Sept06 latest - Association of Dutch Businessmen

MONEY
you will most likely read a lot of articles that confirms this view. If you accidentally come across evidence
that contradicts this view, then you will hold it to a much higher standard of proof and seek out a
rationalisation from one of your sources that you already agree with. This kind of behaviour can be very
expensive, as the market really does not care about your view. You might be right, but as John Maynard
Keynes famously mentioned, you can be right longer than you can remain solvent. The right and only
way to invest is to form an opinion and then seek out all the information you can find to contradict
that opinion. If after that research you are still convinced that you are right, then you might well be.
Herd bias
As the name implies, herd bias is the tendency of people to believe in a certain stock or market trend,
simply because other people, especially peers, do even in the presence of contradictory evidence.
There are an abundant number of examples in history confirming this bias, such as the Dutch tulip
mania, the railway boom and the internet boom. Behavioural finance specialists give various reasons for
this behaviour. One is that people don’t trust their own judgement and look for guidance from others
and so-called specialists. A More powerful reason might be that people feel much less bad about a wrong
decision if the reference group suffers the same fate (i.e. massive losses). Realising this bias can greatly
help your investment results albeit not that simple. For instance, if you did not believe the recent internet
hype and did not invest, eventually you would have been vindicated. However, you would have had to
endure great psychological abuse for more than 2 years as you would not have been part of the ‘in’-crowd
and saw peers amass great sums of (temporary) wealth. It is not easy to be rational in such an environment.
Anchoring
This is the common human tendency for people to rely heavily on one piece of information when making
a decision. In investing this usually refers to the current price of a stock or price development over the
very recent history. Especially stock analysts are very good at that. They rarely like to make bold
predictions but heavily rely on recent data to extrapolate into the future. If a stock is currently trading
around $100 and I would ask you to predict the possible price of that stock in a year’s time, the answer
would very likely be close to that $100. Depending on the recently observed volatility you might answer
within a range of $80-$120. Would it surprise you if a year later this particular stock would trade at $5?
If you were ever invested during the technology boom, then you know very well that this is not an
exaggeration. Another very dangerous result of the anchoring bias is the fact that we have been in a
long-term bull market in stocks. Most investors have not experienced very long and damaging bear
markets. We might well be in one now, but most investors don’t see it given the very powerful bear
market rallies, such as the one we have had over the past 3 years. When some analysts tout that the
Dow Jones Industrial might well go down to 5000 over the next couple of years, most of us think that
this is just impossible given the fact that the DJI is now around 11,000.
Overconfidence
This bias speaks for itself. If you have had a string of good results, you might attribute these wins to
skill and become overconfident. This might lead to overtrading, taking on higher risks and eventually
be susceptible to big losses.
Can we learn from our biases?
Now that we know and understand our biases, we can learn from them and become much better investors,
right? Well, not necessarily. There is abundant research that we fail to learn form our past failures and
tend to make the same mistakes over and over again.
A good example is a simple investment game devised by Bechara et al. Each player gets $20. They
have to make a decision on each round of the game, either to invest $1 or not to invest. If the player
decides to invest, he has got to hand over $1 and the game master will toss a coin. If it is heads, the
player wins $2.50, tails, he loses the coin. Overall 20 rounds are played.
After playing 50 games (50 times 20 rounds) with a group of people, the results were that there was
no evidence of learning as the game went on. If players learnt over time, they would have worked out
that it was optimal to invest in all rounds as the expected value of 20 rounds is 20*(50%*$2.50+50%*$0)=$25.
However as the game went on, players actually stopped playing earlier, becoming worse as time went on.
According to behavioural psychlogists, the major reason that we don’t learn from our mistakes is
due to the self-attribution bias. This is the tendency for good outcomes to be attributed to skill
and adverse outcomes to sheer bad luck. This mechanism prevents us from recognizing mistakes
as mistakes, and hence often prevents us from learning from these errors. An ex Goldman Sachs trader
The long term
investor
can only be
successful
if he ignores
the volatility
of a stock or
sector and only
takes decisions
with respect to
his portfolio
when a change
in fundamentals
of the
individual
stock or sector
gives him a
reason to do
so. In other
words, it pays
to ignore the
noise.
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Vol.16 • No. 7 • September 2006