Monday, March 1, 2010

More psychology of money

SAN FRANCISCO - MAY 14:  A man holds money tha...Image by Getty Images via Daylife
There are several more psychological effects you need to be aware of when it comes to investing. Any of them could cause you to "see things" that aren't there, and make irrational decisions.

Anchoring effect is basically psychology to "anchor" an answer to a number given. Say I ask you... "What is the population of Armenia?" You would have no idea, unless you're Armenian or is a trivia champ. However, if I phrase the question as "is the population of Armenia above or below 100 million?" Then I ask the same question again, you would guess the answer to be a bit above, or below 100 million, depending on which way your logic goes. In investment, it's known as "earning targets", "earning estimates", and so on, and if a company can meet those earning estimates (or not). Your expectations are anchored to it.


Availability error is the tendency for people to see every thing as a repeat of some past event. Every US military expedition since Vietnam was described as "another Vietnam". Iraq was another Vietnam. Afghanistan is another Vietnam. Any political scandal is described as something-gate, as if it can be compared to Watergate. Company-wise, any accounting scandal is another Enron / Worldcom. Any tech company having trouble is another dot-com bust. There is a Chinese saying: once you've been bitten by a snake, you'll be scared by a rope for seven years. Same idea.

Another problem we often run into is known as "confirmation bias". When you search for data to prove or disprove your hypothesis, you tend to pick data what will prove the stuff, and ignore the data that disprove the stuff. You pick the analysts who like your stock, and ignore the ones that don't. Don't you? You pick the technical indicators that way. You pick the good news about the company you liked, and ignored the bad news about the same company. All that are illogical.

Another thing to be aware of it is the "status quo bias". Say someone was given a million and ask how to distribute it among the 4 types of investments: aggressive portfolio, balanced portfolio, bonds, or US treasuries, people will divide it up about evenly, 25% each. HOWEVER, if that same someone was told that they just inherited one million in just one of the four categories, about half would keep the money where it is, doesn't matter which category it is in. It's a bit of "inertia" at work.

Another is the "favoritism bias", or "endowment effect". If you hold something, you attribute more "value" to it. In other words, I love this stock because I own it, instead of it being the other way around. This leads one to hold on to declining stock hoping it'll go back up. In fact, it's been shown that people are less regretful when the loss is suffered passively, instead of actively. An old investment that lost money is far less upseting than a brand new investment that lost money, even if the amount lost is the same.

People feel their losses more than they feel their gains, and will be induced to take great risks in order to "avoid loss". Consider the following mind game: Say in group X, everybody gets $10000, and gets to choose between a) get $5000 extra, or b) depending on coin flip, get either extra $10000, or $0. Most people will choose $5000, the "sure thing", right? Same setup... In group Y, everybody gets $20000, then chooses between a) take back $5000, or b) take back $10000, or $0, depending on coin flip. Most people will choose the coin flip to 'avoid the loss'. The problem is, both scenario have exactly the same odds, and end up with the same results... except for pscyhology: a sure thing for $15000, or coin flip between $10000 and $20000. However, just the way the scenario is presented changes the game. People, in order to "avoid" losses, and "ensure" gains, makes illogical decisions.

Also, the mind perceives loss differently depending on where you "file" the loss in your mental account. Say, you manage to lose your $100 concert ticket on your way to the concert. Do you see yourself as being out $200... $100 in the ticket itself, and $100 for the replacement? Most do. Whereas people lost the $100 cash they plan to buy the concert ticket with... are more likely to just shell out $100 to buy another ticket. Somehow, uncommitted money is slightly less valued. This is a bit related to the favoritism bias, but in a different way.

All of these psychological effects are created by our brain to make "shortcuts" in our analysis of our daily situation in our lives. And when they lead us astray, the results can be spectacular. That's reason behind the adage: hindsight is 20/20. Once the situation has passed, you are no longer emotionally evolved, and thus can analyze the situation with pure logic.

Let's look at a spectacular failure... Everyone remember the Washington D.C. sniper case of 2002? Yep, that case. Police relied on their profilers which predicted that the sniper would be alone, probably overweight white male in late 40's / early 50's, own a van, a bunch of rifles, and books on sniper tactics. As we all know now, the perps does NOT fit any of this. They owned a large older sedan (with modifications), one single rifle, took turns shooting people (they are a pair, J. Muhammad and J. Malvo), and no books at all, and black. The profilers relied on past experiences and statistics, and that lead them astray.

And if you analyze this from a statistical point of view... Let's say there are 4 million people in the area. Ten people have the van, the rifles, and the sniper manual. For the sake of the scenario, let's say ONE is guilty of the shootings. Which is higher:

a) probability that an innocent man would own the van, the rifles, and the sniper manual; or
b) probability that a man who own all the three items would be innocent?

No, I'm not playing word sophistry here. The answers are very different.

a) is about 9 in 4 million (9 innocent owners... out of 4 million -1 innocent total)
b) is 9 out of 10 (there are only 10 of them, and 9 are innocent)

If you don't recognize these psychological / cognitive "blindspots", you will have problems. That's why almost all investment books recommend following a system without fail. Following a system takes the emotion out of the process, and thus, avoiding a lot of these blindspots.

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