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Monday 28 July 2014

Bad Behavior: From A to Z ... and Back Again

Talking Shop

A common reaction to pointing out to investors (or indeed, anyone) that they're as biased as a Fox reporter at a convention of transgender liberal pacifists is for them to respond, not unreasonably, by asking what they should do about it (that's the investors, not the reporters). It turns out that it's a lot easier to say what's wrong than to actually do anything about it.

The A to Z of Behavioral Bias is an attempt to address that issue, but it does rather show that there's no such thing as a common source of biases; bad behavior comes from many sources and requires many solutions. Or does it?

Toxic Arms Races

To generalize, perhaps beyond the point of reason, there are two sorts of bad behavior amongst investors. The first kind occurs because the modern investing industry is designed to be toxic for creatures like ourselves who evolved methods to deal with risk and uncertainty and duplicity in a completely different world. The same argument can be made more generally about the world outside investing, of course.

In addition, the creation of our consumerist society has led to a psychological arms race, as corporations vie with themselves to create redundancy in their products by magicking up a demand that isn't predicated on a genuine shortage of supply.  In investing, as in other areas where services or goods have to be sold, techniques have been evolved, by trial and error, that persuade us into parting with our money by exploiting our biases.

To Choose or Not To Choose

For many of us our problem is not the one that's afflicted humanity for most of its history: it's not that we have too little choice, but that we have too much. Choice overload, as it's known (see Jam Today, Tyranny Tomorrow), has been exploited by the securities industry, amongst others, to keep prices high and reduce competition. History suggests this hasn't been a deliberate attempt to manipulate us, but has developed by trial and error as corporations seek to maximize profits.

But now research is exposing the fault lines in our mental structures and firms and and governments are looking to use this knowledge to actively manipulate us into behaving the way that they want us to. So far, as discussed in The Nudge Unit Goes EAST; Investor Funds Go West governments seem to be using this power wisely, if rather paternalistically. I guarantee this won't last; it's purely a matter of time before the Nudge Wars start.

Corporations, at least, aren't conflicted about their objectives: they are in business to make money and that means getting us to buy their stuff by any legal means possible. The advertising and marketing industries are light years ahead of the psychologists in figuring out how to manipulate us. Default choice, aka nudge theory, was being used by corporations decades ago; consumer inertia has been exploited for as long as merchants have tried to flog stuff, and the use of the decoy effect - creating a comparison product no one ever buys in order to fool us into purchasing higher priced items is common practice (see Birds, Bees and Decoy Effects for a description of how this works). 

Mental Mind Sets

There is, I'm afraid, only one way to deal with this type of problem. You've got to recognize the issue and create the right mental mind set to deal with it. For example, if you're going shopping pay cash. Don't use cards, because as we saw in Disruption by Digital Wallet: The Sailing Ship Effect Rewritten and Putting Down the Credit Cards they distance us from the pain of spending. A single credit card payment hurts only as much as a single cash payment: there are times where avoiding pain is not good for us.

More generally you have to equip yourself with a knowledge of how compliance professionals persuade us to part with our money. Robert Cialdini calls these techniques the "weapons of influence", and shows how our innate compulsion to reciprocate gifts, our deference to authority and our attraction to scarcity can be used to jump us into making purchases we don't need.  Corporations may exist to meet market needs, but they're not adverse to creating new ones where we didn't know they existed. 

This type of bad behavior can be found more specifically in financial markets, too. The securities industry has a long and undistinguished history of finding ways to extract funds from gullible traders. Indeed, it's possible to argue - as I did in The 160 Billion Dollar Bezzle - that the entire securities industry is a machine dedicated to extracting fees from people who think they're investing but are actually being conned into paying fees. It's the classic poker trick where the sucker is the only one around the table who doesn't know they're the sucker. 

Imperfectly Adapted

The second kind of bad behavior is even harder to eradicate, and it's the type of behavior that the A to Z of Behavioral Bias mainly focused on - because it's the type that investors tend to be exposed to (although it's also more generally applicable). This is the problem that because the environment we now live in is radically different from the one we spent a few million years adapting to, it triggers behaviors that were perfectly rational when we lived on the savannah but which are now labelled as "irrational".

Of course, the people who are doing this labelling tend to be economists and psychologists whose knowledge of pre-literate history and non-literate societies tends to be a bit scratchy, but it's fairly evident that they mainly take the current world as a norm, a natural baseline for human activity. The tendency to carry out studies on Western, Educated, Industrialized, Rich and Democratic (WEIRD) subsets of humanity has been noted as being a tad unrepresentative (see Weird Markets) by anthropologists who are one group that recognize that our market led society is not the only way of living.

However, the media machine that fuels markets isn't going to let a few inter-cultural studies stop it, and so we get the vast juggernaut of market commentary that's designed to explain every nuance and twitch of the markets, sometimes down to minute details. Yet when the whole edifice of the market teetered on the edge of oblivion a few years ago the talking heads, experts and gurus were reduced to incoherent ranting and impotent confusion. What kind of expert can explain a 50c change in a stock price today in hindsight but can't see the markets falling off a cliff tomorrow?

The kind that has no special knowledge, of course.

What To Do?

So a lot of the biases we see are triggered by environmental conditions; they're normal behaviors that are badly adapted for a new environment. Unfortunately we can't wait for evolution to catch up with the markets; we'll all be long dead - although the brutally adaptive nature of markets shouldn't be under-estimated - a few more generations in which the greediest, selfish and most self-interested people become the richest and marry people equally as socially isolated as they are will see to that.  But we can do something about this second problem, because we can restrict the effect the environment has on us.

Anchoring is triggered off buy prices - so lose the buy prices. Or if you can't bring yourself to sell a stock at a loss then institute a rule that forces you to buy more of your biggest losers every quarter - because if you won't buy more of a cheap stock it's a pretty strong hint that you're suffering from loss aversion and the disposition effect: sell those suckers and move on.  Mental accounting should be countered by framing more widely and making sure you don't segregate your portfolios - it's all too easy to mentally move stocks about to avoid facing reality. It's one portfolio, treat it as such. 

Social effects, where we're influenced by people around us need to be carefully guarded against. Anonymous internet tipsters may be overconfident because they're successful but it's just as likely they're too stupid to know they're wrong or they're broadcasting their successes and not their failures. Don't blindly follow anyone, especially people you don't know and don't engage in trades where the risk is asymmetric - you'll likely suffer from the winner's curse; chasing prices is the canine equivalent of chasing your tail, you'll waste a lot of energy and never catch up.

Heuristically Challenged

Be wary of using typical mental short-cuts which may be useful in everyday life, but are less so in the counter-intuitive world of markets. So don't make investing decisions by roughly comparing firms or situations you've previously encountered, or by automatically investing in those you're already familiar with or that are simply memorable - do some proper research rather than relying on rule of thumb heuristics.

And don't simply defer to the authority of so-called experts who are actually cherry-picking their evidence, and relying on our brain's limited capacity for thinking of counter-examples to disconfirm them. Getting into the habit of trying to disprove a stock idea or prediction is a thoroughly good behavior to practice, especially as we're constantly being primed to make decisions that aren't really in our best interests.

You also need to guard against physical effects: ego depletion and mood swings due to calendar effects are probably related to physical conditions, so try to make sure you're not tired or hungry or in an emotional state when making investment decisions. And having a few tools in your kitbag can't hurt - an elementary knowledge of statistics, an appreciation of the power of randomness and the ability to turn proportions into absolute values - a 50% rise or fall means nothing unless you know what the baseline was - are valuable tricks of the trade.

Above all, don't think you have any control over what's going on in markets, that's a sign of undue overconfidence and hindsight bias.  As soon as you believe you can predict the future you're wide open to the fear and doubt that any rise in uncertainty will bring. We are but flotsam on the market oceans, just make sure you build a decent life-raft to ride out the unforecastable storms.

Adapt or Lose

What all of this hints at is that behavioral bias isn't any single problem because the brain isn't a single solution; it's a haphazardly evolved set of modules which are loosely orchestrated to get us through everyday life. The jury-rigged nature of the system is only revealed through studies of people who have suffered head injuries, but the result is a mish-mash of functional components, each with its own faults. Some biases are as a result of limitations in a module, some due to flaws in the orchestration under circumstances we didn't evolve to deal with.

So our bad behavior isn't entirely our fault, but it is our decision about whether to do something about it or not. There are no maps, no A to Z guides to tell us exactly how to travel this road, but there is enough information for us to start the journey. We can change ourselves and we can change our environment, the choice is ours - we can adapt, or we can lose.


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  1. Your A-Z series is amazing. 26 different types of errors we can make, or worse, 26 errors we can be *nudged* to make ...

    I keep thinking there has to be some system we can learn and apply that will help us better avoid these types of errors. Right now I am experimenting with Anki ( as a way to keep reminding myself about the various biases and their possible effects on my decision making.

    How do you approach this? Is there a system that can help?

  2. I've been following your blog for a long time now. 7 years? I really enjoy reading it.

    Today I was running a search and couldn't find what I'm looking for. I was wondering if you might have a stash of Images, charts, cartoons (probably the most helpful, actually) that demonstrate some of the concepts in your A-Z Series. I have found some on the interwebs, but I'm giving a presentation and was wondering if you might have a few jewels you could share.

    Any help appreciated, but no obligation or expectation. Thanks. -Daniel