Gentle Reader - We may not be formally acquainted, but I think that I know a bit about you. Read my description of you below and tell me how accurately it describes your personality:
“Although others may see you as put together, inside you are worrisome and insecure. You want to be admired by others and you think about this when making decisions. Although you may not have done big things yet, you feel like that day will come. You feel as though you have a lot of untapped potential. You’re an independent thinker who thoughtfully considers ideas before accepting them. You enjoy a certain amount of variety and change and dislike being restrained by restrictions or limitations. You know you’re not perfect, but you are typically able to use your personality strengths to compensate for your weaknesses.”
So, how did I do? On a scale from 1 to 5, with 5 being the most accurate, how accurately would you say I described your personality? If you’re like most people, you probably ranked that description of you as a 4 or 5, which likely puzzled you since we’ve never met. The paragraph above illustrates what is called “Barnum Effect” or alternately, “Fortune Cookie Effect”. Barnum Effect is named for P.T. Barnum, the great entertainer and circus magnate.
Barnum famously posited that “There’s a sucker born every minute” and used his knowledge of how to sucker people to get them to part with their money. Barnum’s understanding of suckers, though born under the big top, undoubtedly surpasses that of many formally trained academicians. P.T. understood what psychologists call “confirmation bias” or the human tendency to look for information that reinforces ideas we already hold.
When we receive feedback about ourselves there are two simultaneous dynamics that make up the broader phenomenon of confirmation bias. The first of these is “self-verification” which is the tendency to reinforce existing beliefs. The second is “self-enhancement” whereby we attend to information that makes us feel good about ourselves. The function of these two dynamics is clear – to maintain our self esteem and feelings of confidence. In general this is a positive, after all, who doesn’t want to feel about themselves? However, these dynamics work in overdrive in a number of instances – including when our deeply held-beliefs are challenged or our self-esteem is challenged. Confirmation bias becomes problematic when it leads us to maintain the status quo in the face of disconfirmatory information or overlook realistic, negative feedback about ourselves. In these instances, our need to feel competent can cause us to ignore warnings and make bad financial decisions that privilege ego at the expense of making money.
It is for these very reasons that Daniel Kahneman engages in what he calls "adversarial collaboration", basically, doing work with people that disagree with him (enemies, if you're feeling dramatic). The Nobel Laureate says:
"I got into adversarial collaboration because there is a system in the scholarly literature where people critique other people's writings, and then there is is a rejoinder. That's the routine in scientific publications. I was just struck by how totally wasteful this is, because in all these exchanges nobody admits to having made an error...It's just foul actually."
Kahneman understands that his ego - as in-check as it may be - is still keeping him from learning and growing. From testing his assumptions and considering all angles. Asset managers, whose sole job is to make good decisions, would be well-served by such an exercise in humility. When running money, keep your friends far from you and your enemies close.
Want more great content on the intersection of mind and markets? Check out The Laws of Wealth by Nocturne Capital founder Dr. Daniel Crosby - HERE.
Diversification, or the reduction of non-market risk by investing in a variety of assets, is one of the hallmarks of traditional approaches to investing. What is less appreciated, however, are the ways in which it makes emotional as well as economic sense not to have all of your eggs in one basket. As is so often the case, the poets, philosophers and aesthetes beat the mathematicians to understanding this basic tenet of emotional self-regulation. The Bible mentions the benefits of diversification as a risk management technique in Ecclesiastes, a book estimated to have been written roughly 935 BC. It reads:
“But divide your investments among many places,
for you do not know what risks might lie ahead.”
- Ecclesiastes 11:2
The Talmud too references an early form of diversification, the prescription there being too split one’s assets into three parts – one third in business, another third in currency and the final third in real estate.
The most famous, and perhaps most eloquent, early mention of diversification is found in Shakespeare’s, “The Merchant of Venice”, where we read:
“My ventures are not in one bottom trusted,
Nor to one place, nor is my whole estate
Upon the fortune of this present year:
Therefore, my merchandise makes me not sad.”
It is interesting to note how these early mentions of diversification focus as much on human psychology as they do the economic benefits of diversification, for investing broadly is as much about managing fear and uncertainty as it is making money.
Brought to the forefront by Harry Markowitz in the 1950’s, diversification across a number of asset classes reduced volatility and the impact of what is known as “variance drain.” Variance drain sounds heady, but in a nutshell, it refers to the detrimental effects of compounding wealth off of low lows when investing in a highly volatile manner. Even when arithmetic means are the same, the impact on accumulated wealth can be dramatic.
Say you invest $100,000 each in two products that both average ten percent returns per year, one with great volatility and the other with managed volatility. The managed volatility money rises 10% for each of two years, yielding a final result of $121,000. The more volatile investment returns -20% in year one and a whopping 40% in year two, also resulting in a similar 10% average yearly gain. The good news is that you can brag to your golf buddies about having achieved a 40% return – you are an investment wizard! The bad news, however, is that your investment will sit at a mere $112,000, fully $9,000 less than your investment in the less volatile investment since your gains compounded off of lower lows.
Managing variance drain is important, but a second, more important benefit of diversification is that it constrains bad behavior. As we’ve said on many occasions, the average equity investor lags the returns of the equity market significantly. It is simply hard to overstate the wealth destroying impact of volatility-borne irrationality. The behavioral implication of volatile holdings is that the ride is harder to bear for loss-averse investors (yes, that means you).
As volatility increases, so too does the chance of a paper loss which is likely to decrease holding periods and increase trading behavior, both of which are correlated with decreased returns. Warren Buffett’s first rule of investing is to never lose money. His second rule? Never forget the first rule. The Oracle of Omaha understands both the financial and behavioral ruin that come from taking oversized risk, and more importantly, the power of winning by not losing.
“Never underestimate the power of doing nothing.” – Winnie the Pooh
“Far from idleness being the root of all evil, it is rather the only true good.” – Soren Kierkegaard
Imagine a world where you could gain more knowledge by reading fewer books, see more of the world by minimizing travel and get more fit by doing less exercise. Certainly, a world where doing less gets you more is highly inconsistent with much of our lived experience, but is just the way Wall Street Bizarro World operates. If we are to learn to live in WSBW (and we must), one of the primary lessons to be learned is to do less than we think we should.
The psychobabble term for the tendency toward dramatic effort in the face of high stakes is “action bias.” Some of the most interesting research into action bias comes to us from the wild world of sports – soccer in particular. A group of researchers examined the behavior of soccer goalies when faced with stopping a penalty kick. By examining 311 kicks, they found that goalies dove dramatically to the right or left side of the goal 94 percent of the time. The kicks themselves, however, were divided roughly equally, with a third going left, a third right and a third near the middle. This being the case, they found that goalies that stayed centered had a 60 percent chance of stopping the ball, far greater than the odds of going left or right.
So why is it that goalies are given to dramatics when relative laziness is the most sound strategy? The answer becomes more apparent when we put ourselves in the shoes…er…cleats of the goalie (especially of goalies who live in countries where failure on the pitch is punishable by death). When the game and national integrity are on the line, you want to look as though you are giving a heroic effort, probabilities be damned! You want to give your all, to “leave it all on the field” in sportspeak and staying centered has the decided visual impact of stunned complacency. Similarly, investors tasked with preserving and growing their hard earned wealth do not want to sit idly by in periods of distress, even if the research shows that this is typically the best course of action.
A team at Fidelity set out to examine the behaviors of their best performing accounts in an effort to isolate the behaviors of truly exceptional investors. What they found may shock you. When they contacted the owners of the best performing accounts, the common thread tended to be that they had forgotten about the account altogether. So much for isolating the complex behavioral traits of skilled investors! It would seem that forgetfulness might be the greatest gift at an investor’s disposal.
Another fund behemoth, Vanguard, also examined the performance of accounts that had made no changes versus those who had made tweaks. Sure enough, they found that the “no change” condition handily outperformed the tinkerers. Meir Statman cites research from Sweden showing that the heaviest traders lose 4 percent of their account value each year to trading costs and poor timing and these results are consistent across the globe. Across 19 major stock exchanges, investors who made frequent changes trailed buy and hold investors by 1.5 percentage points per year.
Perhaps the best-known study on the damaging effects of action bias also provides insight into gender-linked tendencies in trading behavior. Terrance Odean and Brad Barber, two of the fathers of behavioral finance, looked at the individual accounts of a large discount broker and found something that surprised them at the time.
The men in the study traded 45 percent more than the women, with single men out trading their female counterparts by an incredible 67 percent. Barber and Odean attribute this greater activity to overconfidence, but whatever its psychological roots, it consistently degraded returns. As a result of overactivity, the average man in the study underperformed the average woman by 1.4 percentage points per year. Worse still, single men lagged single women by 2.3 percent – an incredible drag when compounded over an investment lifetime.
The tendency of women to outperform is not only seen in retail investors, however. Female hedge fund managers have consistently and soundly thumped their male colleagues, owing largely to the patience discussed above. As LouAnn Lofton of the Motley Fool reports, “…funds managed by women have, since inception, returned an average 9.06 percent, compared to just 5.82 percent averaged by a weighted index of other hedge funds. As if that outperformance weren’t impressive enough, the group also found that during the financial panic of 2008, these women-managed funds weren’t hurt nearly as severely as the rest of the hedge fund universe, with the funds dropping 9.61 percent compared to the 19.03 percent suffered by other funds.” Boys, it would seem, will be hyperactive boys, but few could have guessed the steep financial cost of action bias. At Nocturne Capital, we believe that active management is most powerful when it's...well...not all that active.
For more great content on the counterintuitive truths found in "Wall Street Bizarro World", please check out "The Laws of Wealth" by Nocturne founder Dr. Daniel Crosby