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Inside the Mind of Wall Street Investors

Developing Investment Confidence

5th Annual Economic & Financial Development ConferenceThe Road to Recovery: Caribbean’s Economic Development &

Pension Funds

Biltmore HotelMiami, Florida - USA

July 14, 2010

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Management 310

Let’s Make a Deal

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The Monty Hall ProblemSuppose you're on a game show, and you're given the choice of three doors: Behind one door is a car; behind the others, goats.

Source: Craig F. Whitaker, Ask Marilyn, Parade Magazine

You pick a door, say No. 1, and the host, who knows what's behind the doors, opens another door, say No. 3, which has a goat. He then says to you, "Do you want to pick door No. 2?" Is it to your advantage to switch your choice?

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The Monty Hall Problem

What are the odds of winning if you switch your choice after being shown a door with a goat?

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Behavioral Finance…

• Explores how people make decisions about money

• Highlights common “decision traps”

• Provides insights for making better decisions

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Monty Hall -- Monte Carlo

Monty Hall: mix cards and place face down

Contestant: point to a card

Monty Hall: turn over a black card

Contestant: switch choice; turn over card

Test strategy:

always switch

goat goat car

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The Monty Hall Problem

Now what do you think the odds are of winning if you switch?

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Solving Monty Hall with Logic

Pick

show

switch to

Goat 1

Goat 2

Pick

Goat 2

Pick

show

show

show

Goat 1 switch

toGoat 1

Goat 2

switch to

switch to

Win

Win

Lose

Goat 2

Goat 1

-or-

3 possible initial choices

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The Monty Hall Solution

Pick either of the 2 goats initially then switch and you WIN.

Pick the car initially then switch and you LOSE.

The odds are of winning if you switch?

2 out of 3

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Insight #1: Intuition Often FailsMaking financial decisions based on intuition or “gut” feel often fails.

For decisions that can be aided by analysis, DO THE ANALYSIS!

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Intuition vs Analysis11/30/2000 Money Market Fund yield = 6.36% 2 Yr Treasury Note yield = 5.88%Intuition suggests:

Analysis reveals:

No brainer; “no risk” MMF has higher yield

MMF wins unless rates go down ≈ 0.55%MMF has reinvestment risk

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Opportunities for AnalysisEvaluating investment strategies under different interest rate scenarios.Evaluating use of compensating balances versus hard dollar fee.

Evaluating fixed versus floating rate debt.Your example:

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Test of Overconfidence

1. Joan of Arc’s age at death

Low High

(90% Confidence)

Range

2. Length of Great Wall of China (in miles)3. Number of territories in Africa

19

4,160

61

4. Height of Mt. Everest (in feet)

29,028

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Test of Overconfidence

5. Year in which Leonardo da Vinci was born

Low High

(90% Confidence)

Range

6. Circumference of the Earth at the equator (in miles)7. Weight of a large blue whale (in pounds)

1452

24,902

400,000

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Test of Overconfidence

8. Odds of winning Mega Millions lottery jackpot (1 in ???).

Low High

(90% Confidence)

Range

9. Population of Ohio

10. Number of cover versions of “Yesterday” by The Beatles

1 in 175,711,536

11,353,140

3,000

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Insight #2: We are Overconfident

If you are accurate in assessing with 90% confidence, you should miss 1 out of 10.Studies show people are routinely overconfident…

…especially in areas where they have expertise.

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What the experts say

Heavier-than-air flying machines are impossible.Lord Kelvin—President of the British Royal Society, c. 1895.

A severe depression like that of 1920-21 is outside the range of probability.Harvard Economic Society—Weekly Letter November 16, 1929They couldn’t hit an elephant at this dist___General John B. Sedwick—Union Army Civil War officer’s last words, uttered during the battle of Spotsylvania, 1864.

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Challenge of Economic Forecasts“The only role of stock forecasters is to make fortune-tellers look good.”Warren Buffett, Berkshire Hathaway annual report

“Put five economists in a room and you’ll get six different opinions.”John Maynard Keynes, economist

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Forecasting Interest RatesBond market experts and economists make predictions about interest rates.The risk of these “single point” forecasts is the unreasonable confidence…...ascribed to predicting something that is very hard to predict.

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A More Intelligent ApproachInterest rate prognosticators are wrong more often than they are right.A more intelligent approach would be to evaluate portfolio strategies under both rising and falling interest rate scenarios.

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You’re the Expert

3 Mo. T-Bill Yield: 11/30/07 = 3.15%

Your estimate of T-Bill yield 12 months from now (with 90% confidence)

Low High

Statistical estimate (with 90% confidence; 1.64 std. dev.)

1.67%

4.63%

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Consequences of Overconfidence

Failure to consider reasonable possibilities.Ignore risks that you don’t see.

Have you ever been overconfident? Write an example:

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Cure for Overconfidence

Recognize that we are all susceptible to overconfidence.

Develop a disciplined process for making decisions.

Per Dr. Van Tharp, the most important determinant in investment success is not strategy or style, but rather articulating and following a disciplined process.

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Solving the Right Problem

Analyzing a problem instead of relying on intuition…

…will not help if you tackle the wrong problem.

…and guarding against overconfidence…

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How We See Things

This glass is half

How we phrase an issue affects how we address it.

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Solving the Right Problem

“Hardly ever do we spontaneously alter the formulation of a problem that is presented to us in a reasonably clear and complete way.”--Massimo Piattelli-Palmarini, MITIn behavioral finance, this is called the “framing effect.”

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Insight #3: We Plunge InPeople tend to gather information and reach conclusions without first thinking about the crux of the issue.

Plunging in on the wrong problem can be very costly in time and money.

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E = mc2

Einstein succeeded where his contemporaries failed because he solved a different problem.Instead of asking, “How can nature appear to act that way when we know that it can’t?”

He asked, “What would nature be like if it did act the way we observe it to act?”

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The Investment Problem

One approach is:How can we maximize yield?

Write an alternate question:

How can we maximize return?

How does the rephrasing of the question affect the solution?

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Framing: Yardsticks

Situation A:

You are in a store about to buy a watch that costs $70. A friend tells you an identical watch is available in another store two blocks away for $40. Will you travel two blocks to save $30?

Yes No

Source: Thaler

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Framing: Yardsticks

Situation B:

You are in a store about to buy a video camera that costs $800. A friend tells you an identical camera is available in another store two blocks away for $770. Will you travel two blocks to save $30?

Yes No

Source: Thaler

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Framing: Yardsticks

In Studies:

Sit. A: 90% of people will travel 2 blocks.Sit. B: 50% of people will travel 2 blocks.

Source: Thaler

People think about savings in percentages, not absolute dollars.

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Investment Yardsticks

List two yardsticks for measuring investment performance.

Source: Thaler

How does the choice of the yardstick affect your decisions?

1.

2.

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How to Solve the Right ProblemGiven the consequences of tackling the wrong problem, it is critical that you tackle the right one.

Source: Thaler

Recognize the tendency to jump in and solve any reasonably posed problem.Ask yourself—and everyone involved—have we framed the right problem?

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Get Whacked

Utilize tools that assist you in viewing issues in more than one way.

Source: von Oech

Roger von Oech – Creative WhackPack“It’s easy to come up with new ideas, the hard part is letting go of what worked for you two years ago, but will soon be out-of-date.”Roger Von Oech“It’s important for the explorer to be willing to be led astray.”Roger Von Oech

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Get Whacked

Challenge the Rules

Source: von Oech

19. According to ancient prophesy, whoever could untie the “Gordian Knot” was destined to become King of Asia.All who tried failed to solve this complicated puzzle. Then Alexander the Great had a turn.

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Get Whacked

Challenge the Rules

Source: von Oech

After fruitless attempts to find a starting point, he was stymied. Finally, he said, “I’ll just have to make up my own knot-untying rules.” He pulled out his sword and sliced the knot in half. Asia was fated to him.

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Get Whacked

Challenge the Rules

Source: von Oech

Most advances have occurred when someone challenged the rules and tried a different approach.

What rules can you challenge?

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Get Whacked

Additional WhackPack Questions:

Source: von Oech

What different ideas can you combine?

What are you dissatisfied about? How can you turn irritation into inspiration?

What’s your blind spot? Where does ego adversely affect your performance?

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Summary: 4 Key Insights

1. Spend time to properly frame the issue.

3. Be careful of relying on intuition. If a problem is subject to analysis, do the analysis.

2. Guard against overconfidence.

4. “It’s easy to come up with new ideas, the hard part is letting go of what worked for you two years ago, but will soon be out-of-date.”

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Questions

Contact Information

Orvell Johns

orvelljohns@hotmail.com