Overcoming Bias

Condemned to Repeat Finance Past

Those who cannot remember the past, are condemned to repeat it. Santayana

I once said:

I'd guess you can get 80% of the improvement that predict markets offer by using a much simpler solution: collect track records.

Case in point - stock investors:

Based on the answers of 215 online broker investors to an Internet questionnaire, we analyze whether investors are able to correctly estimate their own realized stock portfolio performance. We show that investors are hardly able to give a correct estimate of their own past realized stock portfolio performance and that experienced investors are better able to do so.

It is hard to learn from experience if you don't remember what you did and how well that worked. 

Impotence of Belief in Bias

A new study from Leibniz University Hannover finds that the 1/3 of German professional fund managers who believe human biases to be important in financial markets have better calibrated estimates and rely more on momentum and contrarian strategies, but otherwise think and act like other fund managers:

[A] literature in psychology ... has clearly revealed the "bias blind spot" (Pronin et al., 2002), i.e. the belief that one's own judgments are less susceptible to biases than the judgments of others. ... [Among] professional ... fund managers we differentiate ... "endorsers" of behavioral finance ... [who] believe that the approach of behavioral finance truly reflects decision behavior in fund management (and who know the key messages of behavioral finance well) ... [and] non-endorsers. ... We have surveyed [104] fund managers in Germany and classify them according to their self-assessment into these two groups. ...

Whereas [the 37] endorsers recognize significantly stronger behavioral finance effects in other fund managers' behavior than non-endorsers, the perception of their own behavior is largely unaffected by their insights.  When endorsers' are asked about their own behavior with respect to items being linked to behavioral finance, such as hindsight bias or disposition effect, they answer as non-endorsers do. However, there is one exception ... Endorsers show less miscalibration with respect to forecasting the interval of a stock index. ... We [also] find ... endorsers rely more on momentum and contrarian [versus buy-and-hold] strategies. ... Endorsement ... is not closely related to personal characteristics, such as being older or holding a better position etc.

Even for those with strong incentives to correct for biases, knowing about and believing in biases has influenced their decisions little, and not obviously to their benefit.  This suggests that we focus not on trying to correct our personal biases but instead on identifying and promoting institutions, such as prediction markets, to reduce biases. 

Hat tip to Zubin Jelveh and Tyler Cowen. 

Boards of Advisors Don't Advise, Do Board

Now that I've been on several official boards of advisors for a few years I can report:  boards of advisors are almost never asked to give advice, though they do sometimes offer it anyway.  But boards of advisors are usually "boarded", i.e., paid something.

They would be better called "boards of prestige" - the message being "we aren't so clueless that these prestigious people refuse to associate with us."  Or perhaps just "we could afford to buy these prestigious people, even though for a price they'd associate with anything."  Now I have in fact turned down paid affiliations with organizations I thought too clueless, but I can't report how many others are willing to do the same. 

Biases and Investing

This Wired article about the Netflix prize provides an important hint about a valuable result of understanding human biases:

Couldn't a pure statistician have also observed the inertia in the ratings? Of course. But there are infinitely many biases, patterns, and anomalies to fish for. And in almost every case, the number-cruncher wouldn't turn up anything. A psychologist, however, can suggest to the statisticians where to point their high-powered mathematical instruments. "It cuts out dead ends,"

This approach applies to a wide variety of problems, including beating markets.
Not only is it important for investors to avoid dead ends in the sense of failing to find patterns, it's important to distinguish patterns that are sustained by strong human biases from patterns that will vanish when a modest number of people figure out how to exploit them or patterns that are a byproduct of data that are not random samples from the space of all possible market behavior. Or as Coase is reported to have said, "if you torture the data enough, nature will always confess".

There are a variety of known strategies that seem to work even though many people are aware of them. Most seem to be sustained by some combination of Status Quo Bias, Endowment Effect, and Recency Bias, although the benefits of these strategies seem to diminish over time.

Also, since Robin's advice to welcome diversity in analysis rather than beliefs seems too abstract for some, here's how I think of putting it into practice when investing: focus on asking questions that few other people are asking. The more widely discussed a question is, the more likely it is that markets reflect the best answer to it. My best investments have been in companies that few people have heard of, often found by looking through more earnings reports than most investors would be willing to. And one infrequently mentioned result from the cognitive science literature has been more helpful in automating my search for underpriced companies than years of studying what other investors are doing.

Experiencing The Endowment Effect

I recently decided that it was finally time for a new car, so after a lot of shopping around, I picked one out and ordered one.  There was definitely some significant psychic pain involved in spending that much money, but I spent many hours thinking over and discussing the decision, and am happy with the purchase.

The release of the Kindle has made me realize just how much clutter books add to my life - including books I may never get to, and others I've read but will never read again.  To have those books on an SD card instead of piled in my room and shelves sounds wonderful.  So as a first step in decluttering, I'm getting rid of all the books I expect to never open again.  Perhaps then I'll get ebook versions of the books I actually read and get rid of the physical copies.

I'm planning to just give my books to friends or Goodwill, since the effort it would take to sell them (list, package, and ship) would not be worth my time.  Yet in contemplating this, I'm experiencing psychic pain far, far greater than that of buying my new car, even though the total cost of these books is only a few thousand dollars.  Thanks to the damn endowment effect, it is so much easier to convince myself that a high income justifies buying expensive things than throwing away cheap ones.

And it's just so clearly irrational.  If I considered the total income from selling the books, and the time it would take, and I encountered it in the context of "Would you pay this much in order to save that much of your time?", I'm sure I would.  Yet framed as "Would you rather throw these things away, or put in this much time to eke that much value from them", it feels like a terribly wasteful decision.

Ah well.  I've had enough practice at overcoming bias that when I can clearly and consciously identify what's going on, I can usually do the right thing.  I just wish the psychic pain was more amenable to being argued out of existence.

Small Business Overconfidence

The August Journal of Economic Psychology says that across 18 countries "subjective, and often biased, perceptions have a crucial impact on new business creation." For example, the strongest predictor of who starts a new business is "whether the person believes herself to have the sufficient skills, knowledge and ability to start a business."  But for those who do start a business, the higher such confidence, the lower their "approximate survival chances." Furthermore, "some countries exhibit relatively high rates of start-up activity because their inhabitants are more (over)confident than in other countries."

Naive Small Investors

The August Journal of Financial Economics reports that large traders tend to compensate for the fact that "security analysts tend to bias stock recommendations upward, particularly if [the analyst is] affiliated with the underwriter."   But "small traders, instead, follow recommendations literally.

So to help you small investors, I've made a handy guide.  If the analyst is not affiliated with those pushing the stock:

• When the analyst says "strong buy", you should buy.
• When the analyst says "buy", you should hold.
• When the analyst says "hold", you should sell.

If the analyst is affiliated with those pushing the stock:

• When the analyst says "strong buy", you should hold.
• When the analyst says "buy", you should sell.
• When the analyst says "hold", oh my God, sell!!!
  

Acquisitions Signal CEO Dominance

CEOs may try to acquire other companies in order to signal dominance within their firm.  At least this is my interpretation of this article in the Sept. Journal of Economics and Business:

Logistic regression and Australian data ... suggest that both CEO overconfidence and CEO dominance are important in explaining the decision to acquire another firm. When compared to existing US studies, the evidence on CEO overconfidence is robust across two different financial and corporate governance systems. Our results also indicate that CEO dominance is at least as significant as CEO overconfidence in the decision to undertake an acquisition.

Humans constantly struggle to achieve and signal dominance over each other.  Since in equilibrium more dominant CEOs are in fact better able to push through an acquisition, doing so is a credible way to signal that you do in fact dominate decision making in your firm.   And since signals must always "overdo" it to be credible, this may explain why acquisitions appear to be "overconfident."

Btw, I've been wondering: what fraction of a CEO pay is for the value he adds to key decisions, versus the value he adds by being an impressive person for employees to look up to, outsiders to meet, admire, feel comfortable with, and so on? 

Why do corporations buy insurance?

Yesterday I wondered:

Why do corporations by insurance for fire damage and such?  It seems to me that maybe the oughtn't, since the cost of insurance is greater than the expected payouts (due to administrative costs, asymmetric information, moral hazards etc).  Investors should presumably prefer corporations to be pure bets, and reduce risk and volatility by holding suitably diversified portfolios.

Today my colleague Peter Taylor, who worked in the insurance industry for many years, replied (reproduced here with permission):

Corporations certainly do buy insurance against fire and very good value it proves to be for them I must say when a large-scale fire does occur.  Your argument was adopted by some large corporations going "self-insured" or creating  their own "captives" but generally it takes one large loss and they are back in the insurance market.  Moreover, the argument for self-insurance can be about saving a few pennies off expenses rather than assessing the real risk - a recent example was Hull Council deciding to self-insure with its own fund against flood rather than pay the market price - underestimating the losses by an order of magnitude.  The reversion to the insurance market is partly to do with shareholders' wish for stable results as well as their reluctance to accept bad luck.  Shareholders don't seem to accept that accidents/fires/whatever happen and blame the management (Napoleon's unlucky generals) so from a management point of view it is much easier to buy the insurance year on year and avoid getting caned when a loss does occur.

I'm still not sure I completely understand why insurance is bought. It might be that shareholders are biased (which seems to be what Peter suggests).  If so, is this a recognized failing? Do sophisticated institutional investors also prefer that the companies they own stock in buy fire insurance?

Irrational Investment Disagreement

The Spring Journal of Economic Perspectives reviews how many investment puzzles can be explained by irrational disagreement:

One should not be able to forecast a stock's return with anything other than ... riskiness ... Yet ... a large catalog of variables with no apparent connection to risk have been shown to forecast stock returns, .... stocks that have had unusually high past returns or good earnings news to continue to deliver relatively strong returns over the subsequent six to twelve months ... "glamour" stocks with high ratios of market value to earnings, cashflows or book value to deliver weak returns over the subsequent several years ... many of the most interesting patterns in prices and returns are tightly linked to movements in volume ...

We ... argue in favor of... "disagreement" models. ... encompassing ... the following underlying mechanisms: i) gradual information flow; ii) limited attention; and iii) heterogeneous priors. ... this class of models is at its heart about the importance of differences in the beliefs of investors. ...

Gradual information flow by itself can be entirely consistent with a rational model ... What is also required... is that, ... investors do not fully take into account the fact that they may be at an informational disadvantage, ...
limited attention needs to be combined with the assumption that ...  when trading with others, they do not adjust for the fact that they are basing their valuations on only a subset of the relevant information. ... one needs to combine heterogeneous priors with an assumption that the investors do not fully update their beliefs based on each other.