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Monday 15 February 2016

Investors, Still Chasing Hubcaps

Lowing and Highing

As we saw in The Proper Etiquette for Market Panics - which I wrote the last time we had some major market falls - what usually happens in a crisis is that markets fall and then exhibit volatility, as investors roam backwards and forwards in increasingly large herds while asking everyone else why it's happened and what they should do about it. Often the noise they make sounds suspiciously like cattle lowing.

Well, this happens (the volatility, not the lowing) because going down - and up - is what markets do, and if you don't understand that you shouldn't be allowed to play Monopoly, let alone invest in stocks. And asking what you should do about this after the event betrays a depressing level of incompetence and a woeful grasp of history. On the other hand a bit of cognitive dissonance can be just the trigger to for a teachable moment; the point at which a handful of people actually learn to be proper investors.

Dissonant Behavior

Cognitive dissonance is the feeling of discomfort we experience when we act in a way that conflicts with our beliefs about ourselves. Most typical, well adjusted people have a healthy and positive self-image and they don't like to disturb it by doing anything so self-aware as acknowledging any of their numerous vices. So we manipulate our beliefs to bolster our self-image and reduce our feelings of cognitive dissonance.

This can be particularly tricky for investors, especially less experienced ones, who are apt to convince themselves that they're financial geniuses simply because their stock portfolio has gone up in value. When the inevitable reversal comes there are one of two possible reactions to the cognitive dissonance this entails. Firstly the investor could acknowledge that actually they don't have much of a clue and that their prior successes were down to luck; or they could continue to believe that they're an investing genius and attribute their misfortune to the evil machinations of governments or aliens, or evil financiers, or something.

Now what do you think most people do?

Chasing Hubcaps

The evidence suggests that investors chase returns the way dogs chase hubcaps, with much the same results. Money flows into popular fund sectors months after they've become successful and then flows out months after they've started to fail in order to chase the next big thing. It happens with index funds as well (see: The Wrong Way to Use an Index Tracker). People just don't seem to learn that this is a surefire way of underperforming the market - even in bull markets most active investors fail by some distance to capture the market return, because they're too busy trading and congratulating themselves to actually notice some boring index tracker is roasting their returns.

In essence, people are able to put up with, and even learn to enjoy, low levels of cognitive dissonance for long periods of time. By adjusting their beliefs, failing to accurately measure their returns, ascribing the occasional spectacular failure to bad luck or external influences and by re-framing their portfolios to somehow ignore the losers, they stagger on, never learning, never changing their beliefs and, at best, improving only by painful trial and even more painful error.

UFO No Show

Cognitive dissonance was first studied, famously, by Leon Festinger. He infiltrated a group of God fearing folk who believed that the world was going to end on the 21st December 1954 and further believed that they would be rescued by a UFO a few hours before the end of the days. In preparation for this they refused to talk to strangers, gave away all of their belongings and divested themselves of all metal objects including bra-straps and belts (don't ask). You can imagine that there was a certain degree of disappointment in the group when the alien savior failed to turn up, shortly followed by a distinct lack of world ending events.

Now as you might expect this sequence of events provoked a certain amount of cognitive dissonance. Festinger correctly predicted that the group would go public in an attempt to convince other people that they had been right all along, and that only because of their fervent believing had God (and presumably his alien followers) spared everyone: an attempt to lessen the impact of disconfirmation. 

In a more academic study by Festinger, with James Carlsmith, Cognitive Consequences of Forced Compliance, they forced people into a position of cognitive dissonance by making them do and say things that ran counter to their private beliefs: they predicted, correctly, that people would change their opinions to reduce dissonance.  It’s a powerful effect: if you can make people say things they don't originally believe in they may change their minds. That's scary.

Myopic Delusion

Now we know that investors are spectacularly prone to self-serving bias - if I'm successful it's because I'm brilliant and if I fail it's someone else's fault - and that the opportunities for self-delusion are manifold, fuelled by the endless procession of talking heads that the mass media is happy to give airtime to. Sadly that's nothing to do with investing, it's entertainment. There's a difference, you know.

But sometimes, just sometimes, something happens that even the most smugly self-satisfied investor can't entirely ignore. Behavioral bias being what it is the moment will pass, if we're not careful: myopia, our ability to quickly put painful experiences behind us, is one of our greatest adaptive features - it allows us to continue to function in even the most difficult of circumstances. Unfortunately, it's exactly the wrong thing for an investor to do, as distance reduces cognitive dissonance and with it the impetus to change.

So between our continued attempts to maintain a positive self-image and the healing balm of myopia the opportunities for changing our behavior are relatively small, so that when these rare moments happen they need to be seized. There's a term for these times, they're called teachable moments.

Teachable Moments

Teachable moments are usually intensely personal, specific to an individual and triggered by some major event causing cognitive dissonance that we can't adjust to without modifying some of most cherished beliefs about ourselves.  It's the point at which crushing reality simply can't be ignored.

The idea was postulated in 1952 by Robert Havighurst, and although he was really discussing stages in child development it’s increasingly been seen as valid for adults, too, usually caused by some out of the ordinary event. For example, this study on Understanding the Potential of Teachable Moments: The Case of Smoking Cessation looked at the triggers that stopped people smoking: 
“Cessation rates associated with pregnancy, hospitalization and disease diagnosis were high (10–60 and 15–78%, respectively), whereas rates for clinic visits and abnormal test results were consistently lower (2–10 and 7–21%, respectively).”
Perception and Reality

The researchers proposed that for something to really be an effective teachable moment there need to be three interacting psychological changes. Firstly the event must increase the perception of risk, secondly the event must cause a strong emotional response and thirdly the event must redefine the person’s view of their social role.

Do these triggers exist for investors suffering unexpected and massive losses?  I think they do. We recently discussed the gap between actual risk and the perception of risk, and that seems to me to be a real and pressing problem for many investors. All too often we fool ourselves into thinking that relative market calm means that risk has vanished - but it hasn't, it's just dormant. Even experienced investors struggle with this, so it’s not surprising that novices are sometimes shocked by market or stock falls.

As for a strong emotional response – well, we can take that for read, it's what losing lots of money usually does to a person. So it’s the third trigger we need to consider – someone who thinks they’re a great investor, and who revels in that social role will find it hard to accept that they’re wrong. And that’s where cognitive dissonance kicks in.

Humble Bumblers

As I keep repeating, boringly, the proper investor attitude to the markets should be one of humility, and should be governed by patience. Success in investing isn’t a social badge of honor, it’s an act of independence. Investing isn’t a useful thing in it’s own right, it’s what we can do with the proceeds that defines us.

Unfortunately even at teachable moments investors look to the wrong place for advice. They listen to stupid talking heads, seek comfort from their equally dumb peers and read vacuous journals whose purpose in life is to sell more vacuous journals. Sadly there's no way of avoiding going back to basics: learn a bit about investing history, about valuation, about investor psychology and recognize that markets are not a get rich quick scheme. After all, if they were, we'd all be billionaires.


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