Nobel Memorial Prize in Economic Sciences winner Paul Samuelson famously asked a friend to a bet on the toss of a coin in which he would win $200 or lose $100. His friend responded “I won’t bet because I would feel the $100 loss more than the $200 gain. But I’ll take you on if you promise to let me make 100 such bets.”
Our intuition tells us that one toss is not enough to make it reasonably sure that the law of averages will turn out in my favor. But in a hundred tosses of a coin, the law of large numbers will make it a darn good bet.
Samuelson mathematically proved his friend wrong demonstrating that the law of large numbers is not always on your side.
Behavioral finance is an approximately 40-year-old field that seeks to combine behavioral and cognitive psychological theory applied to finance to provide various explanations for why people make irrational financial decisions.
Two of the founding fathers of behavioral economics, Daniel Kahneman and Amos Tversky discovered that the pain of losing is psychologically about twice as powerful as the pleasure of gaining, and since people are more willing to take risks to avoid a loss which is graphed below.
Mental accounting refers to the tendency for people to separate their money into separate accounts based on a variety of criteria, like the source of the money (hard earned vs poker winnings) and intent for each account (treating money for tuition sacred vs vacation money). Individuals assign distinct functions to each group, which may have an irrational or detrimental effect on their decisions and behaviors.
Consider a scenario where you need to sell some stocks. You have two options. Sell ABC, a winning stock where you will lock in a $5,000 gain or sell XYZ, a losing stock where you will lock in a $5,000 loss. Prices for both stocks are stable. Which one would you sell?
Empirical evidence has shown that an overwhelming percentage of investors will pick the winning ABC stock over XYZ. The reason is selling the ABC stock chalks up a success for the investor and if they choose to sell XYZ it adds a black mark to their investing prowess.
Herding and Pursuit of profits (with minimal risk)
Herding behavior is the tendency for individuals to mimic the actions of a larger group. Isolated individuals would not necessarily make the same choice.
There is a saying in professional investment management “No one gets fired for buying IBM” which exhibits herding behavior.
When there are red flags, people tend to ignore them at their peril. Bernie Madoff fooled many investors when he confessed his investment company was a Ponzi scheme. Madoff’s investors were intelligent and educated. They received statements reporting annual returns no higher than 14%. Because the red flags were subtle, most people missed them. The reported returns surpassed the stock index every year except 2001 and 2007, the long-term bond index every year except 1 and the never underperformed the short-term bond index. It never registered with clients that Madoff went 10 or 15 years with only three or four months with negative returns.
Another example is, in the 1990’s Italian retirees invested into Argentinian bonds since they were offering a higher interest rates than Italian bonds. In 2001, Argentina defaulted on US$132B and offered the bond holders about 30% of the face value; resulting in a loss of around 70% for the retirees. The pursuit of profits from the Argentinian bonds blindsided the retirees without looking at the downside risks.
These are classical cases of herding and pursuit of profits.
Framing & Overconfidence
Framing refers to how individuals process information. We use mental framing to receive and filter information and to help us make decisions. It enables us to take short cuts when making individual decisions.
Overconfidence is being overly optimistic about future outcomes e.g. you to overestimate the likelihood of positive events and underestimate the probability of negative events.
Consider you make 10% on a stock versus your neighbor’s 30% return. That can be framed as a 10% gain or a 20% loss relative to your neighbor’s return. Framing is always viewing the information or outcome through a different lens.
Just like it takes lawyers and surgeons years of practice to become proficient, investing is no different. Investing can be compared to like playing against another player. Be very wary when you do not know who is on the other side of the trade or transaction. Investors make framing errors when they see an interview with a CEO on TV promoting the company. You should be asking yourself: "Who else is watching this program, and what do I know that is uniquely different from the other viewers?" If the answer is nothing, you should probably stay away.
Always consider the questions when making a financial decision “who is the idiot on the other side of the trade? Can it be me?”