Monday, October 24, 2016

We Are Not Always So Rational, Part 3

Montparnasse derailment, 1895. Source: Wikipedia

In the previous 2 posts, we discussed the common behavioral biases that we suffer and where they originate from. In this third post, we discuss the impact of our biases: on ourselves, our portfolios and on the markets.

Impact on ourselves

The financial markets affect all investors’ mental health, at least to some degree.

Even the most conservative, long-term oriented investors felt some shock during the 1987 ‘Black Monday’ crash, 2008 financial crises and 2010 flash crash. On the other end of the spectrum, there are the aggressive types that treat the markets like a casino. It is this group that is particularly damaging their mental well-being.

Aggressive traders are ones that routinely do one or more of the following:
  • Watch every tick of the market and binge on financial media
  • Trade based on emotion without a process, or use a highly complex process
  • Take concentrated and/or leveraged positions in volatile securities (eg. micro-cap stocks)
  • Over-trade / day-trade

Engaging in these activities chronically can lead to addiction, stress, anxiety and even depression. It cannot be overstated how bad stress is for us. How can we prove there is a definitive link between money and mental health issues?

Source: Scott Camazine—Getty Images

There has been extensive scientific research done on how the brain is affected by money. There’s even an entire discipline devoted to it: Neuroeconomics. Studies from the past two decades have revealed that there is a whole lot happening in our brains when money comes up.

In 1997, a study performed brain scans on 12 people that played a game in which they could win or lose money. What they found was that players who were about to make money had increased neural activity in their nucleus accumbens – the region of the brain tied to reward, pleasure, motivation and addiction. These scan images were compared to those of addicts who were high on cocaine. Remarkably, the scans were nearly identical.

In one 2003 study, test subjects were paired with complete strangers. Each pair was given a sum of money and asked to split it. One person would act as the “proposer” while the other as the “responder.” If the pair cannot agree on a split, then neither walks away with cash. The study found that the responders rejected over half the unfair offers (which is irrational since something is better than nothing). But more interestingly, the study found these unfair offers activated a part of the brain in the responders associated with anxiety, pain and hunger.

In 2005, a study was done at Stanford University using Functional Magnetic Resonance Imaging (fMRI). Brain activity of participants was monitored as they chose between stocks and bonds given limited performance info of each. The researchers found they could predict whether a participant would choose to buy a riskier security, like a stock, or a less risky one, like a bond, just by scanning their brains. The subjects who had naturally elevated stimulation of their nucleus accumbens would most likely buy the stock.


Impact on our portfolios

"When it comes to investing, you are your own worst enemy." – Barry Ritholtz

Not only do biases cause the average investor to suffer health consequences, they also cause serious financial consequences. Our individual biases cause us to make all sorts of portfolio mistakes:
  • Poor allocations: holding concentrated positions in a few stocks or holding too much cash 
  • Poor timing: Holding losers too long, selling winners too early
  • Frequent trading: getting too caught up in day-day noise, falsely believing you can outsmart the market in the short term, trying to irrationally climb out of a loss

Over the 20 year period ending Dec 2008, the folks at Dalbar show us exactly how much damage the average equity investor did to their portfolios: 

Impact on markets

We see that our irrationality in the markets hurts us mentally and financially. Interesting things happen when you look at the behaviour of all individuals as a group.

Each individual investor may make different mistakes (due to their unique biases, genetics, experiences, knowledge, etc.). They may be more loss-averse or suffer greater overconfidence bias than their neighbour. Occasionally, their biases will even cause them to get lucky. However, it turns out that as a group we are extremely consistent at being wrong.

The chart below shows the average individual’s asset allocation between 1988-2010. The average person had a record high allocation to stocks in Jan 2000 (the peak of the tech bubble) and record low allocation to stocks in March 2009 (the exact month the markets bottomed after the 2008 financial crises).  

We can take this one step further.

The chart below shows the average household’s % allocation to equities (blue) and the subsequent 10 year return for the S&P500 (black). This chart is often dubbed the “single best stock market predictor” because of how accurately current investor allocation to stocks can predict future 10-year returns of stocks.

Source: MarketWatch and Ned Davis Research

Note that the scale for the S&P 500 is inverted. Basically, when everyone is in love with stocks, future stock returns are low (and vice versa).

Thus, the collective biases of all market participants cause markets to deviate from perfectly efficient. The momentum anomaly which I discuss often on this blog is partly explained by two behavorial biases: regret aversion ("herding effect") and availability bias ("recency effect"). Other factors are explored in the first post on this blog: Philosophy of Momentum.

In theory, investor sentiment can directly be used to outperform the market. Contrarian investors buy when the herd is bearish and sell when the herd is bullish. But how is sentiment measured? The main methods include: surveys (eg. AAII), money flows, portfolio allocations and options activity (eg. put/call ratios). There are a few research outfits such as and Ned Davis that make a living off selling sentiment research.

However, sentiment trading suffers the same problem as value investing: something that is hated can become even more hated.  A great recent example of this is commodity stocks, which have repeatedly trended lower since 2011 despite breaking all sorts of sentiment records as early as 2013. John Maynard Keynes famously said: “The market can remain irrational longer than you can remain solvent.

Another point I want to make clear is that sentiment is but one factor that drives markets and for the short-term. There are other factors (such as the business cycle, institutional buying/selling, central bank actions) that also influence markets in the short-term. Over the long-term (eg. 10 years), markets have been observed to respect valuations and mean-revert (eg. the current Shiller P/E ratio is a rough indicator of future 10-year stock returns).

Trend following (and momentum) is a much better approach* at outperforming the market. It aligns itself with the market’s trend, which is the collective result of several forces (sentiment being one of them). *It is important to note that this approach must be simple, systematic, evidence-based, robust and of course, forecast & bias free. GEM is one such approach.

To summarize:

Actively investing solely on your cognitive & emotional biases will result in drastically underperforming the broad market and at a cost to your health. The collective irrationality of individuals (among other factors) leads to markets being less than efficient. By being cognizant of this, we can take a trend following approach to outperform the broad market while simultaneously reducing our stress & anxiety.

I will need to add one more post to this series. In part 4, we will look at techniques that will help reduce the impact our emotions have on our investing to ensure we stick to our plan. Stay tuned.

Sunday, October 2, 2016

We Are Not Always So Rational, Part 2

Recall from our previous post that we investors suffer from behavioral biases that lead us to make poor decisions. There are two main types:
  • Cognitive biases (resulting from lack of knowledge, faulty logic and memory errors) 
  • Emotional biases (making decisions based on impulse and feelings)
We discussed some cognitive biases already, so let’s take a look at the other type.

Emotional Biases

  • Loss Aversion (also known as Prospect Theory) – this is when we strive to avoid losses rather than seek gains.
An investor is said to be risk-averse if they feel more pain from a $1 loss than pleasure from a $1 gain (and risk-seeking if they feel more pleasure from the gain). If offered a stock and told there’s an equal chance of it either falling to $90 or rising to $100, the risk-averse investor would not pay more than $95 (ie. the expected value of the stock) while the risk-seeking investor would. 
An investor that is loss averse may initially be risk-averse, but when faced with losses, can become risk-seeking in an irrational attempt to climb out of the loss. The implications of loss-aversion are massive. They include:  
- Holding excessively conservative portfolios (eg. heavy in bonds or cash)
- Not selling losers in order to avoid a realized loss
- Trying to climb out of a loss by doubling down on losers or trading excessively  
  • Overconfidence Bias – Overestimating your own intuitive ability or reasoning. 
Example: Ask an audience how many think they are below-average investors and few hands will go up. In fact, studies show that 95% of us view ourselves as above-average drivers! Truly astonishing.
  • Endowment bias - We give greater value to things we already own or are familiar with. In investing, this leads to holding securities too long or in concentrated sizes. This is also related to the tendency for investors to concentrate their portfolio in their home country, as it's familiar. 
Example: You're deciding between a Toyota Camry and a Honda Accord and have no idea which is better. 6 months after purchasing one, that car becomes familiar and you say "I don't know what I was thinking even considering the other car!
  • Regret aversion - Making choices simply to avoid potential regret. People often do what others are doing in fear of being left behind, leading to the "herd behavior effect"
Example: During the NASDAQ bubble of late 90's, many individuals were buying into the market for fear of missing out. 
  • Status Quo Bias – Comfort with an existing situation leads to an unwillingness to make changes or consider other, better options. 
Example: Selecting the default asset allocation on an employer defined-contribution plan and not changing it with the passage of time. This leads to a portfolio with inappropriate risk
  • Self-Control Bias - Lacking self-discipline and favoring immediate gratification at the expense of not meeting long-term goals. Too many people do not save enough to fund retirement needs

We’ve now looked at 12 cognitive and emotional biases. This just scratches the surface as it turns out there are at least dozens more that we suffer from. The more you study our decisional flaws, you realize that we are nowhere near the rational, number-crunching computers that efficient market theory assumes we are.

Where do our biases come from?

Psychology identifies what our biases are while biology explains where they originate from. 

We humans evolved very slowly over 6 million years from more primitive origins. Each generation produced offspring with some genetic variation. Those with traits providing a better survival edge (no matter how slight) had higher probability of passing on those traits to the next generation. We were shaped in this progressive and cumulative process over millions of years (though the above picture makes you question the “progressive” part!)

The majority of our history was lived in a perilous world. Our traits are well adapted to suit this environment, helping us fend off predators, hunt prey, build shelter & tools, etc. It is only in the last 6,000 years (or 0.1% of our human history) that civilization as we know it has been around, and only 200 years (0.003% of our history) that we’ve been living in an industrialized world. In a very short period, we enjoyed a dramatic increase in our standard of living. Suddenly, we no longer needed to spend the majority of our time and energy worrying about our survival. 

Our mind and bodies, however, have not been able to keep up since evolution is a slow process. It can be argued that this has led to some major health issues we face today from: a sedentary lifestyle, radically different diet and constant barrage of information and interruptions to name a few. We especially are poorly equipped to manage our investment portfolio. Handheld phones with stock prices refreshing every second are sabotaging our ability to maintain a long-term mindset. 

Perhaps we may never fully adapt to this new world: our standard of living is so high that our biological imperfections don’t significantly hurt our chances of survival. You will still be able to eat even if your portfolio isn’t holding the right asset allocation or if you don’t understand what standard deviation is!

Evolutionary Psychology is a separate discipline that attempts to explain mental traits—such as memory, perception, or language—as products of natural selection. On the most basic level, we feel positive emotions (euphoria, excitement, confidence) when we receive things that increase our survival and replication chances. We feel negative emotions (fear, anger, panic, frustration) when it’s the opposite. 

Some of the behavioral biases we discussed can at least be partly explained by Evolutionary Psychology as follows: 
  • Loss aversion: "For an organism operating close to the edge, the loss of a day's food could amount to death, while the gain of an extra day's food could lead to increased comfort but (unless it could be costlessly stored) would not lead to a corresponding increase in life expectancy." - Wikipedia
  • Endowment bias and Status-Quo bias: you stick to what is familiar because it is safer and reduces risk. It could cost your life if you wandered into a new, unfamiliar part of the woods alone. 

So far in the series, we discussed several behavioral biases that cause us to make poor investment decisions and where these biases originate from. In the third (and last) part, we’ll look further into the impact of our biases on our investing as well as how we can minimize this impact. But first…

Quiz Time!

See if you can identify the behavioral bias in each Dilbert comic strip below. Answers can be found on my twitter feed (@sharpeReturns).