Human foibles
Take advantage of Mr. Market’s behavioral biases
With the passing of Danny Kahneman this past week at age 90, I thought I would do a post on investment psychology, a subject in which his contribution has been immense. He won the 2002 Nobel Prize in Economic Sciences, which is not bad for a psychologist.
One of his main areas of study was decision theory (Prospect Theory). This is essentially the study of how humans make decisions in face of risk. It is part of the field of behavioral psychology. Specifically, he looked at human foibles in the decision-making process, what is called behavioral biases and cognitive errors.
The notion of decision making under risk describes investing perfectly.
From an investing point of view
Most writing about behavioral biases and cognitive errors tends to describe one or make a list and discuss its or their impact. Some of these lists are pretty darned long. The problem with this approach is that it looks at the problem from the point of view of behavioral psychology rather than from the point of view of investing.
I have tried to come at the problem differently. I have tried to identify the areas in investing where human foibles are at play and then see what behavioral psychology can do to help us.
In this post I will list the areas of investing where human foibles operate. Then I will offer some concrete ideas on how investors can not only check the foibles but also gain an investing edge by taking advantage of other investors foibles.
Kahneman’s neat idea of risk policies
Kahneman’s book, Thinking Fast and Slow published in 2001, brings his many years of research and thinking together in one book. It contains a whole chapter on Risk Policies. In this regard, it helps to understand concepts like risk aversion, risk seeking, broad framing and narrow framing.
He writes: “Decision makers who are prone to narrow framing construct a preference every time they face a risky choice. They would do better by having a risk policy that they routinely apply whenever a relevant problem arises.”
Examples he gives are in the insurance context: “always take the highest possible deductible when purchasing insurance” or “never buy extended warranties.” He explains: “The relevant issue is your ability to reduce or eliminate the pain of the occasional loss by the thought that the policy that left you exposed to it will almost certainly be financially advantageous over the long run.” So, the long run becomes the Broad Frame. In this context, Kahneman’s risk policy is used to deal with the problem of Loss Aversion. (Kahneman, Thinking Fast and Slow 2011) pp334-341
So, investors should be able to adopt risk policies to deal with the challenges of investment psychology. Let’s hold that thought for a moment.
The challenges of investment psychology
The greatest failing of most investors, both professional money managers and individual investors, is a failure to understand the impact of their own very human foibles and that of other stock market participants as a whole. As Howard Marks wrote: “Investor psychology can cause a security to be priced just about anywhere in the short run, regardless of its fundamentals.” (Marks, The Most Important Thing Illuminated: Uncommon sense for the thoughtful investor. 2013) p32
There is a fallacious theory that smart investors will step in the moment a stock trades at less than fair value and that prices on the stock market tend to be right (notion of perfect arbitrage). This is just not true as Howard Marks explains.
Readers who are not sure how important investment psychology is to successful investing are invited to read my post Investment psychology explainer for Mr. Market – introduction
What follows is a list of what I think are the most common investment psychology problem areas. They are not listed in order of importance:
Short term thinking;
Today everyone is fretting about inflation and the potential for a recession. Trying to decide on the outlook for these macro-economic things can be a distraction.
Focusing too much on Recent Events;
It is very important not to fall into the attractive trap of extrapolating the most recent past into the future. This is driving by looking in the rear view mirror.
Distorted risk sense;
Our gut needs training. Many of our instinctive feelings are the exact opposite of what we should be doing. We need to control our animal spirits when faced with risky situations.
Our Urge to Do what Everyone Else is Doing;
Herding. All stock market prices are both the cause and result of herding behavior amongst investors.
Changing our minds;
Our minds search for confirming evidence that we are right and shy away from contrary evidence.
Overgeneralizing and Finding Causes;
The strong bias toward believing that small samples closely resemble the population from which they are drawn is also part of a larger story. It’s sometime called, with irony, The Law of Small Numbers.
Over-confidence and Optimism;
Subjective confidence in a judgment is not a reasoned evaluation of the probability that this judgment is correct.
Jumping to Conclusions.
Many of our judgments and decisions are guided directly by feelings of liking and disliking, with little deliberation or reasoning.
Let me introduce two ideas to understand before we think about risk policies for investors – the behavioral gap and the behavioral edge.
By buying and selling at the wrong time, or as a result of any of the other investor foibles listed above, investors suffer from poor results and what has been called the behavioral gap. The gap is the spread between their portfolio results (worse) and the performance of the underlying securities (better).
Through reading and experience investors can develop skill. With time they can enjoy a behavioral edge. They can enjoy superior performance. They are able to do this because their counterparty is Mr. Market.
Risk policies for investors
I offer gap-to-edge rules as the best way to address the problem of behavioral biases and cognitive errors. They are my version of Daniel Kahneman’s risk policies.
The term risk policy suggests an approach that is, in an investment context, purely defensive. Gap-to-edge rules are designed to address both the behavioral gap and the behavioral edge. As well, I have chosen to use the word ‘rule’ rather than Kahneman’s word ‘policy’. The word ‘policy’ suggests a little less discipline in its use. I might have used the expression ‘gap-to-edge maxim’. ‘Maxim’ is the word used by John Templeton to list his essential rules of investing conduct.
Gap-to-edge rules have a dual function. They play defense to help the investor avoid the behavioral biases and cognitive errors that lead to the behavioral gap (the gap in gap-to-edge). That is, they are used to avoid the traps that lead to underperforming the market. At the same time gap-to-edge rules play offence, to help the investor take advantage of Mr. Market’s behavioral biases and cognitive errors, to create a behavioral edge (the edge in gap-to-edge).
The term gap-to-edge rule is not elegant. I would be happier if I could find a more felicitous expression. It does capture my idea clearly. I prefer clarity to sweetness. The idea is to adopt rules to improve your performance.
The gap-to-edge rules need not be followed slavishly. For every rule there is an exception. Kahneman’s word ‘policy’, Templeton’s word ‘maxim’ and my word ‘rule’ carry essentially the same meaning. It may seem inconsistent to propose rules and emphasize discipline in their use and then say there will be exceptions. I don’t pretend the world is simple. Investors have to be both disciplined and flexible.
There is a full list of all gap-to-edge rules in the Motherlode Appendix 3: Gap-to-Edge Rules
The following posts deal with each of the problem areas for investors.
A set of rules to develop a behavioral edge – Part 1 The problem of short-term thinking
A set of rules to develop a behavioral edge – Part 2 The attractive trap of extrapolating the most recent past into the future
A set of rules to develop a behavioral edge – Part 3 Control our animal spirits when faced with risky situations
A set of rules to develop a behavioral edge – Part 4 The herd mostly gets it wrong
A set of rules to develop a behavioral edge – Part 5 Our minds search for confirming evidence
A set of rules to develop a behavioral edge – Part 6 We generalize from limited observations
A set of rules to develop a behavioral edge – Part 7 Over-confidence and optimism bias
A set of rules to develop a behavioral edge – Part 8 Jumping to conclusions
Conclusion
The average investor (and the professional) who is prepared to put in the time to read about and understand investment psychology will be well rewarded.
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Other posts on investment psychology
This post is part of a series. Readers are invited to read Investment psychology explainer for Mr. Market – introduction This will give you a better understanding of some of the terms and ideas and give you links to other posts in the series.
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You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
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You can also use the word search feature on the right-hand side of this page to find references in both blog posts and also in the Motherlode.
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There is also a Table of Contents for the whole Motherlode when you click on the Motherlode tab.
Want to dig deeper into the principles behind successful investing?
Click here for the Motherlode – introduction.
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