Five Good Questions with Terry Odean

5 Good QuestionsTerrance Odean is the Rudd Family Foundation Professor of Finance at the Haas School of Business at the University of California, Berkeley. He is a member of the Journal of Investment Consulting editorial advisory board, of the Russell Sage Behavioral Economics Roundtable, and of the WU Gutmann Center Academic Advisory Board at the Vienna University of Economics and Business. He has been an editor and an associate editor of the Review of Financial Studies, an associate editor of the Journal of Finance, a co-editor of a special issue of Management Science, an associate editor at the Journal of Behavioral Finance, a director of UC Berkeley’s Experimental Social Science Laboratory, a visiting professor at the University of Stavanger, Norway, and the Willis H. Booth Professor of Finance and Banking and Chair of the Finance Group at the Haas School of Business. As an undergraduate at Berkeley, Odean studied Judgment and Decision Making with the 2002 Nobel Laureate in Economics, Daniel Kahneman. This led to his current research focus on how psychologically motivated decisions affect investor welfare and securities prices.

Today I ask (in bold) and Terry answers what I hope are Five Good Questions as part of my longstanding series by that name (see links below). Continue reading

That’s right, the women are smarter

Regular readers will recall that I began my Wall Street career on the ginormous fixed income trading floor of what was then Merrill Lynch in downtown Manhattan. Of the hundreds of people who called the seventh floor of the World Financial Center home during the workday then, astonishingly few were women and even fewer were traders – those who committed hundreds of millions of dollars of Merrill’s capital every single day. Even so, and despite rampant and often aggressive sexism, the women were always amongst the very best of the breed – smart, shrewd, savvy and discerning.

Part of that was to be expected. In such a male dominated, testosterone fueled world, only the very best women would be allowed access to that boy’s club in the first place. And only the very best of them would be allowed to stay. Still, the women traders I knew seemed more calculating and less prone to foolish errors than many of their male counterparts. They were also quicker to recognize and fix the errors they did make. And the research data backs up my anecdotal experience.

Which, in a roundabout way, brings me to my point. Last week I participated in an excellent conference entitled Diversifying Income and Innovations in Asset Allocation put on by S&P Dow Jones Indices in Beverly Hills. I spoke about retirement income strategies. Among the other presenters was Deborah Frame of Cougar Global Investments in Toronto. Her presentation focused on asset allocation and it was very enlightening.

During the cocktail hour, she and I were discussing the research literature that looks at the differences in men and women when it comes to investing. She took exception to my having characterized one of those differences, consistent with the literature, as women being more “risk averse” than men. She made the point that women are more “risk aware” – more cognizant of the risks they face and smarter about dealing with them (in general, of course). In her view, that’s why, for example, women so routinely asked for directions (in the days when phones didn’t come with GPS) when they weren’t sure where they were, and men so routinely refused to do so.

And, by golly, she was right. Since women generally are better investors, they should be portrayed positively (more “risk aware”) rather than negatively (more “risk averse”). Moreover, since men (again, in general) are more risk seeking and more likely to make foolish investment decisions, they should not be the standard to which women are compared. It should be the other way around. It was sexist of me to look at things otherwise.

Thanks, Deborah. Lesson learned (I hope).

We Are Less Than Rational

Investment Belief #3: We aren’t nearly as rational as we assume

InvestmentBeliefssm2 (2)Traditional economic theory insists that we humans are rational actors making rational decisions amidst uncertainty in order to maximize our marginal utility. Sometimes we even try to believe it.  But we aren’t nearly as rational as we tend to assume. We frequently delude ourselves and are readily manipulated – a fact that the advertising industry is eager to exploit.1

Watch Mad Men‘s Don Draper (Jon Hamm) use the emotional power of words to sell a couple of Kodak executives on himself and his firm while turning what they perceive to be a technological achievement (the “wheel”) into something much richer and more compelling – the “carousel.”

Those Kodak guys will hire Draper, of course, but their decision-making will hardly be rational. Homo economicus is thus a myth. But, of course, we already knew that. Even young and inexperienced investors can recognize that after just a brief exposure to the real world markets. The “rational man” is as non-existent as the Loch Ness Monster, Bigfoot and (perhaps) moderate Republicans.  Yet the idea that we’re essentially rational creatures is a very seductive myth, especially as and when we relate the concept to ourselves (few lose money preying on another’s ego). We love to think that we’re rational actors carefully examining and weighing the available evidence in order to reach the best possible conclusions.

Oh that it were so. If we aren’t really careful, we will remain deluded that we see things as they really are. The truth is that we see things the way we really are. I frequently note that investing successfully is very difficult. And so it is. But the reasons why that is so go well beyond the technical aspects of investing. Sometimes it is retaining honesty, lucidity and simplicity – seeing what is really there – that is what’s so hard. Continue reading

The Wyatt Earp Effect

The Big PictureMy first post for The Big Picture, the wonderful blog from Barry Ritholtz, also of The Washington Post and Bloomberg View, is now up. You may read it here. I hope you will.

The Wyatt Earp Effect

Mean Reversion Wins Again

HogeRight after his terrific Super Bowl winning performance, Joe Flacco was deemed the best quarterback in the NFL by ESPN “expert” Merril Hoge.

During presentations on cognitive biases and their impact on investment decision-making throughout this year, I have been using this claim as a great example of recency bias and of a likely failure to understand mean reversion. Flacco’s performance so far this season makes the point.

Flacco was fantastic in the play-offs last season, leading the Baltimore Ravens to a title by throwing 11 touchdowns with no interceptions over that time and averaging a terrific 9.05 yards per attempt. His QBR was 84.4 and his QB Rating was 117.2.  However, in the 80 regular-season games before that, and through the 2013 season to this point, Flacco has been and remains an average NFL quarterback {115 TDs to 74 interceptions (13/13 this year); 7.01 yards per attempt (6.55 this year); 51.7 QBR; 84.9 QB Rating (48.3/75.3 this year)}. Despite the four play-off games that suggested he might be an emerging superstar, I argued, beginning last winter, that his performance would likely revert to his mean, long-term performance. And so it did.

It is possible that near-term aberrations in performance reflect a major change in long-term norms that can be continued going forward. But that’s not usually the case. As Dennis Green (then coach of the Arizona Cardinals) famously expressed it, “They are who we thought they were” most of the time and that doesn’t tend to change all that much.

 

The market corollary to this idea is that when prices are very high they will tend to decline and when they are very low they will tend to rise. Since our objective generally is to buy low and sell high, making good investment decisions in this regard should be pretty easy then, right? Sadly, the answer is a clear no.

Recency bias is our tendency to put too much emphasis upon the recent past to the exclusion of the full data set and to extrapolate recent events into the future indefinitely. Professionals are no less prone to its effects as anyone else. As reported by Bespoke, Bloomberg surveys market strategists on a weekly basis and asks for their recommended portfolio weightings of stocks, bonds and cash.  The peak recommended stock weighting came just after the peak of the internet bubble in early 2001 while the lowest recommeded weighting came just after the lows of the financial crisis. Obviously, following that advice would have been a big mistake and had an investor sold stocks at the peak stock weighting and bought at the rock-bottom weighting – doing the opposite of what the experts said – s/he would have done exceptionally well.

Emotionally, we get afraid when markets tank and euphoric (greedy) when markets are hot. No matter how quick we are to agree with Warren Buffet conceptually (“Be fearful when others are greedy, and greedy when others are fearful”), it’s really hard to do. The financial markets are the only places I know where people want to pay top dollar and resist buying anything on sale. Where else do people want to wait for prices to go up before they buy? That’s largely on account of recency bias and our emotions. Ravens fans were angry when mean reversion was discussed in connection with Joe Flacco’s play-off performance last season. But the numbers don’t lie. He’s still who we thought he was.

The Myth of the Rational Investor

rcm_logo_followMy latest Real Clear Markets piece is available here. A taste follows.

Homo economicus is a myth, of course. But it’s a very seductive myth, especially as and when we relate the concept to ourselves. We like to think that we’re rational actors carefully examining and weighing the evidence in order to reach the best possible conclusions. Oh that it were so.

Here’s the money quote: “Information may be cheap, but meaning is expensive and elusive.”

Better Investing Requires A Broad Perspective

Something Wicked This Way Comes

witchesAs my firm’s Chief Investment Officer, it’s my role (among other things) to provide thought leadership for the organization and its representatives – to outline and explain best practices and approaches with respect to the markets and investing.  Most fundamentally, if metaphorically, my job means standing up and pointing in the right direction.

I have been thinking a lot lately about how to do that more effectively, and the issue was highlighted for me anew yesterday during the outstanding Big Picture Conference here in New York City, hosted by Barry Ritholtz and Josh Brown. As part of the conference, Josh hosted a panel of Chief Investment Strategists: Dan Greenhaus of BTIG, Art Hogan of Lazard and Jeff Kleintop of LPL. All three were intelligent, engaging and very well-informed. Dan’s bio says he “is charged with evaluating both domestic and global macro trends as well as formulating top down investment strategies for clients.” That’s consistent with the way the role is typically conceived. As he put it on the panel, his job is to tell his clients what’s going to happen next. Of course, strategists do what they do for a much wider audience than that, as all are providing opinions regularly across media platforms, including television and radio financial news. They’re out to build their firm’s brand, and their own brand too.

Josh led the three of them on a brisk tour of the world markets.  They talked about macro risks and opportunities – what they think the immediate future has in store. And they were very good at it, impressively weaving together stories, themes and data into a powerful package of possibilities. It was wonderfully entertaining and even plausible. Some bits of it may even turn out to be accurate.

But my thumbs kept twitching (“pricking” in the Bard’s turn of phrase) throughout. Josh hinted at the inherent problem with the approach each took, suggesting that such moment-by-moment commentary and reaction is effectively meaningless.  I’d take Josh’s point one step further and call it wicked. Continue reading

Investment Learning from the Law

lawI went to law school on account of certain skills I possessed – some general academic talent, analytical and writing skills, the ability to marshal arguments, and very good standardized test-taking ability. But I didn’t really understand what attorneys did in any meaningful sense.  Indeed, I had never met one before enrolling in law school at Duke.

As it turned out, I became a pretty good attorney – my skill set was appropriate.  But I never liked it very much and I was better suited for this business.  I favor accommodation, collegiality and collaboration to conflict. I’m better at big picture trends and goals than I am at minute details. I prefer adding value to playing zero sum games. I have a much shorter attention span than the litigation process permits. So I now refer to myself often as a recovering attorney.

But my legal training has helped me in this business in a number of clearly definable ways. Indeed, law school provided a pretty good education for a budding investment professional. I outline five specific and interrelated investment lessons I’ve learned from my legal training and experience below.
Continue reading

Data-Driven Difficulties

BiasedAs regular readers are all too well aware, I am committed to data-driven analysis and investing.  We’re suckers for stories, of course, and are ideological through-and-through, but the goal is to make sure that our investment decisions are based on real, quantitative evidence (at least to the extent possible). 

That’s easier said than done, of course.  We are prone to all sorts of cognitive and behavioral biases — perhaps most prominently confirmation bias — all of which threaten our analysis.  We are also highly susceptible to bias blindness, the inability to see our own biases even when others’ are crystal clear.  And now comes further evidence that our reasoning abilities are even worse than we thought. Continue reading