The Human Factor

The scientific or mathematical view of financial markets, while still strongly supported, is being increasingly challenged by the behaviorist model which states that markets are driven simply by people with all their endearing and sometimes not so endearing beliefs, prejudices, irrationality and idiosyncrasies.

You are invited to participate in a thought experiment.

Let us imagine a mysterious benefactor offers you the chance to win $10,000 on the toss of a coin. This means you have a 50% chance of getting $10,000 and 50% chance of getting nothing. Alternatively you can choose not to toss the coin at all and your benefactor will simply hand you over $3,000 which is yours to keep and do with as you please.

What will you chose?

Irrespective of your decision or outcome let us now imagine that you continued to play this game of toss with your benefactor, risking your own money in the process. After a number of hours, due to a run of bad luck, you now owe $4,000.

The so called benefactor wants to call it a day but gives you one last chance to get out of paying the $4,000 debt.

You again have two choices. Toss the coin one last time. If you win, your debt will be cancelled and you can walk away nothing. If you lose you will then owe the benefactor a total amount of $10,000.

Alternatively you can just pay up the $4000 you owe and be on your way. Again, what will you chose?

In the first instance – (a toss for $10,000 or except $3000 with no toss ) – most people would accept the $3000 and sometimes much less, rather than risk getting nothing. After all, it’s money they didn’t have before.

In the second instance when faced with a certain loss of $4,000, most people say they would toss the coin again and take a chance of breaking even rather than accepting a certain loss. As long as there is a chance of breaking even, most people sustain hope for a favorable outcome and will take on excessive risk.

In the first instance, the utility value of winning $10,000 with a probability of 50% is $5,000 so this is the minimum amount that you should be willing to accept as a fixed amount. Otherwise your chance of success is better served by tossing a coin. In the second instance, the utility value of a possible $10,000 debt with a 50% coin toss is $5,000 so the chances are that you will be better off accepting the fixed $4,000 loss rather than tossing a coin and risking a bigger loss.

From a trading and investing perspective, the responses that most people typically make are sub optimal. They are thought to be based on deeply entrenched subconscious beliefs, passed down to us genetically from the earliest humans who’s somewhat precarious survival depended on them.

The trader’s journey involves replacing these ancient subconscious beliefs or intuitions with ones that are more functional, not just for trading and investment, but for many other areas of modern human activity including science and medicine. This process is therefore something of an evolutionary one. It involves learning to use our brains and minds in a more effective way. The financial rewards for doing so are substantial.

I have tested the above experiment on many students over the years and on friends and acquaintances whenever the opportunity has presented itself. My own testing confirms the results of other researchers. In a few cases, people with good statistical knowledge and anticipating a “trick” were able to work out the more “evolved” answers but most couldn’t.

Another interesting phenomena was the significant number of people who felt threatened and became defensive when the correct answer was explained to them. They often made a significant effort to justify or rationalise what they regarded as the correct answer. This again is very normal human behavior. We typically protect deeply held beliefs even when they work to our obvious disadvantage. What has been passed down through many generations cannot be quickly or easily eradicated.

One young man who I know snapped back the correct answers to me without a second’s hesitation, almost before I had even finished asking the questions. He is not a trader or investor but a semi professional gambler and poker player whose success is dependent on correct statistical thinking. He had obviously mastered this skill to the point where it had become a conditioned response. He didn’t even have to think about it. Changing the way that we think and act, while not necessarily quick or easy, certainly does seem to be possible.

Behavioral Finance

Many consider the Efficient Market Hypothesis (EMH) that we previously looked at flawed. There are significant and frequently occurring market characteristics that the EMH doesn’t explain. An alternative model, based on observations about human behavior, has been spoken about for many years but until quite recently, failed to gain traction, probably because it wasn’t “scientific” enough for many academics who were keen to have their field of expertise recognized as a mathematically based science.

Influential British economist, John Maynard Keynes, introduced the idea of “animal spirits’’ in his 1936 book The General Theory of Employment, Interest and Money. He believed that human instincts, emotions and behavior determined things like consumer confidence which in turn drove markets.

Keynes became a successful trader and investor during his life time but at one point, after suffering significant losses, he is supposed to have ruefully noted just how perversely markets can sometime act. A famous quote often attributed to him is that “the market can stay irrational longer than you can stay solvent.”

It was the work of academic psychologist Daniel Kahneman and his colleague Amos Tverskyl who really gave the behavioral view of markets the credibility that they currently enjoy.

Together they meticulously researched and tested many ideas about the way humans behave under conditions of risk and uncertainty.

Their significant contribution was based on the collection of evidence and proper testing rather than the abstract and often whimsical ideas that have tended to dominate the entire field of economics and financial market theory.

Daniel Kahneman was awarded a Nobel Prize in economics in 2002 and today is often referred to as the father of behavioral economics. Interestingly, he claims to never have undertaken a single course in economics. Amos Tversky died several years earlier and Nobel prizes are not awarded posthumously.

What follows is a list of commonly cited behavioral biases. I will not bother commenting individually on them because they have been written and talked about ad nauseam. If you are not already familiar with these ideas you can look them up somewhere like Wikipedia or read Kahneman’s epic work Thinking Fast and Slow (published in 2011) which summarizes his decades of research. One thing worth pointing out is that there is quite a bit of overlap among some of these descriptions. Our mental and behavioral characteristics often fail to fit into neat descriptive boxes.

Often Cited Cognitive Biases

  • Availability Bias

  • Anchoring Bias

  • Attribution Bias

  • Confirmation Bias

  • Endowment effect

  • Fear of Loss

  • Fear of Missing Out

  • Fear of Letting a Profit Turn into a Loss

  • Fear of Not Being Right

  • Gamblers Fallacy

  • Herd Behaviour

  • Hindsight Bias

  • Loss Aversion Bias

  • Mental Accounting

  • Overconfidence Bias

  • Recency Bias

  • Risk Aversion

In the next article we will start looking at what can be done to overcome some of these counter productive behaviors.

 

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