C&B Notes

Looking in the Mirror

This 1999 speech by Jason Zweig, inspired by his first encounter with Daniel Kahneman (well before Kahneman was a household name), made us want to spend the afternoon rubbing our noses in our biases and common mistakes in an effort to avoid making these same gaffes in the future.  It was also a stark reminder, from a bull market past, of the wealth-destroying inability of so many investors to look much beyond the end of their noses.

You will do a great disservice to yourselves, to your clients, and to your businesses, if you view behavioral finance mainly as a window onto the world.  In truth, it is also a mirror that you must hold up to yourselves.  More worrisome, it is a mirror that magnifies and clarifies and highlights your own warts and imperfections.  After all, it takes no great bravery to look out a window onto the world below and watch the foolish masses aimlessly stumbling nowhere near where they really want to go — while you can see quite clearly, from your lofty vantage point, the simplest and safest path to follow. But it takes a great deal of courage to stare into a mirror and to hold it steady for a long, long time while this image sinks in: Gazing right back at you is someone who relentlessly falls prey to the law of small numbers; to hindsight bias; to over-reaction; to narrow framing; to mental accounting; to status-quo bias; to the inability to evaluate your own future regret; and, most of all, to overconfidence.

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Also, you must continually ask yourselves the most basic possible questions before you buy a stock: How confident can I realistically be that my analysis will turn out to be right?  How have similar analyses worked out for me in the past?  What’s the probability that I could be wrong?  And how prepared am I for the consequences of surprise if I turn out to be wrong?  You’ll be hearing a lot about overconfidence at this conference; take it to heart.  You just don’t know as much as you think you do; none of us do.

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I also think this long bull market has changed the way prospect theory affects investors.  Prospect theory holds that most individuals perceive the pain of loss at least twice as keenly as they feel the pleasure of gains.  But, in this kind of raging bull market, what is a “loss”?  It rarely means losing money.  It might, however, be a diminished gain.  And when risk is coded not as a true loss, but merely as a foregone gain, it becomes much easier for investors to dump an investment.  Instead of kicking themselves, they just kick you instead.  That makes bailing out of an investment — like, say, one of your funds — much easier. For your clients today, firing you is no longer a damaging admission of their own fallibility; after all, they made some money instead of losing it. In short, they’re playing with the house money, as Dick Thaler alluded to earlier.  And that makes firing you easier than ever. That’s why avoiding tracking error has become the prime directive; that’s why relative performance has assumed absolute importance.

In this climate, the agency costs are huge.  If you pick stocks according to the principles of behavioral finance, you’re going to end up with a portfolio that looks nothing like any index. It might be full of dead and dying value stocks, or it might be full of scorching momentum stocks, or it might be full of stocks that keep shocking the daylights out of the analysts.  Whichever approach you choose, in the long run it should make your clients very wealthy. But in the short run, these behavioral strategies may well make you poor — by sending your tracking error shooting straight through the roof, and your clients shooting straight out the door…

Whether you are able to turn the theory of behavioral finance into the practice of superior investment management does not depend on how diligently you master the research of the great minds you’ll hear at this conference.  It depends rather on the strength of your own character, on whether your firm can show the resolve to stand out from the herd and to stick to your strategy when your customers’ dollars are bleeding away by the millions and the billions.  Learning how to invest smarter will do you no good whatsoever unless you are willing to endure the short-term pain of being right in the long run.

That’s why it’s so crucial to realize that behavioral finance is not the study of how “other” people behave.  It is the study of how we all behave.  It is not just a window onto the world; it is also a mirror onto ourselves.  Only if you are willing to use behavioral finance as a mirror — and only if you are willing to pay the necessary price, which is assessed in precious units of self-esteem and foregone management fees — can you really get anything good out of it.  Ultimately, that’s the only way you can pass through the gate.

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