More behavioral finance

[Martha]

Clements’ article in the WSJ this week was fun. He looked at evolutionary psychology for reasons why people make so many financial mistakes. Sorry, no link as the WSJ is subscription only site.

From Terry Burnham, the author of Mean Markets and Lizard Brains and Robert Frank, the author of Luxury Fever, comes the idea that our instincts are out of step with modern financial life, so we tend to make mistakes, such as:

--we keep striving for bigger houses, fancier cars, bigger paychecks even though research suggests these won’t make us happier in the long run. We do this because our ancestors that survived and reproduced had the greatest drive. There is nothing that tells us to stop as we are "maximizing machines."

--Our ancestors were best served by consuming all they could immediately. Hang on to food? It would rot. Hence the difficulty in saving. “Because saving is such a new concept for us, some folks save too much—and many save way too little.”

--The pain we get from losing $1000 is greater than the pleasure we get from gaining $1000. This causes many people to shy away from stocks, worrying about the risk. The evolutionary roots may be the importance of retaining territory outweighing any need to gain new territory.

--The last point was the need of our ancestors to be good at spotting patterns, like where to fish and get other food. But hunting for patterns can be a disaster in the stock market. If something is too popular, it will be overpriced.

Animal instincts? Maybe, maybe not, but it is fun reading.

 

[SecondCor521]

--The pain we get from losing $1000 is greater than the pleasure we get from gaining $1000. This causes many people to shy away from stocks, worrying about the risk. The evolutionary roots may be the importance of retaining territory outweighing any need to gain new territory.


I think this one can also explain market timing sometimes too. I have seen people sell to get out of a market they perceive as high, then watch it drop, then wait until it has gone up a lot before getting back in. They celebrate with joy at avoiding the pain of the loss created by being out of the market when it drops, but I have yet to see an acknowledgement that they also lost real money by not being in for the early part of the runup. For example, the S&P was up quite smartly in 2003, I think, which in my opinion went relatively uncommented upon in the media. I was in for that and enjoyed watching my portfolio go up quite a bit, but there were a lot of people on the sidelines because of 2000-2002 and not really caring that they missed out.

2Cor521

 

[New Thinking]

Martha - This was a good piece..Behavior and not market returns will be the downfall of the majority of retirement failures over the next 50 years.

 

[audreyh1]

It is well known that the pain of perceived loss in value of something is far greater than the joy in gain. A recent article about people being unwilling to lower their asking prices on their homes (in spite of the fact that the transaction would result in a net gain - and sometimes a significant net gain) underscored that point. The loss from the (unreasonably) expected value is just too great for some folks.

But honestly I don't see how territory defense has anything to do with it - that doesn't ring true.

I do know there are a lot of folks who hang on to a stock, waiting for it to recover before selling it (if is ever does) - totally ignoring the opportunity cost - the fact that they could likely buy something else today with a better outlook and recover more quickly.

To me this is more about pride and selling something at a perceived loss feels admitting a mistake to many. I sure can't think of an evolutionary advantage to this type of stubborn behavior, but there must have been. Gosh - there must be an evolutionary advantage to unreasonable pride itself! Must have something to do with status in the social group.

Trading has been going on for a very, very long time in human history - long enough to have been shaped by evolution. There must be some clue in there for how it has shaped modern investor psychology. Bragging rights? How long have bragging rights been going on?

Audrey

 

[Mwsinron]

Too complicated for me. I know I need x amount of funds so when Im x age I can spend the rest of my life doing zip nadda or whatever the heck is in my mind (within my savings )

Maybe Im different. Things dont drive me. But I like to save money and It makes me all tingly when i see it compound and make me more money and then it lump on and compunds again it just oooooo nevermind...

 

[Cb]

WSJ is free today:

http://tinyurl.com/w8l3x

Cb

 

[Mr._johngalt]

Wow, the only thing I have not done was "hunt for patterns in the stock market." Guess I'm pretty lucky to have ERed, with all of those
old timey gene-embeddded tendencies.

JG

 

[Nords]

Martha - This was a good piece..Behavior and not market returns will be the downfall of the majority of retirement failures over the next 50 years.

Yes, all the "new" "old workers" will say that they're back in the cubicles because they're "bored" and "unfulfilled", not "broke".

 

[MooreBonds]

From Terry Burnham, the author of Mean Markets and Lizard Brains and Robert Frank, the author of Luxury Fever, comes the idea that our instincts are out of step with modern financial life, so we tend to make mistakes, such as:

--we keep striving for bigger houses, fancier cars, bigger paychecks even though research suggests these won’t make us happier in the long run. We do this because our ancestors that survived and reproduced had the greatest drive. There is nothing that tells us to stop as we are "maximizing machines."

--Our ancestors were best served by consuming all they could immediately. Hang on to food? It would rot. Hence the difficulty in saving. “Because saving is such a new concept for us, some folks save too much—and many save way too little.”

--The pain we get from losing $1000 is greater than the pleasure we get from gaining $1000. This causes many people to shy away from stocks, worrying about the risk. The evolutionary roots may be the importance of retaining territory outweighing any need to gain new territory.

--The last point was the need of our ancestors to be good at spotting patterns, like where to fish and get other food. But hunting for patterns can be a disaster in the stock market. If something is too popular, it will be overpriced.

Animal instincts? Maybe, maybe not, but it is fun reading.

I know that there will always be stories about "my great grandmother Mary did this and that" which will disprove one theory or another...but, by and large, isn't the current 65-100 year old generations known for their thriftyness and penchant to save money (often cited because of their experiences of not having it in the Great Depression)?

If that's the case, then how can anyone argue that our 'evolutionary genes' supposedly cause us to spend everything? How could the current retirees go against all those genes to lead them to save up? And how could some societies like China/Japan exist, where the average savings rates are 10-20 TIMES what they are in the US? (2% in the US vs 20-40% over there)?

IMO, it has nothing to do with trend changes in humans - it has everything to do with personality traits and some influence by marketing efforts of corporations and many people caving into peer pressure.

 

[dex]

Martha,
Thanks for posting this info.

I'm trying to decide right now should I buy a house or wait for prices to fall more. Also, what size house to buy - Large, Med or Small.

 

[bosco]

anyone read "Fooled by Randomness" by Nassim Nicholas Taleb?

It discusses human behavior and how it hoodwinks us into making unwise investment choices. I found it fascinating.

 

[RockMiner]

--we keep striving for bigger houses, fancier cars, bigger paychecks even though research suggests these won’t make us happier in the long run. We do this because our ancestors that survived and reproduced had the greatest drive. There is nothing that tells us to stop as we are "maximizing machines."

Maybe so, though I think there are lots of reasons. At first more and better stuff is a fun way to keep score. Later, after we become disenchanted with the grind it can become a way to reward ourselves for sticking with it. I find that my need for cool stuff has diminised greatly since leaving work. Gone is the need for "comfort spending" to compensate for the negative sensations generated by the workplace. A former passion for collectables has all but dissapeared. On the other hand it might just be finally wising up :

 

[mickeyd]

Nice link Martha, Thanks.

I always enjoy reading any new information regarding behavioral finance as it's an area of investing that I need to become much more informed about.

"In almost all other settings, it's good or neutral to mimic other people," Mr. Burnham says. "But in the financial markets, it's exactly the wrong thing to do. If something is too popular, it will be overpriced."

Case in point, index funds. I believe that less than 10% of personal investing goes into index funds as most investors want to beat the market and indexing claims to never beat the market. Many long-time investors have tried to beat and re-beat the market for years and finally understand that passive investing beats about 3/4 of the market over the long-term and that is a beautiful thing.

 

[LOL!]

I always enjoy reading any new information regarding behavioral finance as it's an area of investing that I need to become much more informed about.

An accessible book on behavioral finance is Why Smart People Make Big Money Mistakes Maybe it doesn't have any new stuff for you, but it's a good intro for folks.

 

[mickeyd]

Why Smart People Make Big Money Mistakes

Thanks.
Do you have an author on that LOL?

 

[ronin]

Mean Markets and Lizard Brains is a fun read, not overly deep but hits lots of the biological roots of our behavior. I particularly liked Fooled by Randomness as well, although the author's style/personality is offputting to many.

 

[Nords]

An accessible book on behavioral finance is Why Smart People Make Big Money Mistakes Maybe it doesn't have any new stuff for you, but it's a good intro for folks.

Thanks. Do you have an author on that LOL?

I'm not LOL, but the book is by Belsky & Gilovich... an excellent read.

 

[acalianos]

I have a particular take on Behavioral Finance.... Academic BF claims that there are patterned "errors" and "biases" which "rational" investors can identify and profit from in real-time. Yet there is no hard evidence for this. The examples and studies are all rearward looking after-the-fact. My take is this.... in order to take advantage of my "errors" you - the rational investor - would have to be 100% error-free and fully rational and have perfect objective self-knowledge (contradiction in terms) that this is the case. Kind of a slippery slope.

The low hanging fruit of academic BF is to NOT commit the errors they've identified so well (overconfidence, overtrading, loss aversion, anchoring, etc.)

Now, how do we make money? BF is really about the BehaviorS in marketplace. Long-term buy-and-hold retirees BEHAVE diffently than short-term leveraged proprietary day traders at a bank trading desk. When these behaviors overlap we have big moves and the market quickly becomes non-random. If this is true you should be it able to see it in the frequency distribution of returns.

 

[Nords]

[Modified by moderator after poster addressed the original issue.]

 

[modlair]

When these behaviors overlap we have big moves and the market quickly becomes non-random. If this is true you should be it able to see it in the frequency distribution of returns.

I've created an "histogram movie" that shows this. The normal distribution of returns is this tiny little town in Montana that a Masseratti drives through at top speed every now and then.

I believe there was a fellow here that babbled about doing Fast Fourier Transforms of market data waveforms to find frequency distributions of returns. This approach, btw, is:

1) Somewhat more effective than histograms and

2) Not particularly new and has been done before and cannot help one market time because the human components of the market would act a priori on the knowledge

But at least that guy had no spam motivations.

 

[acalianos]

FFT has no relationship to what I am speaking to. FFT is about signal decomposition into component frequencies and amplitudes. This is physics. The math is linear. Markets do not work that way. The moving window of frequency distribution shows a very organic process that is non-Gaussian over any reasonable time frame that is important to investors. Market are self-referential. This is feedback not sine waves. You are correct - what I am suggesting is not new. Edgar Peters and Benoit Mandelbrot both approach the issue differently. Jesse Livermore talked about it. Charlie Kindleberger studied 300 years of this. I'm taking a different cut at the same basic observation: market participants are different. The issue is not rationality - what is a rational decision for a long-term investor at any moment may not be rational for a trader. One billion shares don't trade on the NYSE because of information efficiency or irrationality. Markets exist to accomodate disparate objectives. That is what BF is all about as far as I'm concerned.

 

[modlair]

That is what BF is all about as far as I'm concerned.

Actually, it's probably about a bunch of guys who thought it would be rich dissertation territory with a low risk of getting blown of the water by someone publishing before the defense.

Best of luck with it, though.