Simoleon Sense

Thought and Behavior Contagion in Capital Markets

Miguel — Sat, 13 Mar 2010 16:30:14 +0000

Wanna get smart? Keep learning about influence.

Click Here To Read: Thought and Behavior Contagion in Capital Markets

Abstract (via SSRN)

Prevailing models of capital markets capture a limited form of social influence and information transmission, in which the beliefs and behavior of an investor affect others only through market price, information transmission and processing is simple (without thoughts and feelings), and there is no localization in the influence of an investor on others. In reality, individuals often process verbal arguments obtained in conversation or from media presentations, and observe the behavior of others. We review here evidence concerning how these activities cause beliefs and behaviors to spread, affect financial decisions, and affect market prices; and theoretical models of social influence and its effects on capital markets. Social influence is central to how information and investor sentiment are transmitted, so thought and behavior contagion should be incorporated into the theory of capital markets

Click Here To Read: Thought and Behavior Contagion in Capital Markets

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Guest Post: Tim Richards from PsyFi Blog: An Investor’s Behavioral Guide To Inefficient Markets: The Opportunity of a Lifetime – Again

Miguel — Sat, 13 Mar 2010 16:19:44 +0000

My friend Tim Richards is the master blogger responsible for the PsyFi blog. He has crafted a wonderful piece for us….I feel blessed – Tim’s writing reminds me of James Montier.

An Investor’s Behavioral Guide To Inefficient Markets: The Opportunity of a Lifetime – Again
In 1907 there was a nasty credit crunch. Then there was a financial crisis during the World War I and its aftermath, followed by the Wall Street Crash and the Great Depression. After World War II there was another market slump as everyone expected a repeat of the crashes after the US Civil War and World War I. This was followed by the rise and fall of the Nifty Fifty, an eighteen year long market hiatus with an oil supply crisis thrown in, the unexplained crash of 1987, the Asian Crisis, the Long Term Capital debacle, the dot com crash and, with neat symmetry, another credit crunch. With clockwork precision an investing opportunity of a lifetime has arisen once a decade, if not more often.

This sequence of calamities has happened regardless of the current political orientation, the state of regulatory controls, the dominant investment theory or the world’s latest set of popular Armageddon scenarios. Lots of people come up with explanations in hindsight, a few people get to go to gaol (jail), others legislate to prevent the last crisis and lots of government money gets burnt very quickly. About the only constant is human nature, greedy and fearful by turn.

Efficiency and Uncertainty
From the early 1970’s onwards the main investment ideology was of the efficient markets flavour – the idea being that all market information is reflected in the current price of a security. For a long while this seemed to have solved most of our investing problems but was, in fact, merely a product of a very long bull market run during which pretty much everyone became complacent about tail-end risk – so-called Black Swan events.
Yet stockmarkets have always been a dish characterised by ambiguity, leavened by uncertainty and flavoured with a pinch of irrationality. The world of investment is a swirling mass of contradictory ideas and opinions, most of which are untroubled by any requirement for a relationship to reality, some companionship with evidence or an association with logical thought processes. Anyone trying to make sense of anything is a victim of hope over expectation.

Unprofessional Investing
Most of us spend our lives acquiring certain skills in pursuit of a career. We become plumbers, chefs, cab-drivers, baristas, surfers, doctors, etc, etc. By and large we undergo some form of education program (politicians excepted, of course), develop experience through work, undergo some chastening failures and achieve a few glorious moments of success on the way to attaining the skills we need to succeed in our chosen professions.

Quite why any of this entitles us to think we should be good at investing, a world of mysterious acronyms, undetectable frauds and incomprehensible jargon is one of life’s great mysteries. Yet it’s clear that millions of people take exactly this approach to one of the most difficult environments known to humanity: the perfectly unnatural, mean regressing world of the securities markets.

Cognitive Biases Rule
The standard explanation for this type of bizarre behaviour comes from research into behavioral finance: the study of human psychology at work in the field of investments. The list of behavioral biases that have been shown to underpin people’s irrational investing inclinations is now very long indeed: overconfidence, hindsight, recency, confirmation bias, anchoring, money illusion, mental accounting … the list goes on and on. This paper by David Hirschleifer gives a reasonable overview of the topic.

Despite the wealth of evidence that cognitive biases damage investor returns there’s not yet much follow through into the wider reaches of investment management. To a large extent this is because behavioral finance points us in exactly the opposite direction to the way that the securities industry has been determinedly moving for the last half century: away from a concern with the individual to a mass-market approach that wants to fit everyone into a mental and fiscal straightjacket.
Perfectly Wrong

So, in recent decades the industry’s approach has been to develop mathematical models which can relegate human behaviour to a set of probability equations, thus allowing profitability and risk to be actuarially managed: fraud is no longer unacceptable – it’s now just a number to be factored into earnings forecasts. This is simply the latest in a long line of industry fads, using the ideas of efficient market theories to design approaches which are right quite a lot of the time and then very, very wrong all at once.

Given the amount of money that’s been spent developing these models it’s unlikely that they’ll fade gently away, despite the fact that behavioral finance tells us to a degree of certainty, that only a generation of economists whose next port of call is the grave can now ignore, that individual human biases play a huge role in the unpredictable, uncertain and ambiguous nature of markets. They’re not remotely efficient and it’s just a shame the world had to be brought the edge of financial meltdown before anyone started listening.

Risk Today, and Tomorrow
However, although behavioral finance tells us what’s wrong it doesn’t really tell us what to put in its place. So everyone muddles along, hoping that something better will appear without really knowing what to do. Of course, efficient markets theorists point out that behavioral finance offers no solution to the problems of market prediction and risk management.

Take, for instance, the idea that advisors should ascertain how risk adverse or otherwise their clients are, in order to decide on the type of investments to select for them. Such a simple idea is, under behavioral finance, replete with difficulties. Consider the concept of “risk”. Does anyone really believe that the idea of risk to the person on Main Street is the same as the idea of risk to the person on Wall Street? Even making sure that someone understands the concept is a Herculean task before you start. Pan and Statman cover a lot of this ground in their paper Beyond Risk Tolerance: Regret, Overconfidence, and Other Investor Propensities:

“… investors’ risk tolerance varies by circumstances and associated emotions. High past stock returns endow stocks with positive affect and inflate investors’ exuberance, misleading them into the belief that the future holds high stock returns coupled with low risk. Risk tolerance questions asked after periods of high stock returns are likely to elicit answers exaggerating investors’ risk tolerance. Conversely, low past stock returns burden stocks with negative affect and inflate investors’ fear, misleading them into the belief that the future holds low stock returns coupled with high risk. Risk tolerance questions asked following periods of low stock returns are likely to elicit answers underestimating investors’ risk tolerance”

Of course, the answer given in these two cases will, in hindsight, be perfectly wrong. When everyone thinks that markets can’t fail is the time to be very risk adverse, when no-one wants to invest is the time to be greedy. Yet what’s an advisor to do when the know-your-customer questionnaire tells them to do exactly the opposite of what’s in the customer’s best interests?

No Certainty in an Algorithm
Just because behavioral finance says efficient market theories are wrong doesn’t mean that it can replace the spurious accuracy of the latter’s models. What psychology tells us is that life and markets are unpredictable – which may be uncomfortable for people who want to see certainty in an equation but is nonetheless a truth that needs to be universally acknowledged.

Still, the securities industry is attempting to co-opt behavioral finance to its own ends. Quantitative models being developed along behavioral lines and work on neuroeconomics is attempting to pull economic behaviour out of our brains. There are even a range of behavioral funds which supposedly use behavioral psychology.

For people willing to take the time and effort to get to grips with behavioral finance in the markets this is terrifically good news because, as it stands, it’s impossible to see how the real lessons of psychology in the markets can ever be mastered in this manner. So the opportunities generated from time to time by mass market delusions or crazy industry trends won’t go away.

The Opportunity for Investors
The study of behavioral finance makes available to a much wider group of people than ever before the psychology behind investment approaches and the tools to learn how to control our biases whether it’s through contrarian strategies based on using mass psychology against the crowds or passive investing approaches that allow the craziness to be safely ignored.

Few things in life are predictable so it’s nice that we can rely on investment markets to go completely mad at least once a generation. If you can take comfort in that thought then you’re a proper investor. That’s Simoleon Sense.

To read more from Tim please visit The PsyFi Blog

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Do Investors Overvalue Firms With Bloated Balance Sheets?

Miguel — Sat, 13 Mar 2010 16:02:24 +0000

“This hypothesis is that investors have limited attention; that they allocate this attention to an important indicator of value added, historical earnings; and that this comes at the cost of neglecting the incremental information contained in cash flow measures of value added.”

Click Here To Read: Do Investors Overvalue Firms With Bloated Balance Sheets?

Abstract (Via SSRN)
If investors have limited attention, then accounting outcomes that saliently highlight positive aspects of a firm’s performance will promote high market valuations. When cumulative accounting value added (net operating income) over time outstrips cumulative cash value added (free cash flow), it becomes hard for the firm to sustain further earnings growth. When the balance sheet is ‘bloated’ in this fashion, we argue that investors with limited attention will overvalue the firm, because naïve earnings-based valuation disregards the firm’s relative lack of success in generating cash flows in excess of investment needs. The level of net operating assets, the difference between cumulative earnings and cumulative free cash flow over time, is therefore a measure of the extent to which operating/reporting outcomes provoke excessive investor optimism. Therefore, if investor attention is limited, net operating assets will negatively predict subsequent stock returns. In our 1964-2002 sample, net operating assets scaled by beginning total assets is a strong negative predictor of long-run stock returns. Predictability is robust with respect to an extensive set of controls and testing methods.

Click Here To Read: Do Investors Overvalue Firms With Bloated Balance Sheets?

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Can Individual Investors Beat the Market?

Miguel — Fri, 12 Mar 2010 16:35:53 +0000

One of my favorite papers (mostly because of the academic honesty lacking in typical institutions).

Click Here To Read: Can Individual Investors Beat the Market?

Abstract (via SSRN)
We document strong persistence in the performance of trades of individual investors. The correlation of the risk-adjusted performance of an individual across sample periods is about 10 percent. Investors classified in the top performance decile in the first half of our sample subsequently outperform those in the bottom decile by about 8 percent per year. Strategies long in firms purchased by previously successful investors and short in firms purchased by previously unsuccessful investors earn abnormal returns of 5 basis points per day. These returns are not confined to small stocks nor to stocks in which the investors are likely to have inside information. Our results suggest that skillful individual investors exploit market inefficiencies to earn abnormal profits, above and beyond any profits available from well-known strategies based upon size, value, or momentum.
Findings (via SSRN)

Recent literature has emphasized that on average individual investors are misguided in their trades. We provide evidence here that some individual investors are persistently able to beat the market. Traders that can be classified among the top 10 percent (based on the performance of their other trades) buy stocks that earn abnormal returns of between 12 and 15 basis points per day during the following week. These findings are robust to different forms of risk adjustment, to the removal of small stocks from the sample, and to the removal of any firms in which the account has traded more than once. Similarly, there are also individual investors who consistently place underperforming trades. Traders classified among the bottom 10 percent of all traders place trades that can expect to lose up to 12 basis points per day during the subsequent week. In long horizon (holding period) returns, successful investors outperform unsuccessful investors by about eight percent per year. A trading strategy that exploits the information in investors’ trades earns risk-adjusted returns of about five basis points per day.

Finally, this evidence does not support the efficientmarket hypothesis. The ability of individual traders at a discount brokerage to select outperforming companies is not confined to small firms or to only a few firms in which the traders transact frequently; and some investors persistently trade so as to underperform. These findings suggest that investors’ persistent abnormal performance is not derived primarily from trading on inside information.

Click Here To Read: Can Individual Investors Beat the Market?

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Video: Ted Talk – The magic of the placebo

Miguel — Fri, 12 Mar 2010 16:25:08 +0000

Kind of cool talk, I’m sure its posted elsewhere but I think several of you might like it anyways.

About this talk (via Ted)

Sugar pills, injections of nothing — studies show that, more often than you’d expect, placebos really work. At TEDMED, magician Eric Mead does a trick to prove that, even when you know something’s not real, you can still react as powerfully as if it is. (Warning: This talk is not suitable for viewers who are disturbed by needles or blood.)

About Eric Mead (Via Ted)

Eric Mead is a prolific magician, mentalist and comedian who worked his way up from doing magic on the street to appearing at exclusive events around the world.

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Decision Making: Religion & Savings

Miguel — Fri, 12 Mar 2010 03:42:12 +0000

H/T Liam Delaney @ Geary Behavior Center

Click Here To Read: Decision Making: Religion & Savings

Abstract (Via Geary Behavior Center)

In the Neoclassical growth model the saving ratio and human capital might be seen as the most important factors fostering economic growth. At last since Weber [2005 (1904/05)] it seems clear, that religious beliefs and involvement shapes both social and economic human behavior. This paper tests the hypothesis whether religious belonging and believing influence a household’s economic decision-making in the USA, which was found to foster economic growth, namely the saving ratio at the individual level. Using data from the Panel Study of Income Dynamics (PSID), we find religious effects on saving. Regarding the decision to save money no large differences within the Christian religions, namely Protestants and Catholics, were found. However, large differences exist compared to non-religious people as well as to Non-Christians and Jews.

Click Here To Read: Decision Making: Religion & Savings

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The Boring Age: Is There Really As Much Innovation As We Think?

Miguel — Fri, 12 Mar 2010 03:19:15 +0000

I have to thank Paul Kedrosky for finding this article, it makes me think of many things. Primarily, that us value investors still have hope that is value investors focusing on rather dull, boring, not so sexy businesses.

Click Here To Read: The Boring Age: Is There Really As Much Innovation As We Think?

Excerpt (Via Paul Kedrosky)

We like to believe we live in an era of unprecedented change: technological innovation is proceeding at a rate with no parallel in all of human history. The information revolution and globalization are radically disruptive. Just as Barack Obama would like to be a transformational President, so the rest of us like the idea that we live in a thrilling epoch of transformation. But the truth is that we are living in a period of stagnation.

Surprisingly, this stasis is most evident in an area where we assume we are way ahead of our predecessors: technology. In fact, the gadgets of the information age have had nothing like the transformative effects on life and industry that indoor electric lighting, refrigerators, electric and natural gas ovens and indoor plumbing produced in the early to mid-20th century. Is the combination of a phone, video screen and keyboard really as revolutionary as the original telephone, the original television set or the original typewriter was?

Click Here To Read: The Boring Age: Is There Really As Much Innovation As We Think?

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Influence: A Great Recipe for Employee Productivity…in Five Easy Minutes

Miguel — Fri, 12 Mar 2010 03:14:33 +0000

Interesting article via Noah Goldstein Phd, author of Yes: 50 Scientifically Proven Ways To Be Persuasive

Click Here To Read: Influence: A Great Recipe for Employee Productivity…in Five Easy Minutes

Introduction (via Noah Goldstein)

When it comes to encouraging employees to be productive workers, managers seemingly have many tools in their motivational toolbox at their disposal. For example, perhaps they can increase worker motivation by offering to pay more to workers who are especially productive. Or maybe they can try to enhance overall employee morale by including them in a profit-sharing program. Or perhaps they could try to provide recognition to the best workers by offering rewards such as toasters, iPhones, and vacations. Although all of these tactics have the potential to be effective, they can be extremely costly to implement. However, some new research suggests a recipe for success without spending a dime, all in five easy minutes.

Adam Grant, a scholar in the field of organizational behavior, realized that workers often fail to live up to their potential because they’ve lost track of the significance and meaningfulness of their own jobs. He figured that if he could remind employees of why their jobs are important, they might become more highly motivated, and therefore, more productive individuals.

Click Here To Read: Influence: A Great Recipe for Employee Productivity…in Five Easy Minutes

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Video: The Implications of Overconfidence

Miguel — Fri, 12 Mar 2010 03:09:26 +0000

Via the Your Mind Your Money Show—on Nightly Business Report

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Related Video: Investor Overconfidence

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Time Pressures, Expectations, & Performance

Miguel — Fri, 12 Mar 2010 03:04:46 +0000

David DiSalvo has posted an interesting review on NeuroNarrative of some fascinating research….

Click Here To Read: Time Pressures, Expectations, & Performance

Introduction -via NeuroNarrative

Let’s say that you’re preparing for an extremely important test that you and roughly 100 other classmates will be taking in a week. A few days before the test, you find out that your instructor will be going on a trip not long after the test is over and will be providing written and verbal feedback to the students within a day of the test.

This is unusual, because ordinarily the instructor waits a week or more before providing feedback. About half of the class finds out that they’ll be getting rapid feedback and the other half thinks they won’t receive feedback for several days, per usual.

Which group is more likely to perform better on the test?

That question was investigated by University of Alberta researchers Keri Kettle and Gerald Haubl in a study published in the journal Psychological Science. The researchers hypothesized that the mere anticipation of proximate feedback would result in better performance on a test. Previous research has shown that when feedback is rapid, the threat of disappointment increases. The desire to avoid the negative feeling of disappointment—the feeling you get when you fall short of expectations—is a potent motivator to perform well.

Click Here To Read: Time Pressures, Expectations, & Performance

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