Learn to remember past errors

Maha Khan Phillips

In April this year, Jamie Dimon, chief executive of JP Morgan Chase, called concerns about the bank’s hedging strategy a “tempest in a teacup”. It is a comment he lived to regret, as the bank admitted in May that it suffered about $2bn in losses on large, opaque and complicated derivatives trades.

Rick di Mascio, CEO Inalytics: People go into denial about their mistakes

For some, Dimon’s comments illustrate a systemic problem best explained by behavioural finance. In contrast to the efficient markets theory, behavioural finance holds that individuals often make investment decisions based on irrational factors.

According to this view, investment professionals can be overconfident, secure in their world view and prone to denial. Sheetal Radia, policy adviser for the CFA Society of the UK, the association of investment professionals, believes that people don’t seem to have learnt lessons from mistakes made in previous financial crises. He said: “We never want to look at the root causes of the problem, only the symptoms.”

In a CFA UK paper “Why do we keep forgetting – and how do we start remembering?” Radia highlights four behavioural traits. They are: cognitive dissonance, the dismissal of views that are in opposition to your own; herding and “groupthink”; the illusion of control and overconfidence; and the disposition effect, where market participants prefer not to realise loss-making positions, even though this can mean taking great risks, in the hope that the situation changes.

Behavioural finance has evolved since the financial crisis, with several schools of thought ranging from behavioural portfolio theory, to emotional finance, in an effort to explain why people and markets behaved the way they did. But how useful is behavioural finance in preventing us from making similar mistakes in the future?

 Joachim Klement, chief investment officer at financial consultancy Wellershoff & Partners in Zurich, said: “My personal experience is that reaction to behavioural finance and its psychological effects [is] that people think it can only explain things after the effect, that what you read in the books is descriptive but not normative. As a result people think it is interesting, but doesn’t help in their daily work.”

Klement suggests the industry should keep investment diaries to record manager actions, such as buying and selling, allowing them to look back and detect patterns in their decision-making. Managers should make a quick note of their rationale for each decision and the risk they are taking, much as pilots go through a checklist before each flight. He said: “The investment diary is three short bullet points, what did you do and why you did it and what could go wrong. It’s a very quick exercise that helps you memorise these things and retrieve them.”

Some investment professionals, particularly in private banking, have shown interest in the diary system, according to Klement.

Others also see the practical value of behavioural finance. Research by manager evaluation firm Inalytics found that truly skillful fund managers have three characteristics. They get more than half their decisions right, are able to run their winning stocks (without selling too early) and they are able to cut their losing stocks without holding on in the hopes that things will turn around.

 Rick di Mascio, Inalytics chief executive, said: “People go into denial about their mistakes. JP Morgan is the embodiment of the point that people do not want to cut their losers. It shows the power of our human instincts, that we immediately want to bank a profit when we get one and conversely go into denial, which prevents us from cutting losers.”

Inalytics’ research shows that managers who are able to run their winners and cut their losers outperform their peer group by 5% per year. Di Mascio says Inalytics’ business of researching and quantifying manager skill and conducting due diligence for asset managers and asset owners has more than doubled in the past year, as these investors look to use behavioural factors to measure performance.

There are also developments in portfolio theory. In the 1950s Nobel Prize-winning economist Harry Markowitz advocated the mean-variance theory, whereby investors focus on their portfolios as a whole, on the choice of portfolio weights that provide an optimal trade-off between the mean and the variance of the portfolio return.

In 2010 he presented a mental accounting portfolio theory, which argues that investors have mental account layers that are associated with particular goals and where attitudes toward risk vary across layers, alongside fellow academics Sanjiv Ranjan Das, Jonathan Scheid, and Meir Statman. Statman, who is the Glenn Klimek professor of finance at the Leavey School of Business at Santa Clara University and the author of What Investors Really Want, said: “Mental accounting portfolio theory is a good example of where behavioural finance can help investors.

 “Mean variance doesn’t answer the question: ‘What is the money really for?’ Investors’ goals are mental accounts and, when you put them together with mean variance, you don’t lose anything in terms of efficiency. It is absolutely obvious to anyone who has not been corrupted by finance that people begin by having some use for the money.”

CFA UK’s Radia has come up with four solutions to investors’ financial amnesia. First, the practical history of financial markets should be taught to investment professionals. Second, an index to monitor credit growth and financial innovation should be developed, with a red light warning the minute someone claims “this time it’s different”. Third, boards of financial institutions should take an annual “amnesia check”, which would look at institutions’ risk assessments.

Finally, Radia wants regulators to emphasise supervision rather than regulation, establishing and operating supervisory processes that might mitigate adverse market behaviours. Regulators should be informed and independent from market influence, he said, adding: “People are still in shock and are saying that capitalism is in disarray, but it’s not that. We don’t have enough checks and balances. Our governance system has failed.”

www.efinancialnews.com/story/2012-06-18/learn-to-remember-past-errors

Why smart people are stupid

By JONAH LEHRER - THE NEW YORKER

Here’s a simple arithmetic question: A bat and ball cost a dollar and ten cents. The bat costs a dollar more than the ball. How much does the ball cost?

The vast majority of people respond quickly and confidently, insisting the ball costs ten cents. This answer is both obvious and wrong. (The correct answer is five cents for the ball and a dollar and five cents for the bat.)

For more than five decades, Daniel Kahneman, a Nobel Laureate and professor of psychology at Princeton, has been asking questions like this and analyzing our answers. His disarmingly simple experiments have profoundly changed the way we think about thinking. While philosophers, economists, and social scientists had assumed for centuries that human beings are rational agents—reason was our Promethean gift—Kahneman, the late Amos Tversky, and others, including Shane Frederick (who developed the bat-and-ball question), demonstrated that we’re not nearly as rational as we like to believe.

When people face an uncertain situation, they don’t carefully evaluate the information or look up relevant statistics. Instead, their decisions depend on a long list of mental shortcuts, which often lead them to make foolish decisions. These shortcuts aren’t a faster way of doing the math; they’re a way of skipping the math altogether. Asked about the bat and the ball, we forget our arithmetic lessons and instead default to the answer that requires the least mental effort.

Although Kahneman is now widely recognized as one of the most influential psychologists of the twentieth century, his work was dismissed for years. Kahneman recounts how one eminent American philosopher, after hearing about his research, quickly turned away, saying, “I am not interested in the psychology of stupidity.”

The philosopher, it turns out, got it backward. A new study in the Journal of Personality and Social Psychology led by Richard West at James Madison University and Keith Stanovich at the University of Toronto suggests that, in many instances, smarter people are more vulnerable to these thinking errors. Although we assume that intelligence is a buffer against bias—that’s why those with higher S.A.T. scores think they are less prone to these universal thinking mistakes—it can actually be a subtle curse.

West and his colleagues began by giving four hundred and eighty-two undergraduates a questionnaire featuring a variety of classic bias problems. Here’s a example:

In a lake, there is a patch of lily pads. Every day, the patch doubles in size. If it takes 48 days for the patch to cover the entire lake, how long would it take for the patch to cover half of the lake?

Your first response is probably to take a shortcut, and to divide the final answer by half. That leads you to twenty-four days. But that’s wrong. The correct solution is forty-seven days.

West also gave a puzzle that measured subjects’ vulnerability to something called “anchoring bias,” which Kahneman and Tversky had demonstrated in the nineteen-seventies. Subjects were first asked if the tallest redwood tree in the world was more than X feet, with X ranging from eighty-five to a thousand feet. Then the students were asked to estimate the height of the tallest redwood tree in the world. Students exposed to a small “anchor”—like eighty-five feet—guessed, on average, that the tallest tree in the world was only a hundred and eighteen feet. Given an anchor of a thousand feet, their estimates increased seven-fold.

But West and colleagues weren’t simply interested in reconfirming the known biases of the human mind. Rather, they wanted to understand how these biases correlated with human intelligence. As a result, they interspersed their tests of bias with various cognitive measurements, including the S.A.T. and the Need for Cognition Scale, which measures “the tendency for an individual to engage in and enjoy thinking.”

Read more

RichardDawkins.net

A Conversation by Carlo Rovelli http://www.edge.org/conversation/a-philosophy-of-physics