The Insightful InvestorUsing cutting-edge psychology to invest smarter
Tuesday, December 13, 2011
The Problem: Human Fallibility
Tuesday, December 13, 2011
Investing mistakes
• underperformance
• rack up excessive fees
• failure to reach financial goals
• susceptibility to fraud
Tuesday, December 13, 2011
The facts
$100k investedfrom 1989-2009 S&P 500 Average
investor
Returns (after inflation)
$292,329 $82,288
Dalbar Inc. Study
Tuesday, December 13, 2011
Modern day behavioral finance provides an
understanding of the problems
Tuesday, December 13, 2011
If we know problems, we can create solutions
Tuesday, December 13, 2011
How we make investment decisions
rules of thumb that we turn to quickly to size
up our surroundings
Heuristics
Tuesday, December 13, 2011
our brains are actually hardwired to making
irrational choices
-- Richard Thaler, Author of Nudge
Neuroeconomics
Tuesday, December 13, 2011
Mental models• simply a
representation of an external reality inside your head
• concerned with understanding knowledge about the world
Source: http://www.farnamstreetblog.com/mental-models/
Tuesday, December 13, 2011
As investors, where do we go wrong?
Tuesday, December 13, 2011
Availability Bias
Investors predict
likelihood of future events
based on what is personally
relevant
[perspective matters]
Tuesday, December 13, 2011
Availability Bias
• Mental Model: Availability Bias (Farnam Street)• Judgment under Uncertainty: Heuristics and Biases (Kahneman, Tversky)• Investment Decisions: How to Avoid Availability Bias (Wise Investing)• How professional biases can cloud judgment (Applied Behavioral Finance)• Cognitive Biases Series -- PBS (Meir Statman) [.pdf]
[learn more]
Tuesday, December 13, 2011
Confirmation BiasTendency for investors to
favor information that supports their
preconceptions, regardless of whether it’s
true
[looking for ways to be right]
Tuesday, December 13, 2011
Confirmation Bias
• How to Ignore the Yes-Man in your Head (WSJ)• Overview of Confirmation Bias (CXO Advisory)• Confirmation Bias, Overconfidence, and Investment Performance: Evidence from Stock Message Boards (Park, et al)• Confirmation Bias (Distressed Debt Investing)
[learn more]
Tuesday, December 13, 2011
Anchoring Bias
Investor tendency to
attach or anchor our
thoughts to a reference point
[basing decisions on irrelevant figures and statistics]
Tuesday, December 13, 2011
Anchoring Bias
• The Psychology Behind Common Investor Mistakes (The Big Picture)• Anchoring (Jonah Lehrer)• The Cognitive Bias Song (Freakonomics)• Surprised Again? The Anchoring Bias of Investors (Psychology Today)
[learn more]
Tuesday, December 13, 2011
Overconfidence
We tend to think we are
better investors than we really
are
[overconfidence leads to over trading, lower returns]
Tuesday, December 13, 2011
Overconfidence
• Boys will be Boys: Gender, Overconfidence, and Common Stock Investment (Barber, Odean) [.pdf]• Overconfidence and Over Optimism (Psy-Fi Blog)• Evolution of Overconfidence (Farnam Street)• U.S. Investor Behavior: The Government Report (Portfolioist)• T2 Partners’s Netflix Mea Culpa: A Study in Behavioral Finance (Stone Street Advisors)
[learn more]
Tuesday, December 13, 2011
Hindsight BiasTendency for investors to
look at the past and see events
more predictable than
they actually were
[dang, my judgment is good!]
Tuesday, December 13, 2011
Hindsight Bias
• Hindsight’s not so wonderful (Psy-Fi Blog)• Cognitive Biases: A Visual Study Guide (Scribd)• Heuristics: The Foundation of Adaptive Behavior (Decision Science News)• Blink and statistics: a close reading (Numbers Rule Your World)• Confirmation Bias, Again (Random Roger)
[learn more]
Tuesday, December 13, 2011
Loss Aversion
Investors feel pain of loss 2x
as much as they derive pleasure from an equal
gain
[I’ll take door #3, Chuck]
Tuesday, December 13, 2011
Loss Aversion
• Loss Aversion (Jonah Lehrer)• Loss Aversion (The Economist)• Can Losing Lead to Winning (Farnam Street)• The behavioral economics of Pay-as-you-Drive (PAYD) auto insurance (Nudge)• Regrets? I’ve had a few (Tim Harford)
[learn more]
Tuesday, December 13, 2011
Paralysis by Analysis
Investors facing too many
decisions freeze up and make bad decisions
[Eesh, information overload!]
Tuesday, December 13, 2011
Paralysis by Analysis
• Choice Proliferation, Simplicity Seeking and Asset Allocation (Iyengar, Kamenica)• Decisions, Decisions: Too Much Choice Hard for Investors (AdvisorOne)• When Choice is Demotivating: Can One Desire Too Much of a Good Thing (Iyengar, Lepper)• So many funds, so little time: The case for simplicity (Reuters Money)
[learn more]
Tuesday, December 13, 2011
Mental AccountingDividing current
and future assets into
separate mental accounts,
investors assign different values
to each
[well, I bought the ticket anyway...]
Tuesday, December 13, 2011
Mental Accounting
• The Curse of Mental Accounting (Wired)• The Psychology of Money: The Last Mile of Saving (I Will Teach You to Be Rich)• Mental Accounting Explains Why You Buy Things You Don’t Need (Forbes)• Mental Accounting (Washington Post)• The benefits of mental accounting (Marketplace)
[learn more]
Tuesday, December 13, 2011
Social Proof Bias
Investors ascribe a high
value to investments
other investors are interested
in
[gee, if Bob invested in it...]
Tuesday, December 13, 2011
Social Proof Bias
• Avoid Losses: 5 Ways Investment Researchers Lie to You (FinancialMentor)• How Social Proof Helps Smart Investors (Zero Hedge)• Is social proof a rational approach to investment selection (Quora)• Asch Conformity Experiment (Simply Psychology)• How I lost 89% on 1 stock (Fool)
[learn more]
Tuesday, December 13, 2011
Regret Aversion Bias
We regret and remorse more for actions we did take than
ones we didn’t
[crud, I knew I shouldn’t have bought that stock!]
Tuesday, December 13, 2011
Regret Aversion Bias
• Regrettable Choices (Cabot)• Regret, Portfolio Choice, and Guarantees in Defined Contribution Schemes (Muermann, et al)• 2010 Behavior Study: Conservative Biases (Morningstar Advisor)• Is it OK to overpay (Nudge)
[learn more]
Tuesday, December 13, 2011
Status Quo Bias
Investors tend not to make
changes unless offered a really
compelling incentive
[you know, change is just so scary]
Tuesday, December 13, 2011
Status Quo Bias
• Status Quo Bias in Decision Making (Samuelson and Zeckhauser)• Status Quo Bias (Slideshare)• Barry Schwartz on the paradox of choice (TED Talks)• Our Own Worst Investing Enemies: How We Make Retirement More Difficult (Wise Investing)
[learn more]
Tuesday, December 13, 2011
Vividness BiasUnderestimate low probability
events that haven’t
happened recently and overestimate
them when they have --Buffett
[that couldn’t happen to me]
Tuesday, December 13, 2011
Vividness Bias
• Making the future easier to imagine can improve retirement outcomes (Allianz)• The Vividness of your Future Self: Using Immersive Virtual Reality to Increase Retirement Saving (Stanford Graduate School of Business)
[learn more]
Tuesday, December 13, 2011
The Effects of our Biases
Tuesday, December 13, 2011
Endowment Effect
Investors place a higher value on investments
they already own
[investors have a hard time selling]
Tuesday, December 13, 2011
Endowment Effect
• It’s mine, I tell you (The Economist)• The Endowment Effect (Jonah Lehrer)• Why it’s so hard to let go (MarketPsych)• Why do people hold on to losing stocks (Nudge)
[learn more]
Tuesday, December 13, 2011
Mean Reversion Effect
Belief that investments will return to their
mean
[aw, it’s gotta come back!]
Tuesday, December 13, 2011
Mean Reversion Effect
• Mean Reversion in Stock Prices: Evidence and Theory (Summers and Poterba)• Shrinking margins make stocks’ cheapness just a mirage (Forbes)• 4 Mean Mean Reversions (Pragmatic Capitalism)• Mean Reversion Redux (Quantivity)
[learn more]
Tuesday, December 13, 2011
Overtrading
Trying to profit by excessive buying and
selling
[but, I’ve got the magic touch]
Tuesday, December 13, 2011
Overtrading
• Just How Much Do Investors Lose From Trading (Barber, Lee, Liu)• Annual Dalbar Individual Investor Study (Dalbar)• When to Buy or Sell? Don’t Trust Your Instincts (New York Times)
[learn more]
Tuesday, December 13, 2011
Do nothing
When overwhelmed, some investors just shut down
[thanks for the advice, but I’ll just keep things as is]
Tuesday, December 13, 2011
Do nothing
• Asset Allocation and Information Overload: The Influence of Information Display, Asset Choice and Investor Experience (Agnew and Szykman)• Situational overload and ambient overload (Rough Type)• Data Overload for Retail Investors (onwallstreet)
[learn more]
Tuesday, December 13, 2011
So much boils down to framing
Tuesday, December 13, 2011
Framing is part of our outlook, how we compare things to other things, how we judge our performance.
The way we naturally frame investing hurts us. It causes us to:
• take on more risk than we really should as we reach too far for gains• equate study and hard work with beating the market when it’s not that simple• put too much faith in experts or in stock picks• look at things as all or nothing when in reality, there is an infinite spectrum• take a very short term focus
Framing: It’s all relative
Tuesday, December 13, 2011
Reframing our thinking about investing
• Overcome the need to break even• If investing in individual stocks, set clear exit points and
plan for different scenarios (put this in writing)• There are always two sides of a trade: focus on the
person selling (or buying) you stock and ask yourself why
Tuesday, December 13, 2011
Batting 1.000: winning without losing
The investment game is no longer a buy-and-hold game. It’s a buy and sell game -- it’s called Day Trading. (Meir Statman, What
Investors Really Want, 57)
Investors have shown a reluctance to sell losers -- to their detriment. Dr Richard Peterson of MarketPsych calls this
“hitting the investment snooze button”.
[impossible!]
Tuesday, December 13, 2011
Wow, investors have a lot of biases
Tuesday, December 13, 2011
So, how do we *win* at the investing
game?
Tuesday, December 13, 2011
The Goal
Tuesday, December 13, 2011
The first step is admitting you have a problem
Tuesday, December 13, 2011
But, it’s not just enough to recognize the problem
Need self awareness/
behavioral changes
Tuesday, December 13, 2011
The ability to consistently (always) make money based on an approach or a system
that can be executed with total confidence.
-- Robert Koppel (Investing and the Irrational Mind, 26)
Tuesday, December 13, 2011
Many different systems work
We don’t stick to the systems
BUT
Tuesday, December 13, 2011
“The real secret to investing is that there is no secret to investing.
Every important aspect of value investing has been made available to the public many times over, beginning in 1934
with the first edition of Security Analysis.
That so many people fail to follow this timeless and almost foolproof approach enables those who adopt it to
remain successful.”
-- Baupost’s Seth Klarman, 6th edition of Security Analysis (2008)
Tuesday, December 13, 2011
Emotional Investing
Cognitive Investing
Make the shift
Tuesday, December 13, 2011
Overcoming the animal spirits
In an experiment at CalTech, participants
ranked the most expensive wine the tastiest
(only when they were told of the real price)
Tuesday, December 13, 2011
investors must learn how to
• determine what kind of investor you are• set realistic and achievable investment goals• learn how to be disciplined and patient• manage risk effectively• learn from mistakes• preserve investment and emotional capital
(Investing and the Irrational Mind, 50)
Tuesday, December 13, 2011
Your optimal investing strategy depends on who you
are.
-- Dr Richard Peterson, MarketPsych: How to Manage Fear and Build your Investor
Identity, 27
[big idea]
Tuesday, December 13, 2011
Figure out who you are as an investor
Change/Reframe
if necessary
Tuesday, December 13, 2011
• Are you money-focused or life-focused?• Market orientation vs. self-orientation?• Sporadic vs. Consistent Investing Frames
MarketPsych
Tuesday, December 13, 2011
MarketPsych
Emotional needs Financial needs
?
Tuesday, December 13, 2011
Investments offer 3 types of benefits
1. utilitarian2. expressive3. emotional
tradeoffs
Tuesday, December 13, 2011
To reframe
Dr Peterson of MarketPsych recommends creating a slide show in 5 steps
1. identify topics about future financial life2. make it vivid3. capture the feeling4. record it5. match financial plan
Tuesday, December 13, 2011
Learning from the greatest investors
Tuesday, December 13, 2011
Emotional Intelligence (EI)
Superior Investment Performance
[new evidence]
Sources:Emotional intelligence and investor behavior (Ameriks, et al, 2007) [.pdf]Exploring the Nature of “Trader Intuition” (Bruguier, et al, 2010) [.pdf]
Tuesday, December 13, 2011
Measure your own personality
1. Emotional sensitivity2. Extraversion3. Openness4. Agreeableness5. Conscientiousness
The Big 5
Tuesday, December 13, 2011
Go to:http://www.marketpsych.com/personality_test.php
Test your own investor personality
Tuesday, December 13, 2011
Personality test My score How it affects my investing
My plans to accomodate
Conscientiousness vs impulsiveness
Emotional stability vs. sensitivity
Extraversion vs. introversion
Agreeableness vs. self-interest
Openness vs traditionalism
Sample Personality Test from MarketPsych
Tuesday, December 13, 2011
Traits of the great investors
They remained upbeat after a series of losses, staying
calm, focused, and analytical throughout the ups and downs of the market
(Investing and the Irrational Mind, 26)
Tuesday, December 13, 2011
Not emotionless, but utilize “good” emotions and avoid “bad”
confident, self-aware, goal oriented, organized
Good investors are
Tuesday, December 13, 2011
1. don’t speculate unless you do it full time2. resist so-called information or tips3. before purchasing a security, know everything you can about
the company: its earnings and its capacity for growth4. never attempt to buy at a bottom or sell at a top of a
market: this is a feat achieved only by liars5. take your losses swiftly and clearly -- the first loss is your
easiest6. don’t buy too many securities. focus on a few
investments that can be monitored carefully.7. periodically reappraise all your investments to make
sure that they are appropriate for your particular strategy8. know when you can sell to your greatest advantage (of
course, this also applies to buying)9. never invest all your funds. keep some liquid.10.Don’t try to be a jack of all investments. stick to the field
you know best.
Bernard Baruch’s 10 Rules for Investing Success
Investing and the Irrational Mind, 17
Tuesday, December 13, 2011
The Game: Redefining what investing is all about
Tuesday, December 13, 2011
The game is composed of two parts: the outer game and the inner game.
The Inner Game of Tennis by Timothy Gallwey, captain of the Harvard University Tennis Team
Tuesday, December 13, 2011
Tennis vs. Investing
“The former is played against opponents, and is filled with
contradictory advice.
The latter is played not against, but within the mind of the player, and its
principal obstacles are self-doubt and anxiety.”
(Investing and the Irrational Mind, 25)
Tuesday, December 13, 2011
Putting theory to practice
Tuesday, December 13, 2011
• not defining a loss• not taking a loss/profit• getting locked into a belief• getting lured into status investments• revenge investing• wishful thinking• getting swept up in bubbles• not seizing an opportunity• being more invested in being right than making money• confusing the noise with the signal• not applying investment method consistently • not having a money management plan• not investing in the right state of mind
How investors lose to psychology
Tuesday, December 13, 2011
Becoming a better investor
Tuesday, December 13, 2011
[define a loss]
Rational investors follow the maxim “Cut your losses and let your profits run”
(What Investors Really Want, 134)
understand mental accounting clear hindsight bias
vanquish pride avoid regret
don’t try to get-even/revenge realize losses
[homework]
Tuesday, December 13, 2011
[define a loss]For portfolio
buy individual, fixed maturity bonds including zero-coupons: bought at a discount, avoid mental accounting errors because investors should
get back all invested capital at maturity date
vs.
holders of bond mutual funds never assured that they will not incur a loss when the
sell(What Investors Really Want, 145)
Tuesday, December 13, 2011
[avoid traps in status displays]
conquer the usual suspects
• envy• schadenfreude (happiness at the
misfortune of others)• stay clear of status competitions• be skeptical investments sold on
exclusivity/access
Tuesday, December 13, 2011
Average millionaire spends $31k on a car
[know when to hold ‘em]
Thomas Stanley, Stop Acting Rich
Tuesday, December 13, 2011
[be wary of crowded trades]
“I will tell you how to become rich. Close the doors. Be fearful
when others are greedy. Be greedy when others are fearful.”
-- Warren Buffett
Tuesday, December 13, 2011
[be wary of crowded trades]
• use good judgment of information
• assess consequences of being wrong about the herd
Tuesday, December 13, 2011
[have a money management plan]
• Truly understand tradeoffs of actively managed funds vs. passive index funds
• scrutinize and pay fair fees for advice (regardless of active/passive)• sometimes advice pays because it helps avoid bigger
problems• piggyback others’ ideas, stock picks carefully (great
investors make mistakes)• social investing injects more voices into the discussion
Tuesday, December 13, 2011
• Tradestreaming.com
• FarnamStreetBlog.com
• Psy-Fi Blog
• What Investors Really Want (Statman)
• Investing and the Irrational Mind (Koppel)
• MarketPsych: How to Manage Fear and Build your Investor Identity (Peterson)
• Tradestream your Way to Profits: Building a Killer Portfolio in the Age of Social Media (Miller)
[resources]Web Books
Tuesday, December 13, 2011