Behavioural Investing E-Book

Montier James

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Series
• Sprache: Englisch
• Veröffentlichungsjahr: 2009

Seitenzahl: 957

Beschreibung

Behavioural investing seeks to bridge the gap between psychology and investing. All too many investors are unaware of the mental pitfalls that await them. Even once we are aware of our biases, we must recognise that knowledge does not equal behaviour. The solution lies is designing and adopting an investment process that is at least partially robust to behavioural decision-making errors. Behavioural Investing: A Practitioner's Guide to Applying Behavioural Finance explores the biases we face, the way in which they show up in the investment process, and urges readers to adopt an empirically based sceptical approach to investing. This book is unique in combining insights from the field of applied psychology with a through understanding of the investment problem. The content is practitioner focused throughout and will be essential reading for any investment professional looking to improve their investing behaviour to maximise returns. Key features include: * The only book to cover the applications of behavioural finance * An executive summary for every chapter with key points highlighted at the chapter start * Information on the key behavioural biases of professional investors, including The seven sins of fund management, Investment myth busting, and The Tao of investing * Practical examples showing how using a psychologically inspired model can improve on standard, common practice valuation tools * Written by an internationally renowned expert in the field of behavioural finance

Leseprobe

Table of Contents

Title Page

Copyright Page

Dedication

Preface

I Common Mistakes and Basic Biases

II The Professionals and the Biases

III The Seven Sins of Fund Management

IV An Investment Process as a Behaviour Defence

V Bubbles and Behaviour

VI Investment Myth Busters

VII Corporate Governance and Ethics

VIII Happiness

Acknowledgements

SECTION I - Common Mistakes and Basic Biases

Chapter 1 - Emotion, Neuroscience and Investing: Investors s Dopamine Addicts

SPOCK OR McCOY?

THE PRIMACY OF EMOTION

SELF-CONTROL IS LIKE A MUSCLE

HARD-WIRED FOR THE SHORT TERM

HARD-WIRED TO HERD

PLASTICITY AS SALVATION

Chapter 2 - Part Man, Part Monkey

THE BIASES WE FACE

BIAS #1: I KNOW BETTER, BECAUSE I KNOW MORE

BIAS #2: BIG ≠ IMPORTANT

BIAS #3: SHOW ME WHAT I WANT TO SEE

BIAS #4: HEADS WAS SKILL, TAILS WAS BAD LUCK

BIAS #5: I KNEW IT ALL ALONG

BIAS #6: THE IRRELEVANT HAS VALUE AS INPUT

BIAS #7: I CAN MAKE A JUDGEMENT BASED ON WHAT IT LOOKS LIKE

BIAS #8: THAT’S NOT THE WAY I REMEMBER IT

BIAS #9: IF YOU TELL ME IT IS SO, IT MUST BE TRUE

BIAS #10: A LOSS ISN’T A LOSS UNTIL I TAKE IT

CONCLUSIONS

Chapter 3 - Take a Walk on the Wild Side

IMPACT BIAS

EMPATHY GAPS

COMBATING THE BIASES

Chapter 4 - Brain Damage, Addicts and Pigeons

Chapter 5 - What do Secretaries’ Dustbins and the Da Vinci Code have in Common?

Chapter 6 - The Limits to Learning

SELF-ATTRIBUTION BIAS: HEADS IS SKILL, TAILS IS BAD LUCK

HINDSIGHT BIAS: I KNEW IT ALL ALONG

SKINNER’S PIGEONS

ILLUSION OF CONTROL

FEEDBACK DISTORTION

CONCLUSIONS

SECTION II - The Professionals and the Biases

Chapter 7 - Behaving Badly

THE TEST

THE RESULTS

OVEROPTIMISM

CONFIRMATORY BIAS

REPRESENTATIVENESS

THE COGNITIVE REFLECTION TASK (CRT)

ANCHORING

KEYNES’S BEAUTY CONTEST

MONTY HALL PROBLEM

CONCLUSIONS

SECTION III - The Seven Sins of Fund Management

Chapter 8 - A Behavioural Critique

SIN CITY

ALTERNATIVE APPROACHES AND FUTURE DIRECTIONS

Chapter 9 - The Folly of Forecasting: Ignore all Economists, Strategists, & Analysts

OVERCONFIDENCE AS A DRIVER OF POOR FORECASTING

OVERCONFIDENCE AND EXPERTS

WHY FORECAST WHEN THE EVIDENCE SHOWS YOU CAN’T?

WHY USE FORECASTS?

DEBASING

Chapter 10 - What Value Analysts?

Chapter 11 - The Illusion of Knowledge or Is More Information Better Information?

Chapter 12 - Why Waste Your Time Listening to Company Management?

MANAGERS ARE JUST AS BIASED AS THE REST OF US

CONFIRMATORY BIAS AND BIASED ASSIMILATION

OBEDIENCE TO AUTHORITY

TRUTH OR LIE?

CONCLUSIONS

Chapter 13 - Who’s a Pretty Boy Then? Or Beauty Contests, Rationality and ...

BACKGROUND

THE GAME

THE SOLUTION

THE RESULTS

A SIMPLE MODEL OF OUR CONTEST

COMPARISON WITH OTHER EXPERIMENTS

LEARNING

CONCLUSIONS

Chapter 14 - ADHD, Time Horizons and Underperformance

Chapter 15 - The Story is the Thing (or The Allure of Growth)

Chapter 16 - Scepticism is Rare (or Descartes vs Spinoza)

CARTESIAN SYSTEMS

SPINOZAN SYSTEMS

LIBRARIES

A TESTING STRUCTURE

THE EMPIRICAL EVIDENCE

STRATEGIES TO COUNTERACT NAÏVE BELIEF

Chapter 17 - Are Two Heads Better Than One?

BEATING THE BIASES

SECTION IV - Investment Process as Behavioural Defence

Chapter 18 - The Tao of Investing

Chapter 19 - Come Out of the Closet (or, Show Me the Alpha)

THE ALPHA

THE EVOLUTION OF THE MUTUAL FUND INDUSTRY

CHARACTERISTICS OF THE FUNDS

CONCLUSIONS

Chapter 20 - Strange Brew

THE LONG RUN

THE SHORT RUN

BREAK THE LONG-ONLY CONSTRAINT

ADD BREADTH

NOT JUST AN EXCUSE FOR HEDGE FUNDS

TRULY ALTERNATIVE INVESTMENTS

CONCLUSIONS

Chapter 21 - Contrarian or Conformist?

Chapter 22 - Painting by Numbers: An Ode to Quant

NEUROSIS OR PSYCHOSIS?

BRAIN DAMAGE DETECTION

UNIVERSITY ADMISSIONS

CRIMINAL RECIDIVISM

BORDEAUX WINE

PURCHASING MANAGERS

META-ANALYSIS

THE GOOD NEWS

SO WHY NOT QUANT?

Chapter 23 - The Perfect Value Investor

TRAIT I: HIGH CONCENTRATION IN PORTFOLIOS

TRAIT II: THEY DON’T NEED TO KNOW EVERYTHING, AND DON’T GET CAUGHT IN THE NOISE

TRAIT III: A WILLINGNESS TO HOLD CASH

TRAIT IV: LONG TIME HORIZONS

TRAIT V: AN ACCEPTANCE OF BAD YEARS

TRAIT VI: PREPARED TO CLOSE FUNDS

Chapter 24 - A Blast from the Past

THE UNHEEDED WORDS OF KEYNES AND GRAHAM

Chapter 25 - Why Not Value? The Behavioural Stumbling Blocks

KNOWLEDGE ≠ BEHAVIOUR

LOSS AVERSION

DELAYED GRATIFICATION AND HARD-WIRING FOR THE SHORT TERM

SOCIAL PAIN AND THE HERDING HABIT

POOR STORIES

OVERCONFIDENCE

FUN

NO, HONESTLY I WILL BE GOOD

Chapter 26 - Bargain Hunter (or It Offers Me Protection)

THE METHODOLOGY

DOES VALUE WORK?

THE ANATOMY OF VALUE

THE SIREN OF GROWTH

GROWTH DOESN’T MEAN IGNORING VALUATION

THE DISAPPOINTING REALITY OF GROWTH

ANALYST ACCURACY?

VALUE VERSUS GROWTH

KEY POINTS

REGIONAL TABLES

Chapter 27 - Better Value (or The Dean Was Right!)

Chapter 28 - The Little Note that Beats the Markets

THE METHODOLOGY AND THE DATA

THE RESULTS

QUALITY MATTERS FOR VALUE

CAREER DEFENCE AS AN INVESTMENT STRATEGY

WHAT ABOUT THE LONG/SHORT VIEW?

THE FUTURE FOR THE LITTLE BOOK

TABLES AND FIGURES

Chapter 29 - Improving Returns Using Inside Information

PATIENCE IS A VIRTUE

USING INSIDE INFORMATION

A HEDGE PERSPECTIVE

RISK OR MISPRICING?

EVIDENCE FOR BEHAVIOURAL ERRORS

EVIDENCE AGAINST THE RISK VIEW

EUROPEAN EVIDENCE

CONCLUSIONS

Chapter 30 - Just a Little Patience: Part I

Chapter 31 - Just a Little Patience: Part II

VALUE PERSPECTIVE

GROWTH PERSPECTIVE

GROWTH AND MOMENTUM

VALUE FOR GROWTH INVESTORS

VALUE AND MOMENTUM

IMPLICATIONS

Chapter 32 - Sectors, Value and Momentum

VALUE

MOMENTUM

SECTORS: VALUE OR GROWTH

STOCKS OR SECTORS

Chapter 33 - Sector-Relative Factors Work Best

METHODOLOGY

THE RESULTS

CONCLUSION

Chapter 34 - Cheap Countries Outperform

STRATEGY BY STRATEGY INFORMATION

Chapter 35 - CAPM is CRAP (or, The Dead Parrot Lives!)

A BRIEF HISTORY OF TIME

CAPM IN PRACTICE

WHY DOES CAPM FAIL?

CAPM TODAY AND IMPLICATIONS

Chapter 36 - Risk Managers or Risk Maniacs?

Chapter 37 - Risk: Finance’s Favourite Four-Letter Word

THE PSYCHOLOGY OF RISK

RISK IN PERFORMANCE MEASUREMENT

RISK FROM AN INVESTMENT PERSPECTIVE

SECTION V - Bubbles and Behaviour

Chapter 38 - The Anatomy of a Bubble

DISPLACEMENT

CREDIT CREATION

EUPHORIA

CRITICAL STAGE/FINANCIAL DISTRESS

REVULSION

Chapter 39 - De-bubbling: Alpha Generation

BUBBLES IN THE LABORATORY

BUBBLES IN THE FIELD

DISPLACEMENT: THE BIRTH OF A BOOM

CREDIT CREATION: NURTURING THE BOOM

EUPHORIA

CRITICAL STAGE/FINANCIAL DISTRESS

REVULSION

APPLICATIONS

ALPHA GENERATION

LONG-ONLY FUNDS

SUMMARY

Chapter 40 - Running with the Devil: A Cynical Bubble

THE MAJOR TYPES OF BUBBLE

PSYCHOLOGY OF BUBBLES

COMPOSITE BUBBLES AND THE DE-BUBBLING PROCESS

EXPERIMENTAL EVIDENCE: BUBBLE ECHOES

MARKET DYNAMICS AND THE INVESTMENT DANGERS OF NEAR RATIONAL BUBBLES

CONCLUSIONS

Chapter 41 - Bubble Echoes: The Empirical Evidence

CONCLUSIONS

SECTION VI - Investment Myth Busters

Chapter 42 - Belief Bias and the Zen of Investing

BELIEF BIAS AND THE X-SYSTEM

CONFIDENCE ISN’T A PROXY FOR ACCURACY

BELIEF BIAS AND THE ZEN OF INVESTING

Chapter 43 - Dividends Do Matter

CONCLUSIONS

Chapter 44 - Dividends, Repurchases, Earnings and the Coming Slowdown

Chapter 45 - Return of the Robber Barons

Chapter 46 - The Purgatory of Low Returns

Chapter 47 - How Important is the Cycle?

Chapter 48 - Have We Really Learned So Little?

Chapter 49 - Some Random Musings on Alternative Assets

HEDGE FUNDS

COMMODITIES

WHICH INDEX?

COMPOSITION OF COMMODITY FUTURES RETURNS

THE TIMES THEY ARE A-CHANGIN’

CONCLUSIONS

SECTION VII - Corporate Governance and Ethics

Chapter 50 - Abu Ghraib: Lesson from Behavioural Finance and for Corporate Governance

FUNDAMENTAL ATTRIBUTION ERROR

ZIMBARDO’S PRISON EXPERIMENT

MILGRAM: THE MAN THAT SHOCKED THE WORLD

CONDITIONS THAT TURN GOOD PEOPLE BAD

CONCLUSIONS

Chapter 51 - Doing the Right Thing or the Psychology of Ethics

THE ETHICAL BLINDSPOT

THE ORIGINS OF MORAL JUDGEMENTS

EXAMPLES OF BOUNDED ETHICALITY AND UNCONSCIOUS BIASES

MECHANISMS DRIVING POOR ETHICAL BEHAVIOUR

COMBATING UNETHICAL BEHAVIOUR

Chapter 52 - Unintended Consequences and Choking under Pressure: The ...

EVIDENCE FROM THE LABORATORY

EVIDENCE FROM THE FIELD

BACK TO THE LABORATORY

WHO IS LIKELY TO CRACK UNDER PRESSURE?

CONCLUSIONS

SECTION VIII - Happiness

Chapter 53 - If It Makes You Happy

TOP 10

Chapter 54 - Materialism and the Pursuit of Happiness

ASPIRATION INDEX

MATERIALISM AND HAPPINESS: THE EVIDENCE

PROBLEMS OF MATERIALISM

WHAT TO DO?

WHY EXPERIENCES OVER POSSESSIONS?

CONCLUSIONS

References

Index

For other titles in the Wiley Finance Series please see www.wiley.com/finance

Copyright © 2007 John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester,

West Sussex PO19 8SQ, England

Telephone [phone]

Each of the articles contained in this work is the copyright of Dresdner Kleinwort and is reproduced with permission.

Email (for orders and customer service enquiries): [email protected] Visit our Home Page on www.wiley.com

All Rights Reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except under the terms of the Copyright, Designs and Patents Act 1988 or under the terms of a licence issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London W1T 4LP, UK, without the permission in writing of the Publisher. Requests to the Publisher should be addressed to the Permissions Department, John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex PO19 8SQ, England, or emailed to [email protected], or faxed to ([phone].

Designations used by companies to distinguish their products are often claimed as trademarks. All brand names and product names used in this book are trade names, service marks, trademarks or registered trademarks of their respective owners. The Publisher is not associated with any product or vendor mentioned in this book.

Other Wiley Editorial OfficesJohn Wiley & Sons Inc., 111 River Street, Hoboken, NJ 07030, USA Jossey-Bass, 989 Market Street, San Francisco, CA 94103-1741, USA Wiley-VCH Verlag GmbH, Boschstr. 12, D-69469 Weinheim, Germany John Wiley & Sons Australia Ltd, 42 McDougall Street, Milton, Queensland 4064, Australia John Wiley & Sons (Asia) Pte Ltd, 2 Clementi Loop #02-01, Jin Xing Distripark, Singapore 129809 John Wiley & Sons Canada Ltd, 6045 Freemont Blvd, Mississauga, ONT, L5R 4J3, Canada

Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books.

Anniversary Logo Design: Richard J. Pacifico

British Library Cataloguing in Publication Data

A catalogue record for this book is available from the British Library

eISBN : 978-0-470-68779-6

Typeset in 10/12pt Times by Aptara, New Delhi, India Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham, Wiltshire This book is printed on acid-free paper responsibly manufactured from sustainable forestry in which at least two trees are planted for each one used for paper production.

To Connor The best nephew a proud uncle could hope for

Preface

This book represents the first six years of an ongoing research project. The aim of this project was to truly understand the psychology of finance and investing and explore its implications for practitioners. There can be little doubt that behavioural finance has never been more popular among professional investors. Certainly, if my diary is any guideline, the subject is still in much demand. The chart below shows the number of times in a rolling 12-month period the words behavioural (or behavioral) finance appear in the press.

I reached the conclusion that I was a natural pessimist while looking at this chart, as the first thing that entered my mind was - it’s a bubble. An optimist would presumably conclude that it was a growth industry! I certainly hope the latter interpretation holds true.

My first book on the subject (Behavioural Finance, Wiley, 2002) was really the result of a series of lectures I had given to students. This book draws together research written for a professional audience whose time for reading research is highly limited. For this reason each chapter is written to ‘stand alone’ to allow the reader to dip in and out at will. Each chapter also aims to deal with a practical issue of relevance to the professional investor. However, despite the independent nature of the chapters, I have chosen to group them together into themes, representing the seven major thrusts of my ongoing research project.

I Common Mistakes and Basic Biases

The title here gives the gist. In many ways one of the most powerful insights offered by the literature on judgement and decision making is that we are all prone to the potential pitfalls that psychologists have spent years documenting. Indeed, when I give a lecture to professional investors, those who probably get the most out of the talk are those who identify themselves as the perpetrators of behavioural mistakes. The chapters in this section aim to explore some of the most common biases, and suggest some simple ways in which we might be able to mitigate our susceptibility.

II The Professionals and the Biases

Among some there is a view that the individual investor is the source of all behavioural mispricing. However, I suspect this is far from true. Indeed there are now a number of papers (such as Jackson, Glushkov) that argue convincingly that the professionals may well be the noise traders. The aim of this section is to demonstrate that professional investors are just as likely to suffer behavioural biases as the rest of us. Indeed, in as much as they are experts in their field, they may well be even more overconfident and overoptimistic than lay people.

III The Seven Sins of Fund Management

The aim of this section was to examine a typical large institutional fund management organization and assess its vulnerabilities to psychological critique. The first step on the road to reform is to be able to identify the areas of weakness in the current structure. Issues such as an overreliance on forecasting, the illusion of trading, wasting time meeting company managements, and the dangers of overtrading are covered here.

IV An Investment Process as a Behaviour Defence

If the previous section represented a long list of don’ts, then this section is an attempt to provide a list of dos. It is concerned with investment philosophy/process. Since we cannot control the return on an investment (much as we would like to be able to do), then the best we can do is create a process that makes sense. Here we explore contrarian strategies and value investing as a framework for mitigating behavioural biases. As I am also an empirical sceptic, this section contains many empirical chapters based on demonstrating the principles discussed.

V Bubbles and Behaviour

Of all the areas of behavioural finance none captures the public’s imagination like bubbles. This section explores a paradigm for analysing and assessing bubbles and their paths. It is a good demonstration of the constancy of human behaviour. Every bubble in history has been slightly different, but the underlying characteristics and processes are amazingly similar.

VI Investment Myth Busters

A popular TV show concerned two ‘mad’ scientists who loved nothing more than to explode urban myths. This section represents my attempt to do something similar in finance. We have a bad habit of accepting theories as fact within finance, and of accepting statements as if they were truths. The chapters here try to expose some of the believable but incorrect beliefs that many investors seem to share.

VII Corporate Governance and Ethics

We often interpret other actions as evidence of their underlying nature. However, when people find themselves in a situation, we fail to understand the impact that has on their behaviour. So, rather than bad apples it is more often than not bad barrels, and the chapters here explore how social psychological insights can improve our understanding of corporate governance. We also explore one of economics’ most cherished beliefs - that incentives work - from a psychological perspective, and the results are intriguing, suggesting that optimal incentives are more difficult to design than many economists would have us believe.

VIII Happiness

This section deals with two of the most popular and most controversial notes I have written. They tackle the heresy of money not equalling happiness, which is clearly anathema to many who work in finance. These chapters explore the issue of what makes us happy, and what we can do to increase our level of happiness. These may seem like unusual topics for a researcher employed by an investment bank, but they were borne out of a belief that some of the most miserable people in the world seem to work in the field of finance.

Only you as reader will be able to judge how well I have achieved my aim of applying behavioural finance. Your comments and feedback would be most welcome and I can be contacted via my e-mail address: [email protected]

Acknowledgments

I am never sure who reads acknowledgements. Notwithstanding, there are several people to whom I owe a debt of gratitude. Firstly, my friend and colleague Albert Edwards. It was Albert who had the foresight to see that behavioural finance would be of interest to professional investors, and was prepared to support me in pushing the boundaries of what might be regarded as acceptable research. He also read most of the papers contained herein, and provided many useful suggestions to improve them, and challenge me.

Next, I must thank my co-authors on numerous of the empirical chapters in Section IV, Rui Antunes and Sebastian Lancetti of the Dresdner Kleinwort Quant team. Both gentlemen have more skill at dealing with data and quant models in their little finger than I have in my entire being. They both helped to take my ideas and turn them into raw hard numbers, to satisfy even the most demanding of empirical sceptics.

The head of the Quant team, Andrew Lapthorne, not only graciously allowed me to publish one of his papers (as Chapter 33) but also read almost every paper in the collection and commented on all of them. Andy has been a great sounding board for my ideas over the years, and I thank him very much.

Kathy Alexandrou deserves special mention. She is responsible for taking my work and turning it into the notes that Dresdner Kleinwort clients have been reading. She is a true wizard of turning charts into works of art, and keeping me on track with my notes.

I am also grateful to the research management at Dresdner Kleinwort who have allowed me to publish research that I believe no other bank would have permitted. They also very kindly allowed me to reproduce the notes you will read between these covers.

Amanda Keogan, Jane Atterbury and Cally Smith deserve applause for managing to get me everywhere on time, and back again. At one time or another all these ladies have had the responsibility for looking after my travel and diary. They have all done a sterling job, and I thank them all.

The many academics who provided the papers (both from finance and psychology) that are quoted within these pages also merit a huge thank you. Without their work this book would not have been possible. As Newton said: “If I have seen further it is by standing on the shoulders of giants.”

Jenny Ward of the Dresdner Kleinwort EMIS team has managed to unearth a large number of weird and wonderful papers that I have requested over the years, and I thanks her for all her help.

Also, a huge thank you to all the clients who have expressed their interest in my work over the last six years. Without your support I am under no illusion that I would have been dispensed with years ago. It is your interest in behavioural finance that has kept me employed. Long may it continue!

On a personal note, I would also like to thank my friends and family. They have to put up with me dashing off to scribble down notes and ideas at the oddest of times. A special thanks goes to my parents and my nana for their unconditional love, and to Wendy who encouraged me to write this book and put up with me while I did so. She also read many of the chapters, corrected my English, and questioned me thoroughly. Thanks babes, couldn’t have done it without you.

To anyone I have forgotten to mention, my apologies and thanks. All errors and omissions remain the sole responsibility of the author.

SECTION I

Common Mistakes and Basic Biases

1

Emotion, Neuroscience and Investing:Investors s Dopamine Addicts1

Understanding what happens in our brain when we make decisions may help us to learn to overcome some of the mistakes we make. Emotions are key. Our ability to exercise self-control over such impulses is limited and decreases with use! Too often we succumb to our hard-wired tendencies to focus on the short term and herd.

• Emotional decision-making is the default option for our brains. However, we all like to think that we only use logic to arrive at our decisions. In fact without emotion we would be largely incapable of making any decisions, but all too often we allow emotion to rule unchecked. Welcome to the human condition!

• Neuroscientists have recently uncovered two particular traits of significance to investors. The first is that we are hard-wired for the short term. We tend to find the chance of short<term gains very attractive. They appear to stimulate the emotional centres of the brain, and release dopamine. This makes us feel confident, stimulated, and generally good about ourselves.

• The second is that we appear to be hard-wired to herd. The pain of social exclusion (i.e. betting against everyone else) is felt in exactly the same parts of the brain that feel real physical pain. So pursuing contrarian strategies is a little bit like having your arm broken on a regular basis!

• Self-control over these impulses is very hard. Psychologists have found that self-control is a limited resource. The more we use it, the less we have left to deal with the next occasion when self-control is required.

• The good news is that we continue to make brain cells pretty much throughout our lives. And our brains aren’t fixed forever, we can rearrange the neurons (a process called plasticity). We aren’t doomed, we can learn, but it isn’t easy!

What goes on inside our heads when we make decisions? Understanding how our brains work is vital to understanding the decisions we take. Neuroeconomics is a very new field that combines psychology, economics and neuroscience. That may sound like the unholy trinity as far as many readers are concerned, but the insights that this field is generating are powerful indeed.

Before I head off into the realms of neuroscience I should recap some themes we have explored before that provide the backdrop for much of the discussion that follows. One of the most exciting developments in cognitive psychology over recent years has been the development of dual process theories of thought. All right, stay with me now, I know that sounds dreadful, but it isn’t. It is really a way of saying that we tend to have two different ways of thinking embedded in our minds.

SPOCK OR McCOY?

For the Trekkies out there, these two systems can, perhaps, be characterized as Dr McCoy and Mr Spock. McCoy was irrepressibly human, forever allowing his emotions to rule the day. In contrast, Spock (half human, half Vulcan) was determined to suppress his emotions, letting logic drive his decisions.

McCoy’s approach would seem to be founded in system X. System X is essentially the emotional part of the brain. It is automatic and effortless in the way that it processes information - that is to say, the X-system pre-screens information before we are consciously aware that it even made an impact on our minds. Hence, the X-system is effectively the default option. The X-system deals with information in an associative way, and its judgements tend to be based on similarity (of appearance) and closeness in time. Because of the way the X-system deals with information it can handle vast amounts of data simultaneously. To computer nerds it is a rapid parallel processing unit. In order for the X-system to believe that something is valid, it may simply need to wish that it were so.

System C is the “Vulcan” part of the brain. To use it requires deliberate effort. It is logical and deductive in the way in which it handles information. Because it is logical, it can only follow one step at a time, and hence in computing terms it is a slow serial processing unit. In order to convince the C-system that something is true, logical argument and empirical evidence will be required, and Table 1.1 provides a summary of the main differences between the two systems.

This dual system approach to the way the mind works has received support from very recent studies by neuroscientists who have begun to attach certain parts of the brain to certain functions. In order to do this, neuroscientists ask experiment participants to perform tasks while their brains are being monitored via electroencephalograms (EEG), positron emission topography (PET) or, most often of late, functional magnetic resonance imaging (fMRI). The outcomes are then compared to base cases and the differences between the scans highlight the areas of the brain that are being utilized.

Table 1.2 lays out some of the major neural correlates for the two systems of thinking that we have outlined in Table 1.1. There is one very important thing to note about these groupings: the X system components are much older in terms of human development. They evolved a long time before the C-system correlates.

THE PRIMACY OF EMOTION

This evolutionary age helps to explain why the X system is the default option for information processing. We needed emotions far before we needed logic. This is perhaps best explained by an example using fear, which is one of the better understood emotions.2 Fear seems to be served by two neural pathways. One fast and dirty (LeDoux’s low road), the other more reflective and logical (the high road), and the links to the two systems of thinking outlined above are hopefully obvious.

Table 1.1 Two systems of reasoning

Source: Modified from Epstein (1991).

Table 1.2 Neural correlates of the two reasoning systems

Source: DrKW Macro research.

Imagine standing in front of a glass vessel that contains a snake. The snake rears up, the danger is perceived, and the sensory thalamus processes the information. From here two signals emerge. On the low road the signal is sent to the amygdala, part of the X system,2 and the brain’s centre for fear and risk. The amygdala reacts quickly, and forces you to jump back.

However, the second signal (taking the high road) sends the information to the sensory cortex, which, in a more conscious fashion, assesses the possible threat. This is the system that points out that there is a layer of glass between you and the snake. However, from a survival viewpoint, a false positive is a far better response than a false negative!

Emotions: Body or Brain?

Most people tend to think that emotions are the conscious response to events or actions. That is, something happens and your brain works out the emotional response - be it sadness, anger, happiness, etc. Then your brain tells your body how to react - tear up, pump blood, increase the breathing rate, etc.

William James, the grandfather of modern psychology, was among the first to posit that actually true causality may well flow from the body to the brain. In James’s view of the world, the brain assesses the situation so quickly that there simply isn’t time for us to become consciously aware of how we should feel. Instead the brain surveys the body, takes the results (i.e. skin sweating, increased heart beat, etc.) then infers the emotion that matches the physical signals the body has generated.

If you want to try this yourself, try pulling the face that matches the emotion you wish to experience. For instance, try smiling (see, we aren’t always miserable and bearish despite our reputations). If you sit with a smile on your face, concentrating on that smile, then very soon you are likely to start to feel the positive emotions that one associates with smiling.3

An entertaining example of the body’s impact upon decisions is provided by Epley and Gilovich (2001). They asked people to evaluate headphones. While conducting the evaluation, participants were asked to either nod or shake their heads. Those who were asked to nod their heads during the evaluation gave much more favourable ratings than those who were asked to shake their heads.

In the words of Gilbert and Gill (2000), we are momentary realists. That is to say, we have a tendency to trust our initial emotional reaction and correct that initial view “only subsequently, occasionally and effortfully”. For instance, when we stub a toe on a rock or bang our head on a beam (an easy thing to do in my house), we curse the inanimate object despite the fact it could not possibly have done anything to avoid our own mistake.

Emotions: Good, Bad or Both?

However, emotions may be needed in order to allow us to actually make decisions. There are a group of people who, through tragic accidents or radical surgery, have had the emotional areas of their minds damaged. These individuals did not become the walking optimizers known as homo economicus. Rather, in many cases, these individuals are now actually incapable of making decisions. They make endless plans but never get round to implementing any of them.4

Bechara et al. (1997) devised an experiment to show how the lack of emotion in such individuals can lead them to make suboptimal decisions. They played a gambling game with both controls (players without damage to the emotional centres of the brain) and patients (those with damage to the emotional parts of the brain). Each player was seated in front of four packs of cards (A, B, C and D). Players were given a loan of $2,000 and told that the object of the game was to avoid losing the loan, while trying to make as much extra money as possible. They were also told that turning cards from each of the packs would generate gains and occasional losses. The players were told of the impact of each card after each turn, but no running score was given.

Turning cards from packs A and B paid $100, while those from C and D paid only $50. Unpredictably, the turning of some cards carried a penalty. Consistently playing packs A and B led to an overall loss, while playing C and D led to an overall gain.

Table 1.3 Progress over the game

Source: Bechara et al. (1997).

Performance was assessed at various stages of the game. Four different periods were identified. The first involved no loss in either pack (pre-punishment); the second phase was when players reported they had no idea about the game, and no feeling about the packs; the third was found only in the controls, who started to say they had a hunch about packs A and B being riskier; and finally, the last phase, when (conceptual) players could articulate that A and B were riskier.

Table 1.3 shows the average number of rounds in each phase, and the percentage of players making it through each phase of the game. The patients were unable to form hunches, and far fewer survived the game.

Now cast your eye over Figures 1.1 and 1.2. Figure 1.1 shows the number of cards drawn from packs A and B (bad) and C and D (good) in each phase by the controls. In the pre-hunch phase they are already favouring the good packs marginally. In the hunch phase, controls are clearly favouring the good packs.

Now look at the performance of the patients in Figure 1.2. In the pre-hunch phase they continually chose the bad packs. As noted above, there was no hunch phase. And perhaps most bizarrely of all, even when they had articulated that packs A and B were a bad idea, they still picked more cards from those decks than from C and D! So despite “knowing” the correct conceptual answer, the lack of ability to feel emotion severely hampered the performance of these individuals.

Figure 1.1 Average number of cards drawn from bad and good packs: The controls.

Source: Bechara et al. (1997).

Figure 1.2 Average number of cards drawn from bad and good packs: The patients.

Source: Bechara et al. (1997).

However, similar games can be used to show that emotions can also help us. Bechara et al. (2004) played an investment game. Each player was given $20. They had to make a decision each round of the game: invest $1 or not invest. If the decision was not to invest, the task advanced to the next round. If the decision was to invest, players would hand over $1 to the experimenter. The experimenter would then toss a coin in full view of the player. If the outcome was a head, the player lost the dollar, if the coin landed tail up then $2.50 was added to the player’s account. The task would then move to the next round. Overall 20 rounds were played.

Bechara et al. played this game with three different groups: normals, a group of players with damage to the neural circuitry associated with fear5 (target patients who can no longer feel fear), and a group of players with other lesions to the brain unassociated with the neural fear circuitry (patient controls).

The experimenters uncovered that the players with damage to the fear circuitry invested in 83.7% of rounds, the normals invested in 62.7% of rounds, and the patient controls in 60.7% of rounds. Was this result attributable to the brain’s handling of loss and fear? Figure 1.3 shows a breakdown of the results, based on the result in the previous round. It shows the proportions of groups that invested. It clearly demonstrates that normals and patient controls were more likely to shrink away from risk-taking, both when they had lost in the previous round and when they won!

Players with damaged fear circuitry invested in 85.2% of rounds following losses on previous rounds, while normal players invested in only 46.9% of rounds following such losses.

Bechara et al. also found evidence of just how difficult learning actually is. Instead of becoming more optimal as time moves on, normal players actually become less optimal! (See Figure 1.4.) For the record, a rational player would, of course, play in all rounds.

Figure 1.3 Percentage of players investing divided into the outcomes from the previous round.

Source: Bechara et al. (2004).

Emotion, therefore, can both help and hinder us. Without emotion we are unable to sense risk, but with emotion we can’t control the fear that risk generates! Welcome again to the human condition!

Camerer et al. (2004) argue that the influence of emotions depends upon the intensity of the experience. They note

At low level of intensity, affect appears to play a largely ‘advisory’ role. A number of theories posit that emotions carry information that people use as an input into the decisions they face... ...At intermediate level of intensity, people begin to become conscious of conflicts between cognitive and affective inputs. It is at such intermediate levels of intensity that one observes . . . efforts at self-control...

Figure 1.4 Percentage of players investing by groups of rounds.

Source: Bechara et al. (2004).

Figure 1.5 Probability of forceful behaviour by arousal state.

Source: Loewenstein et al. (1997).

...Finally, at even greater levels of intensity, affect can be so powerful as to virtually preclude decision-making. No one ‘decides’ to fall asleep at the wheel, but many people do. Under the influence of intense affective motivation, people often report themselves as being ‘out of control’ . . . As Rita Carter writes in Mapping the Mind, ‘where thought conflicts with emotion, the latter is designed by neural circuitry in our brains to win’.

Camerer et al. (2004)

It is also worth noting that we are very bad at projecting how we will feel under the influence of emotion - a characteristic that psychologists call ‘hot-cold empathy gaps’. That is to say, when we are relaxed and emotion free, we underestimate how we would act under the influence of emotion.

For instance, Loewenstein et al. (1997) asked a group of male students to say how likely they were to act in a sexually aggressive manner in both a hot and a cold environment. The scenario they were given concerned coming home with a girl they had picked up at a bar, having been told by friends that she had a reputation for being ‘easy’. The story went on that the participants and the girl were beginning to get into physical genital contact on the sofa. The participants were then told they had started to try to remove the girl’s clothes, and she said she wasn’t interested in having sex.

Participants were then asked to assign probabilities to whether they would (1) coax the girl to remove her clothes, or (2) have sex with her even after her protests. Figure 1.5 shows the self-reported probability of sexual aggressiveness (defined as the sum of the probabilities of 1+2). Under the ‘no arousal’ condition there was an average 56% probability of sexual aggression. After having been shown sexually arousing photos, the average probability of aggression rose to nearly 80%!

SELF-CONTROL IS LIKE A MUSCLE

Unfortunately a vast array of psychological research (Muraven and Baumeister, 2000; Baumeister, 2003) suggests that our ability to use self-control to force our cognitive pro-cess to override our emotional reaction is limited. Each effort at self-control reduces the amount available for subsequent self-control efforts.

Figure 1.6 Self-control is a draining experience.

Source: Muraven and Baumeister (2000).

A classic example of Baumeister’s work concerns the following experiment. Participants are asked to avoid eating food for three hours before the experiment began (timed to force them to skip lunch). When they arrived they were put into one of three groups.

The first group were taken into a room in which cookies had recently been baked, so the aroma of freshly made chocolate chip delights wafted around. This room also contained a tray laid out with the freshly baked cookies and other chocolate delights, and a tray full of radishes. This group were told they should eat as many radishes as they could in the next five minutes, but they were also told they weren’t allowed to touch the cookies. A second group was taken to a similar room with the same two trays, but told they could eat the cookies. The third group was taken to an empty room.

All the food was then removed and the individuals were given problems to solve. These problems took the form of tracing geometric shapes without retracing lines or lifting the pen from the paper. The problems were, sadly, unsolvable. However, the amount of time before participants gave up and the number of attempts made before they gave up were both recorded.

The results were dramatic (see Figure 1.6). Those who had eaten the radishes (and had therefore expended large amounts of self-control in resisting the cookies) gave up in less than half the time that those who had eaten chocolate or eaten nothing had done. They also had far less attempts at solving the problems before giving up.

Baumeister (2003) concludes the survey by highlighting the key findings of their research:

1. Under emotional distress, people shift toward favoring high-risk, high-payoff options, even if these are objectively poor choices. This appears based on a failure to think things through, caused by emotional distress.

2. When self-esteem is threatened, people become upset and lose their capacity to regulate themselves. In particular, people who hold a high opinion of themselves often get quite upset in response to a blow to pride, and the rush to prove something great about themselves overrides their normal rational way of dealing with life.

3. Self-regulation is required for many forms of self-interest behavior. When self-regulation fails, people may become self-defeating in various ways, such as taking immediate pleasures instead of delayed rewards. Self-regulation appears to depend on limited resources that operate like strength or energy, and so people can only regulate themselves to a limited extent.

4. Making choices and decisions depletes this same resource. Once the resource is depleted, such as after making a series of important decisions, the self becomes tired and depleted, and its subsequent decisions may well be costly or foolish.

5. The need to belong is a central feature of human motivation, and when this need is thwarted such as by interpersonal rejection, the human being somehow ceases to function properly. Irrational and self-defeating acts become more common in the wake of rejection.

When I read this list it struck me just how many of these factors could influence investors. Imagine a fund manager who has just had a noticeable period of underperformance. He is likely to feel under pressure to start to focus on high-risk, high-payoff options to make up the performance deficit. He is also likely to feel his self-esteem is under threat as outlined in 2 above. He is also likely to begin to become increasingly myopic, focusing more and more on the short term. All of this is likely to be particularly pronounced if the position run resulting in the underperformance is a contrarian one. Effectively, most of the elements that lead to the psychology of irrationality are likely to be present in large quantities.

HARD-WIRED FOR THE SHORT TERM

Having explored the role of emotions and our ability to moderate their influence, it is now time to turn to some examples of how powerful neuroscience can be in helping us to understand investor behaviour.

The first example suggests that we may be hard-wired to focus on the short term. Economists are all brought up to treasure the concept of utility6 - the mental reward or pleasure experienced. Traditionally, economists view money as having no direct utility; rather it is held to have indirect utility, that is, it can be used to purchase other goods and services, which do provide direct utility.

Neuroscientists have found that money actually does have ‘utility’, or at least the brain anticipates receiving money in the same way that other rewards are felt, such as enjoying food or pleasure-inducing drugs (Knutson and Peterson, 2004).

The trouble is that the reward system for the brain has strong links to the X-system. The anticipation of reward leads to the release of dopamine. Dopamine makes people feel good about themselves, confident and stimulated.

Cocaine works by blocking the dopamine receptors in the brain, so the brain cannot absorb the dopamine, and hence nullify its effects. Because the brain cannot absorb the dopamine, it triggers further releases of the drug. So when one takes coke, the dopamine release is increased, taking the user to a high. Neuroscientists have found that the larger the anticipated reward the more dopamine is released.

McClure et al. (2004) have recently investigated the neural systems that underlie decisions about delayed gratification. Much research has suggested that people tend to behave impatiently today but plan to act patiently in the future. For instance, when offered a choice between £10 today and £11 tomorrow, many people choose the immediate option. However, if asked today to choose between £10 in a year, and £11 in a year and a day, many people who went for the ‘immediate’ option in the first case now go for the second option.

In order to see what happens in the brain when faced with such choices, McClure et al. measured the brain activity of participants as they made a series of intertemporal choices between early and delayed monetary rewards (like the one above). Some of the choice pairs included an immediate option, others were choices between two delayed options. The results they uncovered are intriguing.

When the choice pair involved an immediate gain, the ventral stratum (part of the basal ganglia), the medial orbitofrontal cortex, and the medial prefrontal cortex were all disproportionately used. All these elements are associated with the X-system. McClure et al. also point out that these areas are riddled by the midbrain dopamine system. They note, ‘These structures have consistently been implicated in impulsive behaviour, and drug addiction is commonly thought to involve disturbances of dopaminergic neurotransmission in these systems.’ Since money is a reward, the offer of money today causes a surge in dopamine that people find very hard to resist.

When the choice involved two delayed rewards, the prefrontal and parietal cortex were engaged (correlates of the C-system). The more difficult the choice, the more these areas seemed to be used. Given the analysis of the limits to self-control that was outlined above, perhaps we should not hold out too much hope for our ability to correct the urges triggered by the X-system. All too often, it looks as if we are likely to end up being hard-wired for the short term.

Keynes was sadly right when he wrote, “Investment based on genuine long-term expectation is so difficult to-day as to be scarcely practicable.”

HARD-WIRED TO HERD

In the past, we have mentioned that there is strong evidence from neuroscience to suggest that real pain and social pain are felt in exactly the same places in the brain. Eisenberger and Lieberman (2004) asked participants to play a computer game. Players think they are playing in a three-way game with two other players, throwing a ball back and forth.

In fact, the two other players are computer controlled. After a period of three-way play, the two other ‘players’ began to exclude the participant by throwing the ball back and forth between themselves. This social exclusion generates brain activity in the anterior cingulate cortex and the insula, both of which are also activated by real physical pain.

Contrarian strategies are the investment equivalent of seeking out social pain. In order to implement such a strategy you will buy the things that everyone else is selling, and sell the stocks that everyone else is buying. This is social pain. Eisenberger and Lieberman’s results suggest that following such a strategy is really like having your arm broken on a regular basis - not fun!

To buy when others are despondently selling and sell when others are greedily buying requires the greatest fortitude and pays the greatest reward

Sir John Templeton

It is the long-term investor, he who most promotes the public interest, who will in practice come in for the most criticism... For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion

John Maynard Keynes

PLASTICITY AS SALVATION

All of this may make for fairly depressing reading. With emotions we cannot control ourselves, and without them we cannot make decisions. We appear to be doomed to chase short-term rewards and run with the herd. When we try to resist these temptations we suffer subsequent declines in our ability to exercise self-control. Not a pretty picture.

However, all is not lost. For many years it was thought that the number of brain cells was fixed and that they decayed over time. The good news is that this isn’t the case. We are capable of generating new brain cells over most of our lifetime.

In addition, the brain isn’t fixed into a certain format. The easiest way of thinking about this is to imagine the brain as a cobweb. Some strands of that cobweb are thicker than others. The more the brain uses a certain pathway, the thicker the strand becomes. The thicker the strand, the more the brain will tend to use that path. So if we get into bad mental habits, they can become persistent.

However, we are also capable of rearranging those pathways (neurons). This is how the brain learns. It is properly called plasticity. We aren’t doomed, we can learn, but it isn’t easy!

2

Part Man, Part Monkey

Leaving the trees could have been our first mistake. Our minds are suited for solving problems related to survival, rather than being optimized for investment decisions. The result of our inheritance is that we are all capable of making mistakes. The list below provides a list of maxims to remember in order to avoid the most common investment pitfalls.

• These biases apply to me, you and everyone else as well.

• Be less certain in your views, especially if they are forecasts.

• You know less than you think you do.

• Try to focus on the facts, not the stories.

• More information isn’t better information.

• Listen to those who disagree with you.

• Examine your mistakes, failures aren’t just bad luck.

• You didn’t know it all along, you just think you did.

• Judge things by how statistically likely they are, not how they appear.

• Big, vivid, easy to recall events are less likely than you think they are.

• Don’t confuse good firms with good investments or good earnings growth with good returns.

• Use reverse-engineered models to avoid anchoring on the market prices.

• Don’t take information at face value; think carefully about how it was presented to you.

• Sell your losers and ride your winners.

Figure 2.1 The self vs others’ susceptibility to biases.

Source: Adapted from Pronin et al. (2002).

Perhaps the first step down this path is becoming aware of the fact that we are all likely to suffer from what psychologists call heuristics and biases. Heuristics are just rules of thumb that allow us to deal with informational deluge. In many cases they work well, but sometimes they lead us far stray from rational decision-making.

Of course, we all like to think that we are immune to the influences of biases. But the reality is, of course, that we are all likely to suffer some of these mental errors on some occasions. For instance, Pronin et al. (2002) asked people to rate on a 9-point scale (with 5 being ‘somewhat’) how likely the average American was to suffer a particular bias, and how likely they were to suffer the same biases. A booklet describing the biases was provided. Figure 2.1 shows the results. In all cases, people rated themselves less likely to suffer a given bias than average. Across the biases, the average score for the average American was 6.75. For those taking part, the average score was 5.31. All the differences were statistically significant. Pronin et al. refer to this as the bias blind spot.

THE BIASES WE FACE

Psychologists have spent years documenting and cataloging the types of errors to which we are prone. The main results are surprisingly universal across cultures and countries.

Hirschleifer (2001) suggests that most of these mistakes can be traced to four common causes: self-deception, heuristic simplification, emotion, and social interaction. Figure 2.2 tries to classify the major biases along these lines. It outlines the most common of the various biases that have been found, and also tries to highlight those with direct implications for investment.

This may look like a mass of mistakes, and indeed it is; however, for the purposes of exposition, let’s focus on the 10 most important biases that we come across.

BIAS #1: I KNOW BETTER, BECAUSE I KNOW MORE

Let me start by asking you three questions. Firstly, are you an above-average driver? Secondly, are you above average at your job? Thirdly, are you above average as a lover?

Figure 2.2 Taxonomy of biases.

So far in the countless times that I have conducted those questions I have only had one person answer that he is a below-average lover. For the record, he is one of my colleagues, and obviously desperately needs help! Now, why am I asking you these very strange questions? Well, they go to the heart of the two most common biases that we come across - overoptimism and overconfidence. Overoptimism and overconfidence tend to stem from the illusion of control and the illusion of knowledge.

The Illusion of Knowledge: More Information Isn’t Better Information

The illusion of knowledge is the tendency for people to believe that the accuracy of their forecasts increases with more information. So dangerous is this misconception that Daniel Boorstin opined: ‘The greatest obstacle to discovery is not ignorance - it is the illusion of knowledge.’ The simple truth is that more information is not necessarily better information; it is what you do with it, rather than how much you have, that matters.

Nowhere is this better shown than in a classic study by Paul Slovic (1973). Eight experienced bookmakers were shown a list of 88 variables found on a typical past performance chart on a horse (e.g. the weight to be carried, the number of races won, the performance in different conditions, etc.). Each bookmaker was then asked to rank the pieces of information by importance.

Having done this, the bookmakers were then given data for 40 past races and asked to rank the top five horses in each race. Each bookmaker was given the past data in increments of the 5, 10, 20, and 40 variables that the bookmaker had selected as being most important. Hence, each bookmaker predicted the outcome of each race four times - once for each of the information sets. For each prediction, the bookmakers were asked to give a degree of confidence ranking in their forecast.

Figure 2.3 Accuracy vs confidence for bookmakers as a function of the information set.

Source: Slovic (1973).

Figure 2.3 shows how both accuracy and confidence change as the information set grows over time. Accuracy is mainly a flat line regardless of the amount of information the bookmakers had at their disposal!

However, look what happened to the bookmakers’ confidence. It soared as the information set increased. With five pieces of information, accuracy and confidence were quite closely related. However, by the time 40 pieces of information were being used, accuracy was still around 15%, but confidence has soared to more than 30%! So more information isn’t better information; it is what you do with it that truly matters.

That fact doesn’t stop the vast majority of investors desperately trying to accumulate more information than their rivals. The evidence suggests that, just like bookmakers, professional investors are generally much too confident.

Professionals Worse than Chance!

Figure 2.4 is based on a study by Torngren and Montgomery (2004). Participants were asked to select the stock they thought would do best each month from a pair of stocks. All the stocks were well-known blue-chip names, and players were given the name, industry, and the prior 12 months’ performance for each stock. Laypeople (undergrads in psychology) and professional investors (portfolio managers, analysts, and brokers) both took part in the study. At each selection, players were asked to state how confident they were in the outcome predicted.

The bad news is that both groups were worse than sheer luck. That is to say, you should have been able to beat both groups just by tossing a coin! The even worse news was that the professionals were really dreadful, underperforming laypeople by a large margin. For instance, when the professionals were 100% sure they were correct, they were actually right less than 15% of the time! This fits with the mass of evidence that psychologists have uncovered: while experts may know more than non-experts, they are also likely to be even more overconfident than non-experts.

Figure 2.4 Accuracy and confidence on stock selection.

Source: Torngren and Montgomery (2004).

Players were also asked to rank the inputs they used in reaching their decisions. Figure 2.5 shows the average scores for the inputs. Laypeople were essentially just guessing, but were also influenced by prior price performance. In contrast, the professionals thought they were using their knowledge to pick the winners.

The Illusion of Control

The illusion of control refers to people’s belief that they have influence over the outcome of uncontrollable events. For instance, people will pay four and a half times more for a lottery ticket that contains numbers they choose rather than a random draw of numbers. People are more likely to accept a bet on the toss of a coin before it has been tossed, rather than after it has been tossed and the outcome hidden, as if they could influence the spin of the coin in the air! Information once again plays a role. The more information you have, the more in control you will tend to feel.

Figure 2.5 Average rating of input importance.

Source: Torngren and Montgomery (2004).

BIAS #2: BIG ≠ IMPORTANT

Every piece of information can be judged along two dimensions - strength and weight. Confusing these two dimensions can easily generate overreaction and underreaction. For instance, let’s assume that you have interviewed a potential employee and have taken up his or her references. You receive a letter of recommendation, which is full of glowing testimonials to your potential employee’s abilities in almost every walk of life. Sadly, the letter was written by the candidate’s mum.

The strength of the information is represented by the high level of the glowing traits talked about; the weight of the information is very low because the author of the letter is a highly biased source.

Tversky and Griffin (1992) have shown that, in general, a combination of high strength and low weight will generate overreaction, whereas low strength and high weight tends to create underreaction (see Table 2.1).

Investors often seem to confuse these two elements of information. For instance, when a firm announces either the introduction or suspension of a dividend payment, investors tend to underreact. They treat the information incorrectly. In fact, changes in dividend policy are very high weight (management doesn’t alter dividend policy lightly). However, they also tend to be low strength because investors (incorrectly) don’t place much emphasis on dividends.

In contrast, investors seem to almost continually overreact to firms with historically high earnings growth. Investors seem to take tremendous faith from a firm’s past history, rather than focusing on the likely prospects in the future (more on this later).

Table 2.1 The dimensions of information

Source: DrKW Macro research.

BIAS #3: SHOW ME WHAT I WANT TO SEE

Consider the following situation: Four cards are laid out in front of you, and each card carries one alphanumeric symbol. The set comprises E, 4, K, 7. If I tell you that if a card has a vowel on one side, then it should have an even number on the other, which card(s) do you need to turn over to see if I am telling the truth?

Give it some thought. Most people select E and 4. The correct answer is E and 7 as only these two cards are capable of proving whether or not I am lying. If you turn the E over and find an odd number, then I was lying, and if you turn the 7 over and find a vowel then you know I was lying. By turning the 4 over you can prove nothing. If it has a vowel then you have found information that agrees with my statement but doesn’t prove it. If you turn the 4 over and find a consonant, you have proved nothing. At the outset I stated that a vowel must have an even number. I didn’t say an even number must have a vowel!

So why are we drawn to E and 4? We have a very bad habit of looking for information that agrees with us. This thirst for agreement rather than refutation is known as confirmatory bias.