The Investor’s Plague

There is a wide variation of the sophistication of investors. Some have been investing for their entire lives, maybe for a living; others choose not to, or see the learning curve as too large of a barrier to entry.

Regardless of the skill set, or how many acronyms are after one’s name, we are all susceptible to the same biases when it comes to investing. Behavioral finance looks at the psychological and emotional aspects of investors’ behavior in connection to how and when they actually trade.

Overconfidence bias

The idea and mentality that one has the ability to successfully predict future market events through data gathering or analysis runs rampant throughout our industry – the most common side effect? Overconfidence bias. Consistent luck leads to this illusion of control that in turn, causes an uptick in investors risk taking and additional trading.

Hindsight Bias

It is easy to look back at past events and remember predicting an event that transpired. This is more common when a trade was not executed – clients often will want to know why their advisors did not anticipate events that they knew were a sure thing.

Cognitive dissonance, a form of hindsight bias, is when an investor’s memory of past performance is far better than the actual results. This leads to the exaggeration of past gains, and minimizing or forgetting past losses.

Anchoring

Many investors have trouble objectively reviewing and analyzing new information. The investors “anchor” to the first information the review. We are often comfortable with our first impressions of data, especially when it is intuitive and matches our preconceived notions. This is most clearly seen when individuals buy securities that have fallen because they “must” get back up to that recent high.

This belief perseverance is why people are unlikely to change their views given new information. We are inherently resistant to change.

At least two effects appear to be at work. First, people are reluctant to search for evidence that contradicts their beliefs. Second, even if they find such evidence, they treat it with excessive skepticism.

-          Barberis and Thaler (2002)

These physiological biases are constantly at work and ubiquitous throughout all aspects of the field. As financial advisors, it is our job to recognize when and how they are at work not only in our clients, but in ourselves. We must train ourselves to lead our clients through the valley of darkness, a place where the drivers of this mental warfare never sleeps.

Risk and Uncertainty

Risk and uncertainty are often used as synonyms; however, it is important to distinguish the difference between the two. For reasons I will hopefully make clear, a current lack of distinguishment regarding risk and uncertainty is a serious problem in the financial industry in my opinion.

Risk is calculable. It is a known unknown. It is a casino. A roll of the dice. A computer can calculate risk.

Uncertainty is not calculable. It is an unknown unknown. It is life. A black swan event. A computer can’t calculate uncertainty.

Nassim Taleb tells a story about the turkey illusion:

One day a turkey is approached by a man. The turkey is nervous, but the man feeds him. Each day the man returns, and each day the man feeds the turkey. The risk that the man will not feed the turkey decreases each day and is calculable. It is called the rule of succession and was created by Pierre-Simon Laplace- in the turkey illusion it equals (n+1)/(n+2) where n is the number of days the man has fed the turkey. If you plug in a few numbers, you can see that each day the man feeds the turkey the chance he will continue to do so increases (and, conversely, the risk he will not feed the turkey decreases). Everything is great for the turkey until the day before Thanksgiving when the man does something drastically different. 

The turkey illusion illustrates the difference between risk, calculable by the formula (n+1)/(n+2), and uncertainty, that the man will one day do something unrelated to the feed-or-not-feed options to the turkey. A computer can calculate risk. A computer can’t calculate uncertainty. 

The differences between calculating a problem using a computer versus a more qualitative approach is best explained by an example: In the book Risk Savvy the author, Gerd Gigerenzer, discusses how an outfielder catches a fly ball. Essentially, he or she subconsciously uses a rule of thumb. The individual runs towards the spot that keeps the angle of their view on the ball constant. A computer can’t calculate this trajectory as it is occurring. However, if you need to calculate the square root of a twenty digit number, a computer is your go-to choice. Point being, calculations are useful (and better) for some problems but not others.

There are many ways to make money investing; however, there is no “right” way in my view. It all depends on the individual, and some strategies are more responsible than others. In my opinion, quantitative investing can be a successful strategy. Despite this, as demonstrated by the fall of Long Term Capital Management in the late 1990s, models are great for calculating risk but not uncertainty. It is like the Ancient Egyptians who would build flood control systems to protect their villages based on the worst flood that occurred during the last 100 years. That is fine until something new happens in the next 100 years that is worse than before. There is an inherent flaw in creating control systems, such as financial models, based on the worst event in the past. This is because, as I have written before, black swan events are by definition unpredictable. They represent uncertainty and occur in the world we live in. To ignore uncertainty and only focus on risk, or even worse, think you are calculating both uncertainty and risk due to either a lack of understanding or mixing up the two, would be a drastic error.

Loss Aversion

Think about the following scenario - Your friend will flip a coin. If it is tails, you lose $100. How much do you need to win if it is heads to take the bet?

Most people say somewhere between $180 to $220. In a perfectly logical world, you should accept the bet if heads results in you receiving $100.01; however, this is not the case for most people. This is because the pain caused from a loss is greater than the happiness caused from a gain.

In The Art of Thinking Clearly the author, Rolf Dobelli, writes the following:
Losing $100 costs you a greater amount of happiness than the delight you would feel if I gave you $100. In fact, it has been proven that, emotionally, a loss “weighs” about twice that of a similar gain. Social scientist call this loss aversion.

In the investing world, risk and potential return go hand-in-hand. There is no “limited downside with huge upside” investment. Return is not a possibility without taking risk. Due to loss aversion, each person usually has a slightly different answer to what risk-return tradeoff they can handle. Furthermore, this is effected by risk capacity. That is, the amount of risk one can actually afford to take. (The risk capacity of a single 20 year old with zero debt is much different than the risk capacity of a 40 year old with four infant children regardless of their risk tolerance.)

The best investment strategy is one that is specific to the individual. This has to take into account a person’s individual outlook on the risk-return tradeoff, which will almost certainly be affected by loss aversion.