Here are three important questions Chad Slater answers to help you better understand the world of behavioural finance and how investors can utilise its lessons.
To paraphrase from an excellent mind management book, The Chimp Paradox: “to control your inner chimp, you first have to understand him/her”. In reality, this means understanding that your brain makes decisions that are not always in your best interest and the best way to manage your mind is to set rules around certain behaviours to minimize your inner chimp controlling you (you can’t ever rid yourself of your inner chimp).
An example is to set buy/sell rules in advance (loss aversion and diminished sensitivity to gains and losses), knowing that you are likely to be scared/ euphoric if the price falls/rises and your chimp will be running on adrenalin controlling you. A second example could be to understand your “nearness bias” – whereby you tend to rely more heavily on data or anecdotes you can recall. Write an alternate thesis down and test that.
Our firm is, and always has been, a heavy user of the principles of behavioural economics. I attended a university that focused on heterodox economics, rather than the model of the perfectly rational human taught at “neoclassical economics” (Chicago schools) which behavioural economics repudiated to some degree. As a result, I built a process to incorporate these principles, so part of me is gratified (vindicated?) seeing first Kahneman & Tversky and now Thaler recognised for their contributions.
The most obvious implementation is that of stop-loss rules across the firm. This is to stop loss aversion turning into “gamblers ruin”.
A lesser obvious one is “do you really need more information?”. Studies have shown that confidence levels rise the more work that is done on a stock, as supporting evidence is found, but success levels plateau and then fall (Figure 1). Perversely, some level of uncertainty about not knowing the answer actually makes the analyst better!
Source: Psychology of Intelligence Analysis, Centre for the Study of Intelligence
I think the biggest anchoring to old information that’s taken place and which is having the largest effect: Central Banks are using mental models of inflation that are 20 years old and don’t work – and haven’t worked for many years!
These central bankers nearly uniformly attended the aforementioned “neoclassical schools” (Yellen’s thesis was “Employment, Output and Capital Accumulation in an Open Economy: A Disequilibrium Approach”) where credit doesn’t matter in their inflation models. In their quest to target something that is largely beyond their control – the US or Australian CPI is driven by automation and globalization – to fight the memories of inflation from their youth, they have created one of the largest credit bubbles the world has ever seen.
You can read the original Q&A here.
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Two books I recommend to better understand behavioral economics are “predictably irrational” by Daniel Ariely and “thinking fast and slow” by Daniel Kahneman. Having read both these books I feel I have become a better investor. “Misbehaving” by Richard Thaler is a nice history of behavioral economics.