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[1].
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.
[1]
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/
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