Tuesday, January 26, 2010

Mythbusters: Investor Edition

It is prudent periodically to upset the apple cart in order to see what sort of rot and grime are sitting at the bottom. This series, which will include four or five posts over the next few days, will explore some common myths about investing and the investment industry.

The modern investment industry is highly motivated to conceal the realities that I intend to expose. The fat margins investment firms enjoy are predicated on the assumption that the professionals at these firms possess knowledge and information that is not available to the masses. This may be true in some cases, but large, traditional firms are handicapped in ways that more than offset this value.

The single most important take-away from this series is this: almost no one in the investment industry is motivated to take you out of the market when the risk is high. Because of this, almost no one in the investment industry is motivated to create systems and tools that signal when to get out.

Imagine for example that Fidelity, with $1.57 trillion of assets under managment, instructs their managers to pull their funds entirely out of the market. This would cause quite a dislocation. So what did they do? As necessity is the mother of invention, large money managers invented 'buy and hold'.

In this context, it makes sense to begin with a short primer on a a relatively new investment theory called ‘Behavioral Economics’ which is rapidly gaining in credibility, even among investment traditionalists. This theory addresses experimentally the many ways that Modern Portfolio Theory, the most widely adopted model in finance, fails to usefully describe reality.

An anecdote from the book SuperFreakonomics (2009) by Steven Levitt and Stephen Dubner illustrates the power of emotional biases to short-circuit rational behavior. The book describes an experiment orchestrated by Dr. Keith Chen where monkeys are conditioned to understand the utility of money as a way to acquire treats.

Once the monkeys learned they could trade a certain number of coins for different treats, the experimenters introduced ‘price shocks’ to test the monkeys’ rational adherence to the basic rules of supply and demand. When researchers ‘charged’ substantially more for one treat over another, monkeys bought less of the more ‘expensive’ treat and more of the less expensive. The demand curve slopes downward for monkeys as it does for humans.

To test for irrational behavior, the experimenters introduced two gambling games. This is where things really get interesting.

In the first game, a monkey was shown one grape and, depending on a coin toss, either received just the one grape, or a ‘bonus’ grape as well. In the second game, the monkey was presented with two grapes to start. When the coin was flipped against him, the researcher took away one grape and the monkey received the other.

Note that in both games the monkeys got the same number of grapes on average. However, in the first game the grape is framed as a potential gain, whereas in the second game it is framed as a potential loss.

How did the monkeys react? From the book:

“Once the monkeys figured out that the two-grape researcher sometimes withheld the second grape and that the one grape researcher sometimes added a bonus grape, the monkeys strongly preferred the one-grape researcher.

A rational monkey would not have cared, but these irrational monkeys suffered from what psychologists call loss aversion. They behaved as if the pain of losing a grape was greater than the pleasure of gaining one.

Up until now, the monkeys appeared to be as rational as humans in their use of money, but surely this last experiment showed the vast gulf that lay between monkey and man.

Or did it?

The fact is that similar experiments with human beings, investors, have found that people make the same kind of irrational decisions and at a nearly identical rate. The data generated by the capuchin monkeys, Chen says, make them statistically indistinguishable from most key market investors. So the parallels between human beings and these tiny-brained food/sex monkeys remain intact.”

Loss aversion is one of the central principles of behavioral economics. The behavioral literature is consistent in observing that people are about twice as sensitive to losses as they are to gains. Investors manifest this behavior by holding on to losing positions for far too long in order to defer realizing a loss. On the flip side, investors sell their winning positions too soon in order to avoid ‘losing’ their gains.

For evidence that you or your Advisor may be a slave to the loss aversion instinct, look no further than your portfolio. If there are many positions with large losses that have been on the books for several months or years, loss aversion is a likely culprit. Successful investors sell their losing trades quickly while letting their winning trades run.

Loss aversion is just one facet of a broader theory of investor behavior called ‘Prospect Theory’. Behavioral Economics is much broader still, and fills many of the dangerous gaps that are not adequately addressed by Modern Portfolio Theory. Some other important behavioral vulnerabilities are outlined in the diagram below

(click image for larger version).

Source: Butler|Philbrick & Associates

The next post in this series will deal with timing the market. It turns out that there are tried and true rules to distinguish between markets that are likely to trend higher and markets that are in jeopardy of steep drops and volatility. It is the development of, confidence in, and above all adherence to these rules that distinguish successful investors from their poorer peers.

1 comment:

  1. Nobody has ever explained this to me in a way I could understand. Now I understand, thanks to the Monkeys, and you. BTW, what you say is true.