Curb Your Enthusiasm

This is a (slightly adapted) piece I wrote for the Wall Street Journal on behavioural economics. I added a bit of stuff on ancient philosophy which readers of this blog might be interested in.
The Stoic philosopher Epictetus told his students that the wise man “keeps guard against himself as his own enemy, and one lying in wait for him”. Our own selves are so foolish, unconscious and over-emotional, he warned, that anytime you feel a strong impulse to do something you should “guard yourself...against being carried away by it”.

This is a view of human folly shared by the rather younger field of behavioural economics. As James Montier, behavioural economist and member of GMO’s asset allocation team, puts it: “Your own worst enemy when it comes to investment is yourself.”

Behavioural economics has existed as a field since at least the 1970s, but it rose to prominence after the bursting of the bubble in 2000, particularly when Daniel Kahneman, one of its leading thinkers, was awarded the Noble Prize for Economics in 2002.
It has become even more ‘hot’ since the Credit Crunch once again exposed how irrational many of our investment decisions are. Many banks, funds and asset managers now have in-house behavioural economics specialists, and quant teams who claim to run behavioural finance models.

The central idea of behavioural economics is that classical economics is based on the mistaken assumption that humans are perfectly rational calculators of their own utility. In fact, in the words of Dan Ariely, professor of behavioural economics at Duke University and the author of The Upside of Irrationality: “We are more like Homer Simpson.”

Our minds are capable of rationality, according to behavioural psychology, but most of the time they're on auto-pilot, driven by rapid, emotional and automatic responses.

Jim O’Shaughnessy, CEO of O’Shaughnessy Asset Management and a fan of behavioural economics, has long spoken of the need for investors to pursue a 'dispassionate' investing style. He says:Our rapid emotional response system - of fear, greed, hope, and so on - served humans well when we were struggling to survive on the Serengeti, but in the complex environment of the 21st century market, it leads many investors to do exactly the wrong thing at exactly the wrong time - to panic and sell when the market is bottoming out and to get greedy and buy when the market is peaking. Like the Stoics, behavioural psychologists believe many of the mistakes investors make come not from them being 'over-emotional', but from illogical thinking. We process information badly, which leads us to make bad decisions.

Like their cousins, the cognitive behavioural therapists, behavioural economists look for the typical mistakes - or ‘cognitive biases’ - that humans make when interpreting information and making decisions.

The list of such mistakes is endless. There is the confirmatory bias, whereby we seize on evidence that supports our beliefs, while ignoring evidence that conflicts with it. There is the anchoring bias, whereby we become emotionally attached to the price at which we buy an asset, and hold onto it in the hope it will one day rise above this price, even if it is clearly heading south.

There’s the authority bias, whereby we tend to believe information that comes from authoritative sources, like the Federal Reserve for example. There’s the attention bias, whereby investors tend to buy stocks that were recently mentioned in the news - regardless of whether the news was positive or negative.

There are many, many more such biases, which have been tested out and proven in laboratory and field experiments. So what practical help is the knowledge of these biases?
From a seller’s perspective, it can help to know how to appeal to these biases, in order to ‘nudge’ your client and sell your product. For example, humans are prone to the narrative fallacy - they tend to fit complex and confusing data into simple ‘stories’. That means investment bankers need to be story-tellers as much as maths experts.

If you’re a more honest fund manager or wealth advisor, you can use behavioural economics to better understand your client’s typical emotional responses, to try and tailor investment solutions that counter-act their biases.

Greg Davies, head of behavioural finance at Barclays Wealth, says: “We do psychometric tests to see how emotional a client is in investing. If they’re very emotional, and tend to over-react at the top and bottom of the market, we suggest using products that provide short-term smoothing, to eliminate short-term volatility.”

From a buyer’s perspective, in the words of Dan Ariely, “the great hope of behavioural economics is that learning about these biases will make us less likely to fall into them, and capable of more rational decision-making.”

This might be a big hope. Gerald Ashley, managing director of the risk consultancy St Mawgan & Co, and the author of Financial Speculation: Trading Financial Biases and Behaviour, says: “It’s not certain that you can train yourself to overcome these biases.” Besides, as James Montier of GMO has discovered, most investors admit such biases exist, but only in other people.

And yet there are some simple ways investors can try to defend themselves against their own folly. One way is to trade less.

Terrence Odean, professor of behavioural economics at the University of Berkeley, says: “We’ve shown in a study that investors who trade more actively tend to less well than more passive investors.” That’s probably because active investors, who check their portfolios every day and trade inter-day or inter-week, are making more emotional, instinctive and short-term reactions to short-term volatility.

You might also want to read less. Investors are bombarded with information, with highly emotive market ‘noise’, which can actually make it harder to make sensible decisions. James Montier suggests creating moments of monastic silence, in which one switches off one’s Blackberry, and one’s Bloomberg and Reuters terminals, and quietly reflect on one’s investment strategy.

You can try and track your own typical biases, to be more aware of them. Just as ancient philosophers (and modern cognitive therapists) advised that students use 'thought journals' to track our emotional habits, so some behavioural economists advise using 'investment journals', in which one tracks and reviews one's decisions. Try to set an investment framework, an impersonal constitution or set of rules and habits, that you adhere to, even in the most emotional moments. Sir John Templeton, for example, put standing orders on stocks in advance, telling brokers to buy them when they hit lows and sell them when they hit highs. He gave the orders in advance because he knew he wouldn’t have the strength to make the orders when the market was either panicking or rejoicing around him.

You can also set checks on your own impulses. Terrence Odean says: “Electronic trading has made investing a lot quicker and more seamless. But this is not entirely a good thing. Friction and obstacles can be a good check on impulsive behaviour. Investors can create these sorts of checks for themselves, like speed bumps.”

Greg Davies at Barclays Wealth says: “A good metaphor is Ulysses and the sirens. Ulysses knew that, when his ship was sailing past the sirens, he would be unable to resist their song. So he had himself tied to the mast, and stopped up his sailors’ ears. He took steps in advance to curb his enthusiasm.”

For investors, a siren-resistant strategy could be as simple as, for example, only taking investment decisions once a month.

In ancient philosophical terms, investors should seek perhaps to cultivate a Sceptic attitude to your own and other people's beliefs, avoiding over-certainty or over-reliance on models. Nicholas Nassim Taleb, himself an avowed follower of the Sceptic philosophy, calls this avoiding Platonic thinking.

This Sceptic attitude means investors should be wary of any experts who claim to be able to predict human behaviour too accurately. And that includes behavioural economists. There’s always the danger that behavioural economics will itself become the latest dogma, or the latest science used to dazzle credulous investors.

You can also embrace the Cynic attitude of 'defacing the currency', which means not believing the hype that companies try to sell you, but instead looking to pierce through the conventional labelling to the actual behaviour of a company. Appropriately enough, the investment fund that first exposed Enron for the over-hyped and dishonest fraud it was, was a fund called Kynikos Associates, named after the followers of Diogenes.

In general, you can try to be wary of the enemy of your self, and to cultivate a dispassionate, rational, 'Stoic' approach in your own investments, or to put your money into funds that also try and follow such an approach. But be careful of false labelling. One fund, called Stoic Capital, claimed to follow a Stoic-like approach to investing. The fund turned out to be a fraud.