Investment psychology explainer for Mr. Market – introduction

Investment psychology

People are neither fully rational nor completely selfish

I offer an explainer that looks at the key ways psychological problems confound us as investors. I also offer a list of practical things we can do to overcome them.

The practical things are what Daniel Kahneman (Nobel Prize in economics) calls risk policies. Kahneman describes risk policies as decision rules that are always applied in similar situations. Examples he gives are in the insurance context: “always take the highest possible deductible when purchasing insurance” or “never buy extended warranties.”

Some think investment psychology is all about controlling our emotions. In fact that is only a very small part of it. One happy thought is that most other investors, including the professionals, also suffer from the same foibles. Once our investor psychology education is complete, we have a decided edge in the market. It is what I call the behavioral edge.

The great investors and investment psychology

To set the scene, let’s look at the ideas of some investing greats.

Keynes wrote in the 1930s: “It might have been supposed that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of and investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public.” (Keynes, 1936,2007)p.154.

What Keynes is talking about here is the investment industry’s focus on the short term. This is caused by what psychologists call the behavioral bias of ‘narrow framing’.

The old time investors knew a lot about investment psychology. Bernard Baruch is reported to have said: “Without due recognition of crowd-thinking (which often seems crowd-madness) our theories of economics leave much to be desired.” (Lowenstein, 1995,2008)p.306 In future posts we will look more deeply into the ever present danger of herd mentality, madness of crowds and groupthink. These are all behavioral biases that bedevil us.

Everybody knows about Ben Graham’s funny little fellow with incurable psychological problems called Mr. Market. As Warren Buffett explained in the 1987 Berkshire Hathaway letter to shareholders: “At times he feels euphoric and can see only favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.” Mr. Market suffers from a host of behavioral biases, including anchoring, priming, risk seeking behavior, risk aversion, herding and many more.

Peter Lynch one of the great investment managers of the 20th century wrote: “Things inside humans make them terrible stock market timers. The unwary investor continually passes in and out of three emotional states: concern, complacency, and capitulation. He’s concerned after the market has dropped or the economy has seemed to falter, which keeps him from buying good companies at bargain prices. Then after he buys at higher prices, he gets complacent because his stocks are going up. This is precisely the time he ought to be concerned enough to check the fundamentals, but he isn’t. Then finally, when his stocks fall on hard times and the prices fall to below what he paid, he capitulates and sells in a snit.” (Lynch, 1989,1990)p.70. Lynch is talking about what today behavioral psychologists would call, amongst other things, overconfidence, risk seeking and risk avoidance behaviors. These are all pathological behavioral biases.

To bring us up to date here’s something Howard Marks has written: “Whereas the key to ascertaining value is skilled financial analysis, the key to understanding the price/value relationship – and the outlook for it – lies largely in insight into other investors’ minds. Investor psychology can cause a security to be priced just about anywhere in the short run, regardless of its fundamentals.” (Marks, 2013)p.32. These can be caused by halo effect, wysiwyg, priming, anchoring and so on. Readers don’t have to understand all these terms at the moment.

If it wasn’t for the weird impact of investor psychology, the stock market would be fairly efficient. As it is, the stock market gyrates quite erratically. It is essentially a messy and inefficient affair. See my thoughts here on inefficient markets.

Psychological explanation

In the early 1970s, Amos Tversky and Daniel Kahneman, two Israeli psychologists, started working together on the subject of people’s attitudes to risky choices. The standard theory in psychology at the time, indeed in all social sciences including economics, was the ‘expected utility theory’. In 1979, they published their results in a paper titled “Prospect Theory: An analysis of Decisions under Risk.” This was the beginning of the study and application of behavioral psychology to decision making.

Their work was all about ‘violations of rationality’, ‘decision making’ and ‘risky choices’. These are naturally of great interest to investors.

Kahneman explains: “To a psychologist, it is self-evident that people are neither fully rational nor completely selfish, and that their tastes are anything but stable. Our two disciplines [psychology and economics] seemed to be studying different species, which the behavioral economist Richard Thaler later dubbed Econs and Humans.” An Econ is a utility maximizing rational man loved by economists. (Kahneman, 2011)p.269-270. Humans are, well, human.

Mr. Market is described by Warren Buffet as having incurable emotional problems. In truth, his emotional problems are the least part of it. What he really suffers from is behavioral biases and a propensity to make cognitive errors.

Behavioral biases and cognitive errors

So what are behavioral biases and cognitive errors? Psychologists, particularly behavioral psychologists study, amongst other things, both the behavioral side and the cognitive side of Humans. The cognitive side is the mathematical, logical and rational side. Cognitive errors are errors in how we think through problems or solve problems. One example is the problem we have intuiting probabilities and drawing inferences. Investors, like all Humans, regularly make cognitive errors that contribute to poor performance. We will also see that investors, like all Humans, regularly exhibit behavioral biases that also contribute to poor performance. Behavioral biases are systematic errors in our impressions and feelings that result in quirks of behavior that one would not expect of normal rational people i.e. Econs.

Most discussions of behavioral biases and cognitive errors and investing discuss lists of biases and errors and the impact they have on investors. Experts have identified scores of biases and errors. I have come at it somewhat differently. I have identified eight ways in which behavioral biases and cognitive errors harm our investing. In future posts I will go through each of these eight topics and explain the various biases and errors that are at work.

As we look at each of the eights areas I will explain how investors can overcome the problems by using decision rules and risk policies mentioned at the beginning of this post. These decision rules are for the most part derived from great investors. They reflect the learned instincts that they used consciously or unconsciously to counteract behavioral biases and cognitive errors. I call them gap-to-edge rules. To anticipate, here is a list of the gap-to-edge rules I have devised. Appendix 3: Gap-to-Edge Rules. They will be more meaningful once readers have a good understanding of the biases and errors they are designed to cure.

To read more deeply on investment psychology see Part 2: Human Foibles and Investment Decision Making

Specifically Chapter 9. Great Investors and Market Psychology

Chapter 10. The Behavioral Gap

Chapter 11. Two Different Species – Econs and Humans as Investors

For readers who want to look ahead see:

Chapter 12. Short Term Thinking and our Flower Garden

Chapter 13. Overweighting Improbable Outcomes

Chapter 14. Changing our minds

Chapter 15. Jumping to Conclusions

Chapter 16. We Overgeneralize and Find Causes

Chapter 17. Recent Events – Vivid Memories

Chapter 18. Over-confidence and Optimism

Chapter 19. Our Urge to Do what Everyone Else is Doing

Want to dig deeper into the principles behind successful investing?

Click here for the Motherlode – introduction.

If you like this blog, tell your friends about it

And don’t hesitate to provide comments