, and uncertainty rears its wild head we find ourselves lost. The historical signposts are suddenly spirited away in the middle of night and we, in the jargon, find ourselves investing under conditions of uncertainty. Our reaction to this is rather interesting and goes a long way towards explaining stockmarket plunges. It turns out that most of us are hugely adverse to the ambiguity such situations throw up and our preferred option is to run away as quickly as possible.

Urns ‘R Us

The classic experiment demonstrating this was reported by Daniel Ellsberg in 1961. The experiment is simple but the explanation is convoluted. So bear with this.

Ellsberg offered his participants a choice of two urns each of which contained 100 balls. Urn A contained 50 red and 50 black balls. Urn B contained an unknown mixture of red and black balls. Each person was asked to make two decisions – firstly to choose which colour ball they wanted to pick and secondly to choose which urn they wanted to pick it from. Be clear: both decisions were under the control of the subjects.

A significant majority of the participants chose Urn A, the one with an equal number of red and black balls. Yet this creates a paradox, which is the sort of thing that gets psychologists very excited and requires the tranquillisers to be administered by the men in white coats – to the men in white coats.

Ellsberg’s Ambiguity Paradox

Let’s say you chose red and then chose Urn A. You know that you have a 50% chance of getting a red ball. Logically this means you think that if you chose Urn B then you would have less than a 50% chance of getting a red ball. However, this means that if you chose Urn B you think you would have a greater than 50% chance of getting a black ball. Which means that you should have chosen black and Urn B, not red and Urn A. At which point the paradox asserts itself.

Our brains strain against seeing this as a paradox – the majority of people will choose Urn A and insist that it’s less risky to do so. But it isn’t: the probability of selecting a red ball from Urn B is exactly the same as the probability of selecting a red ball from Urn A. The risk is the same, what’s different is the uncertainty.

It turns out that humans are extremely disinclined to operate in conditions of uncertainty unless absolutely necessary. We much prefer a defined risk to an undefined one. Generally this is referred to as ambiguity aversion.

Less Uncertainty, Same Result

Rather than simply accept the findings and throw away their nice models economists have proposed a number of hypotheses to rescue the classical approaches to risk. One is that people naturally expect deceit on the part of the experimenters, so they assume that Urn B is rigged against them. Another is that people simply can’t work out the probabilities of Urn B because there’s too much data and opt for the ‘safe’ choice.

In Size Doesn’t Really Matter Pulford and Coleman set out to investigate these ideas. Remarkably their experiment shows that ambiguity aversion applies even when each urn contains only two balls. This suggests quite strongly that the only factor involved in this is human hatred of the uncertainty involved in the choice.

Dynamic Urns, Dread Markets

Nice and theoretical though this is one might reasonably wonder what it has to do with the real world business of investing or, indeed, life. The answer is, roughly speaking, everything. Our hatred of uncertainty can drive us into all sorts of outwardly irrational behaviour when the hidden ambiguity inherent in many decision making processes is suddenly made clear.

Unlike Ellsberg’s urns the real world of stock investment is a dynamic process in which the balls we draw from the jars are constantly replaced. In normal conditions if we withdraw a red ball a new red ball replaces it. In time we come to expect a certain proportion of red and black balls – winners and losers. We’re instinctively modelling risk but we’re doing so under assumed conditions of certainty. Red ball out, red ball in. We sample the past and forecast the future.

When the randomness that is uncertainty strikes our instincts serve us badly. Suddenly our red ball is replaced randomly by something else. Our initial reaction to this is to assume that it’s a mistake and to continue to operate as though our internal models are still working. However, as it becomes clear that our assumptions of certainty have broken down then ambiguity aversion kicks in: we hate uncertainty and we run from it. Cue stockmarket wobble and then collapse.

Ambiguity and Overconfidence

Even experienced investors may fail to recognise the onset of uncertainty. The stockmarket collapses of the 1970’s as the world reeled under multiple crises certainly seem to have been such a situation. The sudden recognition of problems that had previously not been evident – oil supply worries, corrupt world leaders, flared trousers and glam rock – led to a whole host of reactions including, ironically enough, the first attempts to build risk management models to protect against such future events. The irony, of course, is that these models have themselves ended up contributing to the problems because they don’t – because they can’t – capture the nature of uncertainty.

Interestingly the studies of ambiguity aversion show a clear and consistent balance between those who choose the certain urn A and the uncertain urn B. Roughly 20% to 30% of people embrace the uncertain option: there are people who instinctively see opportunity in uncertainty and rush to take advantage of it. Studies of entrepreneurs, for instance, show that they tend to be much less worried about operating in conditions of uncertainty than the rest of us. Of course, it may be that they’re just significantly more over-confident and deluded than everyone else, but the research is silent on this.

Certainty Is An Illusion

The idea that the future is unknowable goes against the last four hundred years of human progress, much of it built on the idea that we can predict and therefore control what is yet to happen. Nonetheless if it were otherwise our lives would be much less rich in terms of experience. Knowing with certainty what tomorrow will bring would be rather dull, don’t you think?

As for investors, well, we need to learn that uncertainty and ambiguity dog our every step. For it is when we are at our most certain that we are at most risk. Find that in a risk management model.


Related Articles: Alpha and Beta – Beware Gift Bearing Greeks, Correlation is not Causality (and is often Spurious), Risky Bankers Need Swiss Cheese Not VaR

It’s OK To Lose Money

Markets Go Down, Often

It’s hard to believe that markets spend nearly as much of their time going down as up. Obsessing over market or portfolio highs seems to be an international investor pastime, as though some permanently high valuation plateau is the ideal state. It’s not, of course, if you’re intending to buy in the near future.

Losing money investing in shares is a perfectly fine state of affairs as long as you’re not alone. However, if you're losing regularly when everyone else is gaining then you may need to take a long, hard look at what you’re doing and then go and do something different. Probably for the best if it doesn’t involve investing money, though.

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