Sunday, August 28, 2016

We Are Not Always So Rational, Part 1

A personal note

I’m proud to say that I have recently been awarded the CFA charter.

Although I’m fortunate to have passed each of the 3 exam levels on the first try, it took me a long time to complete the program. I wrote level 1 in 2009, followed by level 2 in 2011. At that time, I was working as an engineer and didn’t see the value in finishing.

Also around that time, I first discovered the work of Meb Faber and Gary Antonacci. I continued to research markets on the side since then and Gary has really been instrumental in accelerating my learning curve. A little over a year ago, Gary nudged me to start this blog. And earlier this year when I met Gary in person for the first time, he encouraged me to finish the CFA program. It’s been a very interesting journey so far and I hope to share more announcements with you in the future.

Incidentally, both Meb and Gary are coming to my hometown Vancouver on Sept 6th to give presentations. Small world. If you live in the area, I highly recommend you attend. Register here.

The most interesting topic in finance

Of the 3 CFA levels, the third one taught material I enjoyed the most. It skips the humdrum accounting and statistics of other levels and instead focuses heavily on portfolio management. There were a couple chapters dedicated to Behavioral Finance (BF) – what I consider to be the most interesting topic in investing.

BF is the study of human nature and its impact on our investment decisions. It challenges the main assumption of traditional finance: that individuals are rational and that the markets they shape are efficient. It is where the world of investing intersects the disciplines of psychology, history and biology.

As we will see, investors suffer from numerous behavioral biases that lead them to wreck havoc on their portfolio. It is truly amazing how many distinct biases there are that they need to be categorized into two main categories:
  1. Cognitive – faulty decisions that arise from the lack of knowledge, information processing errors or memory errors
  2. Emotional – faulty decisions that stem from feelings, impulses or intuition

The remainder of this post will discuss some common cognitive biases. There is so much to discuss on the topic of BF, that we will follow up with 2 more posts:
  • Discussion of common emotional biases, plus a quiz!
  • Impact of our biases, how to minimize this impact as well as additional resources

Cognitive Biases

  • Anchoring – New info is not viewed objectively, but rather in relation to an initial view or thought.
Example: Studies show that when a group is asked to estimate the price of a car, the average estimate tends to be reasonable. However, if asked first what the last digit in their phone number is, people who had a higher digit tend to over-estimate the car's price.
  • Framing - When the same information is presented in different ways, it leads to different outcomes.
Example: Sally is loss averse. When her advisor presents a new fund in terms of historical return and volatility, Sally invests. However, when the advisor presents the same fund in terms of probability of a loss, Sally declines to invest.
  • Availability Bias - Giving undue emphasis on info that is readily available and fresh in our minds. This leads to giving higher importance to recent events rather than old events (the "recency effect"). 
Example: Bob chose to invest with XYZ fund because of a billboard ad he sees on his daily commute.
  • Confirmation Bias – looking for new info to support an existing view.
Example: Soon after buying stock XYZ, you selectively search for bullish articles while ignoring any bearish articles.
  • Hindsight Bias – Overestimating what could have been known. People often remember their correct views while forgetting their errors
Example: “I saw the 2008 crises coming all along” 
  • Conjunction Fallacy – before explaining this one, I want you to participate in this question:
Linda holds very strong views about the environment. Which is more likely?

a) Linda is a bank teller, or
b) Linda is a bank teller that donates to an environmental organization

If you said (b), that is incorrect. But don’t feel bad, 80% of people choose that answer.

The probability of Linda being a bank teller is already small. But for her to make a donation in addition to being a bank teller reduces the probability further. This example shows how we can be tricked into believing that two events have a higher chance of occurring together than either one occurring on their own. That’s the conjunction fallacy.

In part 2, we’ll look at some common emotional biases. Stay tuned