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Wednesday 23 December 2009

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 ...

Overconfidence and Over-Optimism

Although elementary statistics tells us that we can’t all be above average, by and large, most of us think we are – at least at the things we feel are important to us, like investing in shares. Our bias to such a positive perspective on the world may well be adaptive – people who are more realistic about their abilities tend to be depressed a lot of the time. Reality often isn’t a good place to live:
"So 80% of students think they're above average drivers, all states claim above average student test scores and, of course, most investors think they're above average moneymakers. There are a lot of seriously deluded people out there.

Overconfidence is only one part of the equation – it’s one thing to believe you have better judgement than you actually have, but it’s entirely another to be biased positively. Over optimistic people will have an unrealistic expectation of how often they’ll get a good result versus a bad result." >> Read More
As the research shows, people continually over-estimate their ability to pick stocks and effectively and consistently trade away their gains. This might not be so bad if they eventually recognised their faulty logic and adjusted accordingly but unfortunately the brain has another trick to play.

Hindsight Bias

Looking back we believe that everything that actually happened was entirely predictable and we then project this predictability into the future. Yet when researchers study what people expected to happen and what actually did happen they find that everyone – experts and laypeople alike – are completely wrong. Even worse, we don’t recognise we were wrong and will insist, even in the teeth of the evidence, that we did foresee events correctly. As the world’s favourite intelligence gathering organisation puts it:
"[hindsight biases are] attributable to the nature of human mental processes, not just to self-interest and lack of objectivity, and that they are, therefore, exceedingly difficult to overcome." >> Read More
There’s something quite odd going on here, to do with the way memory works. As neuroscientists have been discovering, memory is not a perfect storage mechanism – we actually change our memories when we use them and distort them with new information. The idea that we remember anything perfectly is, well, perfectly wrong.

For investors this is a really nasty behavioural trait, since it’s not one we can easily protect ourselves against. Combined with overconfidence in our abilities and over-optimism about the future hindsight bias effectively denies us the ability to learn from our mistakes unless we take the greatest care to do so. Unfortunately we have myriad ways to make such errors.

Loss Aversion Affects Tiger Woods, Too

Loss aversion is one such trait, the tendency to take less risks when protecting a gain than when chasing a loss. It’s one of the key findings of Prospect Theory, the original approach to behavioural finance identified by Kahnemann and Tversky. Rational economics tells us that we shouldn’t be biased one way or another but the evidence says this isn’t so. Researchers have demonstrated this effect in many situations of which golf is just the latest, albeit beautifully done:
"Making a par or not at a single hole is pretty irrelevant, because it’s the overall score over the whole course that really counts. Rationally every golfer should try their hardest to get every shot in the hole. However, what the study shows is that this isn’t the case. When a golfer is trying to make a birdie they succeed less often from the same position than when they’re trying to avoid a bogey. This is classic loss aversion – dropping a shot means more than gaining one. However, this is profoundly irrational – either way they should try their hardest to get every shot in the hole." >> Read More
And, yes, this does change at the end of tournaments, when scores relative to other competitors start to dominate over scores relative to par – a classic framing effect (see below). The net result of this behaviour for investors is that we tend to sell winners and hold losers, which will undermine our overall performance. This behaviour, however, can trigger yet another psychological effect.

Regret

Avoidance of feelings of regret seems to be implicated in lots of mental traits that aren’t in investors' best interests. The loss aversion effects described earlier are entwined with regret driven decisions; we want to avoid selling shares at a loss and this is one reason we keep our duff investments while disposing of our good ones – behaviour also known as the disposition effect. Unfortunately regret has its own perverse and unique pathology over and above loss aversion:
“...regret takes us a step beyond this because it shows that simple loss aversion has longer term effects. Even better – or worse – the disposition effect doesn’t just say that we’ll avoid selling our losers but also that we’ll preferentially sell our winners in order to avoid selling losers. The effect appears to be fairly constant across all sorts of investors – professional and amateur, experienced and otherwise ...” >> Read More
So, feelings of regret or otherwise can bias subsequent decisions, with generally damaging long-term impact on investment returns. What appears to be happening is that out feelings of regret are based on arbitrary reference points.

Anchoring, The Mother of Behavioural Biases

Under conditions of ambiguity we seem to create these entirely arbitrary ‘anchors’ and then implement our other behavioural biases – like loss aversion – against them. Obvious anchors are things like buying prices and peak prices but in situations of uncertainty – like the ‘right’ valuation of a stock in some high-tech, no-earnings industry, we can be induced to anchor on completely irrelevant numbers through the easiest misdirection techniques: of course, we’re completely unaware of our irrationality.

In fact, it only becomes obvious what’s happening when you carry out experiments on large groups of people:
“Anchoring is almost trivially easy to demonstrate and it’s been replicated many times by many researchers in many situations. Perhaps the simplest example is to use peoples’ social security numbers as a reference. As Dan Airely shows here, by simply getting people to write down the last two digits of the number and then asking them to submit mock bids it’s possible to get people with higher numbers to bid up to twice as much as their lower number companions. Unconsciously the brain sets the social security derived number as the reference point and then adjusts accordingly.” >> Read More
Although we’ll develop anchors in all sorts of situations we’re more likely to develop illogical ones where we’re out of our depth and wallowing in uncertainty. Of course most investors don’t ever think they're in such a situation, although their behaviour when the market goes into one of its periodic paranoid phases suggests differently.

Ambiguity Aversion: Investing Under Conditions of Uncertainty

The tendency to do daft things in uncertain conditions is yet another facet of our emotionally biased behaviour. So called Ambiguity Aversion has been neatly demonstrated many times by researchers showing that we much prefer to invest when we think the outlook is set fair rather than when the crystal ball has gone foggy.

Basically, when everything looks scary we sell our stocks and go hide under the bed and, in general, that’s exactly the wrong thing to do. It’s a tough ask to fight this though:
“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.” >> Read More
Although our tendency to run away from situations of great uncertainty is understandable and, again, likely to have been adaptive when real-life involved giant boa constrictors and huge tigers with nasty pointy teeth it’s not optimal behaviour for stockmarket investors. Magnifying the downside of this, however, is the mind’s sneaky trick of framing situations in a way that results in us making multiple mistakes.

Investors, You’ve Been Framed

The concept of a frame is simply a way of making sense of a situation – we create ‘frames’ which aid our understanding of what’s going on: watching a man slap a women causes us to behave differently if we witness it in the street or on a stage. Unfortunately, in investment, we often use frames in a decidedly damaging way:
“OK, so what does that mean? Well ‘narrow framing’ means that each investment choice – so, for example, each individual stock purchase or sale – is viewed in terms of itself only. The frame of reference is purely the individual company. In this context a wider frame would be something like our overall stock portfolio or even overall wealth. Of course, you might reasonably ask, what difference does this make? That’s the thing about framing – it never looks like it ought to make a difference, but the results indicate differently.

Generally those investors who exhibit narrow framing have relatively poorly diversified portfolios compared to those with a wider frame of reference and, as you’d expect, suffer greater volatility – which doesn’t necessarily equate to lower returns in the long term, but certainly equates to higher risk in the short.” >> Read More
Framing isn’t a behavioural bias, it’s just our natural way of making sense of the world being deployed in the unnatural environment of investment situations. We use framing to try and avoid the nasty outcomes of our other behavioural biases and this nicely exaggerates our cognitive failings.

Mental Accounting: Not All Money Is Equal

The concept of mental accounting arises directly out of framing and, basically, says that we create an internal structure of accounts in such a way as to minimise our exposure to the other behavioural biases. So we will tend to artificially separate our investments in different ways in order to create a world that minimises our mental pain and then act as though these mental accounts are hard coded into the fabric of reality:
“For investors, the way that individual holdings are assigned to mental accounts clearly matters. If each stock is held in a separate account then the standard traits of loss aversion and regret will apply to each and every stock. If combined in a single stock account then the aggregation of losses against other gains can reduce the pain and the likelihood of trading – noting, of course, that mental accounting suggests quite strongly that investors will prefer to sell winners and hold losers if separately accounted for, a prediction confirmed by, amongst others, Terrance Odean in Are Investors Reluctant To Recognise Their Losses? (Answer: Yes).” >> Read More
Mental accounting is the second main leg of behavioural finance, after Prospect Theory. Taken together these – and a bunch of other biases we haven’t yet looked at – have the power to change markets, to raise expectations and destroy economies. Yet, in truth, we still know very little about what causes these behaviours.

No End To The Madness

So, currently, we face two different problems. Firstly we can’t model the way people behave based on behavioural biases: the models that we do have don’t include them very well and as soon as we think we have a handle on them people go and do something completely random. This matters, because if we can’t predict – even roughly – market behaviour then guarding against the more extreme events becomes very, very difficult. Regulators, for instance, are currently under pressure for failing to foresee the crash of 2007/2008 – however, it’s not clear how they could have done so and, even if they had, what they could have done about it.

Secondly, we don’t understand exactly what underpins these behaviours. A lot of them are certainly adaptive in our natural, wild, environment and ideas taken from biology about adaptive markets, which change dependent on conditions, are increasingly popular. However, models which take their analogies from physics, embedding randomness and social networking may also have something to offer while neuroeconomics, the study of how behaviour emerges from the brain’s structure is not without its proponents. The way forward is shrouded in uncertainty.

Fortunately all of this uncertainty gives me lots to write about, but trying to figure out how to use an understanding of our behavioural biases to improve our investing decision making is high up the agenda. What it increasingly looks like, though, is that the best we can do is the opposite of what the mad markets are telling us; which, of course, is something value investors figured out a century ago.

 The Little Book of Behavioral Investing: How not to be your own worst enemy (Little Book, Big Profits)IrrationalityHow We Know What Isn't So: The Fallibility of Human Reason in Everyday Life

3 comments:

  1. Hi Psyfi,

    Great job as always. You are quickly becoming my favorite blog.

    -Miguel
    Founder of SimoleonSense.com

    ReplyDelete
  2. 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.

    I don't get this one.

    Taking valuations into account when setting your stock allocation has worked going all the way back to 1870, which is far back as we have records. That's a pretty darn strong track record, in my book. A neat plus is -- taking price into consideration when setting your stock allocation makes sense!

    Rob

    ReplyDelete
  3. Time to rest the synapses for a couple of days. Seasons greetings, everyone.

    ReplyDelete