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Monday 19 May 2014

Maladaptive Investing

Integrated Bias

Writing a book about behavioral investing forces you to think about how everything fits together (quick plug: Investing Psychology: The Effects of Behavioral Finance on Investment Choice and Bias).  And one of the things that’s really striking about behavioral bias, when you take this wide angled view, is that it’s less about people behaving irrationally when it comes to finance, and more about finance behaving irrationally when it comes to people.

We evolved in sync with our environment, such that we were adapted to it.  But finance offers an entirely new type of landscape.  We’re maladapted to investing, which is why conquering our biases is impossible.  But recognizing them sure can help.

Off the Beaten Path

Of course, it’s would take forever to list all of the differences between the pre-modern environment and the present day, but we can make a few broad observations.  In ancient times we would have been forced to make decisions based on the information we could observe, or possibly that we could glean from trustworthy people.  As Jared Diamond’s book, The World Until Yesterday, makes clear, it’s likely that the number of people we could trust was limited to our specific tribal group – a few hundred people at best.  Everyone else was a threat, and death lurked off the beaten path.

Humans are a peculiarly social animal – we have to be, we have poor natural weapons, and we’re not especially fast or venomous or well armored.  What we are is smart, capable of co-ordinated action, and we have the ability to pass on information: before literacy it’s likely that oral traditions ensured that memories could be transmitted across the generations: Homer's Illiad was probably passed down for hundreds of years before being written up.  Above all we’re adaptable – we managed to colonize virtually every corner of the globe before we invented writing.

Graffiti and Cheeseburgers

The evolved skills that served us well in pre-historical times are much the same as the ones we use today, but the pace of technological change over the past few thousand years has far outstripped the pace of evolutionary adaptation.  Bar a complete change of wardrobe and some strategic shaving, we’re pretty much the same ape descendants that were daubing masterpieces in French caves thirty thousand years ago (and the same creatures that partially obliterated the same paintings in a misguided attempt to clean-up graffiti in the 20th century).

This mismatch between our historical and current environments helps explain many of the peculiar behaviors that dog us on a day to day basis.  For instance, the global trend to obesity is linked to our tendency to eat as much as we can while we can in order to lay down reserves of fat for when the food is in short supply:
“That irresistible urge for a cheeseburger has its roots in dramatic environmental changes that occurred some 2 million years ago. Higher quality, nutritionally dense diets became necessary to fuel high-energy demands of humans' exceptionally large brains and for developing the first rudimentary hunting and gathering economy. Today, the imbalance between energy intake and energy expenditure is the root cause of obesity in the industrialized world, according to some anthropologists.”
Illusory Patterns

All of which leads me to suspect that most of the irrational behavior we see in financial markets is not actually irrational at all, if you emerge from the tangled undergrowth of research that assumes financial markets are a perfectly normal environment for a creature adapted to life as a nomadic hunter-gatherer. If we want to improve how people invest we need to change markets, because we’re unlikely to change people on anything other than a glacial timetable.  But for the few who can adapt, even a little bit, then the opportunity is plain.

Consider, for example, our marked tendency to extrapolate from local observations to global predictions.  One of our brains' more brilliant abilities is in pattern recognition, and this served us well when the patterns we observed in our local environment encapsulated our world view.  Now, however, our local environment is the world, but we’re not equipped to manage this.  We still work on the basis of observed frequencies, and end up making illusory correlations on the strength of the tiny window on the world that we have access to.

Investors frequently suffer because of this, especially under conditions of great uncertainty.  Jennifer Whitson and Adam Galinsky have demonstrated this in Lacking Control Increases Illusory Pattern Recognition, showing that people create illusory correlations in order to find structure in markets, even when none exists:
“Illusory pattern recognition may not be entirely maladaptive … Although it is certainly preferable to accurately perceive one’s environment, illusory pattern recognition itself may at times be adaptive by allowing an individual to psychologically engage with rather than withdraw from their environment”.
Unreliable Memories

On top of this our memories are unreliable.  In fact it’s quite likely, as Baruch Fischoff has suggested, that memory is not designed to help us remember the past at all:
“The human memory system is not designed to accurately reconstruct the past (as is explicitly assumed by much of the research on memory which measures memory solely in terms of its ability to accurately remember past events), but rather the human memory system is designed to adapt to the future. This adaptation involves “making sense” of the past in order to better anticipate the future. This is clearly not a perfect system.”
If memory's main use is in modifying our future behavior then anything not useful in that regard is likely to be severely edited.  We certainly remember things that are especially salient to us – but they may not be the things we need to remember to learn the lessons required to become better investors.

And if memory is not reliable, and we can’t trust our observations, then we can’t trust the conclusions we draw from our experiences.  In investing, where everything is topsy-turvy anyway, this would suggest that we will only learn slowly, because we need to accumulate a lot of experience in order to filter out the spurious correlations from the not so spurious ones. 

Ignore the Environment

All of which makes it likely that some people will never learn, because they’ll develop pet ideas about how to invest which will be successful often enough to provide partial reinforcement of their ideas (see: B.F. Skinner's Stockmarket Slot Machines).  Only data can save us from this, and most people don’t even like to record how successful (or, more likely, how unsuccessful) they are, so what chance do they have of learning anything?

If we’re maladapted to the investing environment then probably the best thing we can do is not try to change ourselves, but instead try to change the environment.  In doing this we’ll need to severely limit our exposure to that environment and learn to ignore much of the spurious signals it generates.  Of which more anon.

For now eat more vegetables and less cookies because a long and healthy life is the best investment you’ll ever make: markets always go up in the long-run, we just need to make sure we live long enough to see it happen.

1 comment:

  1. you say - people can't change themselves, neither can change the environment - then what should average investor do to get rid of the bias?