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Thursday, 24 May 2012

Happy People Make Terrible Traders

Happiness causes over-optimism which causes over-trading. Repeat until crash occurs.
Optimistic Fools

People who are happy are more confident and expect to make more money by trading, and anticipate taking lower risks in doing so. This result ought to be enough to depress most people, but most people are optimistic and don’t depress easily. This is especially true if they make money on their random trades, because that makes them happier, more optimistic and more prone to trading.

Even better, over-optimistic people are more socially popular and therefore more likely to be imitated. Whether any of this will really make anyone happier is doubtful, but we can but hope. It certainly won’t make for better investors.

Egos at Large

The research that investors tend to be overconfident is pretty strong. We covered a summary of the evidence in Overconfidence and Over Optimism: investors overtrade and the amount they overtrade is related to their degree of overconfidence. And generally the more they trade the less money they make.

It’s possible this is a problem of self-selection, where it’s mainly over-optimistic people who over-trade. However, this isn’t just a problem in investment. Humans seem, by and large, to be habitually overconfident on most positive traits and, according to this research by Williams and Gilovich, genuinely believe their flattering self-assessments. This, as the researchers suggest, seems to be related to the bias blind spot we looked at in Bamboozled by Your Bias Blind Spot.

Part of this seems to be caused by a basic problem of reference group neglect or egocentrism. People don’t take into account the competition when they’re asked to compete, but simply consider their own abilities at the task in hand. If the task is simple, they feel confident and ignore the fact that it’s easy for everyone else as well. And vice versa when the task is hard. This is the hard-easy bias we touched on in Parsimonious, Big Picture Behavioral Bias.

Leaping Small Rhinos

So it may be that people are mistaking the fact that trading is easy – it’s just a matter of pressing a few buttons – for the point that consistently making a decent return is hard. After all, stockmarket investing is a fiercely competitive environment – are you really better at it than the majority of other people out there?

All this leads to the awkward question of why we’re overconfident. Generally you would think that being overconfident would lead people into doing stupidly rash things, which might be OK in our health and safety conscious world but would probably have been quite dangerous when swinging about in the primeval jungle without a safety net, safety harness, hard hat, all-over body armor and insurance policy.

One possible explanation for this is the superpower of selection for social skills outweighing the possible downside of being eaten alive. Roughly it seems that a human who could negotiate the minefield of social relationships had an evolutionary advantage over one that could wrestle giant pythons, leap canyons and out bench-press small rhinos.

Socially Confident

At least, that’s the hypothesis investigated by Jessica Kennedy, Cameron Anderson and Don Moore in Social Reactions to Overconfidence. Do the Costs of Overconfidence Outweigh the Benefits? The social argument is that overconfidence provides social benefits, such as higher status in groups. One counter to this might be that if someone’s overconfidence was revealed as just that – an self-perpetuating illusion – then this would cause a negative reaction within the social group.

Well, in fact, when the researchers investigated this, the findings suggest that overconfident people are rewarded by a higher social status, and that this isn’t affected by revealing that they’re just as useless as everyone else. We’re just attracted to irrationally confident people. This is a good social reason to explain why we’re inherently overoptimistic – we gain status and influence by presenting such a face to the world.

Happy People, Terrible Investors

There may, however, be another underlying reason for our innate overoptimism – it may be related to feeling happy. When Guy Kaplanski and colleagues looked at the relationship between happiness and investing they found:
“The happier the subject the more optimistic she is with regard to the stock market. Specifically, we find that the better the general mood of the individual, the better the perceived weather, and the better the results of the individual’s favorite soccer team in the days close to the questionnaire completion date, the higher the predicted expected return in the U.S. market as well as in the domestic Dutch stock market.”
Basically happy people expected higher returns and anticipated that they’d get this while taking lower risks. It’s well documented that seasonal effects have an impact on investors – a phenomena we looked at in Rock On, January Effect – but it’s an interesting twist that it’s related to optimism and thence to emotional cues associated with happiness. Of course, if you have to be optimistic to invest then you’ll likely invest more when you’re happy. Cue a vision of happy smiling investors throwing their money at the latest market upturn.

Excited Bubbles

The idea that emotions are related to market booms is one that’s been around a while, but it’s now been specifically investigated in Bubbling With Excitement, by Shengle Lin, Terrance Odean and Eduardo Andrade. They hypothesised that if emotions are linked to investing then they might be able to induce overtrading by putting respondents in a good mood. Their results support the theory:
“We document, in an experimental setting, that magnitude and amplitude of bubbles is greater when prior to trading traders experience high intensity, positive emotions than when they experience low intensity, neutral emotions, or high intensity, negative emotions. Thus rapidly rising prices may trigger the very emotions that lead to larger asset pricing bubbles.”
The twist in the tail is that positive emotions induce more buying, which tends to raise prices, which induces positive emotions, which induces more buying. Squaring the overall circle leads to a suggestion that happy people are more confident about their judgements and are more likely to trade as a result. Add to this our social preference for people who are habitually overconfident, often for no good reason, and our innate herding instincts (see: Herd of Investors) and you can easily end up in a situation of mass delusional positive feedback: aka a stock market bubble.

Perspiration, Not Inspiration

Knowing all this and doing something about it are two different things. Trading because we’re overconfident because we’re happy and feeling happy because trades are successful are primarily unconscious behaviors, as is our tendency to attribute positive qualities to over-confident people. Nor can we turn-off the emotional tap, emotions are designed to keep us safe and to allow us to interact successfully with other people, they’re not things we can switch on and off at will.

The general trick, as most highly successful investors report, is to follow an investment process which reduces the emotional impact of personal judgements as much as possible. By reducing the scope for emotional error we increase our chances of being successful. Learning to distrust other peoples’ opinions, no matter how confidently parlayed, when they’re not evidence based would help as well. Best trick, though, is to fixate on the idea that investing is bloody hard and most people are better at it than we are: less confidence, more effort. Successful investing is mainly perspiration, not inspiration.


9 comments:

Unknown said...

I think brokers have always known this - I always traded more after a nice lunch ..

Ramps said...

Basically have a plan, and stick to it, which is a surprisingly difficult thing to do.

Trading (with consistent success) involves a particular kind of effort; not the same kind that's required in running faster, punching harder, selling more widgets, getting others to do what you want etc. This is why often those who are successful in other professions become spectacular failures when they "take on" the financial markets.

It is a very hard way to make easy money.

RogueTraderette said...

I'm doomed...I'm far to happy to be any good as a trader. Which makes me really sad, so I'll probably be just fine.

Financial Independence said...

I have to confess this is exactly what I did yesterday. The market slipped I went through the energy companies equities, analyse them and bought some.

It is not so much thinking whether we are better or worse than most of the professional traders on the market.
What a professional should do to preserve the money and save for the raining day?

Not much you can do, apart from investing in the stock market. Current inflation is 5%, interest rates are 2% and below.

Charles Faulkne said...

This is really great!

"People who are happy are more confident [Affect bias] and expect to make more money by trading {Overconfidence bias], and anticipate taking lower risks in doing so [Hindsight bias]. ... This is especially true if they make money on their random trades [Intermittent reinforcement], because that makes them happier [Hindsight bias], more optimistic and more prone to trading."

Even better, over-optimistic people are more socially popular [Leaders are Confident] and therefore more likely to be imitated [Mirror Neurons].

Anonymous said...

I love this blog. One of the few guys addressing behavioral investing topics--love it.

Kudos to TV over at Abnormal Returns for his loyal coverage.

Happy or not--all traders are invited to participate in the beta daily market forecasting competition and research study at www.dailydelphi.com.

Participants receive the daily research for free.

keithpiccirillo said...

It's part of the illusory superiority we are hard wired with.
We all believe we are excellent drivers.

"U.S. drivers believe their own driving knowledge, ability and safe driving habits are better than other drivers on the road, 64% rating themselves as “excellent” or “very good” while dishing out those high marks to only 22%t of other drivers their same age. Even among close friends only 29% of motorists ranked their buddies “excellent” or “very good” drivers."

keithpiccirillo said...

It's part of the illusory superiority we are hard wired with.
Most of us believe we are excellent drivers.

"U.S. drivers believe their own driving knowledge, ability and safe driving habits are better than other drivers on the road, 64% rating themselves as “excellent” or “very good” while dishing out those high marks to only 22%t of other drivers their same age. Even amo

keithpiccirillo said...

(continue) ong close friends only 29% of motorists ranked their buddies “excellent” or “very good” drivers.