Much has been written about the psychology of trading, the need to stick with your system, and all of the biases and logical faults of humans as traders. Nearly all of us were born with them, at least nearly all of us that weren’t born as our ancient ancestors, Hunter-Gatherers. There are still a few groups of hunter-gatherers that choose to live more like hunter-gatherers and less like their encroaching neighbors. There are even a few hunter-gatherer bands in the Amazon jungle that have had little to no contact with the outside world. Brazil takes strong measures to assure that these hunter-gatherers are not place in contact with outside peoples.
SO WHAT IS THE AUTHOR YAKKING ABOUT THIS TIME?
Many things have been studied and written about human behavior and economics behavior. Numerous studies have been conducted on these phenomena. They have been with humans at least since the Neolithic Revolution in 8,000 BCE, the time when property rights developed. Many hunter-gatherers do not have strong concepts of ownership and property. They are communal peoples with strong bonds within the group. Much of what they needed and used was available in abundance in their natural environment.
ENOUGH WITH PALEOLITHIC PROPERTY.
Certain economic biases have crept into modern humans over the millennia. Especially when we consider intangible (stocks, bonds, bank accounts, financial instruments) property along tangible property such as real estate and goods. Some have a strong bias toward tangible property. They like land, cash, goods that they can hold onto. Every so often an event occurs where large pools of intangible wealth is lost. Especially before financial stabilizers were put in place in the wake of the Great Depression. And in the 17th, 18th, and 19th centuries, economies, especially the US economy, swung between panics and prosperity.
But even as the nature of wealth changed from tangible to intangible, industrial to intellectual, brains to bazillion bytes, certain biases recurred and where identified.
“IF WE DON’T SELL TOO MANY OF THESE, WE JUST MIGHT BREAK EVEN.” GROUCH MARX.
Some common investment biases are:
1. "Loss aversion." Losses bite more than equivalent gains. In their 1979 paper published in Econometrica, Kahneman and Tversky found the median coefficient of loss aversion to be about 2.25, i.e., losses bite about 2.25 times more than equivalent gains. Simply put, humans will put 2.25 as much “energy” into avoiding a loss than making an equivalent gain.
2. “Sunk Cost Effect.” This effect is a major problem for most of us some of the time and some of us most of the time. This effect causes us to make inefficient and irrational decisions to continue losing money on an asset or a decision. Let’s say you have 15yo used car. Its book value is $1500. You know you need a new car but are holding off buying one. The car is well maintained and all necessary repairs have been made.
The clutch goes out. It costs $700. You decide to put a new clutch in it. Now you have a car worth $1500 that has just had $700 put into it. (I suppose you can guess what comes next.) The head gasket blows and will cost you $800. And the mechanic tells you that the hoses are old and should be replaced. And steering control rods are going out.
At what point do you stop throwing money at it? This effect has a similar effect on losing investments. At what point does an investor sell the losing investment and cut her losses? Do you follow your system and the rules that are designed to manage the risk-reward parameters? Or do you cheat down the stop loss sell order? Or do you decide to wait for a couple more days?
3. "Conditional expected utility" is a form of reasoning where the individual has an illusion of control and calculates the probabilities of external events and hence their utility as a function of their own action, even when they have no causal ability to affect those external events. This is a strange one. Some people think that their favorite team would have won the game if they had been home to watch the game. For investors, it is sitting in front of CNBC or Bloomberg news and watching the Chyron ticker.
We of course logically know that we have no control over such events. It could slightly skew our decision making, but its probably more of a time-waster than a cognitive disaster zone.
4. “Recency Bias,” or the “Party Effect.” Here is a great description of this pernicious bias:
These 4 guests experienced entirely different rate of return outcomes and view their portfolios and thus the stock market completely different. All 4 are correct. All 4 are right and yet they couldn’t possibly have more divergent outcomes. If they don’t have a complete picture of the stock market, like the elephant, they can get themselves in trouble. The difference between the best performing portfolio that is up 12.28% and the worst performing portfolio that is down 21.53% is an astounding 33.81%. Is this too obvious? You may say, of course they have different outcomes, they started at different times but that is not the point. The point is that stock market investing will always produce different outcomes. One guest started at the worst time possible. Another guest started at the best possible time. How they look at the past determines how they see the present. Most importantly, it will determine how they will act going forward.
The Party Effect simply states that stock market participants evaluate their portfolio performance based on their perspective and their perspective only. They do not see the market as it is but as they are. Without an expert understanding of how the stock market works, this leads to incorrect conclusions “time again that people have variable risk profiles. BF demonstrates that fear is a stronger emotion than greed. This means that in our simple 4 guest example, Guests 3 and 4 are more likely to exit the stock market at just the wrong time since their recent, thus Recency Bias, experience is one of losing money. It means that Guest 1 and 2 are more likely to stay invested, thus catching the next wave up that is likely to follow. All 4 have intellectual access to the events of the last 30 months. All 4 can educate themselves on the stock market. However, their particular situation is so biased by recent events that the facts are unimportant. They behave irrationally.
This effect is especially damaging to investors, especially new investors, hunch-and-tip investors, and investors that have unreasonable risk-reward expectations.
There are more of these biases, but the Author Rob thought he would take on a few.
He is reading an investment classic, “The Way of the Turtle” by Curtis Faith. Faith and a few others were selected by legendary investors Richard Dennis and William Eckhardt to trade using a defined methodology. The methodology was a Donchian trend following system. It was in a sense a test of the proposition that trading was a skill that could be taught. The novice investors were given accounts and turned loose. The students that followed the system did well. The investors that allowed psychological biases to effect their trading did not do as well.
The book has been out for more than 15 years and is available at the library or cheap online. The methodology discussion is pedestrian, but tidbits are well worth the read.
July’s Monthly Desert of the Real Economics Newsletter will be out in the second week of this month. Contact Julie or me with any questions, ideas or grudges you are holding.
AS CURTIS FAITH’S DESCENT INTO INSANITY AND PETTY CRIMINALITY MORDANTLY DEMONSTRATES, PAST RESULTS ARE NO GUARANTEE OF FUTURE PERFORMANCE IN THE DESERT OF THE REAL. OR MOST OTHER PLACES.
 Alas, Faith’s life has not lived up to his once-promoting start. He reportedly defrauded investors in various managed future schemes. He was convicted and jailed for various charges and has reportedly promoted schemes that fall on the far end of believable. Mr. Faith had reportedly been working on a buyout of Apple and Disney on behalf of the workers and management as part of a deal where he was going to license all his new computer architecture in an open-source manner in a closed IP pool that artists and programmers all over the world were invited to join. Apple and Disney and Tesla Motors were to be the first acquisitions of a new private Faith-Family office with a very long-term outlook.” https://dropdredd.wordpress.com/2015/06/01/where-in-the-world-is-curtis-michael-faith/