The Illusory Truth Effect And Financial Markets

When we have seen something often, we are more likely to believe it is true. This will weaken the accuracy of decision-making in financial markets and elsewhere

The Illusory Truth Effect is a variant of how we inaccurately use our feelings to make decisions.  We use at least two methods to decide on the truth of a claim or the correctness of new information.  The first method is somewhat allied to one of the philosophical account of knowledge: coherentism.  We assess the claim based on whether it is consistent with what we think we already know.  The second method is to consider how we feel about the claim or purported new information.

Both approaches have drawbacks.  The first method, while probably the best available, can lead people into multiple errors.  If you already believe something false, you are more likely to believe further false claims which are allied to the first false claim.  We see many pernicious illustrations of this; for example, in political polarisation and various forms of prejudice.

The second approach is more damaging.  In fact, deciding whether something is true or not based on how we feel about it looks so odd that you might wonder whether it can possibly be the case that this happens.  This is another example of a puzzling psychological bias which in fact it makes sense for us to exhibit because, on average, it will produce an answer which is “good enough.”

One thing we don’t like is work.  If we have seen a claim a lot before, we don’t need to work too hard to decide whether it is true again.  (This can also be seen as a processing fluency effect.) We are comfortable with the claim or the apparent information.  I don’t need to think about the route to walk to the gym because I have done it a lot before and it always worked.  This familiarity effect or ease of processing effect is fine in relation to the route to the gym.  And there are going to be a lot of daily questions like that where it would be inefficient to reevaluate them.

This is all fine.  However, it turns out that we also do this with false claims which we have seen often.  That of course is going to be a huge problem.  The Illusory Truth Effect is also known as the Reiteration Effect for this reason.  Basically, if I tell you something which is false a lot of times, you are likely to get comfortable with it and more likely to believe it.

This will have frequent damaging effects in financial markets.  For example, in the case of the Bitcoin bubble, which I forecast approximately three days before the peak:

https://timlshort.com/2017/12/20/the-bitcoin-bubble-is-caused-by-the-halo-effect/

— there are I think some causal factors deriving from the Illusory Truth Effect, though as I discuss there, there are many other psychological biases and errors at work in the bitcoin bubble.

In particular, what we saw in the case of the Bitcoin bubble was the cult-like nature of the phenomenon.  Proponents of the cryptocurrency repeated hundred of times the same false claims like “it can only go up;” “Bill Gates is enthusiastic about it;” or “all we have to do is HODL (sic) and everything will be fine.”  Cult members believed all of this partly because they had heard it all many times and so they became familiar with it.

Turning to the professional sphere, we can expect that the Illusory Truth Effect will play a part in any bubble involving more than just the inexperienced investors who became infected in the Bitcoin epidemic.   DotCom caught a lot of people (including myself, because I was young and inexperienced.). We heard many times that anything involving the internet was going to be a huge success.  So we started to believe it.

There are many features of markets that are true until they aren’t.  Try to avoid believing something merely because you have heard it a lot.  Look for evidence.

The Late Evaluation Effect And Financial Markets

Evaluations made later in a sequence are more positive — what effects will this have on the thinking of investors?

It is no secret that people dislike working hard.  The corollary is that they like not working hard.  This much is well-known, but perhaps less obvious is that this can affect our judgments.  There are various experiments reported in the psychological literature which show that if a scenario is arranged such that the people involved are having a better time, or working less hard, they will make more positive judgements.  This can be quite alarming.  For example, it has been shown that judges making parole decisions are more likely to be lenient right after lunch and more strict before it.

A recent experiment has expanded this literature in a direction which I think is interesting in a financial markets context.  The University of Virginia’s O’Connor and Cheema, writing in Psychological Science in the issue of 01 May 2018, describe a bias of this type.  I will term it the Late Evaluation Bias.  They observe the following.

Evaluations become more positive when conducted later in a sequence

The authors examined three particular types of evaluation.  These were those made by judged across 20 years of Dancing With The Stars, university professors who had taught the same course for several years and people judging short stories over a couple of weeks.  In each case, they found that evaluations became more positive as time went on.

I think this is a variant of the types of bias I mentioned at the outset.  People find it easier to do something when they have more practice doing it.  This means they need to put in less effort so they will find it less like hard work.  This is fine, but the strangeness is that this will then lead them to make more positive evaluations.  Note that this is rightly called a bias since it will lead to a systematically false evaluations.

How might this play out in financial markets?  One simple and obvious answer is that investors will tend to be more positive than they ought to be when evaluating a stock they have evaluated many times before.  Someone who has looked at owning GE stock many times in the past will be more likely to find it easier to do again and will therefore be more likely than is justifiable to come to a positive decision on that stock.  This could feed into bubbles such as Bitcoin, although there is no reasoned positive evaluation possible of that cryptocurrency since it is valueless on fundamentals.

Similarly, people will evaluate asset classes with which they are more familiar more positively than they ought to.  This could be behind the well-known and expensive tendency in investors to be over-invested in their home markets.  This tendency can be avoided without entering dangerous frontier markets.  US investors could safely invest in the UK market without taking much additional risk and vice versa.  Both groups would gain valuable diversification.

People who have never bought a corporate bond will find it harder to evaluate than an equity if they have considered equities many times previously.  This will also rob them of a potentially valuable diversification.   The answer, as it often is, is to do more work!

I cover the effects of many other biases in financial markets in my new book:

https://www.amazon.com/Psychology-Successful-Trading-Behavioural-Profitability/dp/1138096288

If You Like Gin And Marmite, You Are Probably A Better Trader

There are correlations between taste preferences and personality (disorders) which are also highly present on the trading floor — so check your tastes to see if you are already likely to be a winner!

Evidence has been reported that there are correlations between liking certain bitter tastes and certain personality factors.  Personality as generally understood does not really exist; the belief to the contrary is known as the Fundamental Attribution Error.  However, there are some stabilities in character which are or approach being diagnosable as “personality disorders.”  These though are very much in the eye of the beholder in terms of whether or not they impair effectiveness.  It turns out that these same personality stabilities are highly prevalent in competitive professions, so these people must be doing something right.

Researchers from the University of Innsbruck reported as follows:

Individual differences in bitter taste preferences are associated with antisocial personality traits

Bitter tastes are basically self-explanatory.  Marmite and gin and tonic are two obvious examples, but tea or coffee without sugar could be others.  One might also start looking at wine types.

The authors found robust correlations between preferences for such bitter tastes and the Dark Tetrad, which is the Dark Triad plus everyday sadism.  The Dark Triad is one of the stable factors in personality.  It consists of Machiavellianism, psychoticism/psychopathy, and narcissism, at levels below threshold for diagnosis as a personality disorder.

Machiavellianism could also be termed manipulativeness.  It reflects how likely someone is to be devious or to manipulate others for their own benefit.  Psychosis means susceptibility to delusions.  Some false beliefs — especially false positive beliefs about the self — are correlated with individual success.

Some authors in the literature include psychopathic tendencies instead of psychosis.  These tendencies come from a wide potential array of behaviours.  Some or all of the following may be present:

  • glibness
  • superficial charm
  • grandiosity
  • pathological lying
  • manipulation of others
  • lack of remorse and/or guilt
  • shallow affect
  • lack of empathy
  • failure to accept responsibility
  • stimulation-seeking behaviour
  • impulsivity
  • irresponsibility
  • parasitic orientation
  • lack of realistic life goals
  • poor behavioral controls
  • early childhood behaviour problems
  • criminal activity

Obviously some of these are very unhelpful.  But we can imagine that others could be extremely useful.

Narcissism is an extreme level of self-absorption and self-belief.  This looks as though it will be really quite useful in terms of allowing people to fail repeatedly with no adverse ego consequences.

We know that the Dark Triad –and presumably also the Dark Tetrad, since that is very similar — are heavily over-represented in certain professions.  That is: investment banking, journalism and politics.  All of these professions are extremely competitive and perhaps also require a certain amount of ability to exploit others.  This can therefore explain why the Dark Triad would often be seen on the trading floor as well.

Of course, this shows correlation rather than causation.  However, since we have a plausible explanation as well as a correlation — it seems likely that being a Dark Triad person will be valuable when trading.  And now, since we have observed correlations* with bitter taste preferences, there is an easy way to check!

(Disclosure: I am well-known for liking ridiculous amounts of Marmite.  I don’t mind a gin and tonic either.  And I wrote this: https://www.amazon.co.uk/Psychology-Successful-Trading-Behavioural-Profitability/dp/1138096288/

So that’s one more data point!)

*The Innsbruck researchers say they have succeeded in:

consistently demonstrating a robust relation between increased enjoyment of bitter foods and heightened sadistic proclivities

The Psychology of Successful Trading: see clip below of me explaining my new book!

 

Getting your trading psychology right and understanding that of others are both essential prerequisites to successful trading in financial markets. I discuss the most important elements of trading psychology in my new book.

Buy the book here:

Thanks to Karine Sawan and film crew for video production.

The US Was Defeated In #Vietnam By Systematic Theory Of Mind Error

The US had vast superiority in all assets that were thought to matter but was still defeated in the Vietnam War — why?

It is clear that the US possessed much more in the way of conventional military assets in the conflict with North Vietnam than the opposing forces.  This point is widely accepted so I will not spend much time arguing for it.  For example, the US had tanks while the Viet Cong had no anti-tank weapons.*  US forces had “superb artillery and air support” (Sheehan, p. 447, 1988) which enabled any US troops facing locally superior odds to succeed.  The entire US army fought with the doctrine of “superior firepower” (Sheehan, p. 243, 1988).  The financial resources that the US was able to apply also hugely outweighed those of its opponents in a largely peasant guerrilla army.  Sheehan (p. 624, 1988) writes that commodity aid to South Vietnam reached the staggering figure of $650m in 1966.

This last point is decisive.  It has been wisely observed that:

“Most wars have been wars of attrition, settled by which side had more staying power through the ability to apply men and materiel.” **

The GDP of North Vietnam in 1965 was $6.0bn in 2015 dollars.  The GDP of the US in 1965 was $4.1tn in 2009 dollars — that is, 683x larger.

So why did the US lose?  Consider the following highly insightful quotation.

“When McNamara wants to know what Ho Chi Minh is thinking, he interviews himself.” ***

Robert McNamara was the Secretary of Defense at the time, and so crucial to  managing the war effort.  It is clearly important to know what the enemy is thinking.  McNamara’s error was to do this in the way that most people do.  This is where we come to Theory of Mind.

Theory of Mind is the label in psychology for the way we predict and explain the behaviour of others.  We all do this all the time.  There is a vibrant debate in psychology as to how we do it.  The mainstream view is called “Theory Theory.” This holds that children as young as five, who already have a serviceable Theory of Mind, have formed it by learning a theory of other people.  They are supposed to have done this by most psychologists in a scientific fashion: they propose hypotheses and then confirm or disconfirm them empirically.

I support the opposing view, which is known as Simulation Theory.**** This suggests that we run our Theory of Mind by putting ourselves in the position of others and seeing what we would do.  This, according to the quotations, is exactly what McNamara did.  And it is why he was wrong and why the US lost.

We can see this same factor in action with another quote from a significant protagonist in Vietnam: Green Beret Colonel Kurtz who makes the following  observation on realising that the Viet Cong have removed the arms of all the children in a village who were vaccinated against Polio by US forces.

And then I realized… like I was shot… like I was shot with a diamond… a diamond bullet right through my forehead. And I thought, my God… the genius of that! The genius! The will to do that!

The surprise of the Colonel is again an illustration of Theory of Mind error.  If his simulation of the Viet Song had been more accurate, he would have been able to predict their action here.  That he was not, and that he was able to see how effective, if inhuman, this strategy was, shows that he was perhaps able to adjust and improve his Theory of Mind more than McNamara was.

It also illustrates the type of Theory of Mind error we should expect.  McNamara was a company man, who was experienced from his time running Ford in systems analysis and data handling.  So when he simulated Ho Chi Minh, he would draw conclusions along the lines of “I am faced with overwhelming odds; all of the analysis says that overwhelming odds always win; I therefore cannot win.”

What this misses out is the “Blut und Boden” point hinted at by Kurtz.  It misses out the will to fight on one’s own soil irrespective of the prospects of success.  It misses out the will to enlist the entire male and female population in the war effort, with many women driving supplies down the Ho Chi Minh trail at night without lights under largely ineffective yet heavy US bombing.  It misses out what the French missed at Dien Bien Phu: the will to disassemble artillery pieces and carry them up jungled mountains by hand.

So this is why the US lost.  It is also presumably why my book is held by the following library:

Institute for Defense Analyses Library
IDA Library

Alexandria, VA 22311 United States

You can also buy a copy at the link below if you want to know more about Theory of Mind. ****

* Sheehan, N. (1988)   A Bright Shining Lie: John Paul Vann and America in Vietnam.  Vintage Books

** “The other side has a vote”, The Economist, Oct 14 2017

***  This quotation is from James Willbanks, an army strategist.  It is written up in The Economist, “Buried Ordnance,” in the issue of Sep 14 2017.  The piece is a review of “The Vietnam War,” a TV documentary by Burns and Novick.

**** Short, T L 2015  Simulation Theory: a Psychological and Philosophical Consideration.  Abingdon: Routledge.  URL: https://www.routledge.com/Simulation-Theory-A-psychological-and-philosophical-consideration/Short/p/book/9781138294349

Attentional Biases And Financial Markets

Attentional Biases are operative in everyone’s psychology; they can affect performance in financial markets because they control what information sources we consider

Are happy people better at picking up information that will make them happen?  Do sad people do the opposite?  Have you wondered how your mood can affect your behaviour in ways you don’t know about?  All of this is true and can be explained by considering one form of a Cognitive Bias called Attentional Bias.

We are subject to approximately 150 Cognitive Biases, at the last count.  All of them affect our thinking without us necessarily knowing too much about when they are at work or what the results are.  My project initially is to list and describe these mental subroutines before critically examining them and assessing how they work in a market environment.  The objective is to allow market participants to look out for the operation of Cognitive Biases in their own thinking and trade on the expectation that they will also figure prominently in the thinking of other players.

One of the most important Cognitive Biases is known as Attentional Bias.  It comes in several forms, but all of them have in common that they systematically slant which information we pay attention to.  Obviously this can be expected to have dramatic effects on thinking and market outcomes.  In this post, I will first describe Attentional Bias and then outline how it might play out in a market setting.

Much of the psychological literature on Attentional Bias looks at what we can term mood congruency.  The basic idea here is that we are more likely to look at information which fits our mood.  So, anxious subjects are more likely to look at anxiety-inducing information and depressed subjects are more likely to consider depressing information.  Clearly this is already rather unhelpful for such subjects, but my aims here are only to look at what this might do in markets.

This is widely important because generalised anxiety affects a significant proportion (estimated at between 5% and 30%) of the population.  This is people who are more-or-less anxious more-or-less all of the time. Since it is a significant  minority, it is likely that some of these subjects participate in financial markets, although it is possible that some anxious individuals will self-select out of stock markets.

Depression of sufficient gravity to merit a psychiatric diagnosis affects about 1% of the population; many more people will experience a less severe depression or a more episodic form.  Again, we can expect plenty of market participants to be depressed when trading.

Experimental investigations of mood-disorder linked Attentional Biases have focused on reaction time studies.  A pair of words was briefly presented to experimental subjects on a computer screen.  Sometimes, one of the words was replaced with a dot, which was the signal that a button should be pressed.  The time it took for subjects to press the button was recorded.  It would typically be in the range of several hundred milliseconds.

Sometimes, the other word presented on the other side of the screen to the dot was a threatening word.  The word could be socially threatening (‘humiliated’) or physically threatening (‘injury.’)  The experimenters found what is known in psychology as an RT spike — or a delay in reaction time.  People took longer to see and react to the dot if a threatening word appeared on the other side of the screen.  These effects were quite large.

Perhaps most interestingly, the RT spikes were larger for anxious or depressed subjects, especially if the threat word was specifically related to either anxiety or depression.

What Effects Of Attentional Bias Should Such Individuals Be Aware Of?

It is obvious that such effects could impair traders on a trading floor who are making rapid trade decisions themselves.  Information near their field of vision which is threatening — such as a negative Bloomberg headline — could grab the trader’s attention and cause a delay in response time even if it is unrelated to the trade under consideration at the time.

While this is a real issue, I want to consider non-professional traders as well. In general, day-trading is best avoided as 85% of day traders lose money.  (Day-trading is popular among people new to investing.  It is called that because the aim is to minimise risk by not holding any positions over-night.  However, the necessarily short-term nature of this approach means that one can really only benefit from ‘noise’ in stock movements and there is no way to rationally forecast noise.  Relying on luck is even worse in markets than elsewhere because the punishment is swift.) It is better to be a buy-and-hold investor.  What effects of Attentional Bias should such individuals be aware of?

If one is episodically depressed or anxious, then these are not times to be trading.  Negative mood-congruent information will grab attentional resources and make traders much more likely to exit positions.  This may or may not be the right decision to make; what is clear is that such a decision should be made rationally and with a fair and open consideration of the relevant data.  Often this will not be what everyone else is doing, so my approach lends itself naturally to a contrarian investment stance.  There are other good reasons to be a contrarian investor, including that it fits with a long-term approach — so it is not something much engaged in by day-traders.

If someone is permanently depressed or anxious, then treatment should be sought and one should abstain from trading until an improvement is seen.  If no such improvement can be achieved, then I am sympathetic, but I would suggest hiring financial advisers in that circumstance.  It would be one thing less to be concerned about and would likely have more optimal outcomes, despite the extra fees involved.

I discuss in much more detail the important effects in financial markets of Cognitive Biases like Attentional Bias in my new book:

https://www.routledge.com/The-Psychology-of-Successful-Trading-Behavioral-Strategies-for-Profitability/Short/p/book/9781138096288

Email me at shorttim1@gmail.com:

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83% of Millennials Regret How They Handle Their Finances: Why?

Hyperbolic discounting explains why we fail to plan early enough, which is the most common financial regret among Americans

It is reported that 71% of Americans express regret about their ability to handle their finances; the percentage rises to 83% among Millennials.  The most common regret, expressed by 48%, is failure to plan early enough.  Why does this happen?  I will explain it using an element of our psychology called Hyperbolic Discounting.  This is one of 150+ different sorts of Cognitive Bias.  In my new book, I discuss the most important Cognitive Biases and how they will affect your investment performance (see link below).

So what is Hyperbolic Discounting and how does it explain our failure to plan early enough?

As with many Cognitive Biases, they have a kernel of value within them.  This has to be true because otherwise we would not have them.  They can be seen as “quick and dirty” heuristics which in most everyday situations are good enough to allow us to get by.  If they are mostly right and avoid any scenarios of catastrophic error, then they probably do enough to pay their way in our mental architecture.

As an example, think of the widespread fear of snakes.  Evolution could have aimed to give us only a fear of venomous snakes, but that would have been difficult to achieve and would have involved a risk of missing some snakes that could kill us.  Better than this is to make people afraid of all snakes.  The cost of that is that people will sometimes run away from some snakes that are harmless.  But that’s fine.  That cost is greatly outweighed by the benefits of avoiding the venomous snakes.

Hyperbolic Discounting is one of these sorts of mostly useful bias.  It is founded on something like the common and accurate idea that “a bird in the hand is worth two in the bush.”  In other words, something I have now is more valuable than something of equal value that I will have in a year from now.

This then raises the question of how to compare the present value of an item I now own and the present value of something I will own a year from now.  This means applying a discount to the future item to account for the delay between now and when I will own it.  In a world of low interest rates, it is easy to forget this.  But when they return to 5% a year, it will be a lot more clear that $100 now is worth 5% more than $100 in a year from now. Because I could save the $100 now and it would be worth $105 in a year from now.

Turning this around, I can work out what the present value of the future $100 by discounting  it.  This means multiplying it by (100/105).  This comes to $95.24.  (You can check this by adding 5% to it and getting back to $100.)

So 5% is the Discount Rate here.  This is how you should discount a future certain $100 by under circumstances where the risk means that is appropriate.  Now we come to the problem with Hyperbolic Discounting.  It seems that our default discount rates are set way too high.  We set far too much store by what we have in our hands now.  This is also perhaps reflected in the way we are prepared to smoke and not go to the gym today.  Those things are easy to do and carry only minor immediate costs. Smoking of course carries an infinite cost at some point in the future because it will kill you.  It is only through Hyperbolic Discounting that anyone can manage to smoke. Similarly, not going to the gym will kill you.  But not today.

These and many other Cognitive Biases are who we are and explain much of our decision making.  The approach I take in the book is to describe some of the financially significant ones and then explain how they play out in financial markets.  Thus, by reading the book, you can obtain two key benefits.  Firstly, you can look out for biases like Hyperbolic Discounting in your own thinking and correct for them.  Secondly, and even more valuable, you can expect them in other market participants and trade accordingly.

https://www.routledge.com/The-Psychology-of-Successful-Trading-Behavioral-Strategies-for-Profitability/Short/p/book/9781138096288

If you want to discuss these and other concepts mentioned in the book, or for more information about the book, you can Send Mail