Insightful investor

The Insightful InvestorUsing cutting-edge psychology to invest smarter

Tuesday, December 13, 2011

The Problem: Human Fallibility

Investing mistakes

• underperformance

• rack up excessive fees

• failure to reach financial goals

• susceptibility to fraud

The facts

$100k investedfrom 1989-2009 S&P 500 Average

investor

Returns (after inflation)

$292,329 $82,288

Dalbar Inc. Study

Modern day behavioral finance provides an

understanding of the problems

If we know problems, we can create solutions

How we make investment decisions

rules of thumb that we turn to quickly to size

up our surroundings

Heuristics

our brains are actually hardwired to making

irrational choices

-- Richard Thaler, Author of Nudge

Neuroeconomics

Mental models• simply a

representation of an external reality inside your head

• concerned with understanding knowledge about the world

Source: http://www.farnamstreetblog.com/mental-models/

As investors, where do we go wrong?

Availability Bias

Investors predict

likelihood of future events

based on what is personally

relevant

[perspective matters]

Availability Bias

• Mental Model: Availability Bias (Farnam Street)• Judgment under Uncertainty: Heuristics and Biases (Kahneman, Tversky)• Investment Decisions: How to Avoid Availability Bias (Wise Investing)• How professional biases can cloud judgment (Applied Behavioral Finance)• Cognitive Biases Series -- PBS (Meir Statman) [.pdf]

[learn more]

Confirmation BiasTendency for investors to

favor information that supports their

preconceptions, regardless of whether it’s

[looking for ways to be right]

Confirmation Bias

• How to Ignore the Yes-Man in your Head (WSJ)• Overview of Confirmation Bias (CXO Advisory)• Confirmation Bias, Overconfidence, and Investment Performance: Evidence from Stock Message Boards (Park, et al)• Confirmation Bias (Distressed Debt Investing)

[learn more]

Anchoring Bias

Investor tendency to

attach or anchor our

thoughts to a reference point

[basing decisions on irrelevant figures and statistics]

Anchoring Bias

• The Psychology Behind Common Investor Mistakes (The Big Picture)• Anchoring (Jonah Lehrer)• The Cognitive Bias Song (Freakonomics)• Surprised Again? The Anchoring Bias of Investors (Psychology Today)

[learn more]

Overconfidence

We tend to think we are

better investors than we really

[overconfidence leads to over trading, lower returns]

Overconfidence

• Boys will be Boys: Gender, Overconfidence, and Common Stock Investment (Barber, Odean) [.pdf]• Overconfidence and Over Optimism (Psy-Fi Blog)• Evolution of Overconfidence (Farnam Street)• U.S. Investor Behavior: The Government Report (Portfolioist)• T2 Partners’s Netflix Mea Culpa: A Study in Behavioral Finance (Stone Street Advisors)

[learn more]

Hindsight BiasTendency for investors to

look at the past and see events

more predictable than

they actually were

[dang, my judgment is good!]

Hindsight Bias

• Hindsight’s not so wonderful (Psy-Fi Blog)• Cognitive Biases: A Visual Study Guide (Scribd)• Heuristics: The Foundation of Adaptive Behavior (Decision Science News)• Blink and statistics: a close reading (Numbers Rule Your World)• Confirmation Bias, Again (Random Roger)

[learn more]

Loss Aversion

Investors feel pain of loss 2x

as much as they derive pleasure from an equal

[I’ll take door #3, Chuck]

Loss Aversion

• Loss Aversion (Jonah Lehrer)• Loss Aversion (The Economist)• Can Losing Lead to Winning (Farnam Street)• The behavioral economics of Pay-as-you-Drive (PAYD) auto insurance (Nudge)• Regrets? I’ve had a few (Tim Harford)

[learn more]

Paralysis by Analysis

Investors facing too many

decisions freeze up and make bad decisions

[Eesh, information overload!]

Paralysis by Analysis

• Choice Proliferation, Simplicity Seeking and Asset Allocation (Iyengar, Kamenica)• Decisions, Decisions: Too Much Choice Hard for Investors (AdvisorOne)• When Choice is Demotivating: Can One Desire Too Much of a Good Thing (Iyengar, Lepper)• So many funds, so little time: The case for simplicity (Reuters Money)

[learn more]

Mental AccountingDividing current

and future assets into

separate mental accounts,

investors assign different values

to each

[well, I bought the ticket anyway...]

Mental Accounting

• The Curse of Mental Accounting (Wired)• The Psychology of Money: The Last Mile of Saving (I Will Teach You to Be Rich)• Mental Accounting Explains Why You Buy Things You Don’t Need (Forbes)• Mental Accounting (Washington Post)• The benefits of mental accounting (Marketplace)

[learn more]

Social Proof Bias

Investors ascribe a high

value to investments

other investors are interested

[gee, if Bob invested in it...]

Social Proof Bias

• Avoid Losses: 5 Ways Investment Researchers Lie to You (FinancialMentor)• How Social Proof Helps Smart Investors (Zero Hedge)• Is social proof a rational approach to investment selection (Quora)• Asch Conformity Experiment (Simply Psychology)• How I lost 89% on 1 stock (Fool)

[learn more]

Regret Aversion Bias

We regret and remorse more for actions we did take than

ones we didn’t

[crud, I knew I shouldn’t have bought that stock!]

Regret Aversion Bias

• Regrettable Choices (Cabot)• Regret, Portfolio Choice, and Guarantees in Defined Contribution Schemes (Muermann, et al)• 2010 Behavior Study: Conservative Biases (Morningstar Advisor)• Is it OK to overpay (Nudge)

[learn more]

Status Quo Bias

Investors tend not to make

changes unless offered a really

compelling incentive

[you know, change is just so scary]

Status Quo Bias

• Status Quo Bias in Decision Making (Samuelson and Zeckhauser)• Status Quo Bias (Slideshare)• Barry Schwartz on the paradox of choice (TED Talks)• Our Own Worst Investing Enemies: How We Make Retirement More Difficult (Wise Investing)

[learn more]

Vividness BiasUnderestimate low probability

events that haven’t

happened recently and overestimate

them when they have --Buffett

[that couldn’t happen to me]

Vividness Bias

• Making the future easier to imagine can improve retirement outcomes (Allianz)• The Vividness of your Future Self: Using Immersive Virtual Reality to Increase Retirement Saving (Stanford Graduate School of Business)

[learn more]

The Effects of our Biases

Endowment Effect

Investors place a higher value on investments

they already own

[investors have a hard time selling]

Endowment Effect

• It’s mine, I tell you (The Economist)• The Endowment Effect (Jonah Lehrer)• Why it’s so hard to let go (MarketPsych)• Why do people hold on to losing stocks (Nudge)

[learn more]

Mean Reversion Effect

Belief that investments will return to their

[aw, it’s gotta come back!]

Mean Reversion Effect

• Mean Reversion in Stock Prices: Evidence and Theory (Summers and Poterba)• Shrinking margins make stocks’ cheapness just a mirage (Forbes)• 4 Mean Mean Reversions (Pragmatic Capitalism)• Mean Reversion Redux (Quantivity)

[learn more]

Overtrading

Trying to profit by excessive buying and

selling

[but, I’ve got the magic touch]

Overtrading

• Just How Much Do Investors Lose From Trading (Barber, Lee, Liu)• Annual Dalbar Individual Investor Study (Dalbar)• When to Buy or Sell? Don’t Trust Your Instincts (New York Times)

[learn more]

Do nothing

When overwhelmed, some investors just shut down

[thanks for the advice, but I’ll just keep things as is]

Do nothing

• Asset Allocation and Information Overload: The Influence of Information Display, Asset Choice and Investor Experience (Agnew and Szykman)• Situational overload and ambient overload (Rough Type)• Data Overload for Retail Investors (onwallstreet)

[learn more]

So much boils down to framing

Framing is part of our outlook, how we compare things to other things, how we judge our performance.

The way we naturally frame investing hurts us. It causes us to:

• take on more risk than we really should as we reach too far for gains• equate study and hard work with beating the market when it’s not that simple• put too much faith in experts or in stock picks• look at things as all or nothing when in reality, there is an infinite spectrum• take a very short term focus

Framing: It’s all relative

Reframing our thinking about investing

• Overcome the need to break even• If investing in individual stocks, set clear exit points and

plan for different scenarios (put this in writing)• There are always two sides of a trade: focus on the

person selling (or buying) you stock and ask yourself why

Batting 1.000: winning without losing

The investment game is no longer a buy-and-hold game. It’s a buy and sell game -- it’s called Day Trading. (Meir Statman, What

Investors Really Want, 57)

Investors have shown a reluctance to sell losers -- to their detriment. Dr Richard Peterson of MarketPsych calls this

“hitting the investment snooze button”.

[impossible!]

Wow, investors have a lot of biases

So, how do we *win* at the investing

The Goal

The first step is admitting you have a problem

But, it’s not just enough to recognize the problem

Need self awareness/

behavioral changes

The ability to consistently (always) make money based on an approach or a system

that can be executed with total confidence.

-- Robert Koppel (Investing and the Irrational Mind, 26)

Many different systems work

We don’t stick to the systems

“The real secret to investing is that there is no secret to investing.

Every important aspect of value investing has been made available to the public many times over, beginning in 1934

with the first edition of Security Analysis.

That so many people fail to follow this timeless and almost foolproof approach enables those who adopt it to

remain successful.”

-- Baupost’s Seth Klarman, 6th edition of Security Analysis (2008)

Emotional Investing

Cognitive Investing

Make the shift

Overcoming the animal spirits

In an experiment at CalTech, participants

ranked the most expensive wine the tastiest

(only when they were told of the real price)

investors must learn how to

• determine what kind of investor you are• set realistic and achievable investment goals• learn how to be disciplined and patient• manage risk effectively• learn from mistakes• preserve investment and emotional capital

(Investing and the Irrational Mind, 50)

Your optimal investing strategy depends on who you

-- Dr Richard Peterson, MarketPsych: How to Manage Fear and Build your Investor

Identity, 27

[big idea]

Figure out who you are as an investor

Change/Reframe

if necessary

• Are you money-focused or life-focused?• Market orientation vs. self-orientation?• Sporadic vs. Consistent Investing Frames

MarketPsych

Emotional needs Financial needs

Investments offer 3 types of benefits

1. utilitarian2. expressive3. emotional

tradeoffs

To reframe

Dr Peterson of MarketPsych recommends creating a slide show in 5 steps

1. identify topics about future financial life2. make it vivid3. capture the feeling4. record it5. match financial plan

Learning from the greatest investors

Emotional Intelligence (EI)

Superior Investment Performance

[new evidence]

Sources:Emotional intelligence and investor behavior (Ameriks, et al, 2007) [.pdf]Exploring the Nature of “Trader Intuition” (Bruguier, et al, 2010) [.pdf]

Measure your own personality

1. Emotional sensitivity2. Extraversion3. Openness4. Agreeableness5. Conscientiousness

The Big 5

Go to:http://www.marketpsych.com/personality_test.php

Test your own investor personality

Personality test My score How it affects my investing

My plans to accomodate

Conscientiousness vs impulsiveness

Emotional stability vs. sensitivity

Extraversion vs. introversion

Agreeableness vs. self-interest

Openness vs traditionalism

Sample Personality Test from MarketPsych

Traits of the great investors

They remained upbeat after a series of losses, staying

calm, focused, and analytical throughout the ups and downs of the market

Not emotionless, but utilize “good” emotions and avoid “bad”

confident, self-aware, goal oriented, organized

Good investors are

1. don’t speculate unless you do it full time2. resist so-called information or tips3. before purchasing a security, know everything you can about

the company: its earnings and its capacity for growth4. never attempt to buy at a bottom or sell at a top of a

market: this is a feat achieved only by liars5. take your losses swiftly and clearly -- the first loss is your

easiest6. don’t buy too many securities. focus on a few

investments that can be monitored carefully.7. periodically reappraise all your investments to make

sure that they are appropriate for your particular strategy8. know when you can sell to your greatest advantage (of

course, this also applies to buying)9. never invest all your funds. keep some liquid.10.Don’t try to be a jack of all investments. stick to the field

you know best.

Bernard Baruch’s 10 Rules for Investing Success

Investing and the Irrational Mind, 17

The Game: Redefining what investing is all about

The game is composed of two parts: the outer game and the inner game.

The Inner Game of Tennis by Timothy Gallwey, captain of the Harvard University Tennis Team

Tennis vs. Investing

“The former is played against opponents, and is filled with

contradictory advice.

The latter is played not against, but within the mind of the player, and its

principal obstacles are self-doubt and anxiety.”

Putting theory to practice

• not defining a loss• not taking a loss/profit• getting locked into a belief• getting lured into status investments• revenge investing• wishful thinking• getting swept up in bubbles• not seizing an opportunity• being more invested in being right than making money• confusing the noise with the signal• not applying investment method consistently • not having a money management plan• not investing in the right state of mind

How investors lose to psychology

Becoming a better investor

[define a loss]

Rational investors follow the maxim “Cut your losses and let your profits run”

(What Investors Really Want, 134)

understand mental accounting clear hindsight bias

vanquish pride avoid regret

don’t try to get-even/revenge realize losses

[homework]

[define a loss]For portfolio

buy individual, fixed maturity bonds including zero-coupons: bought at a discount, avoid mental accounting errors because investors should

get back all invested capital at maturity date

holders of bond mutual funds never assured that they will not incur a loss when the

sell(What Investors Really Want, 145)

[avoid traps in status displays]

conquer the usual suspects

• envy• schadenfreude (happiness at the

misfortune of others)• stay clear of status competitions• be skeptical investments sold on

exclusivity/access

Average millionaire spends $31k on a car

[know when to hold ‘em]

Thomas Stanley, Stop Acting Rich

[be wary of crowded trades]

“I will tell you how to become rich. Close the doors. Be fearful

when others are greedy. Be greedy when others are fearful.”

-- Warren Buffett

[be wary of crowded trades]

• use good judgment of information

• assess consequences of being wrong about the herd

[have a money management plan]

• Truly understand tradeoffs of actively managed funds vs. passive index funds

• scrutinize and pay fair fees for advice (regardless of active/passive)• sometimes advice pays because it helps avoid bigger

problems• piggyback others’ ideas, stock picks carefully (great

investors make mistakes)• social investing injects more voices into the discussion

• Tradestreaming.com

• FarnamStreetBlog.com

• Psy-Fi Blog

• What Investors Really Want (Statman)

• Investing and the Irrational Mind (Koppel)

• MarketPsych: How to Manage Fear and Build your Investor Identity (Peterson)

• Tradestream your Way to Profits: Building a Killer Portfolio in the Age of Social Media (Miller)

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