Tag: behavioral-finance

Proximity Bias

Where an idea comes from seems to influence whether or not people think something’s a good idea. The further away that an idea comes from, the better people think that it is. Our brains are wired to assume that ideas that come from nearby are more concrete so they’re not considered as creative as the more abstract concepts that come from further away.

We are also eager to take advice from someone that sounds intelligent on TV or in an article, without vetting their predictions or doing our own research before making a purchase or sale.

Uncertainty makes people anxious and uncomfortable so we are willing to listen to those that claim they can predict the future to alleviate that tension. No one knows for sure what’s going to happen tomorrow, but it makes us feel better to believe that someone can forecast the future to make us feel better.

Source: Why We Miss Creative Ideas That Are Right Under Our Noses

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Investing and Wealth Creation

 

@awealthofcs has an interesting article on saving for retirement in which he says:

Wealth is created by saving and investing more than you spend from your income stream. A house, boat or car are not considered an investment in terms of wealth creation because they are things that you consume today. You must pay interest, fees, maintenance costs, taxes and insurance on these personal balance sheet items.
 
Investing rests on the assumption that you delay current expenditures so that you have money for future expenditures. Cars and boats are depreciating assets that cost you money now. On average, housing barely keeps up with inflation over the long haul and also costs you money today.

Most people fail to understand the difference between consumption and investment. And therein lies the problem.

Source: 99 Retirement Problems

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Why Do Models Beat Experts?

algorithms

Academic research continue to show that models beat experts. Here’s what we had said back in September last year:

Models beat experts. Models represent a ceiling, not a floor. Humans with a model improve performance, but underperform the model. Humans without a model are ineffective. Following a model, but then trying to add value via intuition, actually destroys the model’s benefit and causes investors to underperform the market. Experts need to design the models, but COMPUTERS NEED TO IMPLEMENT THE MODEL.

We also discussed the “Seersucker Theory” where people generally ignore available evidence and continue paying for forecasts.

We often fool ourselves into believing that the more we pay for advice, the better it is.

One explanation is that the client is not interested in accuracy, but only in avoiding responsibility. A client who calls in the best wizard available avoids blame if the forecasts are inaccurate. The evasion of responsibility is one possible explanation for why stock market investors continue to purchase expert advice in spite of overwhelming evidence that such advice is worthless.

It is not that we are dumb. It is just that we cannot help ourselves. There’s a term for it: “identity protective cognition thesis”, which is a self-sabotage of cognitive ability where it conflicts with a deeply-held belief. Basically, human beings have a tendency to want to hear information presented in the form of a story. This presents the risk of us getting psychologically attached to a single narrative prediction, which could then cloud our interpretation of new and potentially ‘inconvenient’ facts.

Say, for example, you have identified yourself as a raging bull on some US tech stock, the fact such a bias could lead you to make mistakes when analysing fresh data on that business does not bode well for the success of your portfolio.

John Maynard Keynes said: “When my information changes, I alter my conclusions. What do you do, sir?”

Turns out most of us will ignore the information and keep trucking. Is it any wonder then, that models beat experts?

Source:

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Pick your risk factor: value or momentum?

The Capital Spectator has a gem of a piece out:

The term “investing” is a misnomer when it comes to managing money. It’s really a job of choosing a set of risk factors that will produce an expected result. The real challenge is deciding which risk exposures are appropriate and how to manage those risks. But you can’t engineer risk away to nothing in a portfolio, at least not without incurring unbearable expenses. In the end, you can only earn a risk premium as the result of bearing risk and managing it in a way that suits your specific risk tolerance and return requirements.

We had written about this almost a year ago, saying that there is no such thing as “risk free.” Capital and risk are joined at the hip:

The conversations I have been having recently typically ends with “I don’t want to take any risk right now, let me wait and watch.” And therein lies the rub – there is no such thing as “risk-free.” Not in life, not in investing. The total risk in this world is a constant – we only transform it by our action or in-action.

This is where our investment themes come into the picture. By investing across different strategies, you get the benefit of balancing out strategy-specific risks. Worried about choosing between momentum and value? Why not choose both? Keep reinvesting your returns and the winning strategy will automatically become a larger part of your portfolio by the magic of compounding. You can begin by checking out how different strategies have performed here.

Source: The Illusion Of “Investing”

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