Tag: Social Proof

The Psychology of Risk and Reward

The Psychology of Risk and Reward

An excerpt from The Aspirational Investor: Taming the Markets to Achieve Your Life's Goals that I think you'd enjoy.

Most of us have a healthy understanding of risk in the short term.

When crossing the street, for example, you would no doubt speed up to avoid an oncoming car that suddenly rounds the corner.

Humans are wired to survive: it’s a basic instinct that takes command almost instantly, enabling our brains to resolve ambiguity quickly so that we can take decisive action in the face of a threat.

The impulse to resolve ambiguity manifests itself in many ways and in many contexts, even those less fraught with danger. Glance at the (above) picture for no more than a couple of seconds. What do you see?

Some observers perceive the profile of a young woman with flowing hair, an elegant dress, and a bonnet. Others see the image of a woman stooped in old age with a wart on her large nose. Still others—in the gifted minority—are able to see both of the images simultaneously.

What is interesting about this illusion is that our brains instantly decide what image we are looking at, based on our first glance. If your initial glance was toward the vertical profile on the left-hand side, you were all but destined to see the image of the elegant young woman: it was just a matter of your brain interpreting every line in the picture according to the mental image that you already formed, even though each line can be interpreted in two different ways. Conversely, if your first glance fell on the central dark horizontal line that emphasizes the mouth and chin, your brain quickly formed an image of the older woman.

Regardless of your interpretation, your brain wasn’t confused. It simply decided what the picture was and filled in the missing pieces. Your brain resolved ambiguity and extracted order from conflicting information.

What does this have to do with decision making? Every bit of information can be interpreted differently according to our perspective. Ashvin Chhabra directs us to investing. I suggest you reframe this in the context of decision making in general.

Every trade has a seller and a buyer: your state of mind is paramount. If you are in a risk-averse mental framework, then you are likely to interpret a further fall in stocks as additional confirmation of your sell bias. If instead your framework is positive, you will interpret the same event as a buying opportunity.

The challenge of investing is compounded by the fact that our brains, which excel at resolving ambiguity in the face of a threat, are less well equipped to navigate the long term intelligently. Since none of us can predict the future, successful investing requires planning and discipline.

Unfortunately, when reason is in apparent conflict with our instincts—about markets or a “hot stock,” for example—it is our instincts that typically prevail. Our “reptilian brain” wins out over our “rational brain,” as it so often does in other facets of our lives. And as we have seen, investors trade too frequently, and often at the wrong time.

One way our brains resolve conflicting information is to seek out safety in numbers. In the animal kingdom, this is called “moving with the herd,” and it serves a very important purpose: helping to ensure survival. Just as a buffalo will try to stay with the herd in order to minimize its individual vulnerability to predators, we tend to feel safer and more confident investing alongside equally bullish investors in a rising market, and we tend to sell when everyone around us is doing the same. Even the so-called smart money falls prey to a herd mentality: one study, aptly titled “Thy Neighbor’s Portfolio,” found that professional mutual fund managers were more likely to buy or sell a particular stock if other managers in the same city were also buying or selling.

This comfort is costly. The surge in buying activity and the resulting bullish sentiment is self-reinforcing, propelling markets to react even faster. That leads to overvaluation and the inevitable crash when sentiment reverses. As we shall see, such booms and busts are characteristic of all financial markets, regardless of size, location, or even the era in which they exist.

Even though the role of instinct and human emotions in driving speculative bubbles has been well documented in popular books, newspapers, and magazines for hundreds of years, these factors were virtually ignored in conventional financial and economic models until the 1970s.

This is especially surprising given that, in 1951, a young PhD student from the University of Chicago, Harry Markowitz, published two very important papers. The first, entitled “Portfolio Selection,” published in the Journal of Finance, led to the creation of what we call modern portfolio theory, together with the widespread adoption of its important ideas such as asset allocation and diversification. It earned Harry Markowitz a Nobel Prize in Economics.

The second paper, entitled “The Utility of Wealth” and published in the prestigious Journal of Political Economy, was about the propensity of people to hold insurance (safety) and to buy lottery tickets at the same time. It delved deeper into the psychological aspects of investing but was largely forgotten for decades.

The field of behavioral finance really came into its own through the pioneering work of two academic psychologists, Amos Tversky and Daniel Kahneman, who challenged conventional wisdom about how people make decisions involving risk. Their work garnered Kahneman the Nobel Prize in Economics in 2002. Behavioral finance and neuroeconomics are relatively new fields of study that seek to identify and understand human behavior and decision making with regard to choices involving trade-offs between risk and reward. Of particular interest are the human biases that prevent individuals from making fully rational financial decisions in the face of uncertainty.

As behavioral economists have documented, our propensity for herd behavior is just the tip of the iceberg. Kahneman and Tversky, for example, showed that people who were asked to choose between a certain loss and a gamble, in which they could either lose more money or break even, would tend to choose the double down (that is, gamble to avoid the prospect of losses), a behavior the authors called “loss aversion.” Building on this work, Hersh Shefrin and Meir Statman, professors at the University of Santa Clara Leavey School of Business, have linked the propensity for loss aversion to investors’ tendency to hold losing investments too long and to sell winners too soon. They called this bias the disposition effect.

The lengthy list of behaviorally driven market effects often converge in an investor’s tale of woe. Overconfidence causes investors to hold concentrated portfolios and to trade excessively, behaviors that can destroy wealth. The illusion of control causes investors to overestimate the probability of success and underestimate risk because of familiarity—for example, causing investors to hold too much employer stock in their 401(k) plans, resulting in under-diversification. Cognitive dissonance causes us to ignore evidence that is contrary to our opinions, leading to myopic investing behavior. And the representativeness bias leads investors to assess risk and return based on superficial characteristics—for example, by assuming that shares of companies that make products you like are good investments.

Several other key behavioral biases come into play in the realm of investing. Framing can cause investors to make a decision based on how the question is worded and the choices presented. Anchoring often leads investors to unconsciously create a reference point, say for securities prices, and then adjust decisions or expectations with respect to that anchor. This bias might impede your ability to sell a losing stock, for example, in the false hope that you can earn your money back. Similarly, the endowment bias might lead you to overvalue a stock that you own and thus hold on to the position too long. And regret aversion may lead you to avoid taking a tough action for fear that it will turn out badly. This can lead to decision paralysis in the wake of a market crash, even though, statistically, it is a good buying opportunity.

Behavioral finance has generated plenty of debate. Some observers have hailed the field as revolutionary; others bemoan the discipline’s seeming lack of a transcendent, unifying theory. This much is clear: behavioral finance treats biases as mistakes that, in academic parlance, prevent investors from thinking “rationally” and cause them to hold “suboptimal” portfolios.

But is that really true? In investing, as in life, the answer is more complex than it appears. Effective decision making requires us to balance our “reptilian brain,” which governs instinctive thinking, with our “rational brain,” which is responsible for strategic thinking. Instinct must integrate with experience.

Put another way, behavioral biases are nothing more than a series of complex trade-offs between risk and reward. When the stock market is taking off, for example, a failure to rebalance by selling winners is considered a mistake. The same goes for a failure to add to a position in a plummeting market. That’s because conventional finance theory assumes markets to be inherently stable, or “mean-reverting,” so most deviations from the historical rate of return are viewed as fluctuations that will revert to the mean, or self-correct, over time.

But what if a precipitous market drop is slicing into your peace of mind, affecting your sleep, your relationships, and your professional life? What if that assumption about markets reverting to the mean doesn’t hold true and you cannot afford to hold on for an extended period of time? In both cases, it might just be “rational” to sell and accept your losses precisely when investment theory says you should be buying. A concentrated bet might also make sense, if you possess the skill or knowledge to exploit an opportunity that others might not see, even if it flies in the face of conventional diversification principles.

Of course, the time to create decision rules for extreme market scenarios and concentrated bets is when you are building your investment strategy, not in the middle of a market crisis or at the moment a high-risk, high-reward opportunity from a former business partner lands on your desk and gives you an adrenaline jolt. A disciplined process for managing risk in relation to a clear set of goals will enable you to use the insights offered by behavioral finance to your advantage, rather than fall prey to the common pitfalls. This is one of the central insights of the Wealth Allocation Framework. But before we can put these insights to practical use, we need to understand the true nature of financial markets.

The Art of Thinking Clearly

(Update: While the book will likely make you smarter, there is some question as to where some of the ideas came from.)

The Art of Thinking Clearly

Rolf Dobelli's book, The Art of Thinking Clearly, is a compendium of systematic errors in decision making. While the list of fallacies is not complete, it's a great launching pad into the best of what others have already figured out.

To avoid frivolous gambles with the wealth I had accumulated over the course of my literary career, I began to put together a list of … systematic cognitive errors, complete with notes and personal anecdotes — with no intention of ever publishing them. The list was originally designed to be used by me alone. Some of these thinking errors have been known for centuries; others have been discovered in the last few years. Some came with two or three names attached to them. … Soon I realized that such a compilation of pitfalls was not only useful for making investing decisions but also for business and personal matters. Once I had prepared the list, I felt calmer and more levelheaded. I began to recognize my own errors sooner and was able to change course before any lasting damage was done. And, for the first time in my life, I was able to recognize when others might be in the thrall of these very same systematic errors. Armed with my list, I could now resist their pull — and perhaps even gain an upper hand in my dealings.

Dobelli's goal is to learn to recognize and evade the biggest errors in thinking. In so doing, he believes we might “experience a leap in prosperity. We need no extra cunning, no new ideas, no unnecessary gadgets, no frantic hyperactivity—all we need is less irrationality.”

Let's take a look at some of the content.

Guarding Against Survivorship Bias

People systematically overestimate their chances of success. Guard against it by frequently visiting the graves of once-promising projects, investments, and careers. It is a sad walk but one that should clear your mind.

Pattern Recognition

When it comes to pattern recognition, we are oversensitive. Regain your scepticism. If you think you have discovered a pattern, first consider it pure chance. If it seems too good to be true, find a mathematician and have the data tested statistically.

Fighting Against Confirmation Bias

[T]ry writing down your beliefs — whether in terms of worldview, investments, marriage, health care, diet, career strategies — and set out to find disconfirming evidence. Axing beliefs that feel like old friends is hard work but imperative.

Dating Advice and Contrast

If you are seeking a partner, never go out in the company of your supermodel friends. People will find you less attractive than you really are. Go alone or, better yet, take two ugly friends.

Think Different

Fend it off (availability bias) by spending time with people who think different than you do—people whose experiences and expertise are different from yours.

Guard Against Chauffeur Knowledge

Be on the lookout for chauffeur knowledge. Do not confuse the company spokesperson, the ringmaster, the newscaster, the schmoozer, the verbiage vendor, or the cliche generator with those who possess true knowledge. How do you recognize the difference? There is a clear indicator: True experts recognize the limits of what they know and what they do not know.

The Swimmer's Body Illusion

Professional swimmers don’t have perfect bodies because they train extensively. Rather, they are good swimmers because of their physiques. How their bodies are designed is a factor for selection and not the result of their activities. … Whenever we confuse selection factors with results, we fall prey to what Taleb calls the swimmer’s body illusion. Without this illusion, half of advertising campaigns would not work. But this bias has to do with more than just the pursuit of chiseled cheekbones and chests. For example, Harvard has the reputation of being a top university. Many highly successful people have studied there. Does this mean that Harvard is a good school? We don’t know. Perhaps the school is terrible, and it simply recruits the brightest students around.

Peer Pressure

A simple experiment, carried out in the 1950s by legendary psychologist Solomon Asch, shows how peer pressure can warp common sense. A subject is shown a line drawn on paper, and next to it three lines—numbered 1, 2, and 3—one shorter, one longer, and one the same length as the original one. He or she must indicate which of the three lines corresponds to the original one. If the person is alone in the room, he gives correct answers because the task is really quite simple. Now five other people enter the room; they are all actors, which the subject does not know. One after another, they give wrong answers, saying “number 1,” although it’s very clear that number 3 is the correct answer. Then it is the subject’s turn again. In one-third of cases, he will answer incorrectly to match the other people’s responses

Rational Decision Making and The Sunk Cost Fallacy

The sunk cost fallacy is most dangerous when we have invested a lot of time, money, energy, or love in something. This investment becomes a reason to carry on, even if we are dealing with a lost cause. The more we invest, the greater the sunk costs are, and the greater the urge to continue becomes. … Rational decision making requires you to forget about the costs incurred to date. No matter how much you have already invested, only your assessment of the future costs and benefits counts.

Avoid Negative Black Swans

But even if you feel compelled to continue as such, avoid surroundings where negative Black Swans thrive. This means: Stay out of debt, invest your savings as conservatively as possible, and get used to a modest standard of living—no matter whether your big breakthrough comes or not

Disconfirming Evidence

Munger Destroy ideas

The confirmation bias is alive and well in the business world. One example: An executive team decides on a new strategy. The team enthusiastically celebrates any sign that the strategy is a success. Everywhere the executives look, they see plenty of confirming evidence, while indications to the contrary remain unseen or are quickly dismissed as “exceptions” or “special cases.” They have become blind to disconfirming evidence.

Still curious? Read The Art of Thinking Clearly.

Pluralistic Ignorance

“If everyone is thinking alike, then somebody isn't thinking.”
— George S. Patton

***

I bet you live this almost every day.

Imagine you're in a meeting with a lot of important people. The boss comes in, takes a seat, and starts talking about “strategic market knowledge” this and “leveraging competitive advantages” that.

To you, it all sounds like gibberish. For a second you think you're in the wrong meeting. Surely someone else must feel equally confused??

So you take a quick sanity check. You look around the room at your colleagues and … what?? They are paying attention and nodding their head in total agreement? How can this be?

They must know something you don't know.

You quickly determine the best option is to keep your mouth shut and say nothing, hiding what you think is your own ignorance. A wise career move perhaps, but makes for a pretty dull life.

This is pluralistic ignorance, a psychological state characterized by the belief that one's private thoughts are different from those of others. The term was coined in 1932 by psychologists Daniel Katz and Floyd Allport and describes the common group situation where we privately believe one thing, but feel everyone else in the group believes something else.

In the case above, pluralistic ignorance means that rather than interrupting the meeting to ask for a clarification, we'll sit tight and nod like everyone else.

It's a real life version of The Emperor’s New Clothes, the fairy tale where everyone pretends the king is wearing clothes until a child points out the emperor isn't wearing any clothes.

Dan Ariely, in this short video, explains and demonstrates pluralistic ignorance better than I can. Make sure you watch the whole thing, the kicker is at the end.

Basically we look toward others for cues about how to act when we really should take a page out of Richard Feynman's book: What Do You Care What Other People Think?

The Destructive Influence of Imaginary Peers

Imaginary Peers

Tina Rosenberg with a thoughtful op-ed in the NYT on the influence people around us have on our decisions, even, oddly, when they are imaginary.

Bad behavior is usually more visible than good. It’s what people talk about, it’s what the news media report on, it’s what experts focus on. Experts are always trying to change bad behavior by warning of how widespread it is, and they take any opportunity to label it a crisis. “The field loves talking about the problems because it generates political and economic support,” said Perkins.

This strategy might feel effective, but it’s not — it simply communicates that bad behavior is the social norm. Telling people to go against their peer group never works. A better strategy is the reverse: give people credible evidence that among their peers, good behavior is the social norm.

In short, stop nagging people about what they shouldn't be doing and instead tell them how other people are doing the right thing.

Why does this work?

Because when we don't know what to do in a situation, we naturally look around to see what other people are doing. “From that we learn what is appropriate, and what is practical.”

With traditional approaches to behavior change, an outsider comes in, warns you of the dire consequences of your behavior and tells you what to do differently. That often just makes people defensive.

With social norming you tell people what other people are doing, not what they should be doing. But we need to be aware of salience.

“We can only hold one thing in consciousness at a time – and it is that thing that drives behavior,” said Cialdini, who is writing his next book about the topic. Success is more likely if the social norming message hits people just when they are about to make that behavioral decision.

And, of course, you need to make sure the behavior you're norming is credible and accurate.

Also, it helps to compare people’s behavior to the closest peer group possible. For example, Cialdini’s towel study found that people were even more likely to re-use towels when told that most people who had stayed in the same room did so.

If you consider the social norm as a sort of baseline, then the people doing worse than the baseline will improve their behavior. But we're not all below the baseline; some people are above average. Simply knowing that you're actually doing better than your peers can turn you into a slacker.

This is called the boomerang effect, and it is real. Opower initially found that households that were saving a lot of energy relaxed their efforts once they know how other people were doing. But Opower officials solved the problem by providing rewards for good behavior. Well, a computer did – the “reward” was a smiley face or two on their bill. That small change kept people from backsliding, and the boomerang stopped.

One of the mysteries of social norming is that although it is being used by some people in several fields, it isn’t used by a lot of people. Even institutions that used it successfully in the past have abandoned it when the champion left.

Social norms work below our conscious radar. “People don’t see themselves as easily influenced by those around them,” Cialdini says. When people are asked what would make them change a behavior, they rank “what my peers are doing” last. But when tested against what does, in fact, change behavior, it comes first.

Rosenberg concludes that “[f]ollowing the crowd is primal.”

If you're interested in understanding how people persuade you—and how you can better persuade others—you should read Robert Cialdini's books Yes!: 50 Scientifically Proven Ways to be Persuasive and Influence: The Psychology of Persuasion.

Temperament Matters: In Life and Business

Temperament

I love this excerpt from Quiet: The Power of Introverts in a World That Can't Stop Talking on Warren Buffett:

Warren Buffett, the legendary investor and one of the wealthiest men in the world, has used exactly the attributes we explored in this chapter – intellectual persistence, prudent thinking, and the ability to see and act on warning signs – to make billions of dollars for himself and the shareholders in his company, Berkshire Hathaway. Buffett is known for thinking carefully when those around him are losing their heads. “Success in investing doesn't correlate with IQ,” he has said. “Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”

Every summer since 1983, the boutique investment bank Allen & Co. has hosted a weeklong conference in Sun Valley, Idaho. This isn’t just any conference. It’s an extravaganza, with lavish parties, river-rafting trips, ice-skating, mountain biking, fly fishing, horseback riding, and a fleet of babysitters to care for guests’ children. The hosts service the media industry, and past guest lists have included newspaper moguls, Hollywood celebrities, and Silicon Valley stars, with marquee names such as Tom Hanks, Candice Bergen, Barry Diller, Rupert Murdoch, Steve Jobs, Diane Sawyer, and Tom Brokaw.

In July 1999, according to Alice Schroeder’s excellent biography of Buffett, The Snowball, he was one of those guests. He had attended year after year with his entire family in tow, arriving by Gulfstream jet and staying with the other VIP attendees in a select group of condos overlooking the golf course. Buffett loved his annual vacation at Sun Valley, regarding it as a great place for his family to gather and for him to catch up with old friends.

But this year the mood was different. It was the height of the technology boom, and there were new faces at the table—the heads of technology companies that had grown rich and powerful almost overnight, and the venture capitalists who had fed them cash. These people were riding high. When the celebrity photographer Annie Leibovitz showed up to shoot “the Media All-Star Team” for Vanity Fair, some of them lobbied to get in the photo. They were the future, they believed.

Buffett was decidedly not a part of this group. He was an old-school investor who didn’t get caught up in speculative frenzy around companies with unclear earnings prospects. Some dismissed him as a relic of the past. But Buffett was still powerful enough to give the keynote address on the final day of the conference.

He thought long and hard about that speech and spent weeks preparing for it. After warming up the crowd with a charmingly self-deprecating story—Buffett used to dread public speaking until he took a Dale Carnegie course—he told the crowd, in painstaking, brilliantly analyzed detail, why the tech-fueled bull market wouldn’t last. Buffett had studied the data, noted the danger signals, and then paused and reflected on what they meant. It was the first public forecast he had made in thirty years.

The audience wasn’t thrilled, according to Schroeder. Buffett was raining on their parade. They gave him a standing ovation, but in private, many dismissed his ideas. “Good old Warren,” they said. “Smart man, but this time he missed the boat.”

Later that evening, the conference wrapped up with a glorious display of fireworks. As always, it had been a blazing success. But the most important aspect of the gathering—Warren Buffett alerting the crowd to the market’s warning signs—wouldn’t be revealed until the following year, when the dot-com bubble burst, just as he said it would.

Buffett takes pride not only in his track record, but also in following his own “inner scorecard.” He divides the world into people who focus on their own instincts and those who follow the herd. “I feel like I’m on my back,” says Buffett about his life as an investor, “and there’s the Sistine Chapel, and I’m painting away. I like it when people say, ‘Gee, that’s a pretty good-looking painting.’ But it’s my painting, and when somebody says, ‘Why don’t you use more red instead of blue?’ Good-bye. It’s my painting. And I don’t care what they sell it for. The painting itself will never be finished. That’s one of the great things about it.”

Unfinished thought

It's Buffett's comment that really sticks with me because, like a lot of his wisdom, it transcends investing and plays out into many aspects of life.

“Success in investing doesn't correlate with IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”

— Warren Buffett

Temperament matters.

Consider your workplace.

I bet you have bosses. In general, I believe those bosses are probably intelligent people – what causes problems is not their lack of intelligence but rather their temperament. (One way to help neutralize the wrong temperament is to use a process.)

You need a temperament that controls the urges that get other people into trouble. And there is a long list of things that get people into trouble … Buffett offers a great example:

You need a temperament that neither derives great pleasure from being with the crowd or against the crowd.

If they lack the ability to think independently, bosses (like everyone else) can cause great harm to an organization, while claiming to be doing the right thing.

You also need a temperament that allows you to take action where many just sit and watch. Consider the case of a board of directors. In his 1993 Shareholder letter Buffett writes:

a director who sees something he doesn't like should attempt to persuade the other directors of his views. If he is successful, the board will have the muscle to make the appropriate change. Suppose, though, that the unhappy director can't get other directors to agree with him. He should then feel free to make his views known to the absentee owners. Directors seldom do that, of course. The temperament of many directors would in fact be incompatible with critical behavior of that sort. But I see nothing improper in such actions, assuming the issues are serious. Naturally, the complaining director can expect a vigorous rebuttal from the unpersuaded directors, a prospect that should discourage the dissenter from pursuing trivial or non-rational causes.

The temperament of many people is incompatible with critical behavior. Most people go with the path of least resistance.

“Take the high road, you'll find it's less crowded.”

— Charlie Munger

In fact, organizations, by the very nature of how they hire and fire, generally promote people who lack the right temperament. There is an almost unspoken chain of reciprocity.

If you were going to give someone some general advice on how to move up in a large organization you'd probably say something along the lines of: (1) be visible; (2) emphasize the aspects you’re good at; (3) make those in power feel good about themselves; (4) if you must point out a mistake by someone in power, blame the situation or others; and (5) shower those above with flattery.

You'd probably tell them to avoid being critical, giving other people too much credit, and being the only person in the room with a different opinion.

Office politics matter and often that's what we tend to reward.

How does your organization treat people who think differently? How does your organization treat people who think mediocre is not good enough? Does your management take action in situations that require courage? Do you attack problems or gloss over them? Do people admit when they are wrong? Are people curious?

Temperament affects so much and yet we rarely give it thought. What kind of temperament does your culture foster?

Buffett can teach you a lot about management. If you're interested in learning more, pick up a copy of A Few Lessons for Investors and Managers From Warren Buffett.

The sentiments of crowds

A lot of wisdom in this excerpt from Mobs, Messiahs, and Markets: Surviving the Public Spectacle in Finance and Politics:

… if there is one thing we know about the sentiments of crowds, it is that they change. Today it is greed. Tomorrow it is fear. But rarely is it doubt. So, when mass sentiment goes negative, it goes completely negative. People stop worrying about the return on their money and begin to be concerned with the return of their money.