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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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This is especially true for the market, since investors beliefs about stocks or a method of picking them can become a self-fulfilling prophecyThe anchoring effect is not the only way in which our faculties are clouded. The availability error is the inclination to view any story, whether political, personal, or financial, through the lens of a superficially similar story that is psychologically available. Thus every recent American military involvement is inevitably described somewhere as another Vietnam. Political scandals are immediately compared to the Lewinsky saga or Watergate, misunderstandings between spouses reactivate old wounds, normal accounting questions bring the Enron-Andersen-WorldCom fiasco to mind, and any new high-tech firm has to contend with memories of the dot-com bubble. As with anchoring, the availability error can be intentionally exploited. The anchoring effect and availability error are exacerbated by other tendencies. Confirmation bias refers to the way we check a hypothesis by observing instances that confirm it and ignoring those that dont. We notice more readily and even diligently search for whatever might confirm our beliefs, and we dont notice as readily and certainly dont look hard for what disconfirms them. Such selective thinking reinforces the anchoring effect: We naturally begin to look for reasons that the arbitrary number presented to us is accurate. If we succumb completely to the confirmation bias, we step over the sometimes fine line separating flawed rationality and hopeless closed-mindedness. Confirmation bias is not irrelevant to stock-picking. We tend to gravitate toward those people whose take on a stock is similar to our own and to search more vigorously for positive information on the stock. When I visited WorldCom chatrooms, I more often clicked on postings written by people characterizing themselves as strong buys than I did on those written by strong sells. I also paid more attention to WorldComs relatively small deals with web-hosting companies than to the larger structural problems in the telecommunications industry. The status quo bias (these various biases are generally not independent of each other) also applies to investing. If subjects are told, for example, that theyve inherited a good deal of money and then asked which of four investment options (an aggressive stock portfolio, a more balanced collection of equities, a municipal bond fund, or U.S. Treasuries) they would prefer to invest it in, the percentages choosing each are fairly evenly distributed. Surprisingly, however, if the subjects are told that theyve inherited the money but it is already in the form of municipal bonds, almost half choose to keep it in bonds. Its the same with the other three investment options: Almost half elect to keep the money where it is. This inertia is part of the reason so many people sat by while not only their inheritances but their other investments dwindled away. The endowment effect, another kindred bias, is an inclination to endow ones holdings with more value than they have simply because one holds them. Its my stock and I love it. Related studies suggest that passively endured losses induce less regret than losses that follow active involvement. Someone who sticks with an old investment that then declines by 25 percent is less upset than someone who switches into the same investment before it declines by 25 percent. The same fear of regret underlies peoples reluctance to trade lottery tickets with friends. They imagine how theyll feel if their original ticket wins. Minimizing possible regret often plays too large a role in investors decisionmaking. A variety of studies by Tversky, Kahneman, and others have shown that most people tend to assume less risk to obtain gains than they do to avoid losses. This isnt implausible: Other research suggests that people feel considerably more pain after incurring a financial loss than they do pleasure after achieving an equivalent gain. In the extreme case, desperate fears about losing a lot of money induce people to take enormous risks with their money. Consider a rather schematic outline of many of the situations studied. Imagine that a benefactor gives $10,000 to everyone in a group and then offers each of them the following choice. He promises to a) give them an additional $5,000 or else b) give them an additional $10,000 or $0, depending on the outcome of a coin flip. Most people choose to receive the additional $5,000. Contrast this with the choice people in a different group make when confronted with a benefactor who gives them each $20,000 and then offers the following choice to each of them. He will a) take from them $5,000 or else b) will take from them $10,000 or $0, depending on the f l ip of a coin. In this case, in an attempt to avoid any loss, most people choose to flip the coin. The punchline, as it often is, is that the choices offered to the two groups are the same: a sure $15,000 or a coin flip to determine whether theyll receive $10,000 or $20,000. Alas, I too took more risks to avoid losses than I did to obtain gains. In early October 2000, WCOM had fallen below $20, forcing the CEO, Bernie Ebbers, to sell 3 million shares to pay off some of his investment debts. The WorldCom chatrooms went into one of their typical frenzies and the price dropped further. My reaction, painful to recall, was, At these prices I can finally get out of the hole. I bought more shares even though I knew better. There was apparently a loose connection between my brain and my fingers, which kept clicking the buy button on my Schwab online account in an effort to avoid the losses that loomed. Outside of business, loss aversion plays a role as well. Its something of a truism that the attempt to cover up a scandal often leads to a much worse scandal. Although most people know this, attempts to cover up are still common, presumably because, here too, people are much more willing to take risks to avoid losses than they are to obtain gains. Another chink in our cognitive apparatus is Richard Thalers notion of mental accounts, mentioned in the last chapter. The Legend of the Man in the Green Bathrobe illustrates this notion compellingly. It is a rather long shaggy dog story, but the gist is that a newlywed on his honeymoon in Las Vegas wakes up in bed and sees a $5 chip left on the dresser. Unable to sleep, he goes down to the casino (in his green bathrobe, of course), bets on a particular number on the roulette wheel, and wins. The 35 to 1 odds result in a payout of $175, which the newlywed promptly bets on the next spin. He wins again and now has more than $6,000. He bets everything on his number a couple more times, continuing until his winnings are in the millions and the casino refuses to accept such a large bet. The man goes to a bigger casino, wins yet again, and now commands hundreds of millions of dollars. He hesitates and then decides to bets it all one more time. This time he loses. In a daze, he stumbles back up to his hotel room where his wife yawns and asks how he did. Not too bad. I lost $5. Its not only in casinos and the stock market that we categorize money in odd ways and treat it differently depending on what mental account we place it in. People who lose a $100 ticket on the way to a concert, for example, are less likely to buy a new one than are people who lose $100 in cash on their way to buy the ticket. Even though the amounts are the same in the two scenarios, people in the former one tend to think $200 is too large an expenditure from their entertainment account and so dont buy a new ticket, while people in the latter tend to assign $100 to their entertainment account and $100 to their unfortunate loss account and buy the ticket. In my less critical moments (although not only then) I mentally amalgamate the royalties from this book, whose writing was prompted in part by my investing misadventure, with my WCOM losses. Like corporate accounting, personal accounting can be plastic and convoluted, perhaps even more so since, unlike corporations, we are privately held. These and other cognitive illusions persist for several reasons. One is that they lead to heuristic rules of thumb that can save time and energy. Its often easier to go on automatic pilot and respond to events in a way that requires little new thinking, not just in scenarios involving eccentric philanthropists and sadistic experimenters. Another reason for the illusions persistence is that they have, to an extent, become hardwired over the eons. Noticing a rustle in the bush, our primitive ancestors were better off racing away than they were plugging into Bayes theorem on conditional probability to determine if a threat was really likely. Sometimes these heuristic rules lead us astray, again not just in business and investing but in everyday life. Early in the fall arrested a man who owned a white van, a number of rifles, and a manual for snipers. It was thought at the time that there was one sniper and that he owned all these items, so for the purpose of this illustration lets assume that this turned out to be true. Given this and other reasonable assumptions, which is higher-a) the probability that an innocent man would own all these items, or b) the probability that a man who owned all these items would be innocent? You may wish to pause before reading on. Most people find questions like this difficult, but the second probability would be vastly higher. To see this, let me make up some plausible numbers. There are about 4 million innocent people in the suburban Washington area and, were assuming, one guilty one. Lets further estimate that ten people (including the guilty one) own all three of the items mentioned above. The first probability-that an innocent man owns all these items-would be 9/4,000,000 or 1 in 400,000. The second probability-that a man owning all three of these items is innocent-would be 9/10. Whatever the actual numbers, these probabilities usually differ substantially. Confusing them is dangerous (to defendants). Self-Fulfilling Beliefs and Data Mining Taken to extremes, these cognitive illusions may give rise to closed systems of thought that are immune, at least for a while, to revision and refutation. (Austrian writer and satirist Karl Kraus once remarked, Psychoanalysis is that mental illness for which it regards itself as therapy.) This is especially true for the market, since investors beliefs about stocks or a method of picking them can become a self-fulfilling prophecy. The market sometimes acts like a strange beast with a will, if not a mind, of its own. Studying it is not like studying science and mathematics, whose postulates and laws are (in quite different senses) independent of us. If enough people suddenly wake up believing in a stock, it will, for that reason alone, go up in price and justify their beliefs. A contrived but interesting illustration of a self-fulfilling belief involves a tiny investment club with only two investors and ten possible stocks to choose from each week. Lets assume that each week chance smiles at random on one of the ten stocks the investment club is considering and it rises precipitously, while the weeks other nine stocks oscillate within a fairly narrow band. George, who believes (correctly in this case) that the movements of stock prices are largely random, selects one of the ten stocks by rolling a die (say an icosehedron-a twenty-sided solid-with two sides for each number). Martha, lets assume, fervently believes in some wacky theory, Q analysis. Her choices are therefore dictated by a weekly Q analysis newsletter that selects one stock of the ten as most likely to break out. Although George and Martha are equally likely to pick the lucky stock each week, the newsletter-selected stock will result in big investor gains more frequently than will any other stock. The reason is simple but easy to miss. Two conditions must be met for a stock to result in big gains for an investor: It must be smiled upon by chance that week and it must be chosen by one of the two investors. Since Martha always picks the newsletter-selected stock, the second condition in her case is always met, so whenever chance happens to favor it, it results in big gains for her. This is not the case with the other stocks. Nine-tenths of the time, chance will smile on one of the stocks that is not newsletter-selected, but chances are George will not have picked that particular one, and so it will seldom result in big gains for him. One must be careful in interpreting this, however. George and Martha have equal chances of pulling down big gains (10 percent), and each stock of the ten has an equal chance of being smiled upon by chance (10 percent), but the newsletter-selected stock will achieve big gains much more often than the randomly selected ones. Reiterated more numerically, the claim is that 10 percent of the time the newsletter-selected stock will achieve big gains for Martha, whereas each of the ten stocks has only a 1 percent chance of both achieving big gains and being chosen by George. Note again that two things must occur for the newsletter-selected stock to achieve big gains: Martha must choose it, which happens with probability 1, and it must be the stock that chance selects, which happens with probability 1/10th. Since one multiplies probabilities to determine the likelihood that several independent events occur, the probability of both these events occurring is 1 x 1/10, or 10 percent. Likewise, two things must occur for any particular stock to achieve big gains via George: George must choose it, which occurs with probability 1/10th, and it must be the stock that chance selects, which happens with probability 1/10th. The product of these two probabilities is 1/100th or 1 percent. Nothing in this thought experiment depends on there being only two investors. If there were one hundred investors, fifty of whom slavishly followed the advice of the newsletter and fifty of whom chose stocks at random, then the newsletterselected stocks would achieve big gains for their investors eleven times as frequently as any particular stock did for its investors. When the newsletter-selected stock is chosen by chance and happens to achieve big gains, there are fifty-five winners, the fifty believers in the newsletter and five who picked the same stock at random. When any of the other nine stocks happens to achieve big gains, there are, on average, only five winners. |
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