Behavioral Finance Course Transcript

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Behavioral Finance Fundamentals

 1. THE PSYCHOLOGY OF MARKETS

Welcome to this introductory session on behavioral finance.  My hope is that this session provides you with some insight into how behavioral finance allows us to explore market activity & the behavior of investors in more detail.

So let’s first start by exploring what behavioral finance is. In fact it’s the study of the influence of psychology on the behavior of investors or financial practitioners and ultimately the subsequent effect on the markets

In order to understand behavioral finance let’s contrast it first with modern finance.

Modern finance is predicated on the belief that both the market and investors are rational which we know we can shoot holes in. 

Modern finance also is predicated on the belief that investors truly care about utilitarian characteristics, have perfect self-control and they’re not confused by cognitive errors or information processing errors.

Modern finance theory is also predicated on the belief that investors are not only risk average but they are also never averse to regret. Which really means that investors never second guess their decisions which again we can shoot holes in.

Now let’s take modern finance theory and contrast that with behavioral finance.  Behavioral finance treats investors as “normal” not “rational”.  Behavioral finance tells us that investors actually have limits to their self-control. And finally, behavioral finance tells us that investors are influenced by biases. Biases that limit their ability to learn & that they can be confused by cognitive errors that we as human beings in the market can make wrong decisions because we process the information incorrectly.  Now let us explore behavioral finance in more detail.
 

2.  WE ALL MAKE MISTAKES

Ok, so now let’s explore some of the buckets, some of the building blocks that make up behavioral finances.

 As we’ve already talked about behavioral finances really looking investors as “normal” but also as being subject to decision making biases and errors. We can break down decision making biases and errors into at least four buckets.

A bucket of self-deception and self-deception are limits to the way we learn. 

We can also scope out a bucket that is often referred to as Heuristic simplification.  In other words, it is Heuristic simplification is information processing errors.

We can also scope out a bucket that’s related to emotion and we’re not going to dwell on this bucket in this introductory session, but I’m sure we all have an experience where our decisions have been influenced by whether we’re angry, sad, happy and so on. And that’s really what we are getting at, is how mood affects our decision making.    

And the final bucket, and we will talk about this briefly in our session is a social bucket. And what we mean by a social bucket is how our decision making is influenced by others.  So let’s explore these in more detail.

But before we do that I have a question for you. 

I am a, I grew up watching star trek I love star trek so in fact you may not be as passionate as I am but I’d like you to consider this, most of us have probably heard of these two members of the starship enterprise. Spock, the pointy ear fellow from Vulcan and McCoy the doctor. And you might recall that Spock, was the logical one and McCoy always, one of the phrases he would say is “Good God Spock! Don’t you have any heart or emotion?”. So, What I would like you to consider is if I were, if you were to consider yourself & you were to consider whether you were more like Spock or more like McCoy or maybe you’re a bit of both, where would you place yourself?  Are you someone who is more like McCoy that goes with his gut relies on intuition or are you more like Spock? Someone who actually is very logical and analytical in their thought processes and the way you approach decision making is very much on an analytical basis.
 

3. Spock vs. McCoy

So what did you decide? What is your preferred approach to decision making? Do you prefer to approach decision making logically? Or do you prefer to approach decision making more intuitively, going with your gut?

Psychologists will not refer to decision making as a Spock approach or  McCoy approach. Instead when you talk to psychologists they will refer to a Spock approach as a reflective reasoning approach. Some people refer to this as type one decision making. In fact, sometimes it’s been called left brain decision making. But the hallmark of a reflective reasoning approach is that you approach decision making logically. You weigh the pros and cons, you try and analyze all the information you have in front of you and it is typically slower because you have to follow a number steps to consider all the facts and analyze all the facts. It also often requires the deliberate effort of yourself to engage. In fact we as human beings don’t automatically think in a logical way we actually have to engage that left part of the brain to use type 1 decision making.

Let’s talk about McCoy now.. McCoy. Psychologists refer to a McCoy approach which again is making decisions based on your intuition, your “gut” as a reflexive reasoning approach it’s often referred to as type two decision making or right brain.  Reflexive reasoning is a more emotional approach to decision making. And what’s interesting about it is it’s automatic. Its effortless and in fact it’s our default option. We as human beings are hard wired to initially use this approach to decision making. We, then, if we do want to be analytical, we have to deliberately try and engage a “Spock” approach or reflective reasoning approach. So, this is the default option its effortless and automatic and what is powerful about this approach is that it deals with  information based on things like  similarity, familiarity, proximity & time and it can deal with a lot of information very simultaneously.  And psychologists argue that evolution has really guided us towards this as the default option. The reflexive reasoning approach. 

So, let me give you a little example. Let’s imagine I put a glass box on a table right in front of you. In the glass box is a snake & I ask you to lean into the glass box & the snake jumps up. What do you do? Most of us will immediately jump back. Even though we know that there is a glass box. Jumping back immediately, is our reflexive response. Its effortless, its automatic and we don’t have to think about it. Part way through that jumping back you may be thinking, like I would think, “Oh, what am I doing? I’m protected by the glass box.”  When that thought process comes in we’ve engaged our reflective reasoning approach. But by the time we have engaged it, it’s often too late. We’ve already jumped back.

So hopefully that’s given you a sense of both approaches to decision making both reflexive and reflective all of us have a bit of both. Although, some of us have a preference for one more than another. So let’s explore that preference in a bit more detail.  

4.  CRT ANSWERS

Shane Frederick of Yale has come up with a very simple test. Three question test that anyone can do that will give us insight into which decision making approach you prefer to use and how well you actually approach engaging the “Spock” or reflective reasoning decision making process.

So I’ll read out these three questions to you I’d like you to go with your, think through them very quickly your welcome to reflect on them but I’d like you to consider your answers to these three questions and jot them down on a scrap sheet of paper.

Question one.

A bat and ball together cost $1.10 in total.  The bat costs a dollar more than the ball. How much does the ball cost?

Ok, question two.

If it takes five minutes for five machines to make five widgets, how long with it take 100 machines to make 100 widgets? 

Finally question three.

In a lake there is patch of lily pads. Every day the patch doubles in size. If it takes 48 days for the patch to cover the entire lake, how long will it take to cover half the lake?    

5. CRT ANSWERS

Ok, let’s explore the answers to these questions. Recall that what we are exploring is the reflexive decision making process as opposed to the reflective decision making process. And how easy it is for you to engage the reflective or “Spock” type decision making process.

So, the first question we recall is about a bat and a ball costing a $1.10. If you jotted down $0.10, you got the wrong answer. In fact you relied heavily on your reflexive reasoning or “McCoy” approach. Engaging your logical decision making or reflective reasoning approach would tell you that the logical answer is actually $0.05. The bat is $1.00 more than the ball. If the ball is $0.05, the bat is $1.05 and it adds up to $1.10.

Next question. The incorrect answer is 100 minutes. Recall what the question was, the question was and I will have to look back. If it takes five minutes for five machines to make five widgets, how long would it take 100 machines to make 100 widgets? So, naturally your reflexive reasoning is probably hearing 5-5-5 you are then hearing 100 & 100 so, the incorrect answer, that many of you might have gotten, is 100 minutes. But if we actually break this down, logic shows that the correct answer, for making 100 widgets is only 5 minutes.  

Finally, the last question was about that pond with lily pads that is doubling in size every day. The most common incorrect answer using reflexive reasoning is to say something like 24 days. The correct answer, when you think about it, is 47 days. If the lily pads double size every day, the day and the lake is spilled on the 48th day, we know that the day before the lily pads cover half the lake.

So how well did you do? Most people typically, get at least one wrong.  James Moniter, who is an expert in behavioral finance, actually threw these questions out to 300 professional fund managers and 60% of those professional fund managers got at least one wrong.

So, how do we apply this to investing? Well, what this is telling you is how you approach decision making & how easy it is for you or how hard it is for you to engage a reflective reasoning approach, a “Spock” like reasoning approach. The more questions you got wrong, the more you can be influenced by cognitive biases or errors, thinking errors, and various self-deception biases. Limits to your learning. So now, let us explore some of these limits to learning in more detail.
 

6. SELF CONTROL

Ok now that we have done the CRT questions, how do we put this through to use in investing? Well one thing I am hoping you saw, was that the reflexive reasoning approach or “McCoy” approach often, often, leads to incorrect intuitive answers. Warren Buffett, actually amongst many others has repeatedly said that successful investing is all about learning to control reflexive or “McCoy” like decision making.

So how do we guard against this?

Well, the first thing that probably comes to mind is why don’t we use self-control? You may recall that when I talked about modern finance one of the assumptions that modern finance is based on  is that we do have perfect self-control. That might be great in theory but a vast amount of psychological research has been done that suggest that our ability to use self-control, to force our cognitive or logical thinking process to engage, is actually limited.  In fact it becomes even more limited whenever we are under a situation when stress is high and that stress can be high due to  time constraints or when there are high stakes involved. It also, our ability to use self-control is limited, when information is incomplete, ambiguous or its changing. And finally, when our decisions rely upon our interactions with others. Again, what psychological research has found is that our ability to engage self-control is limited. The big issue I’m hoping that you’ll see in these bullet points is that when we talk about the financial markets, all of this typically comes into play. Again our decisions in the market rely upon interactions with others, information is often incomplete and the stakes can be high. Often because we are investing a lot of money or we are trying to do this very quickly and subject to time constraints and we are trying to “buy, buy, buy”, “now, now, now”. So let’s explore. So we know that, we are, we have, we, even if we can engage our logical reasoning or reflective reasoning our ability to engage will be limited in many instances. So, how are we going to prevent ourselves or if we’re fund managers, or we are thinking about clients, how are we going to protect ourselves and other investors from falling into these “emotional” traps?

7. RATE YOUR DRIVING ABILITIES

Ok so how do we protect ourselves or prevent ourselves from falling prey to emotional reactions? Awareness is a big one. So what we are going to explore over the next few slides is just an awareness of these biases cause if we can name them or we are aware of them, we can put processes in place to try mitigate their effects.

So let’s explore some of these. So here is another test for you. I’d like you to consider your driving skills or if you don’t drive or have a driver’s license thinks about someone you often drive with and rate their driving skills. Would you rate your driving skills below average, average, or above average? In fact lets going even a bit deeper. Let’s think about in a scale from one to five. Would you consider yourself so below average that this phrase would be most appropriate. “I don’t think I could pass a driver’s test today?”

Or are you most comfortable with this statement. “I’m okay as long as I avoid tricky parking spots”. Maybe it’s the parallel parking.

Or would you consider this statement as reflective of your driving ability.

“Those accidents weren’t my fault”.

Okay, let us talk about above average. Would you consider yourself very good. Maybe this phrase would be more appropriate. “I’m fast but I avoid trouble.”

Finally consider this last box which states. “I’m excellent in fact I’m better than most drivers”.  Score yourself. 1 – If you think that you couldn’t pass a driver’s test today. Up to 5 – if you think you are excellent & way above average.

Now I’d like to do the same thing with someone else you know.  Someone you’ve experienced being a passenger in their car and experienced their driving. How would you rate them? It could be a parent, a partner, a child, a friend. Think of someone you have driven with recently and rate their driving. 

Now let’s explore the results of a couple of surveys that were done in 2011. There are many surveys in this regard. But what’s interesting is that most surveys show us the same thing. And it highlights, as I said, a need to be aware of some of the biases we have.  A U.S. insurance company called Allstate, did an academic survey of 1,000 U.S. adults in the summer of 2011.  And when they did the survey the vast majority, 64% of drivers, said that they  were above average. We know that’s mathematically impossible. But nonetheless,  most people rate themselves above average and other drivers as below average.

In Canada, one of the national newspapers, The Globe and Mail, did an informal survey where they solicited 12,000 responses again in the summer of 2011. Again, once more, the vast majority of survey respondents, rated themselves above average.  In fact, if you take the 5 various boxes that we listed, that I just listed and you if add up box #4 and 5 in fact, that adds up to 77%. 77% of those surveyed thought they were above average. Which again, is impossible.  So why have I shared that with you? It’s because one of the biases that leads to incorrect emotional decision making is overconfidence. Let’s explore that now in more detail.

8. OVERCONFIDENCE AND OVER-OPTIMISIM

Over confidence is a dangerous bias. But it is a very prolific bias. It fact overconfidence leads to the assumption that we are better than others, not only just at driving but at picking stocks.

Understanding where the markets  going and so on, when most of us are not above average.

James Montier actually again in this survey of 300 professional fund managers asked how many of them believe that they are above average in their jobs. And there were similar results for what we just talked about with driving abilities. 74% responded in the affirmative so 74% believed that they were above average. And of the remaining 26% most thought they were average. In fact, virtually no one thought they were below average. Which again, is impossible.

And what is fascinating is often the fund managers would get quotes like this “I know everyone else thinks they’re above average but I really am.”

The real danger of course is overconfidence. Actually lead to many mistakes in investing and it tends to stem from an illusion of knowledge and an illusion of control. 

So let’s explore what illusion of knowledge and control actually are and think about how do we put this bias, this overconfidence  bias in check.  

9. ILLUSION OF KNOWLEDGE AND CONTROL

Okay so how do we put this overconfidence bias in check. Well we need to understand the root causes. And two key root causes of overconfidence are these. One is the illusion of knowledge and one is the illusion of control. So let’s just explore both and then think about how we deal with these root causes.

One of the tendencies that we have is to assume that the accuracy of our decision making actually increases the more information we have. So the more time we spend, the more information we assimilate and analyze, the more confident and possibly overconfident we become in our decision making.

Here is the sobering news. There are numerous studies that have shown that information actually does not necessarily make investment decisions any more accurate.

What’s worse is that not only does it not make your decision making more accurate it actually leads you to be even more overconfident. Because of this illusion of knowledge.

Many people also believe though that they also have influence over events they do not control. How do we guard against both of these? And again that’s the final bullet on this slide.

On the slide there is a phrase and I’ll just read it out, “ It is what you do with the information you  have rather than how much you  have that matters.” In fact behavioral finance suggests this. Instead of trying to make sure that you have all the I’s dotted and T’s crossed.  And you’ve gathered every single bit of information and analyzed every bit of information. In fact your time would be better spent finding 5 things, key things, about an investment decision. Analyzing those in detail and leaving the rest aside. Let’s see some more biases now.

10. SELF ATTRIBUTION BIAS

You’ll recall, if you think back to one of the earlier slides, that one of our buckets was self-deception. A self-deception bias. And what we’re exploring now are some more of those self-deception biases. So one, is obviously, overconfidence. And the key thing to remember these are, remember these biases limit our learning or our ability to learn.

Here’s another one. It is called a self-attribution bias. And what happens is that we often have a tendency, and we want to keep this tendency in check, to attribute good outcomes to our skill and bad outcomes to sheer luck. Certainly I can, uh, I can think of things that I’ve done recently. Certainly, I do have the tendency, personally, to always think everything is going according to plan it’s clearly my skill. And certainly when things don’t go according to plan clearly I’ve just have bad luck.

This is a dangerous limit to our learning. Because in practice it could, there could be a whole host of reason why we’ve had an unexpected success or an unexpected failure. How do we actually try and mitigate this bias, this limit to our learning? One of the ways that you can do it is actually by recording and recognizing really what happened in the past and documenting what the reasoning behind your decisions and the outcomes that came as a result of that decisions. So, think about keeping an investment log. Jotting down every time you’ve actually, with your reasoning, delivered that good outcome but where you actually you had the right reasoning but unfortunately a bad outcome resulted. In one instance therefore it was skill in the other instance although you had the right reasoning it was just bad luck.

But likewise, when we have wrong reasoning we might have a good outcome but it’s important to acknowledge and label that as good luck. What’s also important acknowledge is that when we have wrong reasoning and bad outcome we clearly have made a mistake and we can learn from those mistakes. We do need to map out the outcome of our decisions and in fact George Soros has mentioned that he does this on several occasions as a way of mitigating this limit to learning.

11. HINDSIGHT BIAS

So we’ve talked about the need to keep an investment diary. We need to map the outcomes of our decisions and the reasons behind those decisions into various quadrants so we avoid that limit to learning. The investment diary though also helps us mitigate against another bias of self-deception bias, which is hindsight bias. Which again limits our ability to learn.  Hindsight bias really prevents us from recognizing our mistakes. And again hence is why I talk about as a limit to our learning because we have a tendency to believe after the fact that we knew about it all along. 

Think about the 2008 financial crisis or think about the dot.com bubble of the late 1990’s. If you talk to many people now they will, they will wax lyrically about how all the signs were there and everyone knew it was coming. However if you go back to 2007  or go back to the mid 1990’s what’s fascinating is the analysts, the investment professionals who were screaming that there was a problem, were not listened to, in fact, the markets ignored them.

So how do we guard against this bias? Well as I said, the investment diary, mapping outcomes to the reasoning behind the decisions we made is a usual way to keep this hindsight bias in check. Let’s explore another bias.

12. SHOW ME WHAT I WANT TO SEE

Another bias that limits our ability to learn is actually called confirmation bias and I have an example for you to work through.

Uh, I have 4 cards for you. One has an E, one has a 4 on one face, one has a K on one face and one has a 7. I’m gonna tell you that if a card has a vowel on one side, like the E then it should have an even number on the other. 

My question to you is which card(s) do you need to turn over to see if I am telling the truth? And more specifically, of the four cards, what’s the minimum number of cards you need to turnover in order to see if I am telling the truth, I’ll give you a minute or less to think about that.

 

13. CARD REVEALED

Okay what did you choose? Most people will choose the E & the 4. Unfortunately, that’s not the correct answer. The correct answer is actually, E & 7.

If you turn over the E, and you find that there is an odd number, you’ve proven that I was lying.

If you turn over the 7 and you find that there is a vowel, then again, I was lying.

By turning over the 4, if there is a vowel on the other side you only prove that, you don’t prove anything, all you do is confirm my statement. In fact, turning over the 4 proves nothing.

So, why are we bias to choose the 4? Let’s explore that in more detail but in short, it’s a confirmation bias.

 

14. CONFIRMATION BIAS

We are all prone to a confirmation bias. Uh, we tend to look for confirming uh, rather than disconfirming evidence. We have a really bad habit for looking for information, in other words, that agrees with us. We also, we have a tendency to form our views and then spend the rest of the day looking for all the information that makes us look right. Um, our naturally tendency is to listen to people who agree with us. Because it feel good, it feels all warm and fuzzy to hear our opinions reflected back to us.

I’d like you to think about where you get your news from. If you watch television, what’s your preferred news source? Do you prefer Fox News? Do you prefer CNN? If you’re based here in Canada, do you prefer the CBC? Where do you get your news from? In fact, many of us, will choose our news again, based on this confirmation bias.

We choose the news that reflects our views and opinions.  But that is disastrous for investment decision making. Instead we should be looking for disconfirming information and disconfirming evidence. That was the basis of Charles Darwin’s work, on evolution. Instead of looking for information that just confirmed he was right, he looked for information to disconfirm his theory.

So start looking for information that actually would possibly disprove your ideas rather than confirm what you want to do. And certainly that is how you try and guard against this bias.

15. THE NARRATIVE FALLACY

Another limit to our ability to learn is what’s called the narrative fallacy.

In other words, We Love Stories. In fact, we’re hard wired to love stories. Why do we love stories? Well typically, stories have an emotional content. Which appeals to our “McCoy” or reflexive reasoning. Because stories have that emotional component they’re very easy to remember.

In fact, when I teach I often use stories. Because I know when I go to participants the next day, and ask them what they remember they’re more likely to tell me the story than any of the formal information I taught.

The problem with stories is that they govern the way we think, we’re hard wired to prefer stories but what’s interesting in the financial markets and as investors, we will often abandon evidence in favor of a good story.  It’s one of the reasons why people actually shy away from value investing. Because value investing forces you to look at stocks that typically do not have good stories. In fact they often have horrible stories. The most admired stocks have the greatest stories but they also have the highest price.

So are you being limited in your learning by stories?  Label the stories set it to the side  and try and focus on the facts.

16. HOW DOES THIS APPEAR?

Okay now let’s move from self-deception biases, which limit our ability to learn, to information processing errors, commonly referred to as heuristic simplification. So let’s imagine this scenario. How does this appear? Consider Laura Smith. She is 31, single, outspoken & very bright. She majored in philosophy at university and as a student she was deeply concerned with issues surrounding equality and discrimination. Is it more likely that Laura works at a bank? Or is it more likely that she works at a bank and is active in the feminist movement

17. representative bias

Many people when asked this question go for option 2 that Laura works in a bank but is also active in the feminist movement. But that is incorrect.

In fact what you’ve done is you’ve actually been influenced by a representative bias.

Um, one of the things you want to think about is you want to judge things as they statistically, or logically as they are, rather than as they appear.

The second option you know that  “Laura works in a bank and is active in the feminist movement” is a subset of the first “Laura works in a bank”. Um, as a result, the second option can’t be larger than the first. But what’s fascinating is that people will often judge events. And again, investors will judge events often as they appear rather than how likely they really are.

So how do you guard against this bias?

Well, once again you may want to consider keeping an investment diary. Jotting down your reasoning and then matching it to the outcomes. Whether they be good outcomes or bad outcomes.

In, In the financial markets, a couple of examples of this representative bias is often investors automatically assume that good companies makes good investments. That is not, not necessarily the case.

Another example is you often will see analysts who will often forecast future results based on historic performance. Just because a company has seen high growth for the past five years doesn’t mean necessarily that this is going to continue for the next five or ten years. 

Let’s explore more some examples of heuristic simplification or information processing errors.

18. Phraising as a gain

Another example where investors’, uh, base information processing errors or possible heuristic simplification relates to something called framing. So let me give you an example. This example is actually from the 1970’s and I’ll share with you, uh, what the studies found in the 1970’s. Let’s imagine a situation where we have a disease is affecting 600 people. We have two choices you need decide between the two, again this decision, like an investment decision. If we implement program A 200 of the 600 people will be saved. If we choose program B there is a 33% chance that all 600 people will be saved and a66% chance that nobody will be saved. Which one do you choose? (Time elapse 00:50 to 00:57). 72% of the people when surveyed in the 1970’s chose Program A. Now mathematically if we look at Program A relative to Program B and we look at expected values the number involved is that 200 people will be saved in this, in Program A we explicitly say Program A, 200 will be people saved. But in program B if we calculate the expected value based on these percentages and the fact that there are 600 people involved the expected value is also 200.  What’s interesting is a couple of things. First of all I want you to look at how this is phrased. In fact this is phrased as a “gain”. We’re talking about 200 people saved as opposed as 200 people lost. And what’s interesting is when things are phrased as gain most people tend to be, to choose the risk adverse option which is Program A because we have the certainty that 200 people will be saved. Now let’s turn the coin on the other side and look in a different way to frame this same example and see how that affects your decision making.

19. PHRASING AS A LOSS

Okay now let’s take the same example but instead of phrasing the option as gains for example 200 people will be saved we’re going to phrase the options as losses. So again we have a disease affecting 600 people and again you have two choices. Program C, instead of saying 200 people will survive, we’re going to say that 400 people will die. Whereas in Program D there is a 33% chance that nobody will die and a 66% perchance, sorry, 66% chance that all 600 people will die.  Which one would you choose? (Time elapse 00:37 to 00:40). When a separate goup, group was surveyed in the 1970’s, 78% of those surveyed choud, chose Program D. whereas in the previous case when we phrased everything as a gain most people chose Program A which is basically identical to Program C. In fact the decision was influenced simply by the phrasing. In this instance, phrasing as a loss, whereas in the previous, previous example we were phrasing it as a gain. This phrasing, the impact of phrasing on our decision making is often referred to as framing.

20. FRAMING BIAS

So what we’ve seen and what we see in the financial markets as it relates to investing is that we can change the phrasing or how a problem is framed and it can cause us, as investors to change our conclusions. What’s fascinating is that when investors are not sure of all the facts or in the presence of many unknowable factors which often, uh,  reflect what’s happening in the market there is in fact a highly possibility of reflexive decision making and therefore an increase possibility of being influenced by framing. How do we guard against this bias? Well one of the things you can do, as an investor, is always challenge the framing. Consider rephrasing the information you’re reading and see what impact that has on your conclusion. The key thing is trying to kick in that logical, reflective or “Spock” approach to decision making.  Let’s move on.

21. ANCHORING BIAS

Another bias that we need to label and acknowledge in order to mitigate against is something called the anchoring bias. If I were to ask you where you think Apple, the company Apple stock, will be in three months, what, how would you approach it? Many people would first say, okay where’s the stock today? And then based on where the stock is today make an assumption on where it’s going to be in three months.  That’s a form of anchoring. We’re starting with a price today and we’re building our sense of value based on that anchor. Anchoring is dangerous but it is prolific in the markets. Anchoring is, uh, uh, the degree of anchoring, I should say, is going to be heavily by how salient the anchor is. Uh, But the more relevant the anchor seems the more people will tend to cling to it. What’s fascinating is also the harder something is to value the more we rely on anchors. So when we think about currency values, uh, which are intrinsically hard to value often anchors get involved. The problem with anchors is that they don’t necessarily reflect the intrinsic value. And we can get hung up on the anchor rather than the intrinsic value. So how do you guard against an anchoring bias? Well, as it say here, there’s no substitute for rigorous critical thinking. When you approach evaluation instead of looking at where the stock is now, why not build up a first principles evaluation using DCF and see where that lies. What’s fascinating is when analysts do that and they find that their evaluation is far out from the actual stock price. The typical analysts will then try to change their evaluation to match the market because again they’re being influenced by the anchor instead of trusting their own due diligence.

22. LOSS AVERSION

Consider again those three CRT questions. The more you got wrong the more likely you are going to be prone to loss aversion. What’s interesting about loss aversion is that investors feel the pain of a loss between 2 and 2.5 times as much as they enjoy equivalent gains. Many investors also believe a loss isn’t really a loss until it is realized. So that together with loss aversion, we actually find, that in practice investors often will want to hold on to their losing stocks and sell their winning stocks when in fact they should be doing the reverse. Selling their losers and riding their winners. In fact when investors studies have been done it has been found that individual investors often twice as likely to sell winning stocks then their losing stocks. Well how do you guard against a bias like this? This loss aversion bias? Well certainly stop losses, which act as a form of pre-commitment, will help mitigate some of the, uh, some of the um, drivers of investors holding on to those losing stocks and selling off their winners.

23. WHICH RESTAURANT DO YOU GO TO?

You may recall at the beginning of this session I spoke about four buckets of decision making errors and biases. We started by talking about Self-deception biases, which are limits to learning. We then moved to Heuristic simplification, or information processing errors. The third bucket was emotion, or how our mood affects our decision making. Which I mentioned we won’t go into detail. But then the fourth bucket and that’s what we’re going to explore now was called Social, or how we’re influenced by others. So consider the following.

You’re in a new city and you’re looking for a place to eat. Its early evening and you see two Greek restaurants right across the street from each other. Which restaurant do you choose?

24. HERDING BIAS

Which restaurant did you choose? The one that’s crowded, full of people or the restaurant with a lot of open tables? It’s interesting; we’re hard wired to herd. When asked, most people will choose the busy restaurant over the anti-restaurant. They’re making their decision based on the decision of others. But what would, what would happen if I told you this. That in fact, the first few tables of people were actually hired actors. The restaurant hired the actors to sit in the restaurant to make the restaurant look busy. How would that affect your decision?

The key thing is that we are hard wired to herd. There is a large weight of evidence of herding in the financial markets. You can think about the dotcom bubble. Where the dotcom’s did not have financially sound business models but everyone bought into it because everyone else is buying into it. You often see herding with analysts recommendations. One of the things to be very wary of is in fact we do feel pain when if we go against the crowd. In some instances psychologists have found that it actually causes physical pain for people to be contrary investors.

So, while everyone’s jumping into Apple stock, if you’re recommending the we actually sell Apple stock that could cause you and/or a client physical pain.

In fact, in one psychological study, they found that “being a contrarian investor or encouraging other people to be contrarian investors, doing exactly the opposite of the crowd, was like actually having your arm broken on a regular basis.”  

The key thing is going against the crowd or non-conformity, does trigger immediately fear in people.

25. INDEPENDENT THINKING

Let’s explore herding in more detail. Because here’s the bigger problem. The problem of herding is exasperated because most of us convince ourselves that we are independent thinkers. In fact, most of us believe that we act without influence from the crowd when in fact we are being significantly influenced by the crowd. One study, for example, of 40 iPod owners, asked them how influenced they were by others, in terms of the trendiness of the product. And in fact, of the 40 iPod owners, most of them said they were influenced in no way by others.

So, how do you guard against this bias? We assume we’re independent thinkers and so in fact we don’t even acknowledge that we’re being influenced by the crowd. Will ultimately come down to the need to be a critical thinker. To have courage to be different and have perseverance to stick to your principles. 

26. FOCUSING ON PROCESS

We’re getting to the end of our session, our introductory session on Behavioral finance. So, how should we conclude? I’ll get you to think back to one of the two core building blocks of this module, which is, are two approaches to decision making. The “Spock”, reflective decision making, its logical but requires effort to actively engage. Verses the “McCoy”, go with your gut, intuitive decision making that’s effortless, automatic and in fact is our default option.

The biases limits to learning the cognitive errors, information processing errors, herding are all symptoms of a reliance on reflexive or “McCoy” intuitive thinking. The more we rely on reflexive decision making the more prone we are to self-deception biases, heuristic simplification, influences of emotion and influences of herding and being influenced by the behavior of others.

So how do we try and mitigate against reflexive decision making? Well one one way, of course, is to try and actively engage logical decision making. How do we do that in practice? Well, talking to investment professionals, what they do is they set up processes, processes, and processes.  Consider setting up processes that guides you through a logical decision making approach and therefore help mitigate the use of reflexive decision making. Get yourself focused on a process rather than outcome. If you’re advising others, try to encourage the people you’re advising to think about the process again, rather than on the outcomes. Focusing on process will lead to better decisions. Because the process helps you engage your “Spock” like reflective decision making.

Focusing on outcomes can create all sorts of unwanted actions. So, for example, portfolio managers may find that they end up buying stocks simply because they find those stocks easy to justify to clients rather than those that really, truly represent the best opportunity.

27. PREPARE, PLAN AND PRE-COMMIT

So what lesson do I want to leave you with for this introductory session to Behavioral finance?  Well Behavioral finance teaches us to invest by preparing, by planning and by making sure we pre-commit. So let me finish with a quote from Warren Buffett.

“Success in investing doesn’t correlate with IQ once you’re above the level of 100. Once you have ordinary intelligence what you need is the temperament to control the urges that get other people into trouble”.

I hope you’ve enjoyed this session; and we look forward to seeing you again. 

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