Thursday, December 01, 2011

How’s Your Financial Behavior? – Redux

There are occasions when most people think they are smarter than they actually are. For example, here is a straightforward arithmetic question: A bat and ball cost $1.10. The bat costs $1 more than the ball. How much does the ball cost?" Quick! What’s the answer?

The obvious answer is that the ball costs 10 cents. However, if that’s the solution you came up with, it’s wrong. Think about it––if the ball costs 10 cents then the bat, at a dollar more would cost $1.10, and that adds up to $1.20, not to the $1.10 limit. (The correct answer is that the ball cost five cents and the bat cost $1.05.) If you did answer incorrectly don’t feel too badly. More than 50% of Princeton, Harvard, and even MIT students also came up with the wrong answer.

Thinking, Fast and Slow

That is just one small sample used in a new book by Daniel Kahneman, a Nobel Laureate and professor of psychology at Princeton, that illustrates the mysterious workings of the human mind. The title of the book, Thinking, Fast and Slow, also hints at the reason that so many give incorrect answers to the question.

The book, published the beginning of October, has received a great deal of publicity, (see below) as has the Professor. There are some who consider Kahneman the most influential living psychologist. In 2011, he made the Bloomberg 50 most influential people in global finance. Although the influence that psychology has on the decision making process can be dated back to the 1700’s, and through a series of economists into the modern era, Professor Kahneman has often been cited as the creator of the field of Behavioral Finance. Kahneman’s new book explores a new segment within that branch of knowledge. However, before we examine the book, the relationship of Behavioral Finance to investing should be reexamined.

As a result, it’s instructive to note that some of you may have read an article I wrote about Professor Kahneman in the April 2003 issue of Viewpointe. That article, under the headline “How’s Your Financial Behavior?,” provided insights into, and an account of the professor’s work. Despite the eight and a half-year time lapse, the facts are still valid today. Portions of that article, quoted below (in italics), explain how his research led to his designation as a Nobel Laureate.

Particularly impressive, as well as distinctly anomalous is the fact that he is a psychologist not an economist. He was however, awarded the 2002 Nobel Memorial Prize in Economic Sciences for his groundbreaking work in applying psychological insights to economic theory, particularly in the areas of judgment and decision-making under uncertainty. What follows, in quotes, is the article.

Here Comes the Redux

“Kahneman and his long time collaborator, Amos Twersky of Stanford who died in 1996 (Nobel Prizes are not awarded to those deceased), developed a new discipline now called ‘Behavioral Finance.’ Both men were originally Israeli psychologists who, with several other academics, developed psychological insights based on empirical observations, testing and measuring results that when integrated into economics and investor actions contradicted the long held EMT [Efficient Market Theory], views that have become so pervasive.

Kahneman’s (and Twersky’s) most famous work was their 1979 paper on “prospect theory,” now one of the most widely cited in economic theory. It determined that individuals are much more disturbed by prospective losses than they are pleased by equivalent gains. This has even been quantified whereby it is estimated that a loss of one dollar is twice as painful as the pleasure received from a one-dollar gain. In addition, people will take more risk to avoid losses than to realize gains.

Another behavioralist finding explains why so many investors are unwilling to sell their losers. They don’t want to admit (even to themselves) that they made an error in judgment—this behavior is termed “fear of regret.”

Additionally, frequent emotional reaction is that triggered by recent experiences and trends that are extrapolated despite being contradicted by long-run averages and statistical odds. For example, investors become overly optimistic about the future when the market goes up (think the latter part of the 1990’s), and unduly pessimistic when the market goes down (like now). During these periods, it is likely that the opposite will occur.

Overconfidence is another behavioral trait exhibited by investors, analysts, and advisors. It can be proven that people consistently overestimate their abilities, not only in things financial but also in even more mundane enterprises such as athletic skills, leadership abilities, and personal relationships. This trait reinforces their decision making process wherein they may deride others, believing their information to be superior and their own choices as more rational. This causes excessive trading, yet most forget that in every trade, each participant probably believes their information is more relevant, still, both can’t be right.

In a recent interview, Kahneman discussed the obstacles of trying to beat the stock market. Here are his responses to the question ‘What general advice can you offer to investors, given their shortsightedness and lack of complete information about the stock market?’ Kahneman replied, ’It’s clear from the research of individual investors, the main mistake people make is they churn their accounts too much. They just do too much. And so, the advice to be diversified and not do too much is standard advice that people do not spontaneously follow. But not taking that advice is costly. And how costly has been demonstrated in recent years…and Internet trading has clearly made things worse in the sense of giving people the ability to do more without making them necessarily smarter about what they are doing.’ To the question, ‘So investors shouldn’t delude themselves about beating the market?’ Kahneman responds, ‘They’re just not going to do it. It’s not going to happen.’ “

Thus, in the final analysis, the advice provided to investors by the behavioralists is not that much different from that offered by the Efficient Market Theorists. Hello, index funds—once again!”

As described in the Viewpoointe article above, Kahneman’s assertion that an investor’s innate (often irrational) behavior dramatically influences his decision making process has been widely accepted. In his new book, he elaborates on additional psychological factors that have influential effects, not only for investors but for what occurs in every day life.

In discussing his book, he explains, “The distinction between fast and slow thinking has been explored by many psychologists over the last twenty-five years. I describe mental life by the metaphor of two agents, called System 1 and System 2, which respectively produce fast and slow thinking. I speak of the features of intuitive and deliberate thought as if they were traits and dispositions of two characters in your mind. In the picture that emerges from recent research, the intuitive System 1 [fast thinking] is more influential than your experience tells you, and it is the secret author of many of the choices and judgments you make.”

System 1 provides our ability to automatically, intuitively, and instantly recognizes patterns, enabling us to make fast decisions––sometimes too fast since it could ignore logic and statistical evaluations. System 2 is slow, deliberate, allowing more time for conscious consideration.

As an example of System 1 thinking he describes a visit to a chief investment officer who bragged about a $10 million investment he had recently made in Ford stock. He had seen the new line of Ford cars at an auto show, loved what he saw, and said, “Boy, Ford really knows how to make cars.”

Kahneman comments, “I found it remarkable that he had apparently not considered the one question that an economist would call relevant: Is Ford stock currently underpriced? Instead, he had listened to his intuition; he liked the cars, he liked the company, and he liked the idea of owning its stock. From what we know about the accuracy of stock picking, it is reasonable to believe that he did not know what he was doing.”

In examining System 2, Kahneman puzzles “Why is it so difficult for us to think statistically? We easily think associatively, we think metaphorically, we think causally, but statistics requires thinking about many things at once, which is something that System 1 is not designed to do.”

He then postulates that “The difficulties of statistical thinking contribute to a puzzling limitation of our mind: our excessive confidence in what we believe we know, and our apparent inability to acknowledge the full extent of our ignorance and the uncertainty of the world we live in. We are prone to overestimate how much we understand about the world and to underestimate the role of chance in events. Overconfidence is fed by the illusory certainty of hindsight.”

In reviewing the book, the Wall street Journal cites Kahneman’s example of the “overconfidence bias” as follows: “The best demonstration of the bias comes from the world of investing. Although many fund managers charge high fees to oversee stock portfolios, they routinely fail a basic test of skill: persistent achievement. As Mr. Kahneman notes, the year-to-year correlation between the performance of the vast majority of funds is barely above zero, which suggests that most successful managers are banking on luck, not talent.”

The Journal then asserts, “This shouldn't be too surprising. The stock market is a case study in randomness, a system so complex that it's impossible to predict. Nevertheless, professional investors routinely believe that they can see what others can't. The end result is that they make far too many trades, with costly consequences.”

Kahneman does not criticize the System 1 concept or its usage. He condemns the practice of jumping to System 1 conclusions without recognizing that this might be a problem that requires a “slow thinking” evaluation (as does the arithmetic question cited earlier). The book has received unanimous approvals from reviewers.

It might not have been coincidence that the very last sentence of the 2003 article in Viepointe read as follows: It all boils down to a quote from Albert Einstein: ‘Only two things are infinite, the universe and human stupidity, and I’m not sure about the former.’ ”

This is an addendum to the above article based on the fact that the day before the deadline for this article was due, a review of Kahneman’s new book appeared in the Sunday New York Times Book Review section. This was a full two-page article, unusual for a book review, a fact connoting that this book was considered to be particularly important.

Indicative of this assumption is the reviewer’s final exhortation. He writes “I overconfidently urge everyone to buy and read it.” Then in a reference to a book titled Blink that encourages decision-making based on intuition and instinct rather than reason, he says, “ If you’ve had 10,000 hours of training in a predictable, rapid-feedback environment –– chess, firefighting, anesthesiology –– then blink. In all other cases think.

But here’s the real kicker –– for me anyway. On the very next page of the Book section, the first sentence of a different review states, “No man but a blockhead ever wrote except for money’, Samuel Johnson declared.” Big bucks is not a hallmark event for Viewpointe writers since no bucks is the norm. So do I apply System 1 or System 2 to this admontion? I’ll have to think about it.


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