Investment Styles

An Introduction To Different Ways To Invest

There are two major investment styles which take completely different approaches.  They are value investing and momentum investing.  The former, also known as contrarianism, seeks to find cheap assets to buy.  It is called contrarianism because often it involves looking for assets which are cheap because no one likes them.  Momentum investing is simpler.  This simply observes that often, assets that have been performing well continue to do so.  So investors adopting this style just look for assets which have gone up and hope that they will continue to do so.

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I favour value investing.  One reason for this is because the problem with momentum investing is that assets which have done well continue to so until they don’t.  There is no way to tell when something which has gone up will stop doing so.  And we definitely know that nothing will appreciate forever!

The difficulty with value investing is knowing when an asset is cheap.  In the early days of investing, the concept of book value was very useful.  This is simply the accounting value.  If a company owns a factory and some machinery, the book value will be close to the value for which the factory and the machines could be sold. If you can buy a share, or a slice of the company, for less than the book value per share, you should.  

Book value is still very useful on many occasions.  But modern companies are very complicated, and often much of what they do cannot be valued simply.  A lot of their worth might be tied up in software, for example, which is harder to value than a building.  Or they might own a lot of IPR — intellectual property which again, is intangible and hard to value.  But the effort is worth it.  Finding a cheap company to buy is one of the best ways to trade successfully. 

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I have written a lot about the importance of psychological factors in investing.  It is absolutely crucial that you understand these, for two reasons.  Knowing about your own psychology will help you understand and improve your decision-making processes. It will be especially valuable to know when cognitive biases are likely to cause you to make errors in evaluating investments.  But just as important is knowing how other investors will think — after all, they have the same psychology as you do!  And knowing what other investors are likely to think of an asset is the key.  Because you want to find an asset which is not just cheap — but unjustifiably so.  Then you can expect it to go up sustainably.

See Also:

The Discerner Art Publication

What Is “Theory Of Mind?”

The Late Evaluation Effect And Financial Markets

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

What Is “Theory Of Mind?”

Psychologists study psychological capacities – what we the call “the mind.” One of the distinctive psychological capacities of human beings is the ability to explain and predict the behaviour and mental states of other humans. Psychologists call this ability “Theory of Mind”. We all have “Theory of Mind” – but how does it work? That is, by what method or mechanism do we explain and predict other people’s behaviour?

People are very good at predicting and explaining each other’s behaviour.  We are so good at it, that often we do not realise we are doing it.  And it is very unclear how we do it.  In this post, I will briefly introduce some ideas in psychology about how we do it.

“Theory of Mind” is the label for how we predict and explain the behaviour of others.  It was originally called that because the first idea was that we have a theory of other people.  On this account, we learn this theory as children, or it is innate — meaning we are born with it.  It ought to be something like a theory in that it has some kind of rules in a system.  They would say things like “everyone who wants some ice cream will go where they think the ice cream is.”

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Subsequently, there was a debate as to whether this was really the right explanation for our Theory of Mind.  Alternative accounts emerged.  This means that some new terminology was required.  The account I have already outlined above, where people use a theory to predict and explain others, became known as Theory Theory.  It was, if you like, the theory that using a theory is how we do Theory of Mind!  We use rules to predict and explain the actions of others.

The challenger account was called Simulation Theory.  This says that people predict and explain others by simulating them.  In other words, I predict what you will do in a situation by imagining that I am in that situation and then deciding what I would do.  I might think (implicitly probably) “I want some ice cream, where would I go?”

We can see that both methods produce results that look plausible, to begin with.  Both of them would account for the way that if I say to you “why did Jimmy go to the ice cream van?,” you don’t have any difficulty coming up with what looks like a good answer.  What we don’t know is whether you came up with that answer by using a rule (Theory Theory) or put yourself in Jimmy’s place (Simulation Theory).

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The debate continues as to whether Theory Theory or Simulation Theory is correct.  The major objection to Simulation Theory was that it could not explain cases of systematic Theory of Mind error.  In the Stanford Prison experiment, for example, the participants acted much more harshly than anyone outside the situation predicted.  Those objecting to Simulation Theory said that if it was the correct account of Theory of Mind, then we would be able to get the right answer.  We would be able to correctly predict the harshness of the participants by imagining that we were there.

I have provided what I think is the only response to this objection.  I call it the bias mismatch defence.  In it, suggest that if there is a systematic error in Theory of Mind, like the one in the prison experiment, it is because the people in the experiment are acting under a common cognitive bias, and the people outside it are not.  They do not simulate the bias, in other words.  There could be several reasons why they do not simulate it.  They might, for example, have no particular emotional involvement in the situation.  After all, being outside prison is much less intense than being in prison!

In this particular case of the prison experiment, I think the bias in question is Conformity Bias.  This is the way we all tend to do what we are told, to some extent.  But I could use this bias mismatch approach much more widely.  It could be used to explain any cases where people systematically fail to predict how experimental participants will react, if those participants can be seen to be exhibiting any cognitive bias.  We know about more than 150 of those so far, so there is plenty of opportunity for bias mismatch to arise.  This bias mismatch happens a lot I think, and it is why so many results in social psychology are interesting and surprising — and also why so often, we fail to understand others.

See Also:

#Narcissism and #Unexpected Behaviour

The Illusory Truth Effect And Financial Markets

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

Simulation Theory: A psychological and philosophical consideration

 

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#Narcissism and #Unexpected Behaviour

There have been claims recently that “collective Narcissism” explains some episodes where people behave in ways that are unexpected viz. elect Trump and vote for Brexit. If Narcissism is interpreted in the formal way that psychiatrists do, this can’t really be true. But, as I will explain, there are ways of constructing the claim such that it reveals some valuable insights.

The way we predict and explain the behaviour of others is known as “Theory of Mind.”  I explain how this works here: https://timlshort.com/2018/09/26/what-is-theory-of-mind but the short version is as follows.  There are two major accounts of how we predict and explain the behaviour of others. They are known as Simulation Theory, where we predict others by simulating them, and Theory Theory, where we predict and explain others by using a theory of them. While the second account is the mainstream one, I have defended the simulationist account in my first book, “Simulation Theory:” https://www.amazon.co.uk/Simulation-Theory-psychological-philosophical-consideration-ebook/dp/B00S1DDMKI

The major objection to Simulation Theory has been that it cannot explain systematic errors in Theory of Mind. These are seen when people contemplate the infamous Milgram experiment, where everyone apparently gives out electric shocks to strangers, while everyone systematically fails to predict this.

I dealt with this objection in my book by positing “bias mismatch” as the answer. If the person you are simulating exhibits a cognitive bias and you don’t, your simulation will fail. For example, in the case of the Milgram Experiment, the bias you are not simulating is Conformity Bias. This is also known as the Asch Effect, and basically formalises the idea that we all tend to do what we we are told to some extent. This effect is surprisingly strong.

Obviously everyone exhibits Conformity Bias on occasions, but the observers do not exhibit it in the same way the participants in the experiment.  in the experiment, the subjects are told very emphatically to proceed with the shocks, the experimenter is in a lab coat, it is the 1960s so a deference culture etc.  So the effects of Conformity Bias are very strong.  This type and intensity of Conformity Bias is not simulated by the observers and so they are surprised by the actions of the subjects.

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Now we come to the Narcissism ideas, which I will situate in the above framework. The claim is that “collective Narcissism” about the greatness of a country causes people to make poor decisions. In the case of the US, they have elected someone who promised to make their country great again. In the case of the UK, they have decided to take huge unwarranted risks with the trade position without any particular upsides in the belief that the UK is better off alone.

The claim cannot really be that substantial numbers of people are actually suffering from Narcissistic Personality Disorder. This is because NPD subjects make up around 1% of the general population. This is quite common: many psychiatric disorders have around a 1% prevalence rate. I hypothesise that this is because if it is much less, we cannot see it, and if it is much more, we redefine it as normal!

So 1% of the population is not enough to elect a President or tilt a referendum. However, people can exhibit Narcissistic tendencies. This could be a much larger element of the population (data are sparse here). In order to look at the plausibility of that, let us consider what Narcissism looks like clinically. To help do that, I will now describe the criteria for a diagnosis of NPD.

Informally, Narcissism could be characterised as excessive self-regard, though it is perhaps unclear how one would characterise such excess and subjects can often be extremely successful high-status individuals. So in a sense, the high self-regard can be merited.

Formally, four criteria must be satisfied in order for a subject to receive a diagnosis of Narcissistic Personality Disorder. These are: impairments in self-functioning, impairments in interpersonal functioning, impairments in intimacy and antagonism. Each of the criteria can be exhibited in either of two ways.

Impairments in self functioning can be exhibited by excessive reference to others for self-definition and self-esteem; or goal-setting may be based excessively on the aim of obtaining approval from others.

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Impairments in interpersonal functioning may be exhibited either by impaired empathy or by impaired intimacy. Empathy is defined as the ability to recognise or identify with the feelings and needs of others or a tendency to underestimate one’s own effect on others.

Impaired intimacy is seen if relationships are largely superficial and exist to mostly serve the ends of the subject.

Finally, a diagnosis also requires antagonism, which may be characterised either as grandiosity, meaning feelings of entitlement or self-centredness, or attention-seeking behaviour.

So here we see how everything fits together. I think we can agree that many more people than 1% of the population could exhibit tendencies like the above. I also think we can regard Narcissistic tendencies, which would look like the above but fall short of being fully diagnosable, as a cognitive bias. This could be much more widely prevalent in the population than the number of diagnosable subjects. If you simulate such people and you do not yourself have the same Narcissistic tendencies about the same issues, you will get it wrong. So we see how the claims that Narcissistic tendencies can explain our failure to predict the explanation of Trump and Brexit, despite abundant data pointing that way, can be because of our failure to account for something like collective Narcissism in others.

See Also:

What Is “Theory Of Mind?”

The Illusory Truth Effect And Financial Markets

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

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

 

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John #McDonnell’s Characterisation Of #Finance Is Misconceived

Yesterday, the Shadow Chancellor gave a speech outside the Bank Of England on the tenth anniversary of the Lehman collapse.  I will argue that his remarks do not display a good understanding of how The City works.  All quotations below are from his speech.

“The key lesson is this: never let the finance sector become the masters of the economy when they should be the servants of the economy” *

This is a misconception.  Finance is never either the master or the servant of the economy so it would be impossible to change it’s status in this regard.  The way corporate finance works is not that different to getting a mortgage to buy a house.  This is true in several ways.  Firstly, if you never buy a house, you never need the finance and you never talk to a bank.  That’s up to you.  So that doesn’t look like a master or servant relationship.

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The second element of the analogy is that if you get a mortgage, there will be conditions attached.  The most important ones will be around debt service and security.  Debt service means that if you borrow money, you will have to pay it back and you will have to pay interest on it until you have paid it back.  Security means that no one will lend you £1,000,000 to buy a house unless that debt is secured on the house.  So if you default on the loan, the bank takes your house.  Again, this is just contractual and reasonable and does not mean that the bank is either your servant or your master.  It is a contractual counterparty.

Corporate finance is the same.  If companies want to borrow, there are conditions they have to satisfy.  No one forces them to borrow.  If they don’t like the terms, they can just walk away.  Or they can access alternative sources of funds, such as bond markets.  There are conditions there as well of course.  It still doesn’t seem to make much sense to say that companies are “servants” of the bond markets.

Similarly, countries are not required to borrow money in the international bond markets.  Norway has a net surplus because it has wisely saved much of its oil income.  The UK is currently not running a deficit — amazingly enough, although progress needs to be measure correctly, as I have observed previously https://timlshort.com/2015/01/04/uk-deficit-no-longer-a-problem — but in the past, it has borrowed heavily.  The total debt will be £1,840bn as of March 2019. All of that debt also comes with conditions though in that case not very many.  You have to pay interest and principal.  Again, the choice is yours and, as said, currently the UK is not borrowing any further.  No master/servant relationship there.

Reuters also report** that McDonnell said that “ordinary people were still paying the price for the crisis through falling living standards and cuts to public services, and a Labour government would redress the balance.”

There have definitely been falling living standard and cuts to public services.  There was definitely also a global financial crisis.  But there needs to be some link between the two for McDonnell’s point to stand.  The collapse of Lehman cost the UK taxpayer nothing.  McDonnell can only mean the bailout of RBS.  This definitely cost the UK taxpayer.  Arguably, a bank needing to be bailed out is the only reason to care about what they get up to.  If they lose a lot of shareholders money, that is no one else’s problem.  The only thing worse than bailing out RBS was not bailing it out.

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The bailout of RBS amounted to £45bn.  The Government spent that amount on buying shares.  It still holds a lot.  It has made a loss of £4bn on what it has sold so far.  It will doubtless make further losses on future sales. However, these amounts are simply trifling when compared to government expenditure.  Welfare spending will be £115bn in 2019 alone.  So it is not the case that the RBS bailout contributed in any meaningful way to public sector spending cuts.

What did cause that was the government’s income — which is entirely sourced from taxation of the private sector — declining.  And what caused that was a global recession.  That was quite plausibly caused by the events of 2008 including the subsequent credit crunch.

But how will Labour “redress this balance?”  Will it force banks to lend?  They are private sector firms. Will it replace them with public sector banks? The record there is not good.  Spain had a network of Caixas: local banks run by local worthies such as trade unionists and priests.  They were massively corrupt and had to be bailed out having funded a large number of white elephant projects.

Meeting with bankers and asset managers, McDonnell said:

“You’ll get a decent rate of return but we’re not being ripped off anymore. Ripped off by speculation, privatisation, job cuts, exploitation of workers.”***

This is a claim that the government received a bad deal as a result of several activities.

Speculation is betting that an asset’s price will move in a particular way.  It is not obvious what the government’s involvement would be in that or why it should care.  If you suggest that RBS needed to be bailed out because it had “speculated” on subprime mortgage bonds, you need to explain why it is speculation to invest in Aaa securities.

Privatisation is a source of funds for the government.  There no obvious way for it to be ripped off by doing that, unless it sells an asset for a low price.  Which again, no one forces it to do.  Perhaps McDonnell means PFI.  That is also excellent value for money if the contracts are drafted correctly.

Job cuts: I have no idea what McDonnell means here.  Obviously I understand what a job cut is, bit what is McDonnell proposing?  That the government will regulate firing?  That is bizarre and generally results in a lack of hiring because you don’t take people on if you have to keep them forever even if they are incompetent, corrupt or don’t turn up.

Exploitation of workers: so what is that exactly?  And why is it not adequately addressed by the current regulations such as employment tribunals?

It does not appear as though any useful answers to the crisis are to be found in McDonnell’s remarks.

See Also:

UK Government Spending: Where It Needs To Be Cut And Why

Where To Cut UK Government Spending: An Alternative Approach

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

Jacob Rees Mogg Is Wrong To Say That Loss of Passporting Will Not Be A Problem For The City

 

https://uk.reuters.com/article/uk-britain-politics-mcdonnell/labour-says-big-london-banks-must-never-again-be-masters-of-the-economy-idUKKCN1LU2VA

**, *** ibid.

#Proust: An Argument For #SimulationTheory

I will argue that Proust’s picture of how we get into the minds of other’s is simulationist, thus following the account that I favour rather than the mainstream one.

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The term in psychology for the way in which we predict and explain the behaviour of others is “Theory of Mind.”  This is, I suggest, something of a placeholder, because it is in fact deeply unclear how we do this.  Or even if we get it right.  It certainly looks like we do, but that’s just because we confirm our results using the same method. (This is sometimes known as the “dipstick problem” in philosophy.  I can’t tell whether my fuel gauge is accurate if I only look at the fuel gauge.)

There are two accounts of Theory of Mind in academic psychology.  One is called Theory Theory.  This is the claim that we have a theory of other people that we learn when young.  This is the mainstream account.  The other account, which I support, is called Simulation Theory:

https://www.routledge.com/Simulation-Theory-A-psychological-and-philosophical-consideration/Short/p/book/9781138816053

Simulation Theory suggests that instead of using a theory of others, what we do when we predict and explain their behaviour is to simulate them.  Metaphorically, we place ourselves in what we think is their position with the information and desires we thing they have, and then work out what we would do.

Anyone who has read Proust knows that he has an exceptionally deep and unusual set of insights into our psychology.  His insights are not paralleled elsewhere in my view, with the possible exception of Henry James.  For this reason, it is unsurprising to me that he also favours Simulation Theory.  Moreover, Proust even seems to suggest the defence of Simulation Theory using cognitive biases which I have proposed.*

There are two key quotations I will use to back up this claim.**  The character Swann is discussing “fellow-feeling,” and remarks to himself as below:

“he could not, in the last resort, answer for any but men whose natures were analogous to his own, as was, so far as the heart went, that of M. de Charlus. The mere thought of causing Swann so much distress would have been revolting to him. But with a man who was insensible, of another order of humanity, as was the Prince des Laumes, how was one to foresee the actions to which he might be led by the promptings of a different nature?”

This tells us that Swann has observed that it is easier for him to predict or explain the behaviour of others when those others are similar to him.  In this particular case, Swann is wondering which of his friends might have sent him a distressing anonymous letter.  Swann believes that Charlus is similar to Swann himself, that Swann himself would not have sent such a letter, and therefore Swann concludes that Charlus did not send the letter.

On the other hand, Swann believes that des Laumes is a very different individual, who is “insensible.”  (I suspect that a more modern translation would use “insensitive” here.). Note that Swann, in a very simulationist vein, does not say “des Laumes is insensitive, so he might have sent the letter.”  Instead, he says “des Laumes is insensitive, so I cannot tell what he would do.”

This is a very simulationist line.  It says, in effect, that Swann is unable, he believes, to simulate des Laumes, because des Laumes is very different to Swann.  Note this is not consistent with the mainstream Theory Theory view.  There is no reason why Swann, an intelligent and perceptive man, could not have a good theory of insensitive behaviour.  There is by contrast every reason why Swann could struggle to simulate insensitive behaviour, lacking as he does the experience “from the inside” of such behaviour.

A further simulationist view is suggested later; someone might be a genius:

“or, although a brilliant psychologist, [not believe] in the infidelity of a mistress or of a friend whose treachery persons far less gifted would have foreseen.”

This is a claim that people may be extremely intelligent and even special gifted in academic psychology but still make Theory of Mind errors in relation to other people not so gifted.  Note how uncongenial this is to Theory Theory.  Intelligent people who are brilliant psychologists should have an excellent theory of others and so be able to make very good predictions of their behaviour.  Simulation Theory, by contrast, will predict exactly what Proust is describing here: brilliant, intelligent (highly moral?) individuals will fail to predict the behaviour of others who do not possess those characteristics.  And similarly, more ordinary mortals will be able to simulate much better and thus predict much better when the person to be predicted is more like the person doing the predicting.

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The major objection to Simulation Theory is that it does not account for surprising results in social psychology, such as the infamous Stanford prison experiment.  Here, people behave amazingly harshly, for no apparent reason. This behaviour is not predicted by anyone.  Theory Theorists claim that Simulation Theory cannot explain this, because we should just be able to simulate being a guard in a fake prison and then predict the harsh behaviour.

I provide a response to this objection on behalf of Simulation Theory.  I suggest that what is missing from the simulation is a cognitive bias.  In the case of the Stanford Prison Experiment, the bias in question I propose is Conformity Bias.  Simply put, this is just our tendency to do what we are told.  This bias is a lot stronger than we suppose, in comfortable repose.

It is gratifying to find Swann also gesturing in the direction of this Bias Mismatch Defence, as I call it.  Swann further observes that he:

“knew quite well as a general truth, that human life is full of contrasts, but in the case of any one human being he imagined all that part of his or her life with which he was not familiar as being identical with the part with which he was.”

This, if Swann is accurate in his self-perception here, is a description of a systematic Theory of Mind error.  It is a form of synecdoche, if you like.  Swann takes the part of the person he knows and assumes that all of the rest of that person is the same.

I have suggested that one of the biases which can throw off our simulations is the Halo Effect.  This means we know one thing about a person or item which has a certain positive or negative perceived value, and we then assume that all of the attributes of the person or item have the same value.  For instance, someone who is a good speaker is probably also honest etc.  There is of course no strong reason to think this, rationally speaking.

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I have discussed the implications of the Halo Effect on predicting behaviour in financial markets previously:

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

In that case, I called the Bitcoin bubble just before it burst by employing the Halo Effect and positing that it was affecting the judgement of buyers.  It is encouraging to see that Swann is also on the same page as me here!

Note that I do not claim to be a Proust expert or even have completed my reading yet!  I do not therefore suggest that the above represents a radical new reading of the whole of Proust.  I make only the modest claim that in this one paragraph, Proust describes a version of Theory of Mind which is more congenial to simulation than to theory.  Since there are only these two developed candidate explanations of Theory of Mind, then that is already interesting.  (There is also a hybrid account which employs both simulation and theory, but that is a mess in my view and there is no evidence of for any theory in the above quotation and therefore no evidence for a hybrid account.)

 

*”IN SEARCH OF LOST TIME – Complete 7 Book Collection (Modern Classics Series): The Masterpiece of 20th Century Literature (Swann’s Way, Within a Budding … The Sweet Cheat Gone & Time Regained)” by Marcel Proust, C. K. Scott Moncrieff, Stephen Hudson).

**It might be argued that this view is not that favoured by Proust himself but by Swann, who is a character created by Swann.  I will not pursue this sort of Plato/Socrates point, but merely observe that it is at the very least true that Proust considers the position worth discussing.  Moreover, I think it is very clear that Swann is rather to be considered an intelligent, discerning individual, if perhaps somewhat afflicted by propensities for self-deception, and so the fact that this view is at least that of Swann is sufficient to make it interesting.  (I am informed by someone who knows Proust better than me that I am likely to revise my view of Swann in a negative direction as my reading progresses.)

See Also:

#Proust On #Memory

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.

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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.

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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.

See Also:

The Late Evaluation Effect And Financial Markets

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

The #Bitcoin Bubble Is Caused By The Halo Effect

The #Anecdotal Fallacy And The #Bitcoin Bubble

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.

high rise buildings
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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!

See Also:

The Illusory Truth Effect And Financial Markets

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

The #Bitcoin Bubble Is Caused By The Halo Effect

The Picture Superiority Effect And Financial Markets