Confirmation Bias Illustrated

Please watch the video here (it can’t be embedded) and thank me later.

“Like, I’m listening to what you’re saying but I only hear what I want to.”

A Behavioral Finance Playlist

It isn’t “Weird Science” (Oingo Boingo)…

…or “Brain Damage” (Pink Floyd)…

…or even “Insane in the Brain” (Cypress Hill).

It’s utterly human (and I write about it often). We are all deeply flawed. We have inherent flaws and weaknesses that impede good judgment and good behavior. Behavioral finance has done a pretty good job outlining these foibles and music does a great job demonstrating them. So let’s get started with our Behavioral Finance Playlist. 

The Jewelry Effect

I’m not a fisherman, but I was fascinated recently to come across an article about the science behind the creation and use of fishing lures. Size, shape, color and even taste all matter. Interestingly, however, there is a surprising degree to which the effectiveness of the lure doesn’t matter commercially. For example, there is a dizzying array of bass lures in variations of blues and purples (see at left, for example) even though bass cannot see those colors as anything other than gray. But people buying lures seem to like those colors. Those involved in the research and sale of fishing lures refer to this phenomenon as the “jewelry effect.”

“We design lures for the fish, but fish don’t buy lures,” says Keith A. Jones, a director of research for an Iowa lure-maker. “It’s hard to convince anglers that a lure’s color doesn’t make much difference.” Scientific reality doesn’t even get much respect in the fishing world.

Jones recognizes that, to be commercially successful, lures need to be aesthetically pleasing to the people who buy them. Accordingly, some lures that work well need a design change to sell. Ted Dzialo, executive director of the National Fresh Water Fishing Hall of Fame and Museum in Hayward, Wisconsin, simply captures the essence of the issue. “I think most lures are designed to catch more fishermen than fish.”

If this sounds remarkably similar to the money management business to you, you’re not alone. So-called “smart beta” is really good marketing because it takes advantage of demand for beta-driven solutions but it is no panacea. Moreover, “factor investing” can trace its origins back to at least Benjamin Graham and is hardly new to smart investors. After the financial crisis, consumers rushed to money managers offering tactical management in order to try to avoid the next big downturn even though there is precious little evidence that it works. And hedge funds continue to lure major assets and major investors – perhaps because those investors want to prove to themselves and others that they’re rich – even though hedge fund performance has been, in two words, truly dreadful.

There are plenty of other examples, of course, but you get the idea. Good investing is necessarily a long-term enterprise and we humans struggle badly with the long-term. The short-term is too alluring. Our efforts at hyperbolic discounting generally suck. Thus we are always prone to eat the cake and skip our work-outs.

Those who market money management are well aware of these tendencies. And, to be fair, there isn’t much that’s sexy about good money management. We want the next Apple rather than diversification. We want to avoid the next big crash but every last drop of upside. We want to get rich quick and think we’re smart enough to find that next big thing. But we are routinely disappointed and, when we think we’ve (finally!) found the Holy Grail, it turns out that Holy Grail Investment Management is run by Bernie Madoff.

Most money management firms set out first and foremost to lure and catch investment dollars and only secondarily to manage the assets won effectively. The jewelry effect is at least as prevalent in money management as in fishing. But pretty it’s not.

A Hierarchy of Advisor Value

I talk often with lots of advisors of all sorts and from a wide variety of firms. They are profoundly disillusioned an astonishingly high amount of the time. When the markets are strong, they are disappointed that they didn’t capture enough of the upside. When the markets are weak, they are apoplectic that they didn’t avoid the downturn. When markets are sideways, they’re just plain frustrated. When they try to anticipate these movements they usually fail and when they don’t – a very rare event indeed – their next moves inevitably don’t keep up the good work. They hate seeming to start from scratch every day and living from transaction to transaction, dependent upon the machinations of markets for survival.

This profound disillusionment is well-earned, of course, and is predicated upon three primary problem areas: execution; expectation; and erroneous priorities. The basis for each of these problems can be established in surprisingly short order.

In terms of execution, the trade ideas they offer rarely turn out well and the performance provided by money managers, when they go that route, almost never meet expectations such that it’s not unfair to say that much of the money management business has been an abject failure pretty much across-the-board, even for the mega-rich. Poor investor behavior makes that dreadful performance even worse — we trade too often, at the wrong times and into the wrong instruments. We chase returns via managers, sectors and trades that have been hot only to be disappointed when mean reversion inevitably sets in. Our inflated expectations make matters worse still because investors expect outperformance as a matter of course and investment managers tell them to expect it, implicitly and explicitly. That’s what makes the sale after all.

Erroneous priorities include a failure to manage to personal needs, goals and risk tolerances as well as “plans” that change with every market movement. It shouldn’t surprise anyone that clients with huge appetites and tolerance for risk when markets are rallying frequently want to go to cash at the first sign of trouble. At the advisor level, the priority problem is even more fundamental and encompasses each of these problem areas. Much of what tries to pass as “financial advice” is actually glorified (or even not-so-glorified) stock-picking. In my experience, most advisors and their clients wrongly think that the advisor’s primary function is to pick good investment vehicles.

Advisors are well aware of the failures of the money management business, of course, as well as the limitations of a transactional business model. That’s a big reason why their disillusionment is so existential. They have been let down again and again by the idea that they have (finally!) come up with a formula for success only for reality to crush those promises. Even worse, and consistent with that conundrum, a 2012 study from the National Bureau of Economic Research concluded that financial advisors reinforce behavioral biases and misconceptions – the problems outlined above – in ways that serve the advisors’ interests rather than those of their clients.

Still, many of these advisors keep hoping against hope. They routinely tell me that if they proposed a data-driven, evidence-based approach with their clients that actually had a reasonable chance for success, their clients wouldn’t perceive a need their services. Not so coincidentally, that’s a big reason why so many advisors are terrified by the proposed Department of Labor fiduciary rule with respect to retirement accounts. And that’s why the Dilbert cartoon reproduced below about index funds (one possible data-driven approach but hardly the only one) is so wickedly funny.

Proper advisor priorities begin with a recognition of what is important and what is achievable. That’s why I have created this hierarchy of advisor value, which was developed for a presentation I have been giving to groups of advisors. 

Managing to this hierarchy won’t make the markets any less infuriating, but doing so will make the financial advice business much more fulfilling and gratifying. It can even make that business more lucrative, at least over the longer-term. Simply put, it will require carefully and truly putting the client’s interests first, even when the client doesn’t see it that way. 

“That’s What They Offered”

Bernie Sanders and Donald Trump are strange bedfellows to be sure. But they were the big winners last night when the first primary votes of the 2016 presidential campaign are cast and counted in New Hampshire as each won astonishing and overwhelming victories in their respective party contests. Let’s be clear. They didn’t just win. They each won by huge margins. And their successes have badly embarrassed party leaders and pundits.

These very different candidates have some surprising commonality. They have each found a rich vein of popular (and populist) support as insurgents attacking the insidious corruption wrought by big money in politics. They see the political fight they are waging not as an ideological struggle so much as a class war. They want to gain control of the presidential process and the political parties at its heart by hostile takeover. As they see it, since the system is rigged, only someone not beholden to big-money special interests can make things right.

The Great Myths of Investing

As the great Mark Twain (may have) said, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” That’s particularly true in the investment world because we know, to a mathematical certainty, that avoiding errors provides more bang for the buck than making correct calls and generating outperformance. Fixing what we “know for sure that just ain’t so” provides a remarkable opportunity for investment success.

On the other hand, it simply doesn’t make a lot of sense to spend enormous amounts of time and energy looking for a strategy or a manager that might (but probably won’t) outperform by just a little bit. As the great Spanish artist Pablo Picasso put it, “Every act of creation is first of all an act of destruction.” What we want to do is to find the next great investor, the terrific new strategy, the market sectors that are about to heat up or the next Apple. But what we should do is eliminate the things that make it so hard for us to get ahead. Accordingly, I will highlight some of the great myths of investing — ideas that lots of people, alleged experts even, claim to be true and act as as though are true “that just ain’t so.”

There are lots of myths at work in our lives, of course, falsehoods that are often believed and which are used to further a favored narrative. But George Washington didn’t really cut down a cherry tree and wax eloquent about not telling a lie as a consequence. Isaac Newton didn’t come up with his theory of gravity because an apple fell on his head. Columbus didn’t discover that the earth was round (that had been established centuries before). Ben Franklin didn’t fly a kite in a storm and discover electricity. And Einstein never flunked math. If any of these are news to you, I’m sorry to have had to break it to you.

Such myths persist because they “work” in some way. Their story elements — ease of recall, readily adaptability, explanatory power — make them useful and even important.  But utility and truth are hardly the same things and neither are utility and helpfulness.

So here is my list of the top ten great myths of investing. Since they aren’t true and are indeed damaging, if you can eliminate them from your mind and your investment process, your results will necessarily improve.

The Maleficent 7

The Magnificent Seven is a terrific 1960 movie “western” about seven gunfighters hired to protect a small Mexican village from marauding bandits. A re-make is currently in the works and the “original is itself a re-make of Akira Kurosawa’s Japanese classic, Seven Samurai. Meanwhile, Maleficent is the “Mistress of All Evil” in Sleeping Beauty who curses the infant princess to prick her finger on the spindle of a spinning wheel and die before the sun sets on her sixteenth birthday. Today I’m offering up a mash-up from these movies to outline what I’m calling the Maleficent 7 – seven inherent human problems and limitations that impede our ability to make good decisions generally and especially about money.

Facts (and Minds) are Stubborn Things

When making his defense of some British soldiers during the Boston Massacre trials in December of 1770, John Adams (later the second President of the United States) offered a famous insight. “Facts are stubborn things; and whatever may be our wishes, our inclinations, or the dictates of our passion, they cannot alter the state of facts and evidence.”  Legal Papers of John Adams, 3:269. In a similar vein, Sen. Daniel Patrick Moynihan once said that “[e]veryone is entitled to his own opinion, but not to his own facts.”

I have often warned about our proclivity to and preference for stories to the exclusion of data (for example, here, here and here). Because stories are so powerful, we want the facts to be neatly packaged into a compelling narrative. Take a look at John Boswell‘s delightful send-up of this technique in the TED context below.

 We crave “wonder, insight [and] ideas.” Facts?  Not so much.

What you’re vacillatin’ between

Francis Paschal

When I was a first-year law student at Duke many years ago, my Civil Procedure professor was the delightfully named J. Francis Paschal. Professor Paschal seemed to like to portray himself as a bit of a good ol’ boy, with a protruding gut, truly dreadful sports jackets, hair slicked and parted just off-center, and a drawl as thick as molasses on a cold day (if not nearly so sweet). That image could not mask a keen mind and a sharp wit. Nor did it hide his erudition — in addition to his credentials in the law, Professor Paschal had a Princeton Ph.D. too.

The good professor led his classes using the Socratic conventions of the day. A student was called upon to answer a series of penetrating and perplexing questions supposedly designed to ferret out the nuances of some legal principle or another but which, in reality, served to demonstrate to a class full of bright and full-of-themselves college graduates that they were out of the minors and into the intellectual big leagues. If we were going to compete at that level, we needed to up our collective game considerably.

One day fairly early in the first semester Professor Paschal called on a woman in the row ahead of me (who I shall kindly refer to — using a pseudonym since she is now a Deputy Attorney General — as “Frieda Clancy”) and asked a typically impossible question. SInce Frieda was a friend, I happened to know that her extremely difficult predicament was actually utterly impossible because she was not prepared for class.  In fact, it wasn’t just that she wasn’t fully prepared (meaning that she had read the required case, all the cases cited therein, the case comments, casebook notes and citations, relevent hornbook and law review materials and anything else we could think of that might be relevant). She wasn’t prepared at all. She hadn’t even read the case at issue.

This was not likely to turn out well.

Phi Beta Football Foibles

On November 24, 1951, Princeton defeated Dartmouth, 13-0, to win its 22^nd straight football game and complete a second consecutive undefeated season for what was described, by the great writer John McPhee, as “Phi Beta Football.” In those days, Princeton still used a then-old, direct snap, pure power offense called the single wing even though most college teams were “mating the quarterback to the center of the line in the formation called ‘T.’” It was also the final game for Princeton tailback and legend Dick Kazmaier, the “Maumee Menace,” a future College Football Hall of Fame inductee and McPhee’s roommate. “Kaz” had been pictured on the cover of Time magazine that week (right) and would soon win the Heisman Trophy (the last Ivy League player to do so) in a landslide. But the game that day is not primarily remembered as having capped off an outstanding season and a brilliant career.

Instead, the legacy of that brisk late autumn afternoon contest rests upon two seemingly unrelated matters: allegations of intentionally dirty play by Dartmouth and our inability to perceive reality with any degree of objective accuracy, especially where we have a major emotional investment. Based upon various sources, the primary narrative from the game is that Dartmouth set out to injure Princeton players – particularly Kazmaier – and that after the Princeton star was injured and forced from the game in the second quarter, matters turned increasingly fractious. But that wasn’t the only proffered narrative.