Insanity Rules

A year from now a voice that has been entertaining radio listeners for four decades will be gone from the airwaves. Garrison Keillor, creator and longtime host of the popular A Prairie Home Companion radio show, announced he's retiring next September. Four million listeners nationwide on nearly 700 public radio stations each week hear the show. Listeners will no longer be privy to the folksy comedy sketches about the idiosyncratic characters living in his fictitious Minnesota town of Lake Woebegon, but it will be difficult to forget his closing remarks at each show describing those inhabitants of that apocryphal municipality “where all the women are strong, all the men are good-looking, and all the children are above average.”

While Keillor is obviously mocking the immaculate perception of his metaphysical hometown’s citizens, he has also penetrated the misconceptions of basic human nature. How is it possible for all the adults in a town to be strong, and good looking and all the children above average? If we use IQ scoring to evaluate Keillor’s remark about the children, the average person has an IQ score of 84-115. A score below that indicates below average. If you believe (or know) you score up to 130, you are above average. Achieving an even higher score, up to 145, is indicative of a gifted individual. If you are indeed above that level... hello genius. (Albert Einstein had an IQ of 160).

IQ Quiz

So what are the possibilities of possessing an above average IQ? Although surveys differ slightly, generally, 68% of the population scores within the average range; 14% score as either below average or above average; and only 2% are either challenged or gifted. The probability of falling into the genius level is 0.13. Considering those odds, unless you know for a fact that you do score in the above average category, there is only a remote 16% probability of actually being considered above average.

The Above Average Syndrome

Despite these odds, numerous studies confirm that there is a distinct propensity for people to believe they are above average, not only in intelligence, but also in many other aspects of life. In psychological terms, this predilection is known as “superior bias,” or “superior illusion.” Not so coincidentally, it has also been dubbed the “Lake Wobegon” effect. (That’s also an indication of the widespread influence of Garrison Keillor’s play on words). It’s not that only uneducated or ill informed people are guilty of displaying this affliction. In studies, most people overestimate their IQ. For instance, in a classic 1977 study, 94 percent of professors rated themselves above average relative to their peers. In another study, 32 percent of the employees of a software company said they performed better than 19 out of 20 of their colleagues.

A number of studies, some going back over 35 years (that are still cited today) provide empirical evidence clearly indicating that individuals consider themselves “above average” in just about every human endeavor including driving ability, a sense of humor, managerial risk taking, intelligence, expected longevity, and investing. Unfortunately, the evidence does not conform to this attitude of human overconfidence, including when it relates to investing.

Unfortunately, the “superior bias” syndrome is just one of many biases that dramatically disadvantage investors in their effort to achieve financial goals. Recognition of these biases led to the discovery of a new economic theory, that of Behavioral Finance. Although The Efficient Market Hypothesis is considered one of the foundations of modern financial theory, that proposition does not account for investor irrationality because it assumes that the market price of a security reflects the impact of all relevant information as it is released.

Memories, Memories

Few investors remember that the theory of “Behavioral Finance” began some 50 years ago and has developed into a full-blown discipline, receiving considerable attention, not only from academia but from the more pragmatic Wall Street practitioners as well. I’m certain that few, if any, readers remember that this subject of Behavioral Finance appeared in the June 2000 issue of Viewpointe in which I also wrote this bit about memory: “When it comes to the market's peaks and troughs, investors often don't react as rationally as they might think. In fact, in times of extreme volatility or poor performance, emotions threaten to commandeer our common sense and warp our memory.”

I then wrote, “Of course, investors are not the only ones whose memories have failed trying to remember long ago study subjects. How many of us can remember the language courses we took, or the mathematical formulas we memorized so diligently? It is somewhat like the two couples conversing. Burt says to Fred, “I understand that you attended a memory clinic recently. Did you find it helpful?” Fred replies, “Absolutely. We were taught how to use mnemonic devices, careful observation, and relational concepts to reinforce our memory abilities.” “That’s very impressive,” Burt replies. “What’s the name of the clinic?” A blank expression comes over Fred and he stutters, “Uh, Oh…Wait a minute.” Suddenly he smiles knowingly and says, “Burt, what’s the name of that red flower with thorns and a long stem?” Burt answers, “Do you mean a rose?” “That’s it,” says Fred excitedly. He then turns to his wife and asks, “Rose, what was the name of that memory clinic?”

Most investors have both a knowledge and memory problem. They are generally not aware that in making investing and other financial decisions, unconsciously these decisions are affected by a whole slew of cognitive biases. In fact, Wikipedia list about 80 of them. In the 1960s psychologists such as Ward Edwards, Amos Tversky, and Daniel Kahneman began to compare their cognitive models of decision-making under risk and uncertainty to economic models of rational behavior. Their research developed into the field of Behavioral Finance, and the recognition that various biases had a dramatic affect on the decision making process.

In addition to the Superior Bias mentioned above, here is only a partial list of biases (selected from various websites) most closely related to the investment process. See if you recognize any that you have experienced. (The biases listed are universal, but the text comes from the website “Above the Market”)

• Optimism Bias:  This is related to Superior Bias. It means that investors are too optimistic in their belief they can make investment choices more accurately than other investors, and are overly positive about the extent to which their investments will perform.

• Loss Aversion:  Investors are highly loss averse. Empirical estimates find that losses are felt between two and two-and-a-half as strongly as gains. Thus the disutility of losing $100 is at least twice the utility of gaining $100. Loss aversion favors inaction over action and the status quo over any alternatives.

• Confirmation Bias:  We like to think that we carefully gather and evaluate facts and data before coming to a conclusion. But we don’t. Instead, we tend to suffer from confirmation bias and thus reach a conclusion first. Only thereafter do we gather facts and see those facts in such a way as to support our preconceived conclusions.

• Planning Fallacy:  In his terrific book, Thinking, Fast and Slow (reviewed in the December 2011 issue of Viewpointe), Nobel laureate Dan Kahneman outlines what he calls the “planning fallacy.” It’s a corollary to optimism bias and self-serving bias. Most of us overrate our own capacities and exaggerate our abilities to shape the future. The planning fallacy is our tendency to underestimate the time, costs, and risks of future actions and at the same time overestimate the benefits thereof. It’s at least partly why we underestimate bad results. It’s why we think it won’t take us as long to accomplish something as it does. It’s why projects tend to cost more than we expect. It’s why the results we achieve aren’t as good as we expect.

• Herding:  We all run in herds — large or small, bullish or bearish. Institutions herd even more than individuals in that investments chosen by one institution predict the investment choices of other institutions by a remarkable degree. Even hedge funds seem to buy and sell the same stocks, at the same time, and track each other’s investment strategies.

• Recency Bias:  We are all prone to recency bias, meaning that we tend to extrapolate recent events into the future indefinitely. As reported by Bespoke, Bloomberg surveys market strategists on a weekly basis and asks for their recommended portfolio weightings of stocks, bonds and cash. The peak recommended stock weighting came just after the peak of the internet bubble in early 2001 while the lowest recommended weighting came just after the lows of the financial crisis. That’s recency bias.

• Self-Serving Bias:  Our self-serving bias is related to confirmation bias and optimism bias. Self-serving bias pushes us to see the world such that the good stuff that happens is my doing (“we had a great week in the market), while the bad stuff is due to something or someone else’s fault (it’s due to China’s poor handling of its economy).

This list could go on for pages. In fact a website titled “Psy-Fi Blog” lists even more of them than Wikipedia, some 130 biases. Frankly, I suspect that going to a memory center like Fred did, in order to remember even the short list of biases above would prove to be just as fruitless (or is it flowerless) as it was to Fred.

The fact is that the imposition of one or more bias while processing an investment decision is generally a subconscious influence embedded in your psyche. It is possible that a particular bias has enabled a successful investment performance. However trying to identify that relationship is somewhat like the advice given by Will Rogers who famously suggested, “Buy a stock. If it goes up, sell it. If it doesn't go up, don't buy it.”