{"id":8767,"date":"2020-11-17T00:01:49","date_gmt":"2020-11-17T05:01:49","guid":{"rendered":"http:\/\/www.jasonapollovoss.local\/?p=8767"},"modified":"2020-11-16T15:18:53","modified_gmt":"2020-11-16T20:18:53","slug":"a-theory-of-behavioral-finance-assumption-1-a-combination-of-factors","status":"publish","type":"post","link":"https:\/\/jasonapollovoss.com\/web\/2020\/11\/17\/a-theory-of-behavioral-finance-assumption-1-a-combination-of-factors\/","title":{"rendered":"A Theory of Behavioral Finance \u2013 Assumption 1 \u2013 A Combination of Factors"},"content":{"rendered":"

Last week I published A THEORY OF BEHAVIORAL FINANCE<\/a><\/span> which was a high-level description of my theory. In that work I promised to explore each of my assumptions in greater depth. This week, therefore, I deepen the discussion around Assumption 1 that posited:<\/span><\/p>\n

Human behavior is a complex combination of multiple factors that must be considered in total to glean insight, these primary factors are:<\/span><\/p>\n

 <\/p>\n

    \n
  1. Biological, with energy and time conservation being the drivers of these factors<\/span><\/li>\n
  2. Psychological, with the level of self-awareness being the driver of these factors<\/span><\/li>\n
  3. Sociological, with the level of social pressures and the level of self-awareness being the drivers of these factors<\/span><\/li>\n
  4. Immediacy of decision making, with time horizon being the driver of these factors<\/span><\/li>\n<\/ol>\n

     <\/p>\n

    I stated in my previous article that one of the things that makes my Theory unique is the recognition that multiple sciences must be invoked in order to explain something as complex as behavioral bias. Previous proposed models of behavioral bias have tried to describe too much with too little, in my opinion. But that is not the only thing missing from other attempts to explain behavioral bias.<\/span><\/p>\n

     <\/p>\n

    Behavioral Bias Examples<\/span><\/strong><\/span><\/p>\n

    To demonstrate that multiple scientific disciplines are needed to explain behavioral bias it is helpful to consider situations in which the evidence of the bias defies any one science\u2019s ability to fully describe its effects. Biological factors tend to focus on things like energy conservation where quick instinctual thinking reduces the energy drain that is key to deep thought. In other words, survival of the quickest and fittest. Sociological reasons likely have a large overlap with biological ones. Namely, the reason I make personal sacrifices in a group setting is that I am more likely to survive if a part of a pack of people. However, psychological factors, so frequently a major part of behavioral biases, are also so frequently a part of too much deliberation\/energy inefficiency.<\/span><\/p>\n

    Let us look at the classic behavioral biases one-by-one in brief to demonstrate that a more holistic view is necessary to fully explain their effects.<\/span><\/p>\n

     <\/p>\n

    Loss Aversion<\/span><\/a><\/span><\/p>\n

    Here, people feel the pain of loss approximately twice as great as the pleasure from gain. Biology serves as a strong explanation for this bias. In the ancient world when confronted with uncertainty it was better to run first and think about what happened second, lest that sabre-tooth tiger eat you at the watering hole.<\/span><\/p>\n

    However, I have worked with firms that believe that they make most of their money by preserving capital, first, and by earning excess returns, second. In other words, they are risk averse, long-term compounding investors. I have also seen closeted risk-takers at these firms who, nonetheless, have become practiced at executing the group norms and their accompanying language. \u201cBoss, I am pitching this stock because it has a wide moat, is liquid, and pays a dividend; all of which provides ample downside protection.\u201d Here sociological factors are also at play. Stranger still, is that a desire to fit in can actually lead to behavioral changes on the part of staff. In fact, \u201ca good cultural fit\u201d is one of the things that many investment firms hire for. But is the fit real, or do people just know how to fake it, until they make themselves a good fit?<\/span><\/p>\n

     <\/p>\n

    Overconfidence<\/span><\/a><\/span><\/p>\n

    This bias strongly violates a purely biological explanation. What overconfidence seems to be preserving is not exclusively energy, but a person\u2019s fragile ego, clearly a psychological factor. Further, if a person\u2019s reputation within a group is that they are a risk-taker, then they are likely to prefer making decisions with little deliberation and with the puffery that is a hallmark of overconfidence, not because of energy conservation but because of reputation conservation. Again, there are likely closeted risk averse investors at event-driven hedge funds, at small cap growth shoppes, and at venture capital firms. The biological basis for overconfidence might be that sans this bias we might not venture out to forage for life-preserving food. That is, we need a kind of hope and confidence in our abilities to confront uncertainty and make decisions.<\/span><\/p>\n

     <\/p>\n

    Confirmation<\/span><\/a><\/span><\/p>\n

    Here people look for evidence that affirms a belief that they hold, and discount evidence that does not. There is a biological case to be made here that treating situations as similar, which is at the heart of confirmation bias, allows for energy conservation because a person does not need to reconsider held beliefs, or new evidence. However, confirmation bias also psychologically allows us to say to a chief investment officer that our view of that credit still holds given the evidence we continue to examine. In other words, ego is being preserved again. Confirmation bias also defers having to admit mistakes, which is unpalatable to the ego, and in many social situations where we do not want to be seen as a faulty thinker.<\/span><\/p>\n

     <\/p>\n

    Herding<\/span><\/a><\/span><\/p>\n

    Mass movement in a single group direction clearly has a psychological and sociological component. This explains fashion and music trends, among many things. A biological explanation though, is that when we move in a herd there is \u201cstrength in numbers.\u201d However, a full unraveling of the factors that lead to herding cannot be had by looking at just one science.<\/span><\/p>\n

     <\/p>\n

    Anchoring<\/span><\/a><\/span><\/p>\n

    Those anchored are stuck on a thought. Mainfestations include the first number uttered in a sequence, the dominant idea in a group discussion, the losses suffered in the Great Recession, and so on. Yes, it conserves energy to not consider other points of view \u2013 the biological explanation of anchoring \u2013 but it is also the case that \u201cgoing with the flow\u201d in a group discussion is sociological more beneficial. However, psychologically the benefit to anchoring is again most likely about ego protection. The reason I am waiting for that stock to get back up to its cost basis before selling is that I do not want to admit that I made a mistake because my self-image is that I am a capable investor.<\/span><\/p>\n

     <\/p>\n

    Availability<\/span><\/a><\/span><\/p>\n

    Overemphasizing information that is easily within reach resource-wise is the hallmark of availability bias. Because something is easily available I prefer it. Clearly this is energy efficient from a biological point of view. However, it is also the case that when speaking to a reporter and asked to describe our investment process that our firm\u2019s investment philosophy is likely to spring to mind and what we spoon feed to the media. This is true even if we have tweaked the firm\u2019s investment process a bit to better deliver alpha for the product we manage. Despite this, we quote the firm\u2019s investment process because we know this is the \u201ccorrect\u201d answer sociologically.<\/span><\/p>\n

    State changes are one of investing\u2019s hardest problems to deal with. Here, our readily available mental models must adjust on the fly if we are to comprehend what has happened. Psychologically, this may be more difficult than intellectually. For example, if I am a value investor circa 2020, it is hard for me to defend my last decade\u2019s worth of returns, so I invoke readily available stories about inflation being a likely outcome from too much monetary stimulus. Again, the factor involved here is psychological \u2013 I am defending my beloved investment philosophy with a readily available theory.<\/span><\/p>\n

     <\/p>\n

    Representativeness<\/span><\/a><\/span><\/p>\n

    Making decisions based on stereotypes is energy efficient, though frequently these representations are incorrect. However, stereotypes also typically form within group settings. Hedge funds and investment banks only recruit from the \u201cbest\u201d schools because they want only the \u201cbest\u201d employees. The result is an overbiased sample based on sociological factors \u2013 we hire from there because that is where we come from, too \u2013 and psychological factors, too. Namely, we may have failed but it is because of hard luck, not because all of us were educated by the same professors spouting the same ideas that we also use as the basis for our thinking.<\/span><\/p>\n

     <\/p>\n

    Mental Accounting<\/span><\/a><\/span><\/p>\n

    The two biases that map most neatly to solely biological factors are loss aversion and mental accounting. Due to the limitations of working memory and its inability to consider too many ideas simultaneously, it is certainly efficient biologically to parse different ideas into different categories and apply different decision rules to them. For example, apportioning your investment portfolio to a group of \u201croom to grow\u201d securities, \u201cdo no harm to my returns, likely to go sideways\u201d securities, and \u201cincome paying\u201d securities. Here, the money is all fungible, but we treat it differently because we have mentally accounted for the securities differently.<\/span><\/p>\n

     <\/p>\n

    In summary, to fully explain the manifestations of behavioral bias we need to invoke biology, psychology, and sociology. Without these three sciences we end up leaving key descriptive aspects of bias out of our understanding. Next up, I consider other things missing from the current work on behavioral finance and its biases.<\/span><\/p>\n

     <\/p>\n

    A Proposed System 3<\/span><\/strong><\/span><\/p>\n

    Amos Tversky and Daniel Kahneman\u2019s groundbreaking research was a significant portion of the wind in the sails of behavioral finance that got the boat moving in the early 1970s. More recently, Kahneman\u2019s highly influential book, Thinking, Fast and Slow<\/em>,[1]<\/span><\/a>has pushed the ship further along its journey. But I believe the ship needs updating.<\/span><\/p>\n

    For those of you not familiar with Kahneman\u2019s work he says that human decision-making is best summarized by two systems, System 1 and System 2. More specifically they are:<\/span><\/p>\n

     <\/p>\n

      \n
    1. System 1 is fast thinking, characterized by instinctual reactions, snap assessments of situations, subconscious thinking, and centered in the brain\u2019s amygdala region.<\/span><\/li>\n
    2. System 2 is slow thinking, characterized by intellectual responses, deep analysis, and centered in the brain\u2019s pre-frontal cortex region.<\/span><\/li>\n<\/ol>\n

       <\/p>\n

      This model, that many mistakenly believe was postulated by Daniel Kahneman,[2]<\/span><\/a> is incomplete. Certain ways of thinking, like intuition, defy this oversimplification of the mind into two systems. Kahneman makes the mistake of using \u201cintuition\u201d as a simile for System 1<\/a> \u2013 a subject covered at length by me elsewhere. This is a mistake, for example, among the Oxford English Dictionary\u2019s definitions of intuition is:<\/span><\/p>\n

       <\/p>\n

      Immediate apprehension by the intellect alone; a particular act of such apprehension.[3]<\/span><\/u><\/a><\/span><\/p>\n

       <\/p>\n

      Note the combination of \u201cthe intellect\u201d \u2013 System 2 \u2013 and \u201cimmediate apprehension\u201d \u2013 System 1 in the OED\u2019s definition. I have proposed elsewhere that there is clearly a System 3 which is supported by neuroscientists that explore intuition\/insight. \u00a0For example, a meta-analysis[4]<\/sup><\/a><\/span> (i.e. a study of studies) by Sprugnoli, et al. (2017)[5]<\/span><\/sup><\/a> found the following neural correlates for intuition:<\/span><\/p>\n

       <\/p>\n