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April 18 - May 25, 2020
Over the last 20 years, the S&P 500 has generated just over 8 percent on average each year.
However, equity fund investors have managed to reduce this to a paltry 1.9 percent per annum.
“Many were increasingly of the opinion that they ’d all made a big mistake in coming down from the trees in the first place. And some said that even the trees had been a bad move, and that no one should ever have left the oceans.”
For the Trekkies out there, these two systems can, perhaps, be characterised as Dr. McCoy and Mr. Spock. McCoy was irrepressibly human, forever allowing his emotions to rule the day. In contrast, Spock (half human, half Vulcan) was determined to suppress his emotions, letting logic drive his decisions.
The McCoy part of our brains, which we will call the X-system, is essentially the emotional approach to decision making. The X-system is actually the default option, so all information goes first to the X-system for processing. It is automatic and effortless. The judgments made by the X-system are generally based on aspects such as similarity, familiarity, and proximity (in time).
The Spock part of our brains, which we will call the C-system, is a more logical way of processing information. It requires a deliberate effort to actually engage this system. It attempts to follow a deductive, logical approach to problem solving. However, it can only handle one step at a time (like any logical process), so it is a slow and serial way of dealing with information.
In fact, very often we end up trusting our initial emotional reaction, and only occasionally do we recruit the C-system to review the decision.
From a survival point of view, a false positive is a better response than a false negative. Emotion is designed to trump logic.
we can test how easy it is to override the X-system. Shane Frederick of Yale (formerly of MIT) has designed a simple three-question test which is more powerful than any IQ test or SAT score at measuring the ability of the C-system to check the output of the X-system.
1. A bat and a ball together cost $1.10 in total. The bat costs a dollar more than the ball. How much does the ball cost? 2. If it takes five minutes for five machines to make five widgets, how long would it take 100 machines to make 100 widgets? 3. In a lake there is a patch of lily pads. Every day the patch doubles in size. If it takes 48 days for the patch to cover the entire lake, how long will it take to cover half the lake?
I’ve found that the number of Frederick’s questions that you get correct correlates with your general vulnerability to a whole plethora of other behavioral biases, such as loss aversion, conservatism, and impatience.
the following conditions which increase the likelihood of X-system thinking: • When the problem is ill structured and complex. • When information is incomplete, ambiguous, and changing. • When the goals are ill defined, shifting, or competing. • When the stress is high, because either time constraints and/or high stakes are involved. • When decisions rely upon an interaction with others.
When asked in the cold light of day how we will behave in the future, we turn out to be very bad at imagining how we will act in the heat of the moment. This inability to predict our own future behavior under emotional strain is called an empathy gap.
psychologists have found7 that imposed deadlines are the most effective.
This experiment provides a possible weapon to place in our arsenal against the behavioral pitfall of empathy gaps and procrastination—pre-commitment.
we should do our investment research when we are in a cold, rational state—and when nothing much is happening in the markets—and then pre-commit to following our own analysis and prepared action steps.
“The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell. ”
The group who couldn’t feel fear displayed their real edge after rounds in which they had lost money.
The evidence above suggests that fear causes people to ignore bargains when they are available in the market, especially if they have previously suffered a loss. The longer they find themselves in this position, the worse their decision- making appears to become.
To put it another way, those who use their quick and dirty thinking systems (X-system thinking) will run out of self-control faster than those who are more inclined to use their logical thinking systems (C-system thinking).
The “battle plan for reinvestment” is a schedule of pre -commitments that acknowledges both the empathy gap we will likely encounter and also helps remove the fear- induced terminal paralysis that we are likely to be suffering.
We have often described our techniques for accomplishing this: willingness to hold cash in the absence of compelling investment opportunity, a strong sell discipline, significant hedging activity, and avoidance of recourse leverage, among others.”
the illusion of control seems most likely to occur when lots of choices are available; when you have early success at the task (as per the coin tossing); the task you are undertaking is familiar to you; the amount of information is high; and you have a personal involvement.
Optimism seems to be the default state and embedded within the X-system of processing information. We already know that the X-system is more likely to be used when a person feels pressured by time.
When imagining positive future events (relative to negative ones) two key areas of the brain showed increased activation: the rostral anterior cingulated cortex and the amygdala. Both of these areas are associated with emotional processing and are generally held to be neural correlates of the X-system.
spandrels, to borrow Stephen Jay Gould ’s expression for the by-products of evolution).
Lionel Tiger
when we are injured, our bodies release endorphins. Endorphins generally have two properties; they have an analgesic property (to reduce pain) and they produce feelings of euphoria. Tiger suggests that it was biologically adaptive for our ancestors to experience positive emotions instead of negative emotions when they were injured because it would reinforce their tendency to hunt in the future.
So optimism may well be a great life strategy. However, hope isn’t a good investment strategy.
Psychologists have often documented a “self-serving bias ” whereby people are prone to act in ways that are supportive of their own interests.
The auditors who were told they were working for the company were 31 percent more likely to accept the various dubious accounting moves than those who were told they worked for the outside investor.
stockbroker research generally conforms to three self -serving principles: Rule 1: All news is good news (if the news is bad, it can always get better). Rule 2: Everything is always cheap (even if you have to make up new valuation methodologies). Rule 3: Assertion trumps evidence (never let the facts get in the way of a good story).
We should get used to asking “Must I believe this?” rather than the far more common “Can I believe this?”
Many of these investors generally run concentrated portfolios, with the default question being “Why should I own this investment?”
one group of people actually see the world the way it really is—the clinically depressed! They have no illusions about their own abilities. It is this realistic viewpoint that tends to lead them to depression.
either be depressed and see the world the way it is or be happy and deluded.
experts are generally even more overconfident than the rest of us.
people prefer those who sound confident and are even willing to pay more for confident (but inaccurate) advisors.
good sense was significantly outweighed by the bias towards confidence. As long as you were wrong but sounded extremely confident, even a poor track record was excused. Such is the power of confidence.
our brain actually switches off some of our natural defenses when we are told someone is an expert.
Expert advice attenuated activity in areas of the brain that correlate with valuation and probability weighting. In other words, the experts’ advice made the brain switch off some processes required for financial decision making.
By virtue of being an expert we endow them as authorities in their fields, and unfortunately we tend to blindly follow authority.
stock markets shouldn’t even really exist in the most extreme form of efficient market theory. Why? If the price is right (as it must be under efficient markets), then why would anyone want to trade, so volumes should be zero.
As soon as you add overconfidence into one of these models, volumes and turnover explode because everyone thinks they know more than everyone else, and hence they trade more.
Women had markedly lower annual turnover rates, 53 percent, compared to men ’s 77 percent. Women ended up with higher net returns than men.
Those men who needed their wives ’ permission to trade outperformed the single guys. Unfortunately, those women who needed their husband’s permission to trade underperformed the single women. So not only are men bad traders, they are a bad influence as well.
I play this game to try to illustrate how hard it is to be just one step ahead of everyone else, to get in before everyone else, and to get out before everyone else.
The good news is that we don’t need to outsmart everyone else. We need to stick to our investment discipline, ignore the actions of others, and stop listening to the so-called experts.
AS THE SIXTH-CENTURY BC POET and philosopher Lao Tzu observed, “Those who have knowledge don’t predict. Those who predict don’t have knowledge.”
This whole enterprise of trying to be a financial soothsayer seems largely doomed to failure because of the behavior pitfall from the previous chapter—overconfidence.
