As I am very agnostic about models, theories, etc, I find this piece superb. I believe history is one of the best guides out there for us investors. So... I strongly recommend reading "Thinking: Fast and Slow" by Daniel Kahneman.
As I've said at the very first piece of this blog. "The Tail Chaser" was started so that I could a/ organize my investing thoughts through writing and 2/ making it public so it would feel awkward to actually write bullshit or non-sense. It is discouraging to write things up and then doing the opposite.
I believe that a very simple way for you NOT to make irrational decisions, in investing, is through publicly exposing your trades and the reasons backing them trades. Doing that you quickly think twice before acting. You don't want to feel stupid. You don't want to say "Buy" and then actually sell.
So this blog serves as discipline.
Now to Daniel's article.
Mad money
Nobel prize winner Daniel Kahneman on the irrationality of our financial system – and the difficulty of fixing it
Daniel
Kahneman is a very modest man — amazingly so for someone who has won
the Nobel prize in economics. When I met him in the lobby of a London
hotel, he never used his very great intelligence in
the way that some very distinguished economists do, to bully or to
intimidate. ‘But then I am not an economist,’ he says with a mischievous
smile. ‘I am a psychologist.’
Prof.
Kahneman smiles a great deal. His eyes sparkle behind his large
spectacles. His cheeriness is infectious, but it is also disconcerting,
given that he is not optimistic about humankind. He thinks,
for instance, that it will be ‘miraculous’ if we manage to do anything
to stop global warming. ‘Let’s suppose that the scientific consensus is
correct: global warming is happening, and it will have some catastrophic
consequences. By the time it becomes obvious
to everyone that it’s a danger, it will probably be too late to do
anything that will be effective in combating it. As a species, our
brains have just not evolved to deal with threats whose effects will be
felt in what, for us, counts as the remote future.
We respond to them by ignoring them.’
But
surely, I protest, if global warming is really happening, we can be
persuaded by reasons and arguments to take it seriously, and to do
what’s necessary now to diminish the effects that will come
later? Kahneman smiles indulgently. Those eyes sparkle. ‘The way
scientists try to convince people is hopeless,’ he states with a broad
grin, ‘because they present evidence, figures, tables, arguments, and so
on. But that’s not how to convince people. People
aren’t convinced by arguments. They don’t believe conclusions because
they believe in the arguments that they read in favour of them. They’re
convinced because they read or hear the conclusions coming from people
they trust. You trust someone and you believe
what they say. That’s how ideas are communicated. The arguments come
later.’
But
he is sensitive to arguments, tables, evidence, figures, etc — so why
shouldn’t the rest of us be? Again he smiles. ‘I am the same as everyone
else. If I ask myself, &"Why do I believe global warming
is happening?”, the answer isn’t that I have gone through all the
arguments and analysed the evidence — because I haven’t. I believe the
experts from the National Academy of Sciences. We all have to rely on
experts.’
He
elaborates: ‘If you accept that view of belief, then you have to change
the way science is communicated to the public. You have to recognise
that people will accept scientific conclusions from people
that they trust, not from anybody. Arguments and evidence are much less
important than trust.’
Kahneman
takes a very dim view of human rationality. Studying the way that
people actually make decisions — as opposed to the way we would like to
make them — led him to reject an idea that is central
to the way that most of us see ourselves. We think we can be relied on
to make rational decisions that will advance our own best interests.
Economists have made our rationality the focal point of their work: the
mathematical proofs of the efficiency of the
market, so central to current economic thought, depend on the
assumption that individuals will make rational choices.
But
in a series of very careful experiments conducted on hundreds of people
with Amos Tversky, Kahneman showed that it just isn’t true. We’re not
reliably rational — in fact we can, in many circumstances,
be relied on not to do what will most effectively advance our own
interests.
This
is not because we’re too moral or too nice to be selfish. It’s because
we’re too stupid. We make silly mistakes in thinking about probabilities
and risks. We think that the only factors that are
going to make any difference are those things that happen to spring
easily into our minds at the particular moment we’re making a decision.
We are swayed by considerations that are utterly irrelevant to the
matters we are trying to make decisions about: for
instance, a sudden cool breeze on a hot day will lead an interviewer to
think more favourably about the candidate he happens to be interviewing
at that moment, and if you ask a judge to write down a high number
before he enters court to sentence someone, he
will end up handing down a longer sentence than if you had asked him to
write down a low number, or none at all.
More
fundamentally, we all tend to be wildly over-optimistic. Many of our
institutions are, in Kahneman’s view, monuments to our irrational
optimism. Take the finance industry, a large portion of whose
business consists in taking people’s money and investing it for them.
Many of us entrust a portion of our savings to someone in a finance
company who promises to provide us with an above average return. It
isn’t only individuals who do this: institutions such
as pension funds and charities do so as well. Finance companies charge
fees for taking your money and investing it for you — but they almost
always fail to keep their promise to provide better returns. They
frequently lose money for their investors.
So
why do so many of us entrust them with our money? ‘It is not a rational
decision,’ says Kahneman. He thinks the explanation is partly that we’re
over-optimistic about the skills of professional
investors, and partly that we’re too intimidated by the process of
professional investing to figure out it doesn’t work, and too worried by
the prospect that, if we invest our money ourselves and we don’t do
well, we will have no one else to blame.
Kahneman
was once asked by a finance firm to help its executives allocate
bonuses more accurately. The firm wanted to be sure that it was awarding
the biggest bonuses to the people who were best at
investing: they picked the stocks that performed best, and so made most
money for investors. Kahneman analysed data going back eight years on
each fund manager — and found that, over that period, not one of them
achieved better results than would have been
achieved by chance. You would have done just as well as the
professional investors, and sometimes better, had you decided what to
invest in by rolling dice or flipping a coin.
To
Kahneman, it was obvious that the firm was rewarding luck as if it were
skill. His research should have led the firm to stop paying bonuses, or
at least to a radical reassessment of how they were
paid. In fact, it had no effect at all: the firm’s managers thanked him
and then ignored everything he had said. Both the executives and the
fund managers continued in exactly the same way, as if nothing had
happened. And so did their investors.
Should
we conclude, I ask him, that the whole finance industry is based on a
con trick? Kahneman hesitates. ‘Well…. They believe in what they’re
doing. And they know about taxes and accounting and
balance sheets. They have solid knowledge to that extent.’ He smiles.
‘It just doesn’t help them pick stocks that will do well.’
So
the correct conclusion is that professional investors are not insincere.
They are deluded. ‘Over-confidence is the phenomenon, much more than
trying to con people,’ responds Kahneman diplomatically.
‘Professional investors actually believe that they are very good value
for money.’ But they are, almost every one of them, wrong about that. As
we are to believe we will do better by entrusting our money to them.
But believe it we do — and our conviction is
amazingly resilient in the face of overwhelming evidence that it is
false.
Overall,
Kahneman’s research into the way we all tend to fall short of being
reliably rational ought to have caused the economics profession to
reappraise one of its fundamental assumptions: the assumption
that we all make rational decisions, all the time. But despite his
Nobel prize, Prof. Kahneman’s work has had almost no effect on the bulk
of the profession. He has got used to being praised and then ignored.
‘The
reality is,’ he says, for the first time with an expression closer to a
frown than a smile, ‘that it is impossible to do conventional economics
if you incorporate irrationality. The maths becomes
too complicated.’
Incorporating
irrationality into economics would also have the consequence that much
of the theoretical edifice that economists have built up over the past
60 years is useless, at least as an explanation
of how the actual economy works, and thus for predicting how it will
behave. Few of those who have made careers constructing that edifice
want to admit that it is wrong at the most basic level. So the vast
majority of economists have sailed serenely on, assuming
the rationality of the decisions made by the people in the marketplace,
and assuring us all of the ‘efficiency’ of the results.
With
hindsight, the irrationality of individual decisions was very obvious in
the build-up to the crash of 2008, when banks were providing huge loans
to people who had no chance of paying them back,
and when many people working for the finance industry did not
understand the inherent risks in many of the products they bought and
sold. Alan Greenspan — the former head of the Federal Reserve, and
responsible for setting the US interest rates at a level
that blew the bubble ever bigger — admitted that he had been ‘shocked’
to discover that banks and finance houses did not act rationally in
their own self-interest. ‘I thought Greenspan was being extraordinarily
naive when he said that,’ Prof. Kahneman comments.
Naive or not, Mr Greenspan was doing no more than give voice to how
most economists thought then, and how most of them think continue to
think now. And it shows the extent to which Kahneman’s work has yet to
penetrate orthodox thinking on economics.
But
in a way, that fact is simply further evidence of that he is right about
the ubiquity of irrationality. ‘We’re all prone to make some very
simple errors when we try to work out what to do,’ Prof.
Kahneman stresses. ‘And we continue to make those mistakes even when
they are pointed out to us.’ So what’s the answer? ‘I don’t have one. I
don’t have a recipe for avoiding the errors we’re all prone to, and I
don’t think there is one. It’s the way we are.
I make the same mistakes. I try not to. But I do. I’m no different to
anyone else.’
*Disclaimer: charts and data are presented as I receive/see them. Sources are usually not checked for validation and my own calculations are of 'back of the envelope'-type. I am aware that some math that I do myself might be wrong and/or misleading to some extent. In financial markets the rate of change of economic data is often more important than the actual level and the perception of 'what is priced in' is more important than 'what is actually going to happen'. This is actually the way people pick entry and exit points. So... yes, sometimes you might say 'This guy is an idiot, this is way wrong!' with a high conviction, being right. Not to worry. Markets are made of expectations and the clash of conviction between its participants. Portfolio managers know that being an idiot is sometimes profitable and being smart is often a bad choice. It is all reality, sometimes good, sometimes bad. By the way: corrections to my analysis and intelligent debate is welcome. theintriguedtrader AT gmail do com
