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Thursday, 29 October 2009

Puke: Don't Invest In The Familar

Sauce-Bearnaise Syndrome

If you’re unfortunate enough to eat something that violently disagrees with you, so much so that you end up vomiting, you’ll likely find yourself suffering from Sauce-Bearnaise Syndrome. Otherwise known as taste aversion, it causes us to associate the taste of the food we’ve puked up with the illness that caused it to such an extent we’re unable to face eating it again.

As I can personally attest, this effect is incredibly strong even when the food in question has nothing to do with the illness. Even knowing this doesn’t help because the primacy we place on personal experience over all others is so strong. However, while this may be of great survival value when grazing forest floors it’s less helpful in investing, where personal experience is often the worst possible guide to the best strategy.

Adaptive, Involuntary and Subjective Investors

The adaptive value of Sauce-Bearnaise Syndrome is pretty obvious. If you’re a hungry semi-evolved simian wandering around a primeval forest and you happen upon a tasty looking mushroom then eating it may make you extremely sick. Assuming you survive the experience it’s a darn good evolutionary trick to find a way of stopping the stupid ape from making the same mistake again – so automatically triggering an aversion to the taste is nature’s way of keeping us alive. Of course, if we ate the other sort of mushroom we'd probably spend a day dreaming of kaleidoscopic antelopes and evolve to become an investment analyst.

However, when I became sick after eating my favourite Indian curry it was nothing to do with the food, but a bug I’d picked up on a skiing trip with a host of plague ridden kids. It took a year and a lot of red wine to overcome the aversion, despite knowing exactly what the problem was. The S-B effect is involuntary and powerful and entirely subjective.

Pavlov's Investors

The persistence of effects like this is a warning that we’re controlled by all sorts of evolutionary contrivances that we’re not really aware of most of the time. These safety valves are, like the S-B Effect, triggered by our personal experience of something and we value such experiences much more highly than any amount of book learning or observation.

So it’s not hard to explain why we rely heavily on our own experiences as we navigate through life. Unfortunately, as in so many other things, investing is one area where personal experience is more likely to lead us astray than guide us straight. The superpower effect of monetary reinforcement seems to be almost as powerful as the automated conditioning of stuff like the S-B Effect: it causes investors to value their own experiences over and above the wisdom of the ages.

Teenage Investors

Investors who overweight their personal experiences are the teenagers of the investment world. Just like proto-adults they overweight their own experiences over and above the sage advice offered by their long-suffering parents. Although, when they get dumped by their latest hot stock at least they don’t usually throw shoes at their dad, scream “I hate you” and lock themselves in the bathroom for hours on end. Well, not always.

The propensity of investors to place undue stress on personal experience is likely to lead to non-optimal investing strategies, particularly when one of the market’s not infrequent upsets occurs. However, it’s also likely to lead to other basic mistakes by inexperienced investors – to invest in stocks that are familiar to them rather than ones that offer the best value. Worst of all it may lead them to weight their portfolios towards the worst possible selection as far as risk goes – their own employers.

Employee Investors

Enron employees found out the hard way that it’s one thing to lose your job but entirely another one to simultaneously lose all your savings. Yet research on the effect of the very public debacles at Enron, Kmart and so on showed that this very visible and public experience had no effect on the retirement savings plans of workers in other US corporations, who continued to overweight their own company’s stock. As the researchers put it, with wry understatement:

"Real-life lessons about under-diversification risks do not seem to translate well into action."
Failing to draw the fairly obvious lesson that their company underperforming was likely to be correlated with share price falls and layoffs is at least irrational, although not something we should be too surprised about. The researchers also note that education doesn't seem to make any difference either, something we've seen previously.

The difference in impact on behaviour between indirectly observed events, including education, and actually experienced ones has been replicated many times in many different contexts. In effect people systematically overweight directly experienced information. It doesn’t take much imagination to see how this can affect both individual investors and the wider investment industry.

Individuals are likely to follow ad-hoc heuristics based on purely random events, while the industry has preferred to use models which assume that all information is treated identically by all investors. Combine the two and you’ll likely get a market that looks like the offspring of King Kong and Godzilla: a giant hairy dinosaur with a penchant for destroying everything in its path, climbing vertical cliff-faces and then falling off suddenly.

Familiar Investors

Still we needn’t just expect this elementary mistake from private investors: there’s plenty of evidence that fund managers do so too. Coval and Moskowitz (1999) showed that managers of U.S. investment funds hold above average quantities of companies with local HQ’s. Meanwhile private investors overwhelmingly prefer to hold stock in companies domiciled in their own countries, despite the plentiful observable evidence that this reduces performance.

The preference for the familiar over the unfamiliar is likely to be yet another ingrained trait – it’s clearly adaptive for people to prefer their own group over that of others. Yet to overweight the familiar like this in investment is potentially hugely damaging since investing in your own employer, your own local companies and even your own country will simply deny you access to a world of opportunity.

Conditioned Investors

However, it’s not just the familiar which triggers investors into making mistakes. We might also expect that personal experience of success and failure in actual investing may bias people’s behaviour. This has been shown in a study of investor behaviour in Finnish Initial Public Offerings (IPO’s) which provided a beautiful real-world showcase for the experiment. An individual investor's behaviour in respect of future IPO’s turns out to be predictable on the basis of their experience of previous ones: forget analysis of the likely returns of the company, it’s all about whether you did well or badly previously.

Kustia and Knüpfer’s “Do Investor’s Overweight Personal Experience” shows simply that the returns an investor gets on previous IPO’s significantly influences their likelihood of investing in the next one. They propose reinforcement conditioning – the kind of thing we discussed in B.F. Skinner’s Stockmarket Slot Machines – as the most likely explanation for this. You do something, it works and feels good, so you do it again. It feels bad and you don’t. Sensible behaviour in the pre-industrial past maybe, but very dangerous in stockmarkets which habitually subject us to miserable experiences in between climbing ever highwards.

Reprogramming Investors

Reinforcement conditioning is a step away from avoiding food because it tastes like your recent memory of puke, but not a big one. By and large investor attachment to the familiar gained through personal experience is an error but one we’re hardwired to make. Overcoming that programming requires hard work and a willingness to learn by observation rather than at first hand.

Of course, some people never seem to learn by personal experience either: but that’s a story for another day. Anyway, it’s time for dinner. Curry, anybody?

Related Articles: Investors, Embrace Your Feminine Side, Don't Lose Money in the Stupid Corner, B.F. Skinner's Stockmarket Slot Machines


  1. Overcoming that programming requires hard work and a willingness to learn by observation rather than at first hand.

    I like the essay a lot.

    The only part that doesn't satisfy is the sentence quoted above. The solution offered here is too vague.

    I've come to see this as a common trait of those in the behavioral finance school. They are great at seeing the problems, not so great at spelling out the solutions. That's a frustrating mix.

    I don't have a solution to offer. I just mean to make the observation that those in the behavioral finance school are going to need to focus more on providing solutions if they are to grow in influence.


  2. PIs prefer to hold companies domiciled in their own country:

    Yep, I'm guilty of that, but don't see it as overwhelmingly bad. Some plus points are being more aware of the markets in which the company operates; having greater access to data/news on the company; and at least having the opportunity to attend AGMs etc.

    Many 'home' companies operate globally to offer the opportunity for market and currency diversification.

    The exception (for me) would be when the 'home' market becomes overpriced and offers poor value compared to accessible alternatives.

  3. Hi LevR

    Essentially the research shows that by investing in overseas markets it’s possible to generate returns greater than those of developed markets. Logically this also makes sense – developed nations like the US and the UK will find it harder to grow proportionately to developing nations like Brazil and Indonesia. The classic case study is Japan from 1945 to 1990.

    So all this is saying is that, over time, by investing in developing markets it’s possible to generate excess returns over a developed market with no extra risk. The “time” piece is important because volatility can be excessive over shortish periods.

    None of this means that the genuinely clever, home based active investor can’t beat these numbers easily and you’ve given a number of good reasons in support of that. The problem is that the evidence also shows that the majority of people who think they’re genuinely clever active investors can’t be: which is why I prefer research to anecdote and logic to opinion :)

    Good to see you here.

  4. Minnie, Mickey's livin' high policy benficiary30 October 2009 at 14:11

    Lesson: the second mouse may well get the cheese but soon learns only when accompanied by a corpse.

  5. In your essay, you note:"despite the plentiful observable evidence that this reduces performance".

    I wish I found the evidence so clear. To me, there is perhaps modest evidence that international diversification improves the risk/reward picture (for US investors), but much of the extra cheese comes from the relatively recent returns in Emerging markets. These are a moving target with not much of a track record that one can ponder in a statistical sense.