Updated: May 25
I’ve been writing quarterly articles for Trustnet over the last couple of years. The first four were on the subject of ‘investment risk’, the second four on ‘value investing’. This year, I will be writing four pieces on the subject of ‘behavioural investing’ (and the related topics of ‘behavioural economics’ and ‘behavioural finance’).
"We filter to survive, but this filtering can cause problems"
It is irrational human behaviour that links these three areas of study. Until fairly recently it was believed that our choices and decisions were always optimal or rational. Robert Shiller, Daniel Kahneman, Amos Tversky, Shane Frederick and Richard Thaler among many others have in recent decades shown us just how wrong this assumption was and how irrational we humans can be.
This makes sense when you understand that what we think of as objective reality is not objective at all. We use our senses to perceive the world around us, whether sight, smell, touch or indeed consciousness or awareness itself. These processes happen in our brains and so the world around us as we perceive it is inside us not outside us (by definition, you cannot perceive reality without using your perception - I suggest you give it a try!). Thus reality is subjective not objective.
And our perception is naturally imperfect. Imagine how hard each day would be if you could perceive every single smell or noise within a five-mile radius. We filter to survive, but this filtering can cause problems. These filters can be thought of as mental shortcuts or rules of thumb, the technical term for which is heuristics. And mental shortcuts drive 95% of our decisions.
There are many recognised heuristics. One example is the availability heuristic. This short cut is used to make judgments about the probability of events by calling on examples that spring to mind. If I told you that the probability of two people in a room of thirty having the same birthday was 71%, I suspect you’d be surprised. What you – or rather your brain! – probably did was work out that probability of two people in a room of two having the same birthday was very low and multiply that by 30 to arrive at ‘low’.
All individuals use a combination of two brain processes to answer these sorts of questions, the “X-system” and the “C-system”. The former is the default option — a spontaneous response — while the latter is reflective, requiring a deliberate, conscious effort.
Yale professor Shane Frederick designed what he called the cognitive reflection test (CRT) to brutally expose the flaws in our thinking. The test involved the below three questions.
A bat and a ball cost $1.10 in total. The bat costs $1.00 more than the ball. How much does the ball cost? _____ cents
If it takes 5 machines 5 minutes to make 5 widgets, how long would it take 100 machines to make 100 widgets? _____ minutes
In a lake, there is a patch of lily pads. Every day, the patch doubles in size. If it takes 48 days for the patch to cover the entire lake, how long would it take for the patch to cover half of the lake? _____ days
The CRT was designed to measure the extent to which people are able to interrupt their more instinctive X-system response, and replace it with the slower, but more logical, C-system process, to produce the correct answer. Turns out, it is harder than you might think (answers at the end of this letter).
Frederick carried out the test at 11 locations on more than 3,000 individuals — mostly students — and found that they averaged just 1.24 correct answers. His results, detailed in his 2005 paper Cognitive Reflection and Decision Making, are instructive at several levels.
For example; those who incorrectly answered the first question thought that 92 per cent of people would answer it correctly. Those that did answer it correctly thought that just 62 per cent of respondents would get it right.
The point here is that people whose X-system is dominant — that is the ones who answered instinctively, and therefore incorrectly — have an over-inflated sense of confidence, misreading the difficulty of challenges.
The X-system response served us humans very well in certain ‘life and death’ situations. When faced with a sabre-toothed tiger, it wouldn’t generally have been a good idea to sit back and slowly weigh up all the options. You might have got to “Run away as fa...”.
But it does get in the way when it comes to investing.
One thought flaw that manifests itself frequently when it comes to investment decisions is the inability to distinguish between ‘pattern’ and ‘noise’. There are countless issues that people worry about and that thus may play a role in their investment decisions, whether Brexit, Trump, Little Rocket Man, Catalonia, hacking, fracking, disappearing bees, killer bees, killer Frisbees, knocking knees, chopped down trees or micro beads.
You may well want to care more for the environment which most would agree without any doubt whatsoever is a good thing to do.
However, believing that issues that are broadcast incessantly by a profit-incentivised media will have a negative impact on financial markets will more often than not be a mistake. The reality is that they either do not have any noticeable effect or if they do it’s too late to do anything about it. In other words – it’s ‘noise’.
A good example of this is Brexit.
On the face of it, our funds were horribly positioned for Brexit. We had no exposure to safe haven bonds, limited foreign currency exposure and our UK equities were mostly mid-caps. In the days following the referendum vote on 23 June 2016, bond yields, sterling and mid-caps all plummeted.
The chart below shows the performance of our income fund relative to the average of its peer group (the IA Mixed Investment 20- 60% Shares sector).
The referendum vote is viciously apparent on the chart. But what is also apparent is that the fund outperformed its sector by a very respectable 8 percentage points over the entire five years (and it did this with lower than sector average volatility not higher).
Brexit fears played no part in our investment thinking and continue to play no part. We changed nothing ahead of the vote and nothing after. I as asset allocation specialist believed like most that the country would vote to remain. I was wrong but it didn’t matter. What mattered was that we remained calm and rational and, as before the vote, changed nothing after it. In fact, our fixed target weight system meant that we were buying mid-caps and sterling in the days, weeks and months following the vote, as market movements took us underweight target. These actions significantly boosted fund performance over the last year and a half (we couldn’t sell Gilts as we didn’t have any but that too would have been a great thing to do).
As asset allocation specialist, my focus is on the business cycle, taking advantage of the fact that different financial asset classes exhibit distinctive performance at each of the four stages: expansion, peak, recession and recovery. If you can gauge where you are on the cycle, which you can by looking at simple things like employment and inflation, you can use business cycle analysis to make informed predictions about how financial markets will behave over the next few years. Pattern. Not noise. Simple really.
Published in Investment Letter, March 2018
Answers to cognitive reflection test:
1. 5 cents
2. 5 minutes
3. 47 days
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.