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Monday 17 April 2017

A Catalog of Investing Errors

Love Lists

We're attracted to lists like moths to flames and netheads to clickbait. The Big List of Behavioral Biases is by some way the most popular page on this website, but it actually provides very little insight into investing successfully.

Behind this, though, lies a deeper truth. Lists are processed more easily by the brain, and they're perfectly optimized for the click and go environment that is the Internet. Here I explain why. In a list. Obviously.

1. The Paradox of Choice

Too much information overwhelms us, we're unable to process it and have to take unsatisfactory shortcuts. The more choice we have the less empowered and happy we feel. I discussed this in Jam Today, Tyranny Tomorrow? but Claude Messner and Michaela Waenke have now taken this a step further.

In When Choice is Demotivating: Can One Desire Too Much of a Good Thing? Sheena Iyengar and Mark Lepper showed that consumers get more satisfaction out of choosing from a smaller selection of options. Now, in Unconscious Information Processing Reduces Information Overload and Increase Product Satisfaction Messner and Waenke demonstrate that this is because more options make people think harder.

Given the choice we'd rather not think, and lists help us reduce the conscious processing load: the list is a simple way of presenting information, and reduces the processing overload on our brains. Of course, financial service providers know we have limited time and brainpower, if we didn't many of them would go out of business.

2. The Certainty of an Ending

People dislike uncertainty. In fact we dislike it to the point of denying it exists, as witnessed by the rapid disaster myopia exhibited by many investors in the wake of market crashes or personal investing disasters  (see Black Swans, Tsunamis and Cardiac Arrests). Lists provide certainty, although that certainty is often illusory.

I covered the classic research in this area, primarily Daniel Ellsberg's Ambiguity Paradox, in Ambiguity Aversion: Investing Under Conditions of Uncertainty: the main point is that people will preferentially plump for the option that provides more certainty, rather than exposing themselves to unknown risks for a larger reward. A list, of course, provides an element of certainty - it will end, and probably without taxing the brain too much. 

3. The Happiness of Completion

It's not just that we like certainty, we also really, really like finishing things. Evidence for this goes back to 1927 when Bluma Zeigarnik showed, in On Finished and Unfinished Tasks, that people remember incomplete tasks twice as well as complete ones: our brains don't give up until we're finished - which, incidentally, is why you should never finish memorizing something before you go to bed.

The buzz that our nervous systems give us on completion of a task is an evolutionary trick to make sure we get things done. Lists are a structured way of ensuring that we complete the task - whether it's reading a clickbait article or getting the house tidy or making sure our portfiolios aren't filling up with questionable junk stocks.

4. Illusory Control

Lists make us feel like we're in control and nothing makes us happier than that feeling. In truth, of course, we're precariously perched on top of a ball of rock spinning through the voids of space at 1000 miles/hour protected by nothing more than a thin layer of atmosphere and a magnetic core whose workings we don't understand.

Ellen Langer's work in this area (illusory control, that is, not planetary geomagnetism) ultimately led to the development of mindfulness and shows that we will go to extraordinary lengths to make ourselves believe we're in control, even when it's clear we're not. Moreover, feeling like we're in control has substantial health benefits. As usual, when applied to investing, the downside is financial - see I is For Illusion of Control for an introduction to the topic.

Making lists - and even better, working our way through them - makes us feel like we have some control over events. 

5. The Simple Pleasure of a List

Lists feel better. Really.

This is odd but true, and the clue is contained in the concept of fluency, as we saw in Fooled By Fluency. As an extension to that Daniel Oppenheimer has shown, in The Secret Life of Fluency, that the subjective experience of ease or difficulty in dealing with a task determines how we feel about it. In fact, what Oppenheimer actually says is:
"The subjective experience of fluency depends critically upon the anticipation of difficulty"
We expect that lists are easy to process which explains why we create them, even in situations where they don't provide any objective benefit, and why we read them (ditto). Although, of course, there's a great deal to be said about feeling good about yourself.

Becoming a Better Investor

Lists make our brains feel better about themselves. They can reduce the issues associated with too much choice, remove uncertainty, guarantee a conclusion, imply control and make us feel better. But do they actually make us better investors? Or simply better people?

Well, lists tend to break up narrative flow. As I should know, it's actually quite hard to write an article with any degree of brevity than doesn't trivialize the issues under scrutiny, but lists force a sequential structure onto the argument, which further removes a degree of freedom. A free-form article allows the development of a narrative structure and complex, multi-threaded arguments to arrive at some kind of reasoned solution, a list doesn't.

Behavioral Finance Writ Small

Which brings us back full circle to the Big List of Behavioral Biases. Other than being a useful reference tool, it's really not much use in understanding what behavioral finance is about (at 150 items and growing it's too large for a start, but I'll gloss over that for reasons of narrative continuity). It's popular, I surmise, because it presents the subject in a list form, that can be dipped into as and when needed.

In truth the topic has no real overarching structure, it's still an infant trying to figure out its place in the world, pulled between the conflicting interests of its parents, hard-edged economics and soft-focus psychology. And because of that it can provide limited value to investors, other than in being aware of the main issues and trying to develop a defense against them. Something like a checklist, for instance ...

Checklist ... Check

In fact the checklist is a powerful tool for investors, largely because it can be customized to the individual. Figuring out the things that you need to check both before buying and periodically when considering re-balancing is important, but is likely to be a highly personal affair.

The checklist allied to a method of obtaining truthful feedback - self-reporting is hard, and we often fool ourselves - which we can then use to modify our rules is probably the best we can hope to achieve at our current level of knowledge. Which, in fact, is probably not a bad result, since the day researchers discover how to predict precisely what we're all going to go is the day the machines really do take over.

The Zeigarnik Effect added to the Big List of Behavioral Biases

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  1. Valuable reminders here, as always. THANK YOU. By any chance will you post or link to a sample checklist that one could use as a nudge?
    Best wishes
    Adam Okhai

  2. I've always been a bit reluctant to post one of my own engineering, because I think they have to be generated through individual experience and specific investment focus. That said there's a good list at ValueWalk that would be worth mining: : Investment Principles & Checklists. If I can find the time I might try to mine this for an example version.

  3. Glad to see you're posting again timmar. Just a thought, but have you considered upgrading the site's look and feel a bit.

    On my fairly conventional modern monitor here the text is incredibly small -- I have to put the page into Reader mode and strip out all the extraneous stuff.

    I'd make the font bigger as a minimum, personally, and probably go further.

    But just some feedback, for what it's worth.