The Experiencing Self Versus Remembering Self: When Average Is Not Really Average For Stock Market Returns

Thinking, Fast and Slow
In the book Thinking, Fast and Slow, the author, Daniel Kahneman, talks about the experiencing self and remembering self. Kahneman first recalls a study involving patients undergoing a painful colonoscopy, for which at the time of the study there was little anesthetic or other drugs to ease the pain. Every 60 seconds patients were asked to record their pain on a level of zero, indicating no pain, to ten, indicating intolerable pain. The experience for each patient varied considerably, with the shortest lasting 4 minutes and the longest lasting over one hour. These measures based on reports of momentary pain were called hedonimeter totals. Surprisingly, the feedback from the patients was not as anticipated. 

The Peak-End Rule and Duration Neglect
Kahneman writes:
When the procedure was over, all participants were asked to rate “the total amount of pain” they had experienced during the procedure. The wording was intended to encourage them to think of the integral of the pain they had reported, reproducing the hedonimeter totals. Surprisingly, the patients did nothing of the kind. The statistical analysis revealed two findings, which illustrate a pattern we have observed in other experiments:

• Peak-end rule: The global retrospective rating was well predicted by the average of the level of pain reported at the worst moment of the experience and at its end.
• Duration neglect: The duration of the procedure had no affect whatsoever on the ratings of total pain.

Experience or Memory?
Kahneman recalled a short anecdote, also alluding to the same phenomenon:
A comment I heard from a member of the audience after a lecture illustrates the difficulty of distinguishing memories from experiences. He told of listening raptly to a long symphony on a disc that was scratched near the end, producing a shocking sound, and he reported that the bad ending “ruined the whole experience.” But the experience was not actually ruined, only the memory of it. They experiencing self had had an experience that was almost entirely good, and the bad end could not undo it, because it had already happened. My questioner had assigned the entire episode a failing grade because it had ended very badly, but that grade effectively ignored 40 minutes of musical bliss. Does the actual experience count for nothing?

As with the medical patients, the retrospective rating was influenced by the peak-end rule. Kahneman notes that mixing up experience with memory is a common cognitive illusion. Here is the problem:
The experience self does not have a voice. The remembering self is sometimes wrong, but it is the one that keeps score and governs what we learn from living, and it is the one that makes decisions. What we learn from the past is to maximize the qualities of our future memories, not necessarily of our future experience. This is the tyranny of the remembering self. 

The Cold-Hand Experiment
This idea led Kahneman and his colleagues to design an experiment where participants submerged one hand in painful but not intolerable cold water for a certain length of time. The participants used their free hand to record the amount of pain they were feeling while the experiment occurred. The participants had two trials. For one, a hand was submerged 14° Celsius water for 60 seconds, after which time they removed it and were given a warm towel. The other trial was for 90 seconds, and while the first 60 seconds were identical to the other trial, the last 30 seconds the experimenter released a valve that warmed the water 1°, a noticeable difference which slightly decreased the pain. Then the participants were asked how they wanted the third trial: exactly the same as the first or exactly the same as the second. 

The first two trials were very controlled. Half the participants experienced the 60 second trial first and the 90 second trial second, and the other half vice versa in order to prevent the sequence of experience influencing the choice for the third trial. In addition, the experiment was designed to conflict the two selves. The experiencing self obviously had a more painful time during the long trial. If the first 60 seconds are the same, why endure the extra 30, even if they are slightly less painful? However, based on the peak-end rule, the long trial is preferable because the ending wasn’t as painful as the short trial, with the peaks being equal. 

What did they participants choose for the third trial?
They choose the long trial. “Fully 80% of the participants who reported that their pain diminished during the final phase of the longer episode opted to repeat it, thereby declaring themselves willing to suffer 30 seconds of needless pain in the anticipated third trial.” 

Why the discrepancy? 
The remembering self had a more favourable memory of the long trial, despite the duration, due to the peak-end rule. Even though this conflicted with the experiencing self, the remembering self is the one that makes the decisions. 

A somewhat recent post from Ben Carlson triggered me to think of how the discrepancies between the experiencing self and remembering self might be present in investing. In Playing the Probabilities, a post he wrote earlier last month, Carlson used this chart: 

It is a solid visual, but one thing really stood out to me - the annual returns were rarely close to the average, represented by the red horizontal line.

To be specific, looking at data compiled by Aswath Damadoran outlining the S&P 500 annual returns from 1928 to 2014, the geometric average of those numbers is 9.60%. However, the individual annual returns tell a different story.

Only one year over this 80+ year time horizon was the annual return within 1% of the average annual return over the same time horizon: 1993 with a 9.97% return. Only three years over this 80+ year time horizon was the annual return within 2% of the average annual return over the same time horizon: 1993 at 9.97%, 1968 with a 10.81% return, and 2004 with a 10.74% return.

What can we conclude? 
Asset allocation requires the use of risk and return assumptions. However, maybe we need to consider the differences between the experiencing self and remembering self. I think most would agree that returning 7.7% in year one and 12% in year two is a different investing experience than returning -10% in year one and 34% in year two, even though they both average out to roughly 9.8% for the two year period. While the experiencing self may go through one encounter, the remembering self may recall something different.

This is essentially what the sharpe ratio is about, calculating risk-adjusted return. A fund manager who returns 15% with a standard deviation of 10 is not equal to a fund manager who returns 15% with a standard deviation of 6. The latter is superior. If we apply the takeaways from Kahneman’s research however, the answer isn’t so black and white. The remembering self is the one that makes the decisions, and the peak-end rule may result in a preference for the former.

Kahneman writes the following:
The cold-hand study showed that we cannot trust our preferences to reflect our interests, even if they are based on personal experiences, and even if the memory of that experience was laid down within the last quarter of an hour! Tastes and decisions are shaped by memories, and the memories can be wrong. The evidence presents a profound challenge to the idea that humans have consistent preferences and know how to maximize them, a cornerstone of the rational-agent model. An inconsistency is built into the design of our minds.

Reflecting back on our investing experiences may not provide true insight into our actual experience. As Kahneman demonstrated, this is because our experience self and remembering self are in conflict. Ultimately, these ideas all delve back to the fundamental idea of investing: determining trade-offs between risk and reward. And if we can’t accurately distinguish between certain preferences, can we accurately assess these trade-offs? If you don’t understand your own risk tolerance, can someone else, such as an financial advisor, hope to do so? While, for example, new technologies, such as Riskalyze, attempt to make strides in this area, advisors need to do more as well. This means spending extra time and effort to learn about client’s risk tolerance and risk capacity, while understanding what one remembers may not be in line with what one experienced. 

Thinking, Fast and Slow is a must-read for any serious investor.

Kobe Bryant and the Human Nature Side of Investing

Kobe Bryant, one of the greatest basketball players of all time, recently announced he will be retiring at the end of the season. Since then, he has been much more candid than he has been in the past. In an interview with Ernie Johnson, Kobe had this to say on what advice he would give his younger self:

I would say “focus on human nature. You have to balance out understanding human nature with the obsession to understand the exact tactics of basketball.” And as I’ve gotten older I understood that you could execute until the cows come home but if you don’t understand human nature, if you don’t understand how to relate to others, if you don’t understand what makes them tick, you’re never going to win a championship.

Replace the word “basketball” with “investing” and I think you have some really wise advice on how to be successful financially. Essentially what Kobe is saying is that emotional intelligence, or EQ, is just as important as IQ. For advisors, as my coauthors and I have written before, understanding the technical side of investing doesn’t matter if one cannot communicate effectively. Empathy is a prerequisite for any relationship.

Furthermore, as we have written and demonstrated previously (see this and this), it is important to be eclectic in one’s learing. Kobe Bryant will go down as one of the greatest ever in his field, and it would be wise to heed his advice. 

My CFP® Story: From Shucking Oysters to Financial Planning

I have known what the CFP® designation was since I was 12 years old. My parents had set me up a meeting with their Merrill advisor because I thought I wanted to become “an investor.” He was patient with me, taking time to methodically answer my questions and describe his day-to-day in great detail. I look back fondly on that meeting remembering how it made me feel, someone as busy as him taking a substantial chunk out of his day to throw time at someone as young and uninformed as myself. Having recently passed the CFP® exam himself, the importance of this accomplishment was made evident to me. This was something that set him apart from his peers, a signal to others that showed not only competence in the profession, but his commitment to uphold a rigorous ethical standard. He educated me about the future opportunities in this industry due to a disproportionate amount of older advisors versus younger advisors seeking out the certificate. (Even today the most recent board published demographics show roughly 3% of CFP® professionals being in their 20s). To a self-proclaimed “student of investing,” helping others achieve their financial goals and make smart decisions with financial resources was an open door I chose to fixate on.

After that meeting in 2005, over a decade ago, I knew that this was the field I wanted to enter.

Throughout high school I worked as an oyster shucker at a local restaurant so I could accumulate funds to invest. My parents opened up a custodial account where I could deposit the several hundred dollars I had saved and start investing. This often led to problems as, more often than not, quarterly announcements would be made while I was in school, and as a result, I was frequently getting into trouble for skipping class to make trades.

While working at the restaurant I began to develop relationships with customers who worked for an RIA headquartered in town. They were frequent patrons and were happy to satiate my seemingly endless financial curiosity. My borderline obsession with the industry helped to earn their respect and led to a job offer as an associate on the investment team.

After my junior year of high school, I began working full-time at the same RIA while attending night classes at a local community college to fulfill my high school senior year requirements. Ultimately, I ended up transferring and commuting an hour each way to SUNY Alfred, a State University offering bachelor’s degrees in Financial Planning. I worked at the RIA for four years, all through college, developing skills and learning my craft. Upon graduation I used a young financial planner recruiting service called “New Planner Recruiting” to locate a job at a RIA in San Francisco, California. I gave away practically everything I owned, loaded my car with books and vinyl and drove across the country.

That move was in January, 2015. Last week, at the age of 22, I successfully passed the CFP® examination.

My study plan was undoubtedly one of the more challenging things I have undertaken. The new city, job, friends and slew of exhilarating adventures stimulated every corner of my brain, and felt as exhausting as several jobs combined. The decision to start the study process was one I never hesitated on, but very quickly made me come to the realization that I was going to have to create a routine like none I’d ever implemented before.

Towards the beginning (6 months prior to the test) I simply tried to spend an hour a day reading the material. This was slow going and incredibly daunting. I felt as If I was blindly stumbling down an ally, slowly feeling the walls and allowing the picture to fill itself in, only to then turn a corner and realize there was another street I had never seen before, let alone known existed.

“The more I learn, the more I realize, the less I know”

               -Einstein

Day by day the walls started to fill themselves in, the universe shrunk and things started to become more manageable. I was at least starting to recognize the edges of the CFP® universe.

About 6 weeks prior to the exam I deleted all social media off my phone. For someone such as myself who is very connected, this was a challenge as I have been using social media for my entire adult life, not to mention much of my youth. I would spend two hours in the morning (5-7am) studying and two to four hours after work (4-7pm). Social sacrifices were initially hard to make, but as you get used to not being available, the people you surround yourself with become used to it too. People stop asking. It is just part of the plan.

The biggest struggle for me was always setting expectations. I wanted to know everything right away. I wanted to wake up one morning and think to myself “ok, I am good.” Even towards the end that never happened. The more you know the more you realize you don’t know, and the more you crave to learn. This test requires an individual to be familiar with a very broad range of topics, and for someone who likes to dive 10,000ft on a single topic, this was a challenge.

Being subjected to the classic case of exam induced insomnia the night before, combined with a complete lack of exposure to standardized testing, did not have me feeling confident the morning of the test. But after a hard run and a long train ride in deep thought, both my body and mind were ready to execute. I sat down at the computer, answered the first three questions, took a deep breath, let the adrenaline kick in, and as I like to say, “played the tape.”

The most exciting thing about the past 6 months for me wasn’t necessarily the fact that I had successfully passed the exam. It was making the decision to extensively study my craft, learn my trade, and pay my dues. For me, this was an unprecedented level of commitment to a specific goal. Similar to moving across the country to a place I knew no one, it proves that these seemingly daunting tasks are actually quite attainable. This has now raised the bar for future goals.

I am now here, at a coffee shop outside of Mission Dolores Park in San Francisco, sitting and thinking of what the next challenge is. I struggled to climb to the top of the largest mountain I could see, only to be standing on the top, seeing hundreds of different, taller mountains that are calling for me to ascend them as well. Studying for the CFP® examination involves following a set curriculum. Topics and concepts are laid out for one to learn, and it is more or less clear what content you are expected to know. I am now tasked with developing my own methods and curriculums in an attempt to constantly ascertain personal deficiencies and improve upon skills. Not being satisfied is a good feeling.