Rock On, January Effect

Born Lucky

Calendar related effects are amongst the most obvious manifestations of the way that collective human mental misbehaviour can impact stockmarket returns. Anomalies like the much observed January Effect, the outperformance of small cap stocks in the US markets during January, point to some kind of systematic bias in the structure of markets.

In fact there’s little doubt that the calendar does impact upon human behaviour but what’s in question is how it does so. Consider, for instance, the odd fact that people born between May and July consistently rate themselves as luckier than those who enter life’s great adventure between October and December. Nothing strange in that, you might think, until you discover that summer babies really are luckier than their winter siblings.

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Investment Forecasts: Known Unknowns

End of Year Epiphanies

At the end of every calendar year we experience a rush of forecasts on the likely direction of various markets and stocks for the next year. You can find thousands of such forecasts on the internet and you can’t pick up a paper without someone or other opining on the subject. In fact, no matter what your preference, you'll doubtless find someone out there predicting whatever you want.

The uselessness of these predictions was carefully explained by the Ancient Greek philosopher Socrates, two and half thousand years ago. Not letting death, the lack of Ancient Greek stockmarkets or the fact he lived in an economy based on slavery get in the way of a good analogy, Socrates noted that he, at least, knew what he didn’t know. Which in investment analysis terms is about as close to an epiphany as you’re likely to get.

From Socrates to Rumsfeld

Socrates seems, as far as we can tell, to have spent his life in philosophical musings, preferring to spend his time asking the supposed wise men of Athens for their insights rather than doing anything more economically useful. His conclusion was, largely, that they didn’t know very much – an insight that echoes down the ages. They, on the other hand, decided that they didn’t like a smartass and the result is a lesson to would-be gadflies the world over.

In particular he seems to have annoyed the powerful by informing them that he knew something they didn’t. Having already upset them by showing up exactly how dim they were he then compounded his crimes by revealing his secret: “I know what I do not know”. If this sounds familiar, you’d be right:

“There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don't know. But there are also unknown unknowns. There are things we don't know we don't know.”

It’s long way from Socrates to investment analysis via Donald Rumsfeld but I think we’ve just managed it.

The Known Unknowns of the Market

Socrates’ known unknowns are important for markets, because each of us can know – with something approaching certainty – that one of these is that there are people out there who know more about investing than we do. If different participants have different abilities when it comes to analysing and interpreting information then, by definition, the markets can’t be strongly efficient. Even if we’re all rational we aren’t all equally gifted.

However, if we are all rational then, if we recognise that other people know more than we do, we ought to stop investing actively. After all, if investment analysts and institutions have this much of an edge on us it makes no sense for anyone without demonstrably superior investing skills to try and compete with them. So if we’re rational maximisers then we ought to buy index trackers and content ourselves with sitting on the sidelines watching the heavyweights slugging it out.

Extending this argument, as the least good investors stop competing, the remaining participants will themselves divide into the best and worst groups with the winners taking the spoils. Once again members of the worst group should, rationally, stop investing actively and this process of winnowing should carry on until there is only one investor left. Who then has no one to invest with, leading to the heat death of efficient markets.

The Unknown Unknowns of the Market

Now, obviously, this isn’t what’s happening. Millions of people continue to dabble in active stockmarket investment in spite of having no obvious ability to outperform markets. Even better, they carry on investing even when they’re losing money, failing to learn from their mistakes. These people, who clearly don’t know what they don’t know, are the inefficient grit in the gears of the efficient market. Bless them, because without them value investing couldn’t work.

The behavioural weaknesses of market participants – certainly their overconfidence and lack of insight into the reasons for past underperformance – are clear and powerful drivers of market inefficiencies. Exploiting these inefficiencies should be the goal of all right thinking investors, which means that we need to be constantly looking for where people are behaving most irrationally.

These manifest inefficiencies mean that making anything approaching a detailed forecast is almost impossible. The end-of-year forecasting bonanza, which is largely driven by the need to fill column inches, is one of the odder and more pointless activities humans engage in, somewhere up there with bog-snorkelling and cheese rolling.

Random Forecasts

There’s so much data out there it’s possible to find evidence to support any theory you might like. Someone, somewhere, will be right – which is nice for them, but not much use for the rest of us trying to avoid losing money. Of course, the people who ought to be best at predicting the motion of the stockmarket ocean are those that are paid for the experience: security analysts.

Going all the way back to the original work of Alfred Cowles' Can Stock Market Forecasters Forecast? in 1932 the evidence for analysts outperforming the market is ambiguous, to say the least. Possibly the best gloss on the situation comes from this paper by Ericsson, Anderson and Cokely who identify that the best analysts do seem to have an edge in making predictions but that seems to be linked to extremely constrained areas of expertise, is not generalisable to wider markets and is too small to be exploitable when costs are taken into account:

“With the possible exception of the advantage of trading by insiders, the advantage offered by expert investors is too small to allow profitable transactions, yet sufficiently large to show reliable gross abnormal returns, before the costs of the transaction are subtracted. From the point of view of expertise research we find that there are consistent individual differences among experts, with experts exhibiting specialization, and demonstrating superior and reproducible investment and forecasting performance”.

So as it stands even the best brains in the business don’t have the ability to outperform the markets so, naturally, the rest of the world – which has next to no experience of market behaviour – expects to outperform the analysts, heaven help us. The only thing that the mass of return seeking mavens has to offer as an advantage over the analysts, who, as we discussed in Rise of the Machines, have the most powerful computer systems, the best researchers and the cleverest algorithms around, is their willingness to outwait the latest trend. Obviously this is, generally, the only attribute they’re not willing to use to their advantage.

Hemlock for the Pundits

The end-of-year forecast frenzy is simply a bit of temporally induced fun which shouldn’t be taken seriously. Recognising not just that we don’t know very much but that most of the people telling us what to do don’t know very much either is an important step towards freeing ourselves from the straitjacket of our social conformity and becoming intelligent investors.

Socrates, of course, ended up drinking hemlock and committing suicide after annoying too many powerful people. That seems like a step too far in search of a perfect investing strategy but being willing to go against the trends and to ignore opinion is absolutely critical. So if you must read the pundits’ predictions at least do so usefully: write them down and then compare them with what actually happens.


Related Articles: Contrarianism, Regression To The Mean: Of Nazis and Investment Analysts, Technical Analysis, Killed By Popularity

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.

A Christmas Cavil

The Return of Marley's Ghost

If it could be said that a chain rattled apologetically then this one did, a feeble jingle, one hardly worthy of the name. Scrooge opened one eye and glared balefully out from under his night covers.

“Hi there,” said his dead ex-partner, Jacob Marley, exuding a blatantly false cheer while once more clinking the chains that bound him in a manner which suggested that he was embarrassed by the whole affair. “How you hanging?”

Scrooge groaned, his now constantly happy mood as the most joyous ex-miser in England undermined by the untimely hour and the hangover from the Christmas Eve party down at the Codpiece and Kettle. “What?” he groaned, “Am I not now the most famously generous man in England, a kind benefactor to all the unfortunates that cross my path and the gentlest employer a man such as Bob Cratchit could ever know? Have I not fully learned the lesson that you and your ghostly accomplices taught me last Christmas but one?”

Marley clanked his chains softly once more and hopped from foot to foot anxiously, his ghostly complexion marred by what looked suspiciously like a blush. “Err, well, yes”, he said, hesitantly, “but you see, we’ve sort of .. umm ... well, we’ve changed our minds”.

“You’ve done what!” shouted Scrooge, involuntarily rising out of his bed like a giant crow, albeit one clad in a long nightdress and a floppy nightcap with matching pink bunny logos across the front of them. “What do you mean you’ve changed your mind?”

Marley stepped back hastily, holding his transparent hands out in front of him as if to ward off an evil spirit. “It’s not my idea”, he said, quickly. “Look you’ll be visited by three ghosts, the Ghost of Christmas Past ...”, he tailed off at the sight of his old partner’s incredulous face. “Oh, you know the drill. Got to go. Byeeeee.”

And go he did, vanishing through the floor, returning moments later to drag his chains after him. Scrooge stood in silence for a moment before shaking his head and climbing back into bed. “Can't a man have just one Christmas Eve in piece?” he muttered to himself, before falling into a deep sleep amid disturbed and confused dreams of the Codpiece’s landlady and Marley’s chains.

The Ghost of Christmas Past

It felt like mere moments before the Ghost of Christmas Past appeared, a clammy hand shaking Scrooge to wakefulness, its candle lit head casting a ghastly glow across the bedchamber. “OK, OK”, he grumbled. “What have you got to show me now?”

“Follow me”, said the Ghost, taking Scrooge by the hand and leading him through the bedroom wall. Outside the sun was shining on the glistening snow while high above cheerful chimney sweeps scampered merrily from rooftop to rooftop singing loudly as they went, only occasionally falling off. Everywhere children could be seen charging about happily on sleighs while flinging snowballs at each other with gay abandon.

“I started that craze last year”, chortled Scrooge happily, as Tiny Tim zoomed by pelting everyone in sight with snowballs fired from his automatic repeating catapult. “Now everyone’s got to have one”. Scrooge cavorted happily in the snow, kicking up a spray of white powder. The Ghost tapped him on the shoulder and pointed to the sight of Bob Cratchit staggering up the road under a weight of Christmas presents.

“Getting the hang of it, isn’t he?” smiled Scrooge, “Get the kids what they want, that’s what I say”.

Suddenly the Ghost grabbed Scrooge and pulled him into a toy shop where a vision of himself confronted the old businessman as he staggered out of the door loaded with a mass of toys. A long queue of parents stood in line, anxiously clutching their wallets and purses, waiting for their turn at the counter. It pushed Scrooge to the butcher’s next door where there too he was exiting loaded up with the largest turkey and hock of ham a man could carry. And once more there was a multitude of people waiting their opportunity.

“You see, Scrooge?” the Ghost said, as they moved from grocers to hardware store and from dress shop to milliners. In each Scrooge was to be found purchasing the latest and the best and the most expensive items and in each he was followed by a thronging crowd, all desiring what he had.

One man turned to the next and muttered: “My wife says that if that fearful miser is buying this stuff then I must as well.” His confident nodded, “and the children, they demand what Cratchit’s mob has – no worse”. Their faces fell as they examined their depleted wallets, “’tis a good job our credit is good”.

The Ghost turned to Scrooge, its candle lit face a mask of misery. “So it begins”, it hissed, and Scrooge found himself back in his bedchamber where he immediately fell asleep, the deep slumber of the man with an untroubled conscience.

The Ghost of Christmas Present

“Ho, ho, ho”, rumbled the Ghost of Christmas Present, rolling Scrooge out of bed by pulling hard at the bedcovers. Scrooge staggered to his feet, rubbing his head. He peered closely at the Ghost.

“Weren’t you wearing green last time?” he asked, suspiciously, "and the beard's new as well."

“Corporate sponsorship,” rumbled the Ghost, clad in a fetching red and white outfit, “it’s all the rage. C’mon, we’ve got stuff to do”.

So saying he grabbed Scrooge and pulled him up through the chimney where an edgy looking bunch of reindeers were precariously balancing on the rooftop while simultaneously trying to keep a large sleigh upright. Scrooge looked askance sideways at the Ghost.

“They’re new to this”, he waved airily, “We tried wolves at first” he whispered confidentially, “didn’t work very well. Kept on eating the children. And each other”.

“Wouldn’t something that can actually fly and perch on roofs have been a better choice?” asked Scrooge. The Ghost looked thoughtful.

“Never thought of that”, he admitted, “too late now, we’ve let the franchise for the next millennium. I’m sure they’ll soon get the hang of it. Giddy up!”

With a confident crack of the whip the sleigh rose uncertainly into the air and Scrooge soared over the rooftops of London, holding tight to the Ghost in terror as they sailed through sooty chimney stacks before eventually descending onto a house in one of the finest suburbs. The Ghost pulled Scrooge down the chimney where he stood, feeling dazed, on the hearth of the nicest house he’d ever been in. “Look”, said the Ghost. And there was Bob Cratchit and his wife and their three children including little Tiny Tim, the apple of Scrooge’s eye, leaning on his crutch.

“My word”, said, Scrooge, looking around the palatial dining room in awe, “I know I gave Bob a generous pay rise but I didn’t know he could afford this”.

The Ghost waved a mortgage statement under Scrooge’s nose. The old ex-miser rapidly calculated the interest owing and his eyes opened. “Cratchit can’t afford that!” he snapped.

The Ghost waved an arm around the room where every modern convenience and contrivance could be seen. The Cratchit parents were happily wrapping their children’s presents, a great mountain of gifts under a huge and wildly decorated tree. Scrooge gaped.

“You see?” said the Ghost, “you see where your largesse has led this family. What inflated expectations they now have and what debt they suffer under to achieve this. But”, he held up a finger, “there is more”.

Grabbing Scrooge by the hand the Ghost pulled him through the wall of the house and into the next and the next and the next and beyond. In each household there was the same story, huge and massive and conspicuous consumption and outside each was a large and gleaming new carriage. Finally the Ghost hauled Scrooge back, breathless, to a rooftop where the reindeers were perched uncomfortably.

“That’s impossible”, said Scrooge, “they can’t afford that sort of lifestyle”.

“But they do”, said the Ghost, “and they follow your example. For they think if the greatest miser in London spends his money like water then they must do the same. And if they do not they are called mean by their families and despised. This is all your doing, Scrooge.”

“Mine!” shouted Scrooge, ”what do you mean, mine! It was you with your bloody warnings of future misery, loneliness and death that started this.”

“Oh yeah”, said the Ghost, shiftily, “Well, we may have exaggerated just a little bit. We weren’t expecting you to take it quite so much to heart. I mean, it was in your own best interests”.

One of the reindeer fell off the roof, dangling over the edge by its reins, kicking its legs feebly. Scrooge raised an eyebrow.

“Perching and flying you say”, murmured the Ghost, stroking his beard. “Do you think vultures would work better?” he asked, hopefully.

The Ghost of Christmas Yet To Come

With a sudden start Scrooge jerked back to wakefulness, staring into the empty eye sockets of the silent Ghost of Christmas Yet To Come. “Hello, Mr. Cheerful”, said Scrooge gloomily, “somehow I don’t think you’ve come to spread great tidings of comfort and joy”.

The Ghost waved a scythe about with a bony hand in a way that somehow conveyed the idea that, no, he wasn’t in the light entertainment business but would be interested in media roles involving seven foot high skeletons with their own garden implements; cookery and home improvement shows being of especial interest. Scrooge eyed the scythe warily: “you could do some damage with that”, he observed. The Ghost nodded carefully, Scrooge got the idea that this was definitely not his day job.

Suddenly Scrooge found himself outside, standing next to the Ghost upon Olde London Bridge in the sleeting rain. Christmas decorations swung dolefully in the wind, a few candles flickered balefully in the windows of distant houses. "Bank Failure!" screamed the headline on the hoardings for the evening paper. A pair of lost looking spotty dogs wandered by followed by an even more lost looking beaver. It was a dreadful, Dickensian night.

The Ghost pointed a skeletal finger and Scrooge followed its line to the great poorhouse by the banks of the Thames. It was a piteous sight, as a heaving throng of desperate people clamoured for safe access to that most grim of buildings, standing tall and foreboding like a great mausoleum, a place where those who entered rarely left alive. As they stood gazing a man in a high hat came to the doors, shook his head at the wailing crowd, many of whom Scrooge recognised as the spendthrift consumers seen in the night’s previous excursions, and slammed shut the portal.

A great groan escaped from the crowd and many ran to the bridge and flung themselves into the abyss below, oft carrying their children with them. Scrooge saw Bob Cratchit and Tiny Tim among the great multitude and his heart fell.

“There”, shouted little Tim, from his father’s arms, “there he is”.

On the bridge, shuffling along, was Scrooge himself, making his way home. Looking up he saw the crowd and the crowd saw him and with a great roar they descended upon him, picked him up above their heads and threw him, terrified, into the black swirling depths of the river. Scrooge sank below the dank surface, leaving only his battered cap washing upon the waters.

“Good riddance”, shouted Tiny Tim, and the crowd cheered him before setting upon each other in a frenzy of desperate consumption. At the last Scrooge saw Tim’s tiny crutch thrown into the air and then broken as the mass of wretched people destroyed each other, desirous of each others' belongings to the very last.

“Oh woe,” sobbed Scrooge, “this is all the result of my profligacy. But how was I to know people would follow my example with credit and not by the sweat of their own brows? Are people mad that they must spend so without the means, merely to keep up with the neighbours? What kind of world is this?”

The Ghost looked as thoughtful as an expressionless skeleton can do. Then he shrugged and hit Scrooge over the head with his scythe.

Christmas Day

Scrooge awoke, in a sweat, and rushed to the window where he threw open the blinds on a bright new Christmas morn. Bells tolled joyously, carollers wassailed in the street and grubby street urchins merrily picked the pockets of portly gentlemen lying unconcious in the gutters before engaging in a spot of spontaneous, yet strangely choreographed, musical theatre.

Dressing quickly Scrooge rushed across town to the Cratchits' new house and rang twice on the door. Bob himself opened the portal and looked at his employer in surprise. “Mr. Scrooge”, he said, “what are you doing here?”

Scrooge grinned, evilly. "Bah”, he said, “old Humbug’s back”.


Related Articles: The Lottery of Stockpicking, The Case of the Delusional Investor, Debt Matters

Zombies in the City of London

Attention Deficit Disorder

Often, as I wend my way around the City of London, I find my way blocked by some slow, shuffling, seemingly moronic creature staggering along, head loosely hanging to one side, as it meanders across the sidewalk in a way calculated to force me into the gutter where I’m assailed by tricycling sandwich trolleys, homicidal hackney carriages and a mulch of yesterday's free newspapers. Yet when I finally get past these drooling monsters it invariably turns out that they’re not zombies at all, merely highly paid financial executives who can’t walk and use their cellphones simultaneously.

In fact they’re suffering from the human inability to multi-task, being unable to attend to two tasks simultaneously – in this case walking and typing. Such minor cases of attention deficit disorder are quite normal but can become a major cause of concern for drivers of automobiles, manufacturers of aeroplanes and all investors – because attention anomalies are at the heart of many flawed investment processes and are, inevitably, used to manipulate investors something rotten.

Don’t Multi-Task in the Driving Seat

The idea that women, or people generally, can multi-task is a myth. Our parallel processing capability is designed for unconscious processing of multiple tasks, not conscious ones. Trying to consciously attend to multiple things simultaneously comes at a price, as we shift our attention backwards and forwards. In essence we have limited cognitive resources and spending these in switching rather than attending reduces our overall performance on all tasks under consideration.

This is increasingly a concern in the cockpits of aeroplanes. Providing too much information to pilots is dangerous, because the more they have to attend to the less likely they are to focus on the really salient issues like the fact that the ground is getting very large very quickly. A similar problem befalls drivers and the increasing range of in-car entertainment and navigation equipment is exacerbating the problem – if a driver stops directly attending to the road for much more than two seconds the risk of an accident increases dramatically.

Incidentally, you might think that if people can’t walk and use their cellphones at the same time then driving and using them might be even less safe. You’d be absolutely right. A mobile phone in the hands of an inattentive driver is one of the most significant dangers facing pedestrians and other road users. For more scary facts like this read Tom Vanderbilt's excellent Traffic.

More Data, Less Information

In investment the limitations of attention have some different and rather peculiar results. Mainly what seems to happen is that investors, presented with too much data, focus on the wrong bits and make important decisions based on irrelevant information. The problem of figuring out what information to worry about and what to discard gets worse the more we’re presented with. This is a situation where more is definitely less.

In general, though, this poses a puzzle. Markets should get more efficient with more information, not less. One possible answer to this is that the real information is hidden in the excess data, so that as more information is presented it becomes harder and harder to see the wood for the trees. In essence, although information may be available in the public domain the harder it is to extract from the underlying data the less likely it is that it will be.

Potentially this is a rational solution to the failures of efficient market theories. If it’s too expensive to extract the data, because the rewards are ultimately less than the cost, then some information will remain undiscovered by the markets. The inverse is also true, however – if information is easy to extract from the data then it will be and markets will react to it. Which leads us to an interesting observation – that if one or more parties involved in the preparation of the data has a vested interest in keeping some information hidden then they’re likely to do so, as long as regulations permit this.

The Incomplete Revelations Hypothesis

One simple example of this are the headlines which accompany most results statements. Most experienced investors know to look for the dog that didn’t bark – things missing, like a profit statement or a dividend rise. This, of course, is a trivial example but it makes the point: managers of companies may choose to massage their public statements in a legally permissible way to obscure the really important information beneath a mountain of irrelevant data.

Robert Bloomfield points to a range of ways in which managers seek to make information extraction more difficult for investors, all of them strangely biased towards supporting higher stock prices. In his words:

• Managers choose and lobby for accounting methods that improve highly visible data, such as earnings-per-share and debt-equity ratios, and conceal expenses and liabilities in less-visible footnote disclosures.
• Managers classify arguably ongoing expenses as non-recurring or extraordinary items, while reporting arguably unusual gains as part of operating income.
• Managers develop “cookie jar” reserves to maintain the capacity for positive accruals to boost earnings in the future (Nelson, Elliott and Tarpley, 2002).
• Managers announce “pro forma” earnings numbers that emphasize improvements relative to their own strategically-chosen benchmarks, while making it more difficult for investors to observe other measures of performance (Schrand and Walther 2000, Krische 2001)

Underlying Bloomfield’s observations is his “Incomplete Revelations Hypothesis” which provides a way of addressing the problem we discussed in the Special Theory of Behavioural Finance; namely how do you marry the Efficient Markets Hypothesis – which describes how investors should behave – with Behavioural Finance – which describes what they actually do. So an investor may rationally choose not to spend their time extracting difficult to analyse information from otherwise obscure data while simultaneously being viewed behaviourally as showing limited attentional capacity.

Presentation, Not Content

The idea that our limited capability for attention is being manipulated by market participants who’d like us to behave one way rather than another, and that this manipulation can be carried out through the use of public information, shouldn’t come as a big surprise to anyone versed in the ways of the markets. However, what’s more interesting is to view this through the lens of metaphor: results statements are the gadget festooned displays of modern vehicles and while we’re busily attending to the obvious we’re being misdirected away from the important. My word, Mr. Pilot, the ground looks really big outside.

More evidence for this was provided by Maines and McDaniel who showed that the format of income statements affected the evaluation of the information by investors. This research was directed only at non-professionals so perhaps you might not find this too surprising. However, as usual with behavioral finance, what applies to amateurs also applies to professionals so when Hirst and Hopkins did the same sort of research on the latter group they found that financial analysts also had difficulty in identifying artificially inflated earnings statements. As they put it:

“...we believe this result is not surprising given the variety of possible ways a company can manage its earnings, the non-trivial effort required in detecting any of these activities, and the difficulty in distinguishing earnings management from other events”.

Quite.

Leave Our Zombies Alone

This type of underlying cognitive limitation comes with the territory of being human and gives the lie to more is better when it comes to data. The truly great investors develop their own analysis methods to cut through the chaff rather than relying on discovery by others, while the oft-quoted advice that people should only invest in what they understand also arises out of this limitation.

From all of this we can gain a few useful rules. Firstly, if you must invest in individual companies do your own research, read the footnotes and make sure you know what they mean. Secondly, avoid using any gadget in a car that requires dividing attention between it and the road. Finally, leave our zombies alone, because interacting with them may cause a significant overload in their liquefying brains. The world of high-finance has enough trouble already without losing its brightest and best under the wheels of a sandwich trolley tricycle.


Related Articles: Buyback Brouhaha, The Halo Effect: What's In A Company Name?, Gaming The System

Stocks Aren’t Snakes

Rational or Emotional?

How do humans make decisions? Are we careful, rational processors of information or emotional, rapid – but possibly illogical – decision makers?

Well, the easy answer is that we’re both. Sometimes we take our time over decisions and sometimes we don’t. Some of us make more decisions one way rather than the other but we all use both methods some of the time. The question is, why do we do this? Why have two decision making processes, the results of which must inevitably lead to different outcomes on occasion? To answer this let's don our outdoor gear and go for a ramble in the wild.

Jungle Thinking

We’re strolling through the jungle, trying to avoid tripping over poorly camouflaged wildlife camera crews and assorted Z-list celebrities, when a sideways glance notices something that looks suspiciously sinuous and definitely snake like. You may have only moments to live. What do you do? C'mon, think!

Well, almost certainly thinking is the last thing you do. Research suggests that your optical nerves flash information to the amygdala in the deep, old reptilian part of the brain and in response you react just about as quickly as it’s possible for the human body to react, given the time it takes electrical and chemical information to flow, something less than 300 milliseconds. With good reason, for your very life may hang in the balance.

Sadistic Researchers

As the above research indicates it’s the old part of the brain that does the processing. This has been demonstrated by sticking people in brain imaging systems and then torturing them by showing them pictures of various creatures they may have phobias about: snakes, spiders and day-time talk-show hosts being especial favourites. The psychologists that perform these types of test aren’t noticeably more sadistic than the rest of the population; they’re just interested in figuring out which bits of the brain process different sorts of information.

These ancient, deep brain functions can produce the kind of speedy reactions needed to have a chance of escaping certain, hissing death because they require no conscious processing. However, this rapid response comes at a cost – we’re quite likely to mistake sticks, shadows and virtually any vaguely slender, long thing as a snake. In adaptive terms this isn’t too bad – misidentifying bits of forest furniture a dozen times doesn’t matter much as long as we get it right the one time it does: this type of unconscious, automated processing costs us very little in energy terms.

Modern Thinking

Exchanging one jungle for another we find ourselves uncomfortably seated, in a chair that seems to have significantly shrunk since we last used it, at the front of the class while being harrangued by a harridan disguised as a teacher. "What's 32 * 7?" she demands as the rest of the class snickers. C'mon, think!

Well now we actually do think. Placed once more in the brain scanner we can see that it’s the new, frontal part of the brain that starts to grind away to produce the answer. Grind is what it does, as it engages in deep and detailed processing. The last time we thought this hard was when we tried to calculate our tax return.

These newer parts of the brain are adapted to the social world we live in, engaging in culturally mediated tasks that require the higher functions of our neural circuitry. Such processing generally doesn’t need to be particularly fast and that’s fortunate because this type of thinking consumes the body’s energy resources as the brain churns away to come up with the answer. This is the type of processing that we only want to do if we really need to, because in an environment where food is scarce, using these areas of the brain more than we absolutely need to is not sensible. That’s why math seems hard for most of us – because it is.

Reptile Brain, Ape Brain

It’s possible to characterise these different parts of the brain in these different ways. The old reptilian part – the limbic system – manages automated stuff – like breathing – and handles processes which require fast reactions but have a fairly high rate of error, albeit with low energy costs. The new ape part – the prefrontal cortex – handles things that require intensive processing, costing lots of energy but generally only engaged in through conscious effort – supposedly meaning that we’ll only do them if we really need to. There would seem to be sound evolutionary reasons for not thinking any harder than necessary, assuming we developed in a world in which food was a scarce resource.

This type of dual model of the brain is hardly revolutionary, pre-dating even the "I think therefore I am" dualism of René Descartes, but has been brought comprehensively up-to-date by the discoveries of neuroscience. There's lots of work in this vein around - see Animal Spirits: Affective and Deliberative Processes in Economic Behaviour by George Loewenstein and Ted O'Donoghue for a good example.

So we consider the question, consciously, and eventually arrive at the answer by dint of sticking our tongue out and taking off our socks to use our toes as well as our fingers. We're dismissed ignomoniously from school and end up doing what most people do if they're rubbish at math: yep, we become a stockmarket trader. Now we’re presented with the annual results of a well known company, hot off the press, and with only moments before the market opens. Buy or sell? C'mon, think!

Excited and Wrong

Once more our neural pathways flash into operation – but which decision making process gets engaged: the old, error prone emotional ones or the new, energy intensive conscious analytic ones? Somehow our neural processes have to decide which type of process to engage in and this decision must be unconscious. Somehow we need to make a rapid judgement about whether we need to react to a snake or whether we can take our time and think.

The trigger for this choice is emotion – when we’re excited the brain tends to fall back on the more automated, emotion driven processes. Often stock investment is done under time pressure and in an emotional environment which kickstarts the old, rapid emotional decision making processes. Only stocks aren’t snakes and while we have carefully adapted automated processes for dealing with the situation where we encounter a hissing coil of death we have no such mechanisms for handling investment decisions. So if we tend to use the emotion driven, error prone ancient processing of the rear brain to deal with stocks, rather than the consciously considered but energy intensive – and therefore downright hard – processing of the fore brain we will see all sorts of strange results.

Time is Not Of The Essence

This, of course, would explain how come some people consistently make dumb investing decisions but it isn’t quite enough to explain why they actually behave this way. Some of us, obviously, are driven by our emotions more than others and may get ourselves overly excited by some go-go stock that we’ve just spotted. However, what seems likely is that we're getting ourselves emotionally confused by the concept of time.

When faced by our potentially deadly snake time is absolutely critical. Engaging our rapid reaction processes is essential and the brain’s complex mix of chemical and electrical processing is engaged to this end. Unfortunately if we get ourselves excited and then convince ourselves that time is of the essence we can also induce the same reactions in less critical situations.

The problem for anyone trying to trade in these kinds of tight timescales is that the brain doesn’t have a good way of making error-proof decisions. You can’t engage the right bits of neural processing at that speed and so mistakes – lots of mistakes – are inevitable. The alternative, slower but harder, conscious decision making processes are obviously the better ones to use for investing.

And, Breathe ...

This, of course, is just another piece of a behavioural jigsaw that points to the types of errors we’re inclined to make, one that can be loosely described as the new science of neuroeconomics. Generally putting ourselves under time pressure to make investing decisions is bound to result in a high number of errors because it means, by definition, that the only thing we’re not doing is thinking. In fact using ancient, automated processes to handle modern, difficult decision making is probably one of the common factors underpinning many of the irrational behaviours of investors.

To be positive, however, these are errors we can learn to overcome. It isn’t that hard to learn that investing decisions shouldn’t be made in a hurry. Of course, this means that occasionally we’ll miss that exceptionally hot stock available for a bargain price for a few moments but mainly it’ll lead to us not investing in a bunch of dog-eared dead-ends that cause us nothing but losses. In stocks it’s avoiding the big mistakes that usually matters most.


Related Articles: Ambiguity Aversion: Investing Under Conditions of Uncertainty, Get An Emotional Margin of Safety, What's Your Financial IQ?

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 ...

Investing in the Rear-View Mirror

The first thing to note about all valuation exercises is that they’re based on historical data. You’ll often find some wisecracking smart-ass pointing out that this is the only kind of data we have – which is true, but is still no reason to use it like a finance minister predicting next year’s economic growth. The problem is we don’t have enough information because:

“... to get enough data to model the future we need to inspect the market events of all of the parallel universes where different conditions apply. So far we don’t know how to do that, although we’re trying to tunnel through by creating a Black Hole under Switzerland which we’ll start just as soon as we figure out where the contractors put the fuse box.” >> Read More

The idea that our understanding of the structure and order of the world is an illusion is extremely hard for people to accept. Most can’t, preferring quite rightly to live in a fog of forgetfulness rather than accepting the brutal role of chance in our lives. Yet if you want to be truly successful at the investing game recognising that trying to predict the future from the past is nearly always futile is a necessary, if not a sufficient, condition for success.

Black Swans, Tsunamis and Cardiac Arrests

The great proponent of the idea that randomness is the dominant theme of investment is Nicolas Taleb. Taleb’s contention is that great disasters occur far more regularly than the standard theories, based on extrapolation from past data, suggest. The relative rarity of these devastating events is what leads to the failure to anticipate them: people think that because such things happen only occasionally they can be ignored:

“Stockmarkets are classical territory for Black Swans and are where Taleb’s ideas originated. Although returns oscillate about a stable midpoint over many years out at the extremes we see many more surprises than you’d predict. Yet despite the relative regularity of these Black Swan events – think 1907, 1929, 1931, 1936, 1973, 1987, 1989, 1997, 2000, 2008 – most commentators and fund managers simply ignore them in any analysis of stockmarket returns.” >> Read More

The psychological condition that leads people to discount low probability, high impact events is known as Disaster Myopia and it seems to be a facet of the availability heuristic. Basically stuff that hasn’t happened recently gets completely discounted. Stockmarkets are particularly prone to this type of situation and every time it happens mentally unprepared investors lose huge amounts of money as their evolutionary fight and flight mechanisms kick in at exactly the wrong time.

Panic!

The sheer range of financial crises that have occurred is, when viewed from a historical perspective, quite extraordinary. Indeed there are so many of the bloody things it’s almost impossible to believe that most investors spend most of their time proceeding on the basis that something very bad isn’t about to go wrong:

“The list of panics and crashes over the past few hundred years is fearful. From 1720 up until the end of the twentieth century Kindleberger lists 32 – or one every eight years or so. Most of these were international in nature. For those people convinced that globalisation is a modern phenomena it’s a sobering read”. >> Read More

Unfortunately market participants fall prey to the Fallacy of Composition, in which everyone acting in their own self-interest ends up dooming the markets. Everyone assumes that as markets climb to ever more irrational levels that they will be able to flip their holdings to a Greater Fool. When everyone does this then everyone’s the Fool. And while this is happening there’s always someone out there explaining why it’s OK, because it’s different this time.

It’s Not Different This Time

The trouble is that it never is different. There are certain fundamental rules of investment logic that don’t go away no matter how much you twist and pervert them. Our current version of the Black Swan was founded on financial institutions falling prey to a standard set of psychological biases: availability, over-optimism, perverse incentives and simple self-interest were all it took to send us into our personal circle of market madness.

Hoping, however, that we can use this experience to prevent this happening again would be a triumph of unreasoning hope over evolutionary expectation:

“Of course, memories will fade, new systems of risk management will be created, overconfidence will kick in, the incentives to behave perversely will creep through the global network and one day we’ll have another crisis. I probably won’t be around to see another one on this scale but I absolutely guarantee that you’ll find earnest financiers explaining once more how that it’s different this time”. >> Read More

However, if you avoid the psychologically supercharged confusion of the mass markets and take a long-term view you can, at least, avoid the worst of the problems.

It’s OK To Lose Money

Despite all of the real problems that markets face if investors can steel themselves to ignore the mental confusion and frantic followers of investment fashion then it’s perfectly possible to trade though the irregular panics that occur. Acknowledging that we can’t foresee the future, and realising that nobody else can with any accuracy, no matter what the ‘expert’ label is they run with, is the start of developing an investment philosophy that can stand the test of time.

“The point about viewing stocks as earnings machines is that the cumulative effect of earnings being compounded has hugely beneficial impacts on investors’ long term wealth. Retained earnings should, all things being equal, lead to future company earnings increasing, while distributed earnings – primarily dividends – can be profitably reinvested in other earnings machines. Taken together the overall outcome is nicely satisfactory for investors who can afford financially and psychologically to take a long term view.” >> Read More

Following some kind of long-term strategy based on fundamental valuations and mixed asset classes will generally reap decent rewards. The trick is to understand the psychological determinants of our investing behaviour: and then learn to override them.

Depressed Investors Don’t Need Feedback, Everyone Else Does

That there’s a relatively simple trick for gauging investment performance which most people don’t use is almost an inevitable consequence of our inherent natures. If we spent a lot of time looking closely at what we said and did in the past we’d be horrified by the changes we’ve undergone. People just aren’t very good at accurately remembering what they did and there’s probably a sound reason for this to do with maintaining a coherent self-image.

Unfortunately this tends to mean we don’t much like cross-checking our own performance as it forces us to face up to our own inadequacies. Yet in those rare disciplines where this is enforced the ability of people to calibrate and improve their results is remarkable.

“The alternative is to continue to stumble blindly around in the hope that everything will turn out to be OK. If people insist on becoming active investors rather than passively letting the markets take their course, then they need to concentrate on improving their abilities. Experts get to be expert by practicing, not by simply wishing it to be so. Of course, if you accept the arguments of the more extreme proponents of efficient market theories then you’d conclude that this is a waste of time. However, that argument was roundly demolished many years ago some geezer called Warren Buffett in The Superinvestors of Graham and Doddsville which demonstrated that certain pre-selected investors were able to outperform the markets over many, many years.” >> Read More

If investors can force themselves into self-calibration and start examining their own decision making then they're half-way to a successful strategy. At least then their decisions should stand the test of the onslaught of real-world uncertainty, whenever it hits.

Ambiguity Aversion: Investing Under Conditions of Uncertainty

Still, before people can invest properly they need to learn to live with uncertainty. Most of us aren’t naturally very good at this and many of our mental processes are attuned to avoiding ambiguity. It’s genuinely difficult:

“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

Once we've recognised that uncertainty is with us always, especially when it seems to have been banished forever, then we're at least avoiding the perils of sleepwalking into failure. Having learned to calibrate ourselves to build decent investment portfolios the last thing we need is to be frightened into giving up our gains because everyone else is running scared.

Living in the Shadow of Doom

Understanding that markets are inherently unstable and that there’s always a crisis just around the corner is the starting point. Which brings us neatly back to the plethora of self-help investing guides out there. Different styles of investing will suit different styles of person and only trial and error will help you figure this out. But before launching out into the world of valuation metrics and trading signals it’s important for the novice investor to have some understanding of themselves.

If you spend a lot of time investing then if, at some point, you don’t end up facing a 50% loss on your investments from some artificial high you’ll be very, very lucky. How you deal with that will do more to determine the eventual returns you make than any clever investing tricks you pick up along the way.

As people entered through the portal of the great Oracle at Delphi they were confronted by a message above the entrance. All the advice that the Oracle gave was worthless unless the supplicants understood the meaning of that message, and it stands up well today as a summary of the essence of this article: “Know Thyself”.

Mental Accounting: Not All Money Is Equal

Coherent Holes

Now listen carefully, because this is where the bizarre, byzantine and seemingly disparate behavioural biases that afflict our every monetary movement start to coalesce into a single, coherent whole. Or at least a set of coherent wholes. Or is that coherent holes?

Mental accounting isn’t about the madness of the dark denizens of accounting departments, although that’d be as good a subject as any. No, in fact it’s the strange way that we humans turn the perfectly designed medium of exchange we call “money” into an irrational, segregated and non-transferrable set of silos to which we then apply all the normal battery of biased behaviours, thus gearing up our irrationality to a marvellously unhinged degree.

Not All Money is Equal

The result of these odd and unnecessary accounting practices is that not all money is equal, some can’t be spent – ever – and some is frittered away wastefully without a second thought even when we need it for other purposes. Roughly speaking, mental accounting is at the heart of some of the most gratuitously stupid displays of monetary mismanagement we engage in. Which is quite some statement, given everything else we’re financially useless at.

If you’ve ever had a special pot of money for paying the household bills, or stashed it separately for a holiday or even just set some aside for a rainy day then you’re engaging in mental accounting. Nothing wrong in this, in its own right, but when applied to wider savings and investments it all starts to look familiarly illogical, only multiplied several times over.

Jack-in-the-Box Thaler

Mental accounting is the brainchild of Richard Thaler, who keeps on popping up like a psychological jack-in-the-box at the moment, largely because his ideas have caught the zeitgeist of the time: (traditional) economics is dead, long live (behavioural) economics. The world is more than ready to listen to someone whose basic thesis is that people do stupid things all the time and that expecting us to behave idiotically is the only sane way to proceed. Even better, mental accounting actually helps us make predictions about the way that people will behave. Some of them even come true.

So, roughly, mental accounting suggests that people segregate money between different “accounts” and that they then apply different sets of rules to these accounts. This can lead to all sorts of peculiar behaviour in investing.

Fungibility

One of the many properties of money is that it’s “fungible”. This means that it can be used interchangeably: money is money is money. Only mental accounting, at root, says that this isn’t true and, if that’s the case, it fundamentally calls into question a lot of economic theories that the world’s been using for the last four hundred years or so. So tough luck, Adam Smith.

The idea that humans use illusory but non-fungible boundaries to separate different pots of money – i.e. that an account assigned to long-term saving is not easily transferrable to weekly household spending due to psychological barriers – leads to a whole range of predictions. So, for instance, losses will hurt less if they can be offset by other gains in the same account and purchases are more likely if assigned to an account not in the red.

Anchoring, Anchoring, Anchoring

Now, of course, the issue of what actually constitutes a gain or a loss implies that people are operating against some reference point – as we saw in Anchoring, The Mother of Behavioural Biases attaching ourselves to arbitrary reference points seems to be a part of the human condition. What mental accounting adds to this is that anchoring applies, simultaneously, to all of the mental accounts that we run. People may take risks to reverse losses on one account – such as the oft-observed phenomena of racetrack betters taking big risks on longshots on the last race of the day in order to offset losses on their day’s betting account – that are irrelevant to other accounts. So, as discussed in The Lottery of Stockpicking, we simultaneously both gamble on the lottery and buy insurance.

All of which suggests that many of the behavioural biases we’ve previously seen are not to be looked at as single phenomena affecting individual people in the same way, but will be dependent on how each individual sets up their internal accounts. Loss aversion, for instance, may be a major driver of the way people create their accounts as they aim to ensure that multiple losses can be combined within the one account, minimising the feelings of regret. This also explains why people will buy more of a stock at price lower than their original purchase but not at a higher one.

Setting Boundaries

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).

The fact that entirely fictitious and partly arbitrary boundaries can change the way we behave means that how these boundaries are set is critical. As Investors, You've Been Framed described, by modifying boundaries we can potentially reframe a profit to a loss or vice versa – many’s the stopped-clock expert who’s used this to their advantage by pointing out that the stockmarket boom/crash that they predicted many years ago has finally happened. However, the idea can also be used to explain one of the great mysteries of stockmarket investment – the so-called equity premium puzzle.

The Equity Premium Puzzle

For reasons that have long been debated equities seem to provide significantly greater returns than bonds over long timescales. This finding is a bit like discovering dinosaurs alive and well in the management suite of Goldman Sachs – both slightly surprising and somewhat undermining of mass extinction theories.

In particular the equity premium doesn’t make any sense because if we are to believe the fundamental theories of economics then the excess returns of equities should attract investors greedy for additional returns, driving prices up and eventually leading to lower returns equivalent to those of other asset classes. The persistence of these effects over very long periods suggests that there’s something awry in the economic machinery.

The standard explanation is that equities carry greater risks – so an individual stock is more open to unexpected and unpredictable stuff happening. This drives risk-adverse investors into hiding in safe government bonds, thus seeing their returns decimated over long periods. However, the research doesn’t support this theory, risk aversion isn’t sufficient to explain the finding.

Getting Jiggy With It, Occasionally

Riding to the rescue come Thaler and Benartzi who’ve proposed that the equity premium is, in fact, a consequence of mental accounting. They suggest that if you have two possible investments, one that pays a safe 1% and one that pays 7% over long periods but with massive variations over shorter periods (think bonds and stocks) then loss averse investors need to avoid accounting for losses too frequently, because the fear of losing money will drive irrational behaviour. This is known as myopic loss aversion.

The authors' analysis suggests that the equity premium is caused by investors' need to see that their choice of investment is outperforming over their chosen evaluation period. Working backwards from this they suggest that most investments are analysed about once a year and, presumably, adjusted based on the findings.

Essentially if investors frequently and constantly reset their anchoring points on their separate stock mental accounts so that they are continually assessing their status against current success or failure then they will be tricked, constantly, into getting jiggy with their stocks: selling their winners and holding their losers. This effect is enough to allow long-term investors the luxury of excess returns. Basically investors are the equivalent of serial fornicators, constantly getting their rocks off on new stocks.

Go Long-Term Young Man

If correct then mental accounting suggests that long-term investing in stocks based on fundamentals will, eventually, lead to significant outperformance over more active traders. The catch is that “long-term” can be excessively extended – Arnott and Bernstein suggest that the equity premium is really only about 2%: enough to make you very rich over a long time but not enough to allow you to avoid long periods of underperformance.

Of course, we’ve just had a very long period of stockmarket underperformance but whether this heralds a longer-term resurgence in stocks is impossible to predict. If nothing else markets can stay irrational for considerable periods so, as usual, all the sensible investor can do is invest in multiple asset classes and rebalance occasionally: remember, just don’t mentally account for each asset class separately.


Related Articles: Save More ... Tomorrow, So What's Behavioural Finance Ever Done For Us?, Investors, You've Been Framed

Springing the Liquidity Trap

Bad Omens

We’re in the middle of one of the most dramatic experiments financial markets have ever seen. Central banks, across the world, have bet your house and mine on a gamble of extreme proportions yet, such is the unpredictability of markets, we’ll only know the outcome of this with hindsight, a notoriously unhelpful bedfellow.

The problem is that changes in monetary and market liquidity can trigger outbreaks of investor insanity and by pumping the world full of cheap money central bankers are gambling that they can manipulate markets to beat behavioural biases. The omens are not especially good for them getting this right.

Untradeable Assets

At a simple level significant market movements can be explained in terms of a combination of liquidity and stupidity. Liquidity comes in many different forms, mutating just about as soon as economists think they've nailed it down. They spend lots of time arguing over definitions of liquidity but we can roughly think about it as the available money in the system.

Cash in the bank account is part of it but so's the credit card limit and the overdraft limit and that huge secured loan we took out against the garden shed where we store our limited edition garden gnome collection. Which is fine, just as long as no one comes to actually value the desirable bijou detached timber-framed residence at the bottom of the yard. Were they to do so then the liquidity in the system may drop suddenly, along with the clearing price of gnomes as the market's flooded with the things.

Liquidity helps drive markets – when there’s more money entering the market than leaving it then stocks will, on average, go up. When the reverse is true they’ll go down. Large flows of liquidity then drive human fear and greed, depending on the overall market direction, causing over and under-reactions.

The Liquidity Trap

This is a trivially laughable description of the way markets operate. Yet there are times when “trivially laughable” comes uncomfortably close to the truth in our sophisticated modern markets. Such an occasion was the backend of 2007. As the Bank of England's Paul Tucker puts it:

"... the current crisis has illustrated just what a mess can result from liquidity draining out of [capital] markets. Market liquidity is endogenous: participants thinking that it might dry up can contribute to its doing so. In the early phases of this crisis, by virtue of holding large ‘trading’ books that were marked to market, banks and other traders found themselves having to make very large portfolio write downs in the face of sharp rises in liquidity premia in asset markets. As highly-levered institutions, those markdowns depleted their net worth to the point of imperilling solvency. That caused a retrenchment in the availability of credit, helping to plunge the world economy into recession, and so impairing the value of more traditional loan books, in a vicious spiral."

Yeah, what he said.

The Downward Spiral

Basically many of these assets – far too many – had been bought with borrowed money which suddenly needed to be repaid pretty damn quickly when fearful and stressed lenders called in their dues. Unable to sell mark to model assets, on account of – as we discussed in Quibbles with Quants – no one believing the model valuations, institutions started selling whatever they could – primarily assets traded on open markets with guaranteed counterparties – stuff like quoted stocks. So thus we came to our very own Minsky Moment:

"Minsky rejected conventional economic ideas such as the efficient market hypothesis. His financial instability hypothesis holds that the structure of a capitalist economy becomes more fragile over a period of prosperity ... The expansionary phase of the financial instability hypothesis leads to a Minsky moment. Without intervention in the form of collective action, usually by the central bank, a Minsky moment can engender an economic meltdown (i.e., plummeting asset values and credit, falling investment and output, and rising unemployment)."

As institutions withdrew liquidity from markets to shore up their balance sheets stocks fell even more, sometimes to dramatically low levels. This effect was exacerbated by the realisation that even sound companies might not be able to roll over their debts due to the lack of money in the system. A combination of declining stock prices and ever increasing volatility triggered all the standard behavioural biases: many investors panicked and also sold, pulling yet more liquidity out of the markets.

Exit the Greater Fool, followed by bear market.

The Last Resort

Rather late in the day governments and central bankers decided that the foundations of the world’s financial system were really crumbling and, as is invariably the case under these situations, stepped in as the lender of last resort to provide liquidity to financial institutions at incredibly low rates of interest. In doing so they're following the dictum of the nineteenth century English journalist Walter Bagehot, whose advice under these conditions was expressed by Tucker, thus:

"Bagehot’s famous dictum, in Lombard Street, was that, to avert panic, central banks should lend early and freely (ie without limit), to solvent firms, against good collateral, and at ‘high rates’."

The panic eased as the market participants realised that debts would be repaid, albeit with government money, and the desperate round of beggar-thy-neighbour behaviour finally slowed, stopped and then grindingly went into reverse.

All this is typical of most major financial crises – as we saw in Panic! in the end governments nearly always step in as the lender of last resort for fear of something far worse. However, this time not only have governments underwritten the savings of retail investors they've also implicitly guaranteed the continued existence of many of the investment institutions responsible for this mess by allowing them to borrow our money at knock-down prices against assets that are little better than my garden gnome-house. The calculation, presumably, is that the global financial system is too weak to survive on its own and the early removal of massive financial support risks a worse problem than the alternative.

To be fair, as Tucker points out, for central banks to stick to a policy of lending only against the soundest assets when the very lack of those assets is causing the crisis is stupid:

"In other words, a central bank policy of lending against only the best assets is likely to prove time inconsistent when it comes to the crunch ... This is not an ivory tower problem. It is a real problem."

This scenario, frankly, isn’t very attractive either. However, letting the free market sort the problems out on its own would lead to millions of otherwise innocent people becoming victims of a scandal that’s nothing to do with them. So moral hazard has to go hang, at least temporarily.

Investor Behaviour

The trouble with this calculation is that it requires extremely fine judgement as to the psychological behaviour of investors. Cheap money is seeping out into real-world assets – stockmarkets are booming, property markets are showing signs of tentative recovery too. The return of liquidity is encouraging investors back into markets, as they operate under the illusion that uncertainty has been banished.

Of course, some recovery should be expected. In the depths of 2008 and early 2009 the withdrawal of liquidity saw many assets being driven down to valuations that were clearly stupid. Their recovery as cash, and some sense of proportion, returns is simply an elastic rebound. However, as we can see from the net flows of money into investment funds an element of exuberance is returning to investors: from a global net outflow of $41 billion in the first quarter of 2009 to a net inflow of $93 billion in the second quarter. Meanwhile net flows into overpriced government bonds soared to $165 billion, another behavioural bubble waiting to burst.

As we would expect, at the very point markets reached their low points, when rational investors should have been throwing funds at the market like there was no yesterday, they were, in fact, pulling it out in record amounts in the apparent belief that tomorrow would never come. This was all entirely predictable to anyone with even a basic knowledge of stockmarket history: yet, as Charlie Munger recently said, anyone not willing to temporarily lose 50% of the value of their stock portfolio deserves everything they get.

Exuberance and Uncertainty

The problem is that there can be little or no guarantee that investors will behave as expected from now on. We’ve moved on from the obvious irrational lows to the intermediate indeterminacy of a market recovery. Yet while there’s cheap money washing around the system you’ll likely see prices climb and more and more investors come off the sidelines, bringing yet more money with them. People are irresistibly drawn to where the action is. As Uri Simonsohn and Dan Ariely have shown in When Rational Sellers Face Non-Rational Buyers, using EBay as a test bed, people much prefer to bid on auctions where there are more bids. As prices rise, more people will join the game.

Quite how governments and regulators intend to control this behavioural spiral is, at the moment, unknown. The levers of excess liquidity – so-called quantitative easing – and interest rates take time to work. Calming the irrational exuberance of the masses without causing another recessionary plunge will take considerable skill and judgement. Recent regulatory history doesn’t promote optimism in this regard.

Spin the Wheel

Investors whose approach is essentially activist and short-term face a period of more than normally difficult decision making. In truth the future is never really predictable, but the current forecasts are even more than usually opaque. The alternative, taking a long view, is anathema to many investors despite the abundant evidence that it works, if you’re smart enough to avoid most of the obvious bear-pits.

Trying to second-guess how this will all turn out is impossible. In essence the central bankers are betting that they can use the levers of liquidity to control human stupidity. To pull this off and spring the liquidity trap will require one of the greatest finesses ever. History is not on their side.

Short-term investors need to place their bets. The rest of us should settle down in the viewing gallery to watch. It promises to be a lot of fun.


Related Articles: Quibbles With Quants, Get An Emotional Margin Of Safety, Is Intrinsic Value Real?

The Lottery of Stock Picking

Risk Seekers, Risk Fearers

On average stock traders lose money. So do people who play the lottery. Yet both sets of people will often buy insurance as well. On one hand people are risk takers, engaging in risky and usually unprofitable activities, yet on the other they’re risk adverse, looking to protect themselves against possible, although often unlikely, losses.

Mostly we don’t find this particularly odd. Yet it poses a particular problem for economists and psychologists trying to disentangle the various threads that make up the skein of the human condition. They feel we should either be risk seekers or risk fearers: to be simultaneously both suggests something strange is going on. Stock pickers take note: sell insurers, buy lotteries. Or is it the other way around?

Markowitz’s Lottery Puzzle

One of the earliest researchers to note this gambling/insurance peculiarity was Harry Markowitz who we've met before in Markowitz's Portfolio Theory and the Efficient Frontier. In the same year he published the paper that eventually led to modern Portfolio Theory, the efficient markets mayhem and a Nobel Prize he also wrote The Utility of Wealth in which he both described this confused risk model and sought to explain it.

It’s a bit of surprise to find the father of rational investing theories elaborating on a subject which describes how irrational people really are. However his two 1952 papers are linked. While The Utility of Wealth describes how people really behave Portfolio Selection describes how they should behave to maximise their wealth. We can’t blame Markowitz for the investment industry using his ideas with all the subtlety of a Mob family collecting a debt from the man who wasted their mother with a cheesegrater.

Models which really aim to describe the way humans deal with risk are deluded and denuded if they exclude the risk-seeking part of the human experience. Deluded because they ignore the evidence of everyday life and denuded because they strip away the essence of human experience. Humanity would still be trolling around on its knuckles in East Africa if curiosity about what was on the other side of the forest canopy hadn’t got the better of our ancestors.

Utility and Gambling

Yet we can’t ignore the fact that we’re also risk adverse under many conditions. Buying insurance is sometimes an intensely rational thing to do – to pay a small premium to protect against the loss of a large asset such as our home makes a lot of sense. As commonsense people rather than academic economists, we don’t see the problem in a combination of risk seeking and risk aversion. After all, a small flutter on the horses or a bit of bungee jumping adds to the spice of life.

The classical economic explanation of these contradictory behaviours is full of complex equations and inflecting graphs which worry about the nature of something called the utility function. Utility is, roughly speaking, the value that a person gets out of an activity. Utility can be considered, roughly (OK, very roughly), as ‘happiness’ and many people have pointed out that the apparent inconsistency between risk seeking and risk aversion can be explained if you view the positive utility of pleasure people get from gambling as exceeding the utility they lose through the monetary expense.

Utility and Stock Trading

However, there are other sorts of gambling of which, for our purposes, the business of stock trading is the most important. When the same trigger that makes minor gambling on lotteries and horses enjoyable also encourages major risk taking in stock investment this supposedly harmless pastime suddenly becomes a deadly serious problem. As Meir Statman puts it in Lottery Traders:

"People confuse the stock-holding game with the stock-trading game. The stock-holding game is a positive sum game : buyers of stocks can expect to receive, on average, more than they spend. However, the stock trading game is a negative-sum game. In the absence of trading costs, management fees and expenses, stock traders can expect to match the return of an index of all stocks. But they can expect to lag that index once trading costs are considered. "

The problem with utility based models is that they rather ignore the fact that people process information very inefficiently. We can, and often are, fooled into thinking that the utility of a thing is different from what it actually is. So buying a long-term warranty on a fridge is usually a waste of money and so is buying a lottery ticket or actively trading stocks, no matter how much pleasure we get out of these activities. We miscalculate – and sometimes it’s a good job we do, otherwise life would be a drab procession of accountancy courses.

The Utility of Social Class

The problems lie deeper than this. Studies of lottery gamblers show that the people who spend the most money are those who can least afford it. Conversely those who spend the most on insurance are those who can most afford the losses they’re insuring against. Markowitz’s paper points to a possible explanation for this: people aspire to move up from their current social class and to avoid dropping down to a lower one.

Developments of this by Coelho and McClure also offer a hint of an explanation for the old aphorism that there’s nothing more damaging to a man’s happiness than his brother-in-law becoming rich. If our happiness is determined relatively – by assessing our wealth against our peers – then our peers getting richer than us will make us unhappy. Or, in the jargon, our utility reduces. And, the researchers predict, we're likely to gamble more in the short-term to try to make up the defecit until our expectations about our peer group change.

The Illusion of Control

The sheer range of ways to invest gives investors every chance to delude themselves that they’re in charge. Ellen Langer pointed out as long ago as 1975 that illusion of control, the idea that people will behave as though they’re in control in situations where every outcome is actually determined by chance, seems to be part of human nature. As she puts it:

"...the more similar the chance situation is to a skill situation ... the greater will be the illusion of control. This illusion may be induced by introducing competition, choice, stimulus or response familiarity, or passive or active involvement into a chance situation. When these factors are present, people are more confident and are more likely to take risks".

Given that the vast majority of active funds and active traders do worse than simply buying and holding a basic index tracker you’d have thought the message would have got through by now. Illusion of control may cause more than financial risks. People still prefer to drive themselves for the same reason, despite the evidence that cars are the most dangerous way to travel any significant distance.

The only safe way of investing is to be constantly risk averse. There’s no contradiction in stock market investment and risk aversion – it simply means you need to insure yourself against the worst that can happen. Investing as though something is about to go badly wrong is the only safe option. After all, something is always about to go badly wrong, somewhere.

Avoiding Capital Mistakes

What most people can’t do is trade their way safely to riches – that’s to take on the risk seeking side of the equation. To do so at all is one thing, to do it without recognising it as an extension to natural risk seeking behaviour is entirely another.

There’s a part of us which embraces risk in order to better ourselves – to find the next fertile pasture, to seek a better world, to enrich our families and to remove ourselves from the monotony of the everyday grind. Without the drive to explore and take risks we’d still be wrestling chimps for food and using gravel as dental floss.

Risk taking is part of the human condition, to be embraced and cherished. But all things in their time and everything in its place – mistaking the stock market for a real world adventure playground is to make a capital mistake, in every possible sense.


Related Articles: Momentum Trading Madness, Markowitz's Portfolio Theory and The Efficient Frontier, The Psychology of Scams