Omission Bias and Financial Markets

Omission Bias is the tendency to judge the omission of an act more harshly than its commission.  It is widely studied in psychology and has been reliably replicated in a variety of scenarios.  In the context of financial markets, this can have adverse effects because there is no practical difference between investing $100 in a stock that declines 10% the next day and failing to buy one that appreciates 10% the next day.

This of course assumes that you actually have $100.  If you don’t have a float of cash available at all times, then you will not be in a position to seize opportunities.  So that would be the first piece of advice.  Maintain a certain percentage of your investable assets in the form of cash —  perhaps 10%.  Alternatively, you could arrange for a line of credit in a similar amount but make sure you do not do too much of this because it is high risk.  Conversely, holding 10% cash acts to reduce risk.

Another adverse effect of Omission Bias is that it impairs your ability to assess performance.  This is of crucial importance.  Many investors do not have clear enough data of what has worked for them and what has not.  It is essential to have a good focus on this for a number of reasons.  

One benefit is that you can only manage your portfolio appropriately if you have been examining its performance precisely.  A second benefit is that you might be able to identify some specific sorts of trade that you are particularly good at.  You can then seek to identify relevantly similar situations and exploit them.  Also — you might have a chance of avoiding disasters from the past occurring again!

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Our ability to look at our failures and learn from them is also impeded by our natural distaste for thinking about the unpleasant — but failures are always more instructive than successes.  One might almost say that any fool can succeed — but only an expert can fail well…

A major practical impediment to any attempts to correct for Omission Bias is due to the sheer scale of the problem.  The number of shares you did not buy yesterday is absolutely huge.  There is no way you can think about all of those.  Nor should you.  The more useful comparison is to think about the shares you could have bought or the ones you almost did buy.  So that tells us that you should be looking at several buy options at a time.  Look at what factors led you to choose the one you did choose.  

Maybe you were looking at three oil companies.  You compared them on price/earnings ratios, dividends and price/book value.  You made a choice.  Did that work out?  (Don’t do this next day.  Wait for a reasonable period.  Otherwise you will just be looking at noise.)

What fundamentally is going on with Omission Bias is a sort of agency effect.  If something bad happens and you could have prevented it but did not, this is seen as morally less culpable than if you did something which caused a bad outcome.  After all, “you didn’t do anything.”  I think this perception might be strengthened by the fact that the law says a lot about what we cannot do but rarely says anything about what you must do.  You are at liberty to walk past a baby drowning in a pond.  You are not at liberty to throw a baby in a pond.

This might be fine morally.  But stock markets are not outlets for moral action.  They are locations where you can profit.  Or not.  Bear in mind the possibilities of Omission Bias affecting your judgements of your own decision-making and your decisions will get better and more profitable.

Learn more in the video below:

Plan Continuation #Bias And Financial #Markets

Plan Continuation Bias is a major factor driving investor losses in stock and other financial markets.  For example, many investors tend to hold on to losers for too long when they should cut their losses.  In this article, I will outline how this bias permeates our psychology by looking at how it works in air crashes, and then go on to examine its effects in financial markets. Investors will learn how to address this bias and improve trading performance.

Plan Continuation Bias, simply put, is the tendency we all have to continue on the path we have already chosen or fallen into without rigorously checking whether that is still the best idea or even advisable at all. Operating with this bias, as with the other 180+ biases that are an unavoidable feature of our psychology, is generally a good idea. We simply don’t have the time to constantly re-analyse our decisions.

Berman and Dismukes wrote a NASA report on this problem, which they describe in a brief article. They define Plan Continuation Bias as follows:

a deep-rooted tendency of individuals to continue their original plan of action even when changing circumstances require a new plan

Berman and Dismukes “Pressing the Approach” Aviation Safety World, December 2006, pp. 28–33

The authors describe two air crashes which were in their view caused by the operation of Plan Continuation Bias. Flight 1420 into Little Rock, Arkansas crashed in June 1999 because the pilots ignored alarms and persisted with an approach in difficult weather conditions. Similarly, Flight 1455 crashed in March 2000 in Burbank, California because the pilots continued with an approach even though they knew that they were flying at 182 knots which they knew was 40 knots above the target touchdown speed.

It is very easy for us to sit here on the ground and do armchair flying. We would not have made these errors we say to ourselves, wrongly. If we saw that we were flying too fast or that there were multiple alarms sounding, we would abort the landing and go around. This is not difficult to do. This quick and wrong simulation of the pilots misses out many germane factors. The pilots are under some pressure to land planes quickly and efficiently for cost reasons. There are no guarantees that going around will improve weather conditions. But ultimately, the major factor in these crashes in human cognitive bias.

Plan Continuation Bias has significant effects on the psychology of all of us. As the authors observe,

Our analysis suggests that almost all experienced pilots operating in the same environment in which the accident crews were operating, and knowing only what the accident crews knew at each moment of the flight, would be vulnerable to making similar decisions and errors

Berman and Dismukes “Pressing the Approach” Aviation Safety World, December 2006, pp. 28–33

Plan Continuation Bias is just as relevant a factor in making decisions in financial markets. We can be just as liable as the pilots described above to sticking to the plan. We bought a stock, it was a good idea at the time, and we continue to hold it even though the original reasons for it being a buy have dissipated or not transpired.

In trading, while no one is going to be killed, it is still an environment in which decisions need to be made on an inadequate data set and sometimes under time pressure. It is also going to be a highly charged situation emotionally. The inadequate data set could result from factors such as the impossibility of predicting the future or the sheer scale of the operations of a listed company. Time pressure is particularly prevalent in day trading, but even more long-term investors are susceptible to effects such as feeling that “money is burning a hole in their pocket” and they need to put a trade on right now. The emotional charge comes from losing money. We are all highly averse to losses — in fact, we seem to be 2.5x more averse to losing money than we favour gaining the same amount. It hurts to lose. It challenges our self-perception.

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These observations lead to immediate suggestions as to how one can prevent Plan Continuation Bias from impairing one’s trading psychology.

  • Try to minimise the effects of an inadequate data set by either doing more research or not trading unless you are certain or can set downside limits. Don’t take trades where it looks like you need to know everything about a company or where you think other market participants can easily know more than you. Don’t trade things you don’t understand like Bitcoin.
  • Don’t do anything under time pressure. You will need to get used to FOMO because “just getting one more trade on” will kill you quite quickly. It’s fine to miss things. It is much more important to get a small number of decisions right than to try to catch every opportunity
  • Don’t trade when feeling strong emotions and try to trade emotionlessly. This is hard to do. It is particularly hard to learn this from practice/dummy accounts. It simply doesn’t hurt very much to lose play money. You should still start here, but be prepared for real life to be much harder. Get more Zen about it. It doesn’t matter if a trade loses as long as you are up over the year.
  • Learn more in the video below:

Asking Mark Field MP To #StopBrexit

From: Tim Short
Sent: 17 November 2018 10:45
To: FIELD, Mark
Subject: Brexit Is Economically Catastrophic

To The Rt Hon Mark Field MP

Dear Mr Field,

I would like to know as a constituent of yours and an investment banker what actions you are taking to prevent the severe adverse economic consequences of Brexit, which were extremely clear at the time of the referendum, and yet are becoming more apparent daily.

As you will be aware, we cannot replace the many FTAs we currently enjoy in virtue of our EU membership quickly or easily. It is a chimera to believe that trade with the Commonwealth can replace trade with the EU since it is an empirical law that trade volumes anti-correlate with distance.

There are three components of GDP growth, of which an increased workforce — meaning migration — is one. Increasing the other two — productivity and capital intensity — is difficult. We therefore require greatly increased levels of skilled migration, especially in the light of likely future demographic developments. Migration is harmed by Brexit since it creates a strong and accurate perception abroad of UK hostility to migration.

There is as you will know a composite sector model of the UK economy on the day before the referendum composed of the appropriate weightings of sectors in other OECD economies. Naturally, those other OECD economies have been exposed to the same global economic environment as has the UK economy. Nevertheless, UK GDP is currently underperforming the composite model by £500m per week.

I have never understood what it was that the Brexit voters wanted, but whatever it is, we simply cannot afford it.

I look forward to hearing what actions you intend to take to stop Brexit.

Yours faithfully,

Tim Short
timlshort.com/abouthttps://timlshort.com/about

More Data Explaining Why #Women Are Better #Traders Than Men

Why women are better traders and investors than men — a psychological explanation

Warwick University Business School (“WUBS”) have conducted a fascinating study on the investment performance of men and women.  They show that women perform significantly better with a good sample size and temporal range.  They make some interesting remarks on why this might be.  I think I can add some extra psychological depth to this — so we can see that female traders appear to have some quite deep natural advantages and they should feel encouraged about managing their own investments.

What WUBS did was collaborate with the share dealing service offered by Barclays Bank.  They looked at 2800 investors over three years.  There are various ways of measuring stock market performance, but one of the most common is to compare the performance of a portfolio with a relevant stock market index.  (I explain what a stock market index is here: What Is A #Bear #Market?)

It is quite hard to outperform an index consistently.  This fact is what lies behind the recent strong growth of tracker funds.  You may as well buy the index if you can’t beat it.  The results from the WUBS study showed that women consistently outperformed the FTSE-100 index and men did not.  The male investors returned 0.14% above the index which is basically statistically consistent with having performed equivalently to it.  However, I suspect that these investors would have been better off just buying the index rather than paying a lot of trading fees to obtain the same performance.

The female investors outperformed the FTSE-100 by a massive 1.80%.  This may not sound much, but it is actually huge.  Done over a lengthy period, it would lead to significantly improved results.  Let us assume that the FTSE-100 returns 5% a year.  If you started with £10,000 and performed as the male investors do, you would end up with £45,000 after 30 years.  (It is always important to think long term in the stock market; to prefigure part of the answers I will discuss below, the women seem to understand this.)  The female investors would turn £10,000 into £72,000 over the same 30 year period.  That is a huge improvement over £45,000 and bear in mind that the female investors have taken the same risk, making it even more impressive.  (One caveat is in order here: no one performs this consistently over the long-term–if they say they do, it is a huge red flag.  Remember Madoff?  But the point stands.)

How are female investors outperforming?

WUBS and Barclays set out a few reasons which could explain the outperformance.  One of them is the one we already know about.  Women are less over-confident than men.  I explain how that works here: Women Are Better Traders Than Men.  In summary, women tend less often to think that their new idea is brilliant and then abandon their previous idea before it has had time to work.  Men on the other hand just get extremely convinced about their new sure-fire idea and go with it.  Interestingly, women’s lack of over-confidence is not manifested in what they say about their beliefs.  They just don’t act on them as often.  We could discuss philosophically what that means about our account of belief — but the key point is that women are less likely to trade in deleterious ways!

But there are new reasons suggested.  There are three that I think are especially interesting.

  • Women stay away from terrible ideas like #Bitcoin (this explanation is proposed by a Guardian commentary from Patrick Collinson; see links below)
  • Women avoid “lottery style” trading
    • It has always struck me as insanity to own a lot of penny stocks which are supposed to return ten times the amount you invest in a year because this almost never happens.  As I discuss in my book, The Psychology of Successful Trading, traders can get seduced by vivid stories, incorrectly over-estimating massively their likelihood of coming about.  A far better approach is just to sit still in major stocks for a long time, with maybe some spicy options for fun in a minor section of the portfolio.  The problem with picking the next Amazon (or Bitcoin, for that matter) is that you can’t.  You would have to own a million penny stocks for each Amazon or Apple.  So this strategy is exciting but completely unsuccessful.
  • Men hold on to their losers
    • It seems that women are better at getting out of something which hasn’t worked.  This came very close to home for me.  Infamously, I am still holding Deutsche Bank stock, partly because I recommended it in my book as a contrarian trade.  Banks are supposed to trade at at least book value (in fact, 2.0x before the crisis).  So if you buy a bank at 0.25x book value, you can’t lose right?  Because it is buying something for a quarter of its value.  That hasn’t worked for me yet — maybe a female trader would have got out of this position a long time ago.

In conclusion, we have seen some deep-seated psychological advantages which female traders will have over male ones.  This should encourage women in their investing.

Links:

WUBS: https://www.wbs.ac.uk/news/are-women-better-investors-than-men/

Guardian: https://www.theguardian.com/money/2018/nov/24/the-truth-about-investing-women-do-it-better-than-men

I would like to thank Dr M R Hampson for suggesting I look at this.

 

Optimal #Trading #Psychology

Understanding  basic psychology is one of the most important but also most neglected tasks for investors.  Of course, everyone realises that they need to analyse the investments they are considering buying.  But many traders do not realise that winning in investment is also about successfully predicting what other market players will do.  And that is a psychological task.

Most of the advice on the internet is not really psychology.  It is quasi-psychology.  You might get famous traders telling you things like “I always played tennis in the morning before my best trades to make sure I felt good.”  This is useless.  By all means, study what these guys do to get insights into how they analyse opportunities and maybe any tricks they have for bouncing back from a loss.  But famous traders don’t have any specific training in psychology so if you are specifically wanting to improve your own trading psychology, adopting their tips (such as the tennis one above) won’t really help you in achieving that goal.

Alternatively, there are some actual psychologists who write on the topic and are experts in the field of psychology.  But be careful about their specialisms.  Someone who is a clinical psychologist may be an expert  in schizophrenia but not necessarily other aspects of human psychology.  And of course the main thing is that these experts do not have any serious trading experience, so they also can’t help you improve your trading psychology.

photo of head bust print artwork
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To identify the right sort of person, you need to ask two questions: does this person have significant trading experience and are they qualified in a related field?  I am one of these people.

To try to convince you of this, I will outline my ideas on how to optimise your trading psychology.  The first thing to know about is that we have a lot of cognitive biases —  mental shortcuts that are often useful when we want a quick and dirty answer and often very unhelpful when we are trying to get something right.  One example is Confirmation Bias, where people look only for evidence that supports what they already believe.  There have been many robust psychology experiments published, that show time and time again that we do this often and consistently.

The first thing to note here is that if you use this bias when making your own trading decisions, you will make bad decisions.  Every time!  So you will definitely not be optimising your trading psychology.  But here’s the key point: everyone else in the markets will be doing it too.

So what does that mean?  It means you need to know about Confirmation Bias and think about it in a market context.  Look out for it in yourself and be careful.  Expect it in other market players and trade accordingly.  

That’s how you stand the best chance of optimising your trading psychology. 

See Also:

The Psychology Of Successful Trading – Behavioural Strategies For Profitability

Why #Value Investors Should Buy #Bank Stocks

The Illusory Truth Effect And Financial Markets

Bad Arguments for the Permanence of Bitcoin

 

What Is A #Bear #Market?

People often ask what the common stock market terminology of bullish or bearish means.  While these have standard meanings in normal speech — bullish being positive or optimistic, and bearish being the opposite — at least the term “bear market” has a precise technical definition in the arena of stocks.  I will explain this here.

The formal definition of a bear market is a market that has declined 20%.

brown bear in body of water during daytime
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The first item to clear up on the way to understanding the definition is “what do we mean by a market?”  Normally people will be talking about a particular stock market index, such as for example the Dow Jones Industrial Average (“DJIA”), the S&P 500 or the Nikkei-225 (“N-225”).  So now we want to know what a stock market index is.

Individual shares go up and down all the time.  One cannot say what is happening in more broad terms to “the market” by looking at single shares because of this volatility.  So instead, one looks at a basket of shares.  That is what an index is: a basket of shares listed in a specific location.  There are thousand of these, and they can be selected in many different ways.  

To illustrate this, the DJIA is a basket of 30 major US shares that are selected so that they represent a good spread of major US stocks in different sectors such as computers, aircraft manufacture and banking.  The S&P 500 is a broader basket of shares issued by the 500 largest public companies listed in the US.  The N-225 is somewhat different as it is made up of the 225 largest stocks listed in Tokyo.  It is price weighted, meaning that more expensive stocks will be more heavily influential in the movement of the index.

So, put simply, if all of the component stocks in the DJIA go down 20% in a period, the whole index will also go down 20% over that time.  Since this index and the others are a broader measure of market sentiment than any single stock, if the DJIA goes down 20% in a period, we can say that it was a bearish episode for the market.  Since that is an approximate measure of the health of blue chip US equities, one would also be justified in saying that that period was a bearish period more generally for major US companies.

The DJIA has been published since 1896.  The graph looks like a long uptrend punctuated by occasional bear markets.  You can see this below.

Untitled

People tend to talk less about the technical definition of a bull market — they will often use it more colloquially to just mean “stocks are going up.”  But if one wanted to be precise, it would just be the opposite of a bear market.  It would mean that a particular index had increased by 20% from a trough.

See Also:

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

Why #Value Investors Should Buy #Bank Stocks

What Is “Theory Of Mind?”

Cognitive Biases And How They Affect Stock Markets

Why #Value Investors Should Buy #Bank Stocks

I recently discussed (in Investment Styles) the two major different styles of investing: value and momentum.  One difficulty with following a value approach is the difficulty in measuring value, since much of it these days is tied up in intangible assets.  I will suggest here that, counter-intuitively, buying bank stocks is the solution to this problem.

bank bars business commerce
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The value approach to investing is simple to understand, though perhaps a little harder to implement.  The basic idea is that you buy things when they are cheap.  Finding cheap assets would classically rely on looking at concepts like “book value,”  which is just the accounting value of everything owned by the firm in which you are thinking of investing.

In previous decades, book value would have been simple to calculate: you could just look at the published accounts and examine how much the accountants said each asset was worth.  A company making cars, say, would own a lot of items like factories, car parts, machinery and land.  You could look at all of those items that you could walk up to and touch, and add up all the values, and that’s it: you have calculated book value.  If you can buy the stock for less than book value per stock, you have made a good investment.  If the company sold all of its assets, and turned that book value into actual cash, each shareholder would get more than book value.  That’s why value investing is a good idea, and why you should try to buy stocks at less than book value.

This simple approach is more difficult in modern times, because IP — Intellectual Property — is much more important than it used to be.  IP is anything the company owns which is valuable but that you can’t touch.  It could be a suite of software, the value of a brand, or

close up of computer keyboard
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simply the know-how involved in producing the products or services that the company produces.  To illustrate the scale of this IP problem for value investors, consider the following estimate.  Ocean Tomo, an investment bank, reckoned that the proportion of the value of S&P500 companies which was tied up in IP increased from 17% in 1975 to a huge 84% in 2015.  So it is clear that there is a very serious problem in adopting a value investment approach these days, and that’s unfortunate because in my opinion, it is the only approach that works.

So what should investors do about this?  I think they should look at bank stocks.  This will seem dramatically strange at first sight, because banks own hardly anything at all that is tangible.  However, we already saw above that this is true for all companies now, so it can’t be avoided.  The key point though is this: there is a well-determined market value for everything owned by a bank.

business charts commerce computer
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If you look at the balance sheet for Deutsche Bank, for example, you will see a very large number of items.  They will all have market values though.  That will be true of shares, bonds, interest rate swaps, credit default swaps, loans to corporates, futures and options, office buildings, warrants, cash in various currencies and any of the other myriad financial assets.  There will also be a certain amount of brand value but I think that will be fairly low in the mix.  So basically everything owned by Deutsche Bank could be turned into cash, and a known amount of cash, quite quickly.

Banks typically traded at 2.0x book value before the crisis.  The rule of thumb for value investors in the sector was “buy at 1.0x book value, sell at 2.0.”  Something like this is still true: you can buy Deutsche Bank at 0.3x book value and I think you should.  That’s the right approach for value investors today.

See Also:

Investment Styles

What Is “Theory Of Mind?”

The Illusory Truth Effect And Financial Markets

The #Bitcoin Bubble Is Caused By The Halo Effect