In Financial Markets, Relying on the “Wisdom of Crowds” Can Be Very Risky

We all tend to do what everyone else does. This saves time and effort on many occasions, but it can cost you a lot of money in financial markets

 

We all tend to do what everyone else does, even when we can see that everyone else is wrong.  In financial markets, this can lead to bubbles and herd behaviour.  It is important to be aware of this tendency within our psychology, so you can at appropriate times avoid joining in the bubbles.  It is important to do this because you will lose a lot of money if you participate or, once in, fail to exit before everyone else does.

In this post, I will briefly outline the relevant psychology so you can both look for the effects in your own thinking and expect those same effects in other market participants.  This will improve your trading.  I discuss this bias and many others in a financial markets context in my new book (see link below).

Conformity Bias is also known in the literature as the Asch Effect, after the pioneer experimenter.  Asch obtained really surprising results, which will show you how strong this effect is.  He had a naive member of the public sit in a room in front of a blackboard with four other people.  The member of the public thought that the other four people were also naive members of the public, but in reality they were actors who were going to behave in a specific way suggested by Asch.

A line of a certain length was drawn on the left side blackboard.  Some other reference lines of different lengths were drawn on the right hand side.  One of them was clearly the same length as the reference line and all of the rest were clearly much shorter or much longer.  Asch then had the people say which of the test lines on the right was the same length as the reference line.

If the naive member of the public went last and heard all of the actors give a wrong answer, he tended to go along with them even though the answer was obviously and clearly wrong.  Amazingly, Asch found that most people gave an obviously wrong answer some of the time and also that some people gave wrong answers most of the time.

This is how strong Conformity Bias is: it works even when the answer is obvious.  Imagine how much more dangerous it is in financial markets where the answers are much less clear cut and much ambiguous and conflicting data must be weighed.

I think this is one factor behind a lot of famous bubbles in financial history. Right now, it looks to me as though the cryptocurrencies, most notably Bitcoin, are exhibiting bubble characteristics.  One sign of this is the enthusiasm of a particular football manager, one noted for his lack of financial acumen, for Ethereum.  I do not say this is a scam; I merely suggest that one should look to more fundamental underpinnings for value than “everyone likes it and it has gone up a lot.”

Avoid Conformity Bias and trade better by trading the other way when you see it happening.

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

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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

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Cognitive Biases And How They Affect Stock Markets

There are an extraordinarily large number of cognitive biases which change the way we think — it is important to know about these in stock markets both in order to look for them in one’s own thinking and expect them in that of other market participants

A Cognitive Bias is an element in our psychology which makes decisions for us.  In fact, given there are so many of them, you might even say that our psychology is just Cognitive Biases.  I discuss about 20 of them and give market context in my new book:

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

One example which I discussed in a previous post is Hindsight Bias.  This makes us think that everything which has happened was inevitable.  This in turn makes us very bad at knowing what level of probability we assigned to past events.   We seem to remember that we said that a prior event was going to occur with 90% probability when in fact, we gave it a probability of 30% before that event occurred.  This will obviously have unhelpful effects in the context of markets.  It will make us greatly overestimate our chances of knowing what is going to happen next, which may make us trade with over-confidence.  There is nothing quite like over-confidence to kill market performance.

As I said, the book covers around 20 biases and their effects in markets in much more detail than I can give above.  The thing is though, that there are way more biases than that.  In fact, from the chart below, which is due to Bence Nanay, you can see just how many there are.

Every one of these biases will affect your market thinking and that of everyone else involved.  So it looks like we all have some work to do!

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Empathy Is Useless

Empathy is popular but I argue not helpful in financial markets or elsewhere

I have recently seen an interview with a poker champion in which he claims that “empathy” is one of the strengths of his game.  I will suggest this is false for a couple of reasons.  Firstly, we don’t know what it is.  Secondly, what is more likely to be useful is the related but distinct concept of “Theory of Mind.”  I think there are many parallels between poker and financial markets, so my position amounts to an argument that you don’t want empathy to make your stock portfolio perform.

I discuss at greater length the sort of psychology which is more likely to be useful in my new book: 

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

There are several things that empathy might be.

  • I feel the same emotion as you
  • I can say what emotion it is that you are feeling
  • I feel a similar emotion to you
  • I feel a weakened form of the emotion that you feel
  • I “sympathise” with your situation
  • I can imagine what I would feel in your situation

This is already complicated enough, without asking difficult philosophical questions like “what does ‘same’ mean here?” or “what is the effect of similar?”  And we haven’t got on to the main point yet.

In poker and in markets, what you want to be able to do is predict and explain the behaviour of others.  That is what is known in psychology as a Theory of Mind task.  I have argued in my first book that the way we do this is by simulating others.  We imagine that we are in the situation that the others are in and see how we would feel.  We then predict that they will behave the same way as we would given the resulting emotions.  Note that this does not fit neatly into any of the categories above.

This I think shows the first problem with claiming that empathy is good for performance.  This isn’t a useful piece of advice without defining what empathy actually is.  And secondly, think about what it would do if you felt people’s emotions.  Do you want a surgeon who is about to operate on you to be paralysed with fear because you are?  Do you want a pilot to experience the emotions of passengers as he wrestles with the controls in a storm?

I think that when it comes down to it, what you want is actually a good Theory of Mind.  In fact, as I discuss in my book, there is experimental evidence that better traders have better Theory of Mind.  For that reason, I spend an early chapter explaining how we think Theory of Mind works.  It can be improved I think by taking account of cognitive biases and that will lead to better trading performance.  It will probably improve your poker game too!

Women Are Better Traders Than Men

Women are better traders than men because they are less over-confident. It is also possible that they benefit from superior abilities to predict and explain the behaviour of others.

There is a good amount of evidence that female non-professional traders outperform male non-professional traders.  I discuss this at greater length in the final chapter of my new book:

The Psychology Of Successful Trading

This evidence is not widely discussed or known I believe.  It should have a wider audience.

I do not mean to imply that female professional traders under-perform male professional traders.  I have not seen a lot of data one way or the other on that point, though apparently there are some indications the female-run hedge funds also outperform.

There are a few interesting reasons as for why this might be.  One is that females are better at “Theory of Mind” than males.  Theory of Mind is the label for how we predict and explain the behaviour of others.  One would expect then that since much of market out-performance is driven by predicting the behaviour of other market participants, that strong Theory of Mind would be possessed by better traders.  And this indeed is what the data show.  Since I don’t believe that anyone has explained Theory of Mind to traders, I also devote an early chapter of the book to that topic.

The other interesting possibility relates to confidence.  There is a curse of over-confidence that afflicts at least non-professional traders.  They fall in love with their own judgment.  But it is only a fickle love.  In three months, they will be in love with a new idea and a new stock.  This makes traders commit the cardinal error of over-trading.  It is well-known that “buy-and-hold” outperforms as a style over the long term.  The fact is though that many retail trading accounts turn over several times in the course of a year.

It turns out that females are not less over-confident than males in one sense: they also form beliefs which they assert as confidently.  However, it seems that female traders are less likely to act on these beliefs.  So they are protected by this from letting their over-confidence lure them into over-trading.

This is just one account of the data.  I cover more in the book.  If you are interested in Theory of Mind, you could also take a look at my first book:

Simulation Theory

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Investing Like Geoffrey Boycott

Investors are very bad at forecasting political events.  This is well-known to me after many years of trying.  It is discussed in a good recent article in The Economist:

https://www.economist.com/news/finance-and-economics/21726084-wishful-thinking-may-lead-them-astray-investors-are-not-great-predicting

For example, they — and I include myself in this — were wrong about all of the following events.

  • The election of Trump
  • The effects that election would have on markets
  • Whether Trump would pass any legislation
  • The Brexit Referendum
  • The subsequent UK General Election

Interestingly, many non-experts were “right” about these events.  I put “right” in quotation marks because I think that The Economist is right to say that wishful thinking is partly what got people to their forecasts, rather than pure rational analysis.  This is an example of what Kunda(1990) calls motivated reasoning.  In other words, it is a psychological bias operative in financial markets.  In my new book:

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

— I argue that understanding the wide array of psychological biases active in oneself and other market participants is crucial to driving financial performance.

Now we come to Geoffrey Boycott.  I will briefly explain cricket to the extent we need to know about it here.  It is somewhat like baseball.  You want to score without getting out.  The parallel with financial markets is that you want to make money without “getting out” — which I interpret as meaning you take a loss so large that you abandon markets.

Now, Boycott was famous for patience.  He would score freely when opportunity presented itself, but otherwise he would just make sure he didn’t get out.  In the jargon, he “occupied the crease.”  This meant he might be there all day.  The key point is this: if you stay there long enough, the runs will come.  Similarly, in financial markets, if you stay the course, the profits will come.

So I did not see Brexit.  But I was invested in US equities at the time.  So I got the overnight 15% boost from sterling depreciation.  You might call that luck.  I call it occupying the crease.

PFI: The Real Problem with “Bringing the Contracts In-House” Will be the Bonds

Today, a pledge was announced at the Labour Party conference that PFI contracts would be reviewed and if necessary, brought back in-house.  This is reported here:

https://www.theguardian.com/politics/2017/sep/25/john-mcdonnell-labour-would-bring-pfi-contracts-back-in-house

It is apparent that private investors who have put money into PFI schemes will need to be compensated.  This is acknowledged by a spokesman saying “a future Labour government would compensate shareholders in PFI companies by swapping their shares for government bonds.”  That might well be acceptable, though equity holders may not be at all happy about being placed in a different part of the capital structure with a completely different risk/reward structure and also having their exposure changed to a different entity.  This however will be acceptable providing they are given enough government bonds.  I am not sure how popular a “stuff their mouths with gold” policy to ensure silence (and no lawsuits) will be but we will see.  The real problem however lies elsewhere.

The way PFI works is that the government or an NHS trust signs a contract with a private sector entity, often a consortium the members of which will include prominently construction and financial firms.  The contract, very basically, will say “you agree that we will have a usable hospital between three and thirty years from now” and “we agree to pay you cash amounts for the same period.”  This removes risk from the government because it no longer has to build the hospital — which incidentally it probably cannot afford to do in any case — and any other interruptions to service during the lifetime of the contract.  This by the way is why it is not an objection to PFI that it costs more: it should cost more because the government has avoided a great deal of risk.  We know how prone government expenditure is to going over-budget: with PFI that risk is passed to the private sector.

The private sector consortium now has a good chance of receiving government cashflows for 30 years, providing it can build the hospital without problems.  These cashflows are excellent for backing bonds: or in the jargon, they are good candidates for securitisation.  Because they are such good candidates, almost all of them will have been.  One reason why they are so good is that there is very strong demand for such long bonds — from everywhere in these low rate times — but especially from pension funds.  Naturally they want long bonds because they have long liabilities.

Here’s the problem.  These investors are very focused on Repayment Risk.  This is the risk that you give them their money back before they were expecting it.  This sounds like good news for the investors, but it isn’t because the pension fund was hoping to get paid interest for 30 years at a rate fixed today and now you have given them their money back they won’t get that.  This is especially painful for them if rates have declined in the meantime.  The current ultra-low rates environment just underlines this.  Imagine 10 years ago you bought a bond paying you 6% a year for 30 years and now they give it you back and say “go ahead and find another bond that pays you that much…”

Because investors hate this so much, they insist on what is known as a Spens clause.  This basically says that if you repay early, you have to roll up the remaining excess interest payments for the remaining life of the bond and hand that over now.  This will be unimaginably expensive because the excess interest will be calculated primarily from the original rate paid by the bonds and the general rate available.  That difference will be huge in a lot of cases because rates generally are so low.  So you will have to roll up a huge difference for maybe 20 years.

Conceivably the government could legislate to take out the Spens clauses.  But that would mean government had intervened radically in contracts agreed between consenting experts in full possession of their faculties…and would destroy the reputation of the City as a secure global marketplace.  We don’t need that ahead of Brexit.  In any case, it would also kill most of the pension funds.  Many of those are foreign, so even if the government were able to lean on the local ones, they would still pick up some fearsome litigation.

I spent almost a decade on the fixed income trading floor of various investment banks.  I concluded that psychological factors were extremely important in driving market events. I am just about to publish a book on this topic.  You can learn more at the link below.

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