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Thursday, 1 November 2012

On the Invariant Nature of Investor Ineptitude

Behavior is Forever, Not Just For Life
One of our themes here is the unchanging nature of human behavior across time and space.  It doesn’t much matter whether we’re in 1st century Rome, 17th century Holland, 18th century Britain or 21st century America, if you put large groups of people in the same situation they’ll tend to behave the same way when they have money at stake: irrationally.

There’s plenty of evidence from history that this thesis is true, but a recent paper on the seventeenth century’s equivalent of a behavioral finance blogger helps to emphasise the point.  We were irrational then and we’re irrational now, and three hundred plus years of technical advance hasn’t improved this situation one iota.

Delusional

Perhaps the most famous set of essays about the permanence of investor irrationality down the ages is Charles Mackay’s Extraordinary Popular Delusions and the Madness of Crowds:
“Money … has often been a cause of the delusions of multitudes.  Sober nations have all at once become desperate gamblers, and risked almost their existence upon the turn of a piece of paper … Men, it has been well said, think herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.”
Mackay was writing in 1841, and he traces a range of manias, some financial such as the South Sea Bubble, the Mississippi Scheme and Tulipmania, and others not.  All, however, he adduces from the historical evidence that we’re inclined to go barking mad on a quite frequent basis.

Railway Hallucinations

In fact Mackay himself was to live through one of the great investment bubbles of history – the Railway Mania, which he oddly didn't write about.  This mania, at its height, required an investment equivalent to over $1 trillion dollars for the United States today, all funded by private individuals, and substantially more than the British defence budget at the time.

Andrew Odlyzko describes this in Cognitive Hallucinations and Inefficient Markets: The British Railway Mania of the 1840’s, and suggests that this huge amount of investment was the outcome of a set of collective delusions on a grand scale, yet which were easily falsifiable, had anyone chosen to do so:
“Investors neglected to do the simplest checking, and instead relied on a widespread belief that traffic takers’ demand projections had in almost all cases been substantially exceeded. This false belief arose from an intensive public relations campaign by the railway interest, supported by some scholarly studies. This campaign was based on diverting the public’s attention from the metrics for success that truly mattered, namely revenues and profits, to another one, namely the raw number of passengers … Any single one of these delusions was easily shown to be false. Hence one might think that with more opportunities to find fatal defects in the rosy profit projections, investors could not but wake up and realize they were being led astray. But that simply did not happen ... The multiple delusions, each easily falsifiable, reinforced each other and created a powerful collective hallucination that required a hard fall off a cliff to dispel.”
If this rings current bells it shouldn’t be surprising, our ability to prefer a good story over nasty numbers is a permanent part of the human condition.

Historical Herding

We can go back still further in history to find evidence of investor bias, back to Confusion de Confusiones, written by Joseph de la Vega in 1688, a book which gives us a clear picture of the behavioral biases at work in the stockmarket of seventeenth century Amsterdam: a rudimentary affair with only two constituents, the Dutch East India Company and the Oriental Indies Company of the Netherlands (which went bust taking his fortune with it).  De la Vega’s book is the first ever written about the operation of stockmarkets but more importantly, for our purposes clearly sets out a number of our favorite biases.

Take herding, for instance, quoting from Teresa Corzo, Margarita Prat and Esther Vaquero’s paper on de la Vega he states:
“There are times in which the powerful investor is followed by many, even at the cost of losing money”
The idea that people will blindly follow leaders with little or no clue what they’re doing is an attribute of herding, our tendency to cluster together and to take our cues from others, rather than doing the heavy lifting of thinking for ourselves.  As de la Vega goes onto say: 
“It is not important that the basic value of the shares be practically nothing as long as there are other people willing to close their eyes and support those contradictions”
Forget fundamentals, just chase the crowd.

Historical Overconfidence

On overconfidence de la Vega waxes lyrical, noting that investors tend to overtrade, that they’re over-sensitive to short-term information, and that they often don’t have a clue as to why they’re trading, although they’re ever loathe to admit this:
“They will sell without knowing the motive; and they will buy without reason. They will find what is right and they will err for fault of their own.”
As we’ve continually found, overconfidence is implicated in terrible returns: we lose money in fees in trading and we tend to sell things that do better than what we buy.  It’s no surprise at all that de la Vega found the same behavior over 300 years ago.

Historical Regret

Aside from overconfidence and herding de la Vega also finds the third of the unholy trinity of biases: regret aversion, our tendency to manifest regret when our decisions go wrong.  As he says, some people are unhappy whatever they do.

Regret aversion usually manifests itself as the disposition effect – we sell winners to lock in our profits and keep losers in order to try and recover our losses.  And we do this regardless of what the fundamentals of the stock are telling us.  De la Vega’s advice to investors is ample evidence of the effect in operation – sell when you make a profit, you never know what might be just around the corner.

The Four Principles

Perhaps de la Vega’s most memorable legacy was his four great principles of investment.  To paraphrase these:
  1. Don’t advise anyone to buy or sell shares.
  2. Accept your profits and your regrets without looking back.
  3.  Profit in the stockmarket is transitory.
  4.  To succeed you need money and patience.
As we saw in The Zeitgeist Investor, repeated patterns of stockmarket behavior can traced to consistent patterns of responses to particular situations.  The lessons of the Railway Mania and de la Vega simply reinforce this: we are creatures of peculiar and certain habits, and managing these is a critical aspect of investing.  It was true 330 years ago, and probably 3330 years ago, and it’s certainly true today.

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