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18-02-2012, 11:22 PM
Business Times - 18 Feb 2012
Learning to mistrust your instincts
Prof Daniel Kahneman and his acolytes argue that investors don't always act in their own best interests and are consistently led astray by emotional motives and cognitive errors. By John F Wasik
PEOPLE'S intuition is often wrong when it comes to investing. We often buy when we should be selling, or focus on red herrings. So are there ways to overcome these tendencies? After a flood of research in the growing field of behavioural economics, we know the answer is yes, although doing the right thing with money involves recognition and discipline.
Many tenets of prudent financial decision-making can be found in the work of Daniel Kahneman and his acolytes. Prof Kahneman's best-selling book, Thinking, Fast and Slow, (Farrar, Straus & Giroux, 2011) opens up some new vistas on human behaviour that can be applied to our worst investing mistakes.
Prof Kahneman, a psychologist who won the Nobel Prize in economic science in 2002, has turned classical economics on its head in many ways, noting that it is folly to engage in day trading or to think you have an advantage in picking securities. Investors don't always act in their own best interests and are consistently led astray by emotional motives and cognitive errors, he said. Overconfidence is a bugaboo.
Overriding fear of loss
'People have little idea, by and large, of the investment world,' Prof Kahneman argued. 'They are convinced they have an advantage.'
One of the most common errors investors commit, he has found, is making bad decisions simply because of the overriding fear of loss, an important concept of the so-called prospect theory he pioneered with his fellow researcher, Amos Tversky, who died in 1996.
Investors will also 'anchor' to a target price for a security for arbitrary and irrational reasons, often holding the stock long after it should have been sold.
Instead of portraying investors as idealised rational beings who always act in their own best interests - often the case in standard financial economics - behavioural economics casts them as 'normal' people who chase biases that have little connection to the statistical truth or the right thing to do.
Our brains, in Prof Kahneman's view and according to neurological research, rely more on a so-called System 1 that processes information rapidly and intuitively than a System 2 that is more analytical and deliberate.
One cognitive bias is called 'faulty framing'. Say you buy a stock at a certain price and it plummets. You are reluctant to sell it because of the emotional distress of taking a loss. Because it is a paper loss, you hold it in a protected mental account as something that still has hope, even though the market has decided otherwise.
Here are some other common errors researchers have identified:
Misreading short-term results: Regarding what happens in the short term as predictive of a future outcome is a frequent mistake - for example, when an investor views last year's strong performance as a sign that a manager's hot streak will continue.
Most good runs are a matter of luck, Prof Kahneman said. 'If a manager had three or four good years, you're asking for trouble,' he explained. 'Go with real statistics, not small samples.'
Trusting gut instincts: Intuitive insights have proved to be consistently unreliable as a basis for picking profitable investments. Prof Kahneman suggested 'taking the outside view' and mistrusting your intuition.
Reacting to outside events: No doubt the eurozone mess, debt problems in the United States and other world calamities are threats to global investing. But such problems often involve too much information to process. Investors need to make decisions one at a time, in a manner that corresponds to their own goals. 'There's very little relation to the importance of problems and the time we spend thinking about them,' Prof Kahneman said.
Meir Statman, a finance professor at Santa Clara University in California and author of What Investors Really Want (McGraw-Hill, 2010), said: 'We can overcome System 1 by employing critical thinking.' Instead, he added: 'Think like a scientist.'
Prof Kahneman and Prof Statman have found that amateur investors get into the most trouble when they start actively trading, a situation in which they have no real advantage. They are likely to lose money, several studies have shown. 'In every trade there is an idiot,' Prof Statman said. 'If you don't know who it is, it's you.'
While Prof Statman does not begrudge investors the thrill of trading, he suggests limiting the activity. It may be all right to play the market, he said, 'as long as it won't imperil your retirement'.
Extreme possibilities
Most behavioural economists are wary of active management, which applies to buying mutual funds and other vehicles where professional managers are trying to time market conditions. Even the best stock pickers failed to foresee the consequences of the 2008 financial crisis. That is an additional shortcoming most investors share - the failure to anticipate and prevent damage from a worst-case situation. Market savants call this 'tail risk'.
'People are underinsured against extreme and unlikely possibilities,' Prof Kahneman said, citing Nassim Nicholas Taleb's book The Black Swan (Random House, 2007), which examines highly improbable events.
Most behavioural finance experts counsel that for the majority of people, a passive investment approach is the wisest. Devise a portfolio that measures and limits the amount of risk you can afford to take, align it to your specific goals - college financing, retirement, estate building - and leave it alone. Prof Statman recommends low-cost index funds. 'I just let them ride,' he said.
Prof Kahneman suggests avoiding highly leveraged funds and keeping an eye on inflation. Having experienced high inflation while living in Israel more than 30 years ago, he has invested in Treasury inflation-protected securities, known as TIPS, which can be bought individually through the US Treasury or packaged in mutual funds like the iShares Barclays TIPS exchange-traded fund.
'We need to be more systematic,' Prof Kahneman said. 'We need to slow ourselves down.'
Reflection may be the biggest ally in avoiding investment folly. To be successful in sidestepping our System 1 tendencies, one of the best strategies is to shelve a hot investment idea for a week and think about it analytically - or employ a trusted adviser to analyse the idea carefully.
In this regard, perhaps an old proverb offers some of the best advice. Haste can indeed make waste. -- NYT
Learning to mistrust your instincts
Prof Daniel Kahneman and his acolytes argue that investors don't always act in their own best interests and are consistently led astray by emotional motives and cognitive errors. By John F Wasik
PEOPLE'S intuition is often wrong when it comes to investing. We often buy when we should be selling, or focus on red herrings. So are there ways to overcome these tendencies? After a flood of research in the growing field of behavioural economics, we know the answer is yes, although doing the right thing with money involves recognition and discipline.
Many tenets of prudent financial decision-making can be found in the work of Daniel Kahneman and his acolytes. Prof Kahneman's best-selling book, Thinking, Fast and Slow, (Farrar, Straus & Giroux, 2011) opens up some new vistas on human behaviour that can be applied to our worst investing mistakes.
Prof Kahneman, a psychologist who won the Nobel Prize in economic science in 2002, has turned classical economics on its head in many ways, noting that it is folly to engage in day trading or to think you have an advantage in picking securities. Investors don't always act in their own best interests and are consistently led astray by emotional motives and cognitive errors, he said. Overconfidence is a bugaboo.
Overriding fear of loss
'People have little idea, by and large, of the investment world,' Prof Kahneman argued. 'They are convinced they have an advantage.'
One of the most common errors investors commit, he has found, is making bad decisions simply because of the overriding fear of loss, an important concept of the so-called prospect theory he pioneered with his fellow researcher, Amos Tversky, who died in 1996.
Investors will also 'anchor' to a target price for a security for arbitrary and irrational reasons, often holding the stock long after it should have been sold.
Instead of portraying investors as idealised rational beings who always act in their own best interests - often the case in standard financial economics - behavioural economics casts them as 'normal' people who chase biases that have little connection to the statistical truth or the right thing to do.
Our brains, in Prof Kahneman's view and according to neurological research, rely more on a so-called System 1 that processes information rapidly and intuitively than a System 2 that is more analytical and deliberate.
One cognitive bias is called 'faulty framing'. Say you buy a stock at a certain price and it plummets. You are reluctant to sell it because of the emotional distress of taking a loss. Because it is a paper loss, you hold it in a protected mental account as something that still has hope, even though the market has decided otherwise.
Here are some other common errors researchers have identified:
Misreading short-term results: Regarding what happens in the short term as predictive of a future outcome is a frequent mistake - for example, when an investor views last year's strong performance as a sign that a manager's hot streak will continue.
Most good runs are a matter of luck, Prof Kahneman said. 'If a manager had three or four good years, you're asking for trouble,' he explained. 'Go with real statistics, not small samples.'
Trusting gut instincts: Intuitive insights have proved to be consistently unreliable as a basis for picking profitable investments. Prof Kahneman suggested 'taking the outside view' and mistrusting your intuition.
Reacting to outside events: No doubt the eurozone mess, debt problems in the United States and other world calamities are threats to global investing. But such problems often involve too much information to process. Investors need to make decisions one at a time, in a manner that corresponds to their own goals. 'There's very little relation to the importance of problems and the time we spend thinking about them,' Prof Kahneman said.
Meir Statman, a finance professor at Santa Clara University in California and author of What Investors Really Want (McGraw-Hill, 2010), said: 'We can overcome System 1 by employing critical thinking.' Instead, he added: 'Think like a scientist.'
Prof Kahneman and Prof Statman have found that amateur investors get into the most trouble when they start actively trading, a situation in which they have no real advantage. They are likely to lose money, several studies have shown. 'In every trade there is an idiot,' Prof Statman said. 'If you don't know who it is, it's you.'
While Prof Statman does not begrudge investors the thrill of trading, he suggests limiting the activity. It may be all right to play the market, he said, 'as long as it won't imperil your retirement'.
Extreme possibilities
Most behavioural economists are wary of active management, which applies to buying mutual funds and other vehicles where professional managers are trying to time market conditions. Even the best stock pickers failed to foresee the consequences of the 2008 financial crisis. That is an additional shortcoming most investors share - the failure to anticipate and prevent damage from a worst-case situation. Market savants call this 'tail risk'.
'People are underinsured against extreme and unlikely possibilities,' Prof Kahneman said, citing Nassim Nicholas Taleb's book The Black Swan (Random House, 2007), which examines highly improbable events.
Most behavioural finance experts counsel that for the majority of people, a passive investment approach is the wisest. Devise a portfolio that measures and limits the amount of risk you can afford to take, align it to your specific goals - college financing, retirement, estate building - and leave it alone. Prof Statman recommends low-cost index funds. 'I just let them ride,' he said.
Prof Kahneman suggests avoiding highly leveraged funds and keeping an eye on inflation. Having experienced high inflation while living in Israel more than 30 years ago, he has invested in Treasury inflation-protected securities, known as TIPS, which can be bought individually through the US Treasury or packaged in mutual funds like the iShares Barclays TIPS exchange-traded fund.
'We need to be more systematic,' Prof Kahneman said. 'We need to slow ourselves down.'
Reflection may be the biggest ally in avoiding investment folly. To be successful in sidestepping our System 1 tendencies, one of the best strategies is to shelve a hot investment idea for a week and think about it analytically - or employ a trusted adviser to analyse the idea carefully.
In this regard, perhaps an old proverb offers some of the best advice. Haste can indeed make waste. -- NYT
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