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Investing is like playing golf Sometimes your brain does not help Intro ©
Why The components of the brain fit into two categories –The Reflexive: Anciently evolved components which operate at the subconscious level and are meant to deal with short term survival –The Reflective: Recently evolved components which operate at the conscious level, are meant to deal with human thought but are subject to being overridden by reflexive portions of the brain –Neurological studies using FMRI equipment confirm that much of what occurs in the brain when investment decisions are entertained occurs in the reflexive portions of the brain and that’s what gets us in trouble –Use of the reflexive portions of the brain is largely out of our conscious control, they are compulsively reactive –Learning how we are affected by the reflexive portions of our brain when contemplating investment decisions is the principle way to overcome the failures and mistakes investors make over and over Intro ©
Behavioral Economics Many years ago I read an article which dealt with Behavioral Economics. I became fascinated with the psychology of investing and have studied the literature over the years. In my job I am constantly involved with the interaction of investors and the market. I have had first hand experience with how psychology comes into play when investing. Here are some principles of Behavioral Economics that I have observed which tend to get in the way of good decisions: Intro ©
Net Worth An individual's view of the value of their assets is not what they currently have but rather a mental picture of what they expect to have at some specific time in the future. Probability Neglect 1 ©
Loss Framing When an individual perceives that they will not have the assets specified in their mental accounts they "frame" a "loss" and consider it as a loss rather than a potential failure to reach a goal. Probability Neglect 2 ©
Increase in Risk Assumption An individual who frames a loss reacts by desiring to increase the level of risk in their investment portfolio to make up for the perceived loss. Probability Neglect 3 ©
Social Comparisons Increase Risk Assumption Individuals engage in social comparisons in investing and increase the level of risk in their investment portfolio when they perceive that they are falling behind their peers in their investment performance. Probability Neglect 4 ©
Overconfidence People exhibit overconfidence in their ability to predict future events leading to an underestimation of risk. Probability Neglect 5 ©
Self Esteem Self-esteem is a motivating factor in the investment arena. Successes are attributed to the exercise of skill. Failures are attributed to external causes. Probability Neglect 6 ©
Risk assessment Risk taken by an investor often takes the form of failing to perceive and appreciate the risk as opposed to its deliberate assumption. Probability Neglect ©
Probability Neglect The more we dread an outcome, the more anxious we get, and the more anxious we get, the less precisely we calculate the odds of the outcome actually happening. If the consequence of an event is significant we over estimate the probability that it will happen. Probability Neglect 8 ©
Probability Neglect part two Optimism bias - is the convenient belief that risks that apply to other people don't apply to us. People rationalize risky behavior that also confers some benefit to their ego (such as rapidly trading stocks). People underestimate risk to a larger extent when they feel they have some control over the situation (transactional business) than they do when they do not have as much control (managed business). Probability Neglect 9 ©
Illusion of Control People tend to believe that they have or will have some influence over an investment after investing. This illusion leads an investor to ignore important information before and feedback after the investment thereby increasing the risk that the investor has undertaken. It actually reduces the one control an investor does have and that is deciding whether to buy, hold or sell. Probability Neglect 10 ©
What Happened People overestimate the accuracy and precision of their knowledge and that leads to overconfidence (and a lack of perception of the amount of risk they are undertaking) in making financial decisions. LTC, Internet Bubble, Mortgage Backed Bubble: “ When you combine ignorance and borrowed money, the consequences can get interesting. ” -Warren Buffett Probability Neglect 11 ©
The Yearn to Confirm People tend to search for or interpret new information in a way that confirms their opinions or beliefs. They avoid information and interpretations which contradict their opinions or beliefs. If you really want to prove something –try proving it wrong. Probability Neglect 12 ©
Projection Bias We subconsciously and involuntarily project our current emotional state into the future. We firmly imagine that the way we feel now is the way we will feel in the future (even though we can remember the different moods we had in the past). This is why you buy junk food when you go to the grocery store while you are hungry. This bias causes havoc with our investment planning. –Feeling flush with cash ( a good mood) causes us to discontinue or postpone investing for retirement. –Feeling fear causes us to “flee to safety” in one fixed income security and undo the benefit of diversification in a portfolio. –Feeling fear causes us to refrain from buying when the market has declined and wait to do so until a bull market is well underway. Projections 1 ©
Trend Continuance People believe that whatever is happening will continue to happen even if what is happening is against the odds. Projections 2 ©
Yes but this time it’s different It never is. Why do you think they named it the “mean?” Maybe because of the harsh way you can be re- taught an old lesson when something reverts to it. Projections 3 ©
Winners and Losers People become more upset about holding onto a "loser" too long than selling a "winner" too soon But they do it anyway Projections 4 ©
Pride and Regret Closing out a winning position promotes a feeling of success and pride. Closing out a losing position promotes a feeling of failure and regret. People sell winning positions (so they can lock in that feeling of success and pride) too soon and hold onto losing positions (to postpone and possibly avoid the feeling of failure and regret) too long. –Why you still own it (after riding it all the way down) Projections 5 ©
Loss Aversion People will actually agree to incur a larger risk to avoid a loss over the risk they would take to obtain a gain. Projections 6 ©
When its mine it’s mighty fine when its not it’s not worth a lot People place a higher value on something if they own it than they do if they do not own it (the “endowment effect”). We have a bias in favor of the status quo. Not surprisingly behavioral economists call this the “status quo bias” (clever people). Projections 7 ©
What is done is done People often make a decision based on the time, effort and funds they’ve already committed and not on what would be the best decision going forward. It’s called the “sunk cost” fallacy and the production of the supersonic airliner the Concorde is a good example of the operation of this phenomena. Projections 8 ©
Don’t forget to evaluate the Stock When people consider which stocks to buy they often consider some stocks they have previously owned. When the previous experience has been a realized gain they tend to buy more. When the previous experience has been a realized loss they tend to avoid the stock. How about stocks they still own? It depends on how the stock has done. If they have an unrealized loss they tend to buy more and if they have an unrealized gain they don’t. Projections 9 ©
Recent News People place far too much emphasis on the most recent news about a subject and do not put it in the proper overall context. This overemphasis on the most recent news causes people to overreact to both good news and bad news. This overreaction is a principle cause of panic selling and impulsive buying in the retail investment world. A significant study shows that stocks investors sell tend to do better (subsequently) than the stocks that are purchased to replace them. © Recency 1
How we deal with the Universe (of Stocks) We tend to buy stocks from a set of possible stocks. That set is composed of stocks that have caught our attention by either (i) recent news, (ii) recent unusual trading volume, or (iii) recent extreme returns. Recency 2 ©
Mental Shortcuts We use mental shortcuts to simplify and solve difficult problems of judgment and choice that confront us. These mental tricks (psychologists call them "judgmental heuristics") are subconscious and although they can be helpful generally, in our world they are often wrong and harmful. - Example “Law of Small Numbers” People often make investment decisions based on small, statistically insignificant or inconclusive samples, e.g. last years hot investment sector or buying shares in a restaurant chain because the lines are long. Recency 2©
Time is money People will take a small payoff if its immiment over a larger payoff later. On the other hand when the smaller payoff is more distant in time, people tend to prefer a larger even later payoff, even though the time lag from the smaller to the larger would be the same as before. ©
Bassackwards People invert the importance of small events versus their financial life picture. We obsess about the drop in the price of a stock in our portfolio rather than the value of our portfolio. ©
Arbitrary Coherence We are subject to the power of suggestion when trying to determine what something is worth. The suggestion is often unintended and irrelevant. ©
Chaos Theory and a complex system such as the stock market Predictability: Does the Flap of a Butterfly’s Wings in Brazil set off a Tornado in Texas? and that everyone, is why Peter Lynch and Warren Buffet are correct when they say they have no idea what the market is going to do. ©
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