Today we have a very interesting guest post from Tom, founder and editor of High Income Parents. He is a doctor and father of five with a passion for parenting and finance. When he isn’t skateboarding, riding BMX, or jumping on the trampoline with his kids, he is reading and writing about personal finance. The goal of the site is to help high income parents educate and mentor their kids to become financially, emotionally, and intellectually self-sufficient. Enjoy the read!
Have you ever heard of a heuristic? A psychologist named Herbert A. Simon first described the notion. Two other famous psychologists named Amos Tversky and Daniel Kahneman (Danny) later popularized the concept.
Danny and Amos are two Israeli psychologists who couldn’t be more different in personality. Amos was the life of the party and did whatever he wanted. Danny didn’t go to parties and was constantly trying to please everyone. Amos looked at every idea and tried to disprove it. Danny tried to find the factual and valid part of any idea before dismissing it.
The beautiful thing is these two professors of psychology came together to work on some amazing theories and popularized the idea of heuristics.
A heuristic is an approach to problem-solving or learning that is practical but might not provide a definitive solution. When a problem is complex, often you don’t have all the details. You use what you have. What you have is rule of thumb, an educated guess, an intuitive judgment, stereotyping, profiling, or common sense.
These two innovators learned that you could easily control people’s answers and judgment due to bias. The general public’s preconceived notions of how to solve a problem were clouded based on how the researcher presented the problem.
Image a scenario where you see a grown man about to cut into a small girl with a knife. Do you try to stop him? Do you run for help? What if I told you that the man is in an operating room and the small girl has a heart defect? He is the girl’s surgeon and is there to repair the defect. Does that change your mind?
We use the information we have to make the decisions we make. If we don’t have sufficient information then we can make some bad decisions. There are plenty of opportunities to make decisions without sufficient information when it comes to investing and financial planning.
Heuristics can be applied to financial decisions and the way that we invest our money. For instance, look at each generation. The greatest generation lived through a depression and fought a world war. They watched as their family and friends couldn’t find work and then had to go fight. They left their families to take care of the home and hope for their return. Their outlook on investing in the stock market was a low priority. They viewed the market as a dangerous place.
After the Greatest Generation returned and started having children, the Baby Boomers were born. When they entered their careers, it was the start of the greatest bull market of all times. They were excited and optimistic to invest in the stock market. They see it as a wealth building tool.
The gen-X-ers come after the boomers. The gen-X-ers got their start investing right at the tech bubble burst. Then they rode out a lost decade and finished it with a housing collapse. As you can imagine the X-ers are skeptical. They saw the greed and competition of their parents lead to a Great Recession and anemic market returns.
The Millennials are just now starting their careers and the older members had their first taste of investing during the Great Recession market collapse. The are hesitant and fearful of another market event that would squash their meager savings at this point. Unfortunately, so many of them are hamstrung by debt that the thought of investing only exists in a fairytale land.
The reality is that the market remained a great vehicle to accumulate wealth throughout all of these generations. With dividend reinvested and continued contributions, any person in each generation could grow wealth through buying stock.
Why do so many people have different views of the same market? One of the answers is hindsight bias. They only see what just happened and think that future events will mirror previous events. Some people think that because the stock market or a particular mutual fund has performed well, that fund should continue to perform well. The opposite could also be true.
Some people may think they are better at some things than they really are. They may also think they are worse at some things than they really are. This is where subjective probability comes in. Subjective probability is when a person assigns odds to an event based on their beliefs and experiences. Depending on the data you give or the way you ask the question, you can influence subjective probability.
For example, say you have a man that is retiring from work. Others characterize him as shy, quiet and secluded. You are asked whether you think he is a computer programmer or a salesman. Most of you would probably guess he is a computer programmer because most people associate an introverted personality with a computer programmer rather than a salesman.
Then what if I told you that there are 100 salesmen for one computer programmer. Then what would you guess as the profession of the man retiring? If you valued the probabilities, it is 100 times more likely that the man is a salesman because there are 100 times more salesmen. This is a problem called insensitivity to the base rate. Lots of us will let one piece of data cloud our judgment and not factor in some other pieces of data that have much more weight in the decision.
I ask you this question.
How do you go about picking the top funds you think will perform better than their benchmark? If you know that 86% of funds underperform their benchmarks you then know you are already behind the eight ball. Does that change how you would go about picking the funds?
Say you decide to pick the top 25% of funds and ride those out for the next five years. If you look at the top 2,862 funds and hold them over the next five years, how many will still be in the top 25% and outperforming the S&P 500 after 5 years? If you simply take the top 25% of this group of funds each year, by random chance, they should have had three funds finish in the top quartile each year. In reality, only two funds finished in the top 25% after five years. If you extended it on to the sixth year even those two funds looked to drop out.
Efficient Market Theory
Now let’s look at the other side. Some people see the stock market as a random walk. This was popularized in 1973 when author Burton Malkiel wrote “A Random Walk Down Wall Street.” This is also sometimes called the efficient market theory. They think the market prices will either go up or down due to random and unforeseeable reasons. They say all information is priced into the stocks in the market and therefore no one could exploit this to gain a higher return.
The people that ascribe to this method may think that because a stock or fund has made a long run up and deviated from the mean, it is time for the fund to drop. The opposite may be true as well in their minds. These investors would be contrarians and bet on the fund to regress back to the mean. That means for any stock or fund that outperforms or underperforms its peer, the fund is destined to fall back or climb up to the average.
This was demonstrated in jet pilots in the Israeli army. Commanders noticed that when a pilot had not performed the maneuvers up to standard in the previous days training exercises if they scolded the pilot they would perform better on the next outing. The same was true of pilots that performed a maneuver exceptionally well. If they were praised, the next time out they would fall back with everyone else and complete the maneuvers worse than before.
The commanders naturally thought that their expert advice and scolding or praising caused the behavior. In reality, if the commanders had said nothing at all the pilots would have behaved the exact same way because of regression to the mean.
The Gambler’s Fallacy
The gambler’s fallacy can explain the same effect. The gambler’s fallacy states that when a sequence of events deviates from the norm, the future events are expected to smooth out the sequence. For instance, I tell you that there are equal numbers of baby boys and baby girls born. We watch the birth records of a hospital and see that ten boys were born in a row one day. If I asked you to bet on the gender of the next baby born what is your inclination? If you are like most people you predict that a baby girl is more likely to be born next. The truth is the probability remains the same value, 50/50.
Our Own Worst Enemy
The truth of the matter is that the average investor produces inferior returns compared to the average market return. For the twenty years ending 12/31/2015, the S&P 500 Index averaged 9.85% a year. The average equity fund investor averaged only 5.19%. That is pretty consistent over the years. It usually fluctuates between 4% and 5%. Even when an investor invests in the funds that return the highest returns, they don’t achieve those returns due to psychological biases and poor judgment.
Are We Totally Hosed?
So we have established that we can’t look at the way a stock or fund has performed in the past and trust that it will continue to perform that way. We have also found that we can’t look at a stock or fund and predict that it will change directions because it has been performing a certain way.
How then do we choose the right investment? If you can’t choose to go against the trend and you can’t choose to continue the trend, then how do you invest and get the greatest gain?
Meet Dr. Goldberg
This goes back to another psychologist. Dr. Lewis Goldberg earned his Ph.D. in psychology from the University of Michigan in 1958. Complex decision making interested him. I think we can all agree that picking the right stock or mutual fund is a complex decision-making process if you are trying to pick the best of the best.
Dr. Goldberg set out to create an algorithm for selecting the right answer to a complex problem. He chose the task of proving an algorithm to diagnose stomach cancer with x-rays. He went directly to the radiologists and asked them how they diagnose stomach cancer on an x-ray. They gave him seven criteria they analyzed for each x-ray to determine if a patient had stomach cancer or not.
He thought he would develop a basic model or algorithm and then later need to adapt his model to include other criteria and judgments to approach the success rate of the doctors’ ability to diagnose cancer.
He was a little sneaky though. Goldberg and his team would show x-rays of the patient to the radiologists. Later in the session, the researchers would slip the previous patients’ films back in the stack. He was trying to figure out not only the judgment of the seven criteria discussed earlier but also the additional less obvious judgments each doctor was making.
There were a few findings that blew Goldberg away.
- The radiologists would not agree with each other about the severity of various x-ray diagnostic criteria. Each radiologist could inject his biases into the reasoning behind each diagnosis. I was not all that surprised that several doctors would disagree on diagnosis but it shows that there was a subjective component to their decision making.
- The researcher also would reincorporate the same images from the same patient later on in the review period. The amazing part about this is the same radiologist would give a different diagnosis than he just had done earlier in the day. He didn’t realize that the image was a repeat of the same patient. The radiologist would contradict himself.
- Once they sent the data for analysis between the simple algorithm and the diagnoses of the radiologist, it turned out that the simple algorithm did a better job of diagnosing stomach cancer than the radiologist. The model needed no further complex additions to achieve a superior outcome.
The outcome could be different today since this study occurred before doctors concentrated on evidence-based medicine. The move to evidence-based medicine has helped doctors improve how they think about treating patients. We are now taught to look at the data and not jump to our own conclusions about diagnoses and treatment without considering the results of properly done studies. I don’t know that the same results would occur if the study were repeated today because of the emphasis on evidence or data-driven treatment and diagnoses.
Data and Investing
Investing follows similar patterns. Many active fund managers develop their own criteria for investing. They don’t always line up with the evidence that benefits the investor. Many fund managers have external forces that can compromise even their own investing rules. There are many instances where random probability beats professional active fund managers. Investors are paying higher fees to have actively managed funds and end up getting inferior results.
If money flow into the fund is high, the fund manager may have to put funds to work in inferior investments just so he can say the funds are working. If money flows out of the fund, the manager may need to sell investments when they are down just to cover the outflow responsibilities. As a fund succeeds, often more and more money flows in. Sometimes, success is its own worst enemy because the manager has too much to manage for the philosophy or system that he employs. Then returns start to dip.
Why do we make the decisions we do?
The next question is why would anyone choose an actively managed fund. I think we can answer this by asking someone what he prefers between these two choices.
- Take a sure $5000 loss
- Flip a coin to either lose $10,000 or $0
Overwhelmingly Tversky and Kahneman showed that when looking at a loss, people will take more risk to avoid that loss.
If we turned the question around and asked:
- Take a sure $5000 gain
- Flip a coin between $0 and $10,000 gain
Most people would prefer to take the sure thing. I think, when it comes to investing, some people feel a sense of loss if they aren’t part of the group beating the averages (indexes) no matter how small that group is. This is why active fund managers will always have a place in the marketplace in my opinion.
We can’t escape our own psychology
The reason I go through all this is we can make better financial decisions once we know the biases we are combating. Once we separate emotion from our decision making we are more likely to make the decisions with the highest probability of investment gain.
Even some of the most ardent index investors keep a small “play money” account in which they try to beat the market. They know full well that contributing every last cent to the investment in the widely diversified index funds with low expense ratios has shown the highest returns. We just can’t relinquish the fact that someone else might be making more money than us.
I think it is similar to a salesman getting a year-end bonus and expecting $10,000. If he received only $5,000 he feels a sense of loss. If he receives $10,000 then he feels adequately compensated, that is until he finds out another salesman received $20,000. Then he feels the loss even though moments before he felt adequately compensated.
We cannot remove our emotions and biases from our decisions. The best thing we can do is subscribe to the algorithm that fits best with our personality and appetite for risk. Then we need to adhere to that algorithm through thick and thin. This will give us the best results over the long run.