Mentor

Anyone can see an apple in a tree.

But can you see the tree in the apple.

Those who can, ask for nothing but will be remembered for generations.

Keeping Up With Your Neighbor

We tend to engage in social comparisons when we consider our investments and increase the level of risk in our investment portfolio when we perceive that we are falling behind our peers in our investment performance.

Forget (for a moment) about whether you have the same investment objectives, time horizon or risk tolerance as your neighbor. Remember instead that every investor is “right” at least some of the time1. That doesn’t mean your neighbor is any smarter than your brother-in-law Bob2.


1. Remember the line about a broken clock being accurate twice a day.

2. My reference to “Bob” is fictional. There is no “Bob”, never was a “Bob” and never will be a “Bob.” Ain’t that right – Bob?

Projection Bias

People tend to project their current emotional states into the future.


We can remember that we have had other emotional states in the past. Nevertheless we can not imagine that we will feel differently in the future in any fashion other than how we feel at the present time.


This “projection bias” is one of the strongest biases we have. It plays havoc with our ability to plan intelligently for our future1.


Using an independent source to assist in planning helps overcome this bias.


1. This bias explains the extent to which we buy high calorie food while shopping at the grocery store when hungry and explains why we continue to sit in cash until a bull market is well underway before investing.

· OK SO NOW WHAT?

Recently I wrote about “why you still own it.”  Now I think it’s important to discuss “OK so now what.”  What I mean by that is while we are sitting here thinking we are the dumbest bag of hammers on the planet for riding “that sucker all the way down” we have to step back and say “ok we did it and we are going to have to deal with it – so now what do we do?”

In my footnote for the earlier Observation I emphasized that you should understand that market action like this puts you under stress and the longer this goes on and the lower the market goes the more chronic the stress becomes. I stated very plainly that you should not let chronic stress and your desire from relief from that be the cause of the divestiture of your economic assets. In large part your decision should be based on an objective analysis of the assets you hold.  A good way to make the decision to hold or sell an asset is to objectively evaluate whether you would buy the asset if, hypothetically, you had some cash.

Notice I used the word “objectively” and remember that in my view true objectivity is impossible in the investment world.  The best course for us then is to become aware of the emotions affecting us and the biases in investing they cause and then armed with that knowledge try and overcome them (or at least take them into consideration) when making our analysis and decisions. In short, we need to recognize and acknowledge our situation, the emotions we are experiencing and the consequent biases to which we become subject and deal with them as strongly as we can.

OK so how about now?  Well in the current market negative emotions are predominant.  While all negative emotions have the same vector (direction as in “lower” or if you are in California "bummer" dude*) they do not have the same effect on investment decision making.  A short list of negative emotions includes disgust, sadness, fear and anger.

The negative emotion of disgust has been confirmed in behavioral economic studies to cause people to “expel.”  They want to get rid of assets they own.  They do not want to buy new items – their reflexive brain is screaming - get out of the market.

Sadness on the other hand does not cause the desire to “expel.” Studies have confirmed that sadness causes investors to value items that they own less and increase their perceived value of things that they do not own. Sadness reverses the “endowment effect (July 2, 2007 Observation “If it’s mine its mighty fine and if its not it’s not worth a lot”). In other words sadness causes people to (subjectively) want to turn their portfolio over. Although the endowment effect is not good for us, its reversal isn’t either.

The negative emotions of fear and anger have the opposite effect on investors. Fearful investors have been confirmed in studies to be uncertain and pessimistic in their outlook.  This causes them to be risk averse.  Risk aversion increases a subjective desire to sell and flee to “safe assets” even when their account is perfectly balanced and diversified.  As we now know even safe assets can take a drastic decline, so fear is a dangerous emotion because it causes clients to want to de-diversify (is that a word?).

Angry investors oddly enough have been confirmed to have a belief that they have control over their situation.  They are much more certain about the future than uncertain. As a result angry investors are much more optimistic about the future and are not risk averse but risk takers.  When investors become angry (not disgusted) they amplify their risk. If you need convincing take a look at how the markets behaved once the initial shock and fear over September 11, 2009 dissipated and the American public became “angry” – investors caused the markets to engage in strong rallies. Anger may in fact be a beneficial emotion in our current market conditions.

The takeaway here is: identify the negative emotions you or your clients are experiencing, remember what biases then come into effect and what they temp someone to do, deal with that temptation and do your best to recommend or make objective decisions.

That’s enough for this week.  Next week I am going to talk about the fact that people compulsively believe that the way they “feel” (their current emotional state) will be the way they “feel” in the future and how this hurts our ability to plan for our financial futures.

* For those of you not currently sitting on a surf board this word is correctly pronounced "dahoude."

Why You Still Own It

Understandably people have difficulty believing they have ridden a particular stock down (say from slightly above __ to its present price). The answer isn’t that their IQ is below average or that they are otherwise somehow intellectually deficient.

The answer lies in normal human psychological traits which only very experienced professional money managers (say for example Buffett ,Munger or Soros) overcome.

What are those traits? The first is what behavioral economists call “anchoring” and the second is what is called “loss aversion.” The first is not always a necessary ingredient unless the owner tends to hold the stock over time. The longer the time the more significant “anchoring” becomes as a cause of “riding it down.”

Anchoring is a well documented tendency people engage in when asked to analyze something and then make a decision. They establish a reference point – often one that is suggested to them. In the markets the suggested reference point is the price of the security. What price? Almost always it’s the purchase or acquisition price initially. As time goes on (studies say approximately 12 months) the reference point or “anchor” becomes the high for the period in question. For us that morphed into a price somewhere between __ and __ (I will explain why we didn’t lower it as the market price declined or at least to the extent of its decline). What happened to us is that we did not use our actual cost basis but instead used our reference point as our “basis” for making our decision. Anchor is a good choice for the word that describes this trait. It’s heavy and it’s very stubborn and resistant to change once it is set in its place.

There is a second trait that comes into play here and is the real killer. That trait, again well documented, is “loss aversion.” Two prominent economists conducted a study on this phenomenon (other studies followed and confirmed). In short we now know that people have an intense desire to avoid taking a loss from an unrealized (potential) state to a realized (actual) state. Neuroeconomic studies tell us that those portions of the brain which are associated with the emotions of fear and regret become highly active when subjects are forced to decide whether to realize a loss or postpone it. This explains two things. First, why the reference point (anchor) we pick to evaluate whether something is a loss is what economists call “sticky upward” (or when the market price goes up people will move their reference point up but will not move it down when the market price goes down). Second it explains why we ride the stock down – neurons are firing in the portion of your brain (the amygdala) that is telling you to avoid the regret one experiences when the “game” score is final and its a loss (book it Danno). This is subconscious and involuntary (meaning compulsive).

Don’t feel so bad, two geniuses were also significantly affected by this, Newton and Clemens.


Advisors such as Buffett and Soros tell us: never lose track of why you are holding the stock. From time to time reevaluate a particular holding and when you do - evaluate whether you would then make a purchase of the stock (assuming you had some money). Such an evaluation should be a major component in your decision to hold vs. sell 2. Oh and be aware what your anchor is and why you are using it as opposed to a different reference point.


1. Behavioral Economists use the term “disposition effect.”
2. When we have a position that is declining and has been from time we undergo stress. If that decline continues for a sufficiently long time that stress becomes chronic. Chronic stress is debilitating and eventually it overcomes “Loss Aversion.” Chronic stress is the chief cause for investors “throwing in the towel” and abandoning a position that has declined over a significant period of time. This action is taken by mere mortals who are attempting to end the chronic stress they are experiencing. They are seeking emotional relief by disassociating themselves from their “predicament” and they do so by ending the “pain.” It is ka-put, enough already with the stress, who needs it. Emphasizing the “would I buy it now” approach goes along way to relieve this stress and will help eliminate the sale of a good stock at the very time it should not be sold.

Say, if you are so smart why can’t you keep from going broke?

Most often when risk is assumed it is unintentional – by overconfidence in the accuracy and completeness of possessed information and analytical skill. The nature and extent of presented risk is simply not perceived rather than consciously assumed.


People learn lessons in the market – but not for ever. Sooner or later they forget them. They once again become overconfident in their information and analytical skill. They unknowingly assume risk that they did not perceive. The question of a repeat of a past disaster is not if, but when.

Witness:


Remember Long Term Capital Management’s debacle (1998). The lesson learned was found in Merrill Lynch’s contemporaneous annual report where it was observed that mathematical risk models "may provide a greater sense of security than warranted; therefore, reliance on these models should be limited."

We learned for a while but the use of the Gaussian Copula formula* as a risk modeling device in rating sub-prime mortgage pool securities was not limited and provided an unjustified sense of security (even to, you guessed it, Merrill Lynch) which led to 2008’s even bigger debacle.

That’s why.
 * see  http://gregtevis.blogspot.com/2011_02_01_archive.html

Arbitrary Coherence

In my last Observation I mentioned that people use a point of reference to analyze a situation and make a decision. In effect it is a mental shortcut (aka judgmental heuristic) we use to solve a problem.


Sometimes that reference point resides in our subconscious mind and is in no way relevant to the matter at hand. Psychologists call this tendency “arbitrary coherence” and it’s a companion bias to “anchoring” the bias I discussed last month.

If I asked you to think of the last two digits of your social security number and then evaluate the intrinsic value of a certain stock, did you know that (multiple studies have shown) your responses would vary depending on the value of the ssn digits.

Those of you that have two tailend ssn digits closer to 99 would tend to value the stock higher than those of you that had digits closer to 00.

Like many of the mental biases we have being aware of this tendency allows you to adjust for it - but doesn’t make it go away.

Anchoring

People use a reference point to decide something. Psychologists call it an “anchor.” Often the use of a reference point is not a conscious decision and not a rational choice.


In the world of personal investing price is often the reference point when deciding whether to hold or sell a position. If the position has been held less than a year then we tend to use the purchase price in deciding whether to hold or sell. More than year then the reference point is the year to date high price.


My advice is to make sure the anchor is a known and rational choice.

To Invest or Not to Invest. That is not the Question

To invest for the future you have to invest. When, how much and in what are all subject to debate but not whether to do it at all. That goes for far more than financial matters.

Really? Is that a fact?

Too often people phrase an opinion as a statement of a fact. When we do that we polarize1 the minds of those listening. It’s a great way to end a dialogue and begin an argument.


People frequently do the same with what are in reality conclusions2. This again is a great way to end a dialogue and begin an argument.

Adding “in my view” keeps those minds and dialogues open. We don’t need a bi-polar society3.

1. By this I mean that the listeners immediately react in conformity with their prior convictions and cease further analysis. Those that agree see the “statement of fact” as confirmation of their belief and we know how confirmation bias then affects them. Those that hold a contrary belief see the expression of the “fact” as contrary to their belief and then affected also by confirmation bias, discard the “fact” without further consideration.

2. As a tip off, it is not uncommon to see “judgmental” modifiers included in the statement.

3. The analogy is not apt; this last sentence is an example of what I was discussing.

Football and Politics

Several years ago I wrote an Observation that given recent developments bears repeating. I reproduce it here and give an update.

• Demigod (Demon)

Corporate culture has a negative aspect I would like to address. I call it the deification (often later demonization) of senior executives. These folks are not demigods (or demons). They are not smarter (or vice versa) than before they got promoted (appointed, whatever) and their intelligence and acumen does not vary with the fortunes of the firm. They are humans just like the rest of us. Nonetheless this process of deification goes on constantly, often the result of actions by their subordinates.

We are neither unintelligent nor uneducated and don't help ourselves or the firm by buying into the process I have described.

We should overcome the temptation to do so.

- 07/07/2008



• Football(Coaches) and Politics(Candidates)

Sometimes the folks placed in positions of power come to believe that the deification process is justified. Such beliefs can be manifested by actions which demonstrate “I know better” or “the rules don’t apply to me” attitudes. I guess it takes a level head to resist that temptation.

We don’t help matters when we go along with this.

Overcomming Confirmation Bias

Confirmation Bias1 is a real and material problem for us as individuals and as a society. It destroys our ability to make intelligent and informed decisions. Although it occurs subconsciously and reflexively the bias is not impossible to overcome.


The best way to overcome it is to take an assertion or opinion and try to prove that it is false.

For example -

A money manager says that he or she adds value by selling stocks that have declined by 20 percent.

Try and prove that the assertion (value is added) is false by asking:

How did the “sold” stocks do after they were sold?

Another example –

A consulting firm tells you it achieves superior results by firing underperforming money managers.

Test the assertion (that they achieve superior results) by asking for data on the performance of those “fired” managers after they were fired.

Finally-

If you think you are a good stock picker, then take a look at three groups of stocks.

Those you own.
Those you have already sold.
Those you thought about buying but ultimately didn’t.

In deep east Texas they don’t say “you’re right.” They say “you ain’t wrong.” Who would have thought that the Deep East Texans would even know about the scientific method? Bubba Newton? Or maybe Billy Ray Bob Bacon.

1. In an earlier Observation I discussed Confirmation Bias. You can find that Observation at: http://gregtevis.blogspot.com/2011/08/why-impasse.html

Moral Hazard

I am not politically inclined but I distinctly recall which politicians were screaming about the financial bailout, wailing about the moral hazard. I distinctly recall which politicians were and are so enthusiastic about tort reform.  The same ones.


In economic theory, moral hazard is a situation in which a party insulated from risk behaves differently from how it would behave if it were fully exposed to the risk.

Many of you may recall that I was on the commuter train that crashed head on into a freight train in Chatsworth California on September 12, 2008. The calculations of the combined speed at impact vary between 82 and 96 miles an hour. Twenty five people were killed in the crash and well over 100 were seriously injured many with significant permanent disabilities. Five of the 225 passengers on the commuter train suffered no visible physical injuries.  I was one of those five.

I thought I might relay my subsequent experience with “Tort Reform” and moral hazard.

I didn’t sue anyone - but I got sued.  Sure enough in Federal Court even and by the very people that were responsible for the crash.  Why you might ask.

There is a federal statute enacted as tort reform that caps single train crash damages. Those that caused the crash had the cap amount in insurance coverage so they filed a lawsuit (interpleader) to dispose of this mess once and for all, deposited the insurance proceeds in the cap amount with the court, sued me and the other unfortunates as defendants and said essentially, judge: “let us go and let‘em fight over the cap money between themselves.”  The judge followed the law, absolved the culprits of any further financial responsibility wherever and whenever it was sought and assigned another judge as the “Decider” in allocating the funds between the unfortunates.  Each unfortunate was assigned an allocation of damages hearing before the Decider.  By the time the Decider got to me, I was ready¹.  Ready to tell him I didn’t want any money that would otherwise go to the other unfortunates.  I did want, however, to make sure none of it went back to the people that caused the wreck.

I didn’t get the chance to say that, in fact I didn’t get to say much at all.  Out of the box the Decider tells me there isn’t enough to go around even for those seriously injured. My hearing wasn’t fun, but as every lawyer knows some times in court you have to keep your mouth shut and let the judge verbally beat the crap out of you about something that you didn’t do².

The Decider turned out to be a pretty smart person.  He issued a stunningly descriptive opinion (the description starts on page 5) and I recommend that you read it. I provide the link to it below. Not for nothing but I “withdrew” my “claim”.

So at the end of the day this Tort Reform law transferred all of the realized risk caused by the people who caused the crash to the pocket books and broken bodies of the unfortunates.  Is there moral hazard in that? I don’t know.  Read the Decider’s opinion.  It should be entitled “The foreseeable consequences of driving a locomotive while texting on your cell phone.”

http://ww2.lasuperiorcourt.org/hp/dbf4wnmpnfvzelfnieu4hw45/1461782185.pdf

1. The lawyer for one of the culprit/plaintiffs actually filed a brief in opposition for my hearing stating that I had not proved I was on the commuter train and in the crash.  This is so despite listing me as a passenger in his complaint and specifically naming me as a defendant/passenger in the Interpleader action and then having me (as opposed to some other Greg Tevis) personally served with the lawsuit. As Bill Murray in Caddie Shack says “so I got that going for me [at the hearing] which is nice.”

2. The Judge was troubled that I had not initiated a lawsuit against the culprits contending that such a failure deprived him of jurisdiction over me. This was so notwithstanding the fact that the plaintiffs specifically admitted in their pleadings that I had a “claim” and that the Federal Judge transferred the claims to the Decider’s court for the claim allocation process. Given the Decider’s expression of immense frustration over the lack of adequate funds for those truly in need, I didn’t think that it was beneficial for me to point out among other things, that his court (a California state trial court) was a court of general jurisdiction and if nothing else the parties could be deemed to be subject to its jurisdiction by consent (we were present and had not filed objections to the court’s jurisdiction).  So as I say above I kept my mouth shut while he talked.  I knew I was going to try and get my “claim” “withdrawn.”

The Yearn to Confirm

A human condition, which operates subconsciously and compulsively - called “confirmation bias” by psychologists - may help explain the impasse we see in ongoing political debate. It has been confirmed to cloud economic decisions and probably has a significant effect on people who decide the outcome of trials and arbitrations.



In short people tend to search for or interpret new information in a way that confirms their existing opinions or beliefs. They avoid information and interpretations which contradict their opinions or beliefs.


Some quotes from Tolstoy on this subject


"I know that most men, including those at ease with problems of the greatest complexity, can seldom accept the simplest and most obvious truth if it be such as would oblige them to admit the falsity of conclusions which they have proudly taught to others, and which they have woven, thread by thread, into the fabrics of their life"


"The most difficult subjects can be explained to the most slow-witted man if he has not formed any idea of them already; but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he knows already, without a shadow of doubt, what is laid before him.”


A quote from Francis Bacon


“The human understanding when it has once adopted an opinion ... draws all things else to support and agree with it. And though there be a greater number and weight of instances to be found on the other side, yet these it either neglects or despises, or else by some distinction sets aside or rejects.”


Google “confirmation bias” if you want to research this phenomena. Wikipedia has a good piece with substantial footnotes on the psychological studies which identified or discussed this bias.

People Overreact to News both Good and Bad

When we are asked to recall a list of items in any order (free recall), we tend to begin recall with the end of the list, recalling those items best (the “recency effect”).



People tend to place far too much emphasis on recently announced “news.” Rather than placing the appropriate emphasis on more salient but “distant” information, we emphasize what we can recall and the easier it is to recall (some might say “fresher or vivid in our minds”) the more importance we place on that information.


The foregoing phenomenon helps explain the sudden swings in our financial markets.

As For Me - a Message for July 4th

Politics is a lot like economics. Take for instance free enterprise or for that matter freedom in general. Most participants in human endeavor talk the talk but don’t walk the walk. We as Americans do and we need to remind our children that we do and how hard this is to do so. As we approach July 4th we should remember that we are in the minority. Most participants talk about freedom but wish for a system that is rigged in their favor.


Last year I directed your attention to the words of our national anthem.


This year I direct you to words uttered on March 23, 1775. I believe it does our souls good to read these words and recognize they reflect what we are. To read them visit

http://www.law.ou.edu/ushistory/henry.shtml

As for me..... I think the gentleman was correct.

Congressional Idiots - part two

If you want to make certain that a statement you make in response to a personal question is not believed - equivocate.

Educated guesses are the best we can do

"Suppose you were an idiot, and suppose you were a member of congress; but I repeat myself.”
                                                                         - Mark Twain


Economics is, at best, an uncertain science. No one - not even Nobel prize winning economists - “ knows” the economic effect of any activity, effort or event. Yet members of congress (from both parties) constantly pontificate as if they do. Any one of them who makes a statement like that is an idiot. But I repeat myself.


Consider this in the coming debate.

A Temptation that is Terrible

Even when a risk is real sacrificing due process of law is terribly tempting but also tempting something terrible. Yet even in this country we see it urged upon us from time to time. Like the dogs of war, once you begin to trade liberty for safety….

The Distinction between a question of if and a question of when

I was listening to the evening news last night when I heard Brian Williams say “the Japanese government is using helicopters, fire trucks and water cannon to try and contain the nuclear disaster at the Fukushima Daiichi power plant.”

Helicopters, fire trucks and water cannon are the tools we are reduced to using to solve a disaster at a plant over which billions of dollars were spent in its design and construction. Presumably some of that money was spent with safety in mind.


So let me see if I have this straight (think back to your high school geometry training):

1. Japan and its east coast in particular sit at the center of earthquake universe.


2. The location of the major fault and the structure of the ocean floor off the east coast of Japan are well known and make it certain that a tsunami will occur after an earthquake there.


3. Tsunamis are giant ocean waves followed by a flood.


4. You build your nuclear plant on the coast right where the tsunami will strike if an earthquake happens.


5. It isn’t a question of if an earthquake will happen it’s a question of when.


6. Pumping water into the reactors is the critical and only method of averting a meltdown disaster.


7. The pumps require power to operate.


8. After billions of dollars in design you put the backup power systems right on sea level at the plant and even put them between the reactors and the seashore. As Jon Stewart would say – at the seashore, on sea level, right where the tsunami is going to strike.


9. If the power to the pumps goes out the rest of the design safety doesn’t make any difference.




Well then you had better make sure you keep the helicopters, fire trucks and water cannon nearby but for heaven sake don’t put them in the same spot you put the back up power supply – on the seashore, at sea level, right where the tsunami will strike.
Because remember it is not a question of if, it is a question of when.
And another thing, remember when I said we are not stupid, well forget that.




Will Rogers, where are you man?