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Contribution of Kahneman and Tversky to Behavioral FinanceFeb 18th 2017
Economic theory is often just as stodgy as it sounds; models and theories and rationales about the way people buy, sell, trade, spend, and save. So imagine the reaction in 1979, when Daniel Kahneman and Amos Tversky first presented their own hypothesis, called Prospect Theory, that people do not make financial decisions based solely on maximizing their potential wealth, but rather see the world in terms of gains and losses, and will largely avoid any decision that risks losing what they already have.
The crux of this theory lies in the idea that people will act irrationally to avoid feeling negative emotions, regardless of what economic models predict. The logic of the theory is that if you gave the average person two equal chances: one to win $10, the other to win $20 but then lose $10, they would take the option where they simply won $10, even though both options have the same net result.
It has nothing to do with math and everything to do with human emotions, specifically that our brains are geared towards giving us as many positive experiences and as few negative experiences as possible.
When two unequal choices are positioned, Prospect Theory postulates that most people look for the safest option possible that gives them a positive gain. For instance, let’s assume someone is given a $100 bill and offered two choices to improve on it.
In Scenario 1: They have a 100% chance of earning an additional $50.
In Scenario 2: They have a 50% chance of earning another $100, but also a 50% chance of earning nothing additional.
People who are slightly more willing to take risk would choose Scenario 2, figuring they come away with either the original $100 or $200, while those more risk averse select Scenario 1 and it's guaranteed $50 payoff. Those choosing Scenario 2 are more willing to gamble a bit because they don’t stand to lose anything beyond the $100 that they were originally awarded.
Kahneman and Tversky used this to theorize that people are usually only willing to partake in risky behaviors financially if they know they can limit their losses, thus implying that they weigh the potential for negative outcomes more than positive ones.
This theory opened up a whole new world of economic theory, one that suggested that emotions and instincts had just as much if not more to do than rationality and the logical desire to maximize one’s money. It was this type of thinking that opened the floodgates to books like Freakonomics and The Tipping Point in the last 15 years, and won Kahneman the Nobel Peace Prize for economics, a mean feat considering he was not an economist.
Together Kahneman and Tversky came up with eleven “cognitive illusions” that biased our judgment and gave us standardized responses for why things happened the way they did. The purpose here is not to demean ourselves, but rather to understand our propensity to fail and use it to get better insight into our own psyche, thus giving ourselves the ability to make better decisions in the future.
Kahneman put it best when he said, “We’re beautiful devices. The devices work well; we’re all experts in what we do. But when the mechanism fails, those failures can tell you a lot about how the mind works.”
The Power of ChoiceApril 18th 2017
The power of choice is one of our most powerful gifts of free will, doubly so when it comes to our finances and investments. Once you’ve paid your taxes, it truly is ‘your’ money, you can choose to put it under your mattress, bet it all on the Chicago Cubs to win the World Series (not a great idea), invest in a Systematic Investment Plan, or invest 100% of your paycheck in penny stocks (also not a great idea).
Having unlimited options is both a blessing and a curse - a blessing because it lets us do things like research, trial and error, and using our intuition; and a curse because it activates two critical blind spots in our general way of thinking: 1) that we love having the power of choice, and usually enjoy having more choices than less; and 2) we intuitively believe that the more choices we have, the more likely we are to find one that will satisfy our needs be they social, financial, or occupational.
But as the number of choices goes up, our confidence in our ability to choose wisely shrinks. If you’ve visited the US federal government’s health insurance marketplace, you no doubt have experienced this sensation - page after page after page of options, each slightly different, leave even the most studious of buyers wondering if they got what they wanted when they finally signup.
This phenomenon is described best by Prof. Sheena Iyengar in her book, “The Art of Choosing”, in which she reveals a study about the unlikeliest of thought-provoking choices - buying jam at the grocery store.
With a display of six brands of jam, 30% of customers buy at least one jar. When the number of brands is increased to 24, a mere 3% of customers buy anything. Clearly a case of diminishing returns is at play here - our brain casts doubt that we can make the most satisfying choice when the number of options increases.
For financial advisors, there is a huge lesson to be learnt in this revelation. If you overwhelm your clients with options of how best to invest their money, they are likely to hit the ‘eject’ button and go with an option that gives them a more forward-facing, simplistic approach to how and where to sock away their money for whatever goals they wish to obtain.
Think about it: If the majority of customers seeking out financial advice were already savvy in navigating the multiple markets, tax shelters, mutual funds, and other obstacles of financial investing, they wouldn’t be coming to you in the first place. Your job should be to simplify complex ideas for them into language they can understand and have confidence in.
This can be done as simply as using visual cues to represent more complex investment ideas to giving clients the ability to 'pre-filter' investment options based on their income, financial goals, etc. This can weed out entire discussions on definitions and pros/cons of parts of the financial realm that would only serve to confuse and steer clients away from your service offerings.
To Trade or Not to TradeMarch 27th 2017
If you’ve ever watched a news story, movie, TV show, or even stock footage about the way the stock market works, no doubt you’ve seen the frenetic pace at which traders on the floor buy and sell. It is intense, often incomprehensible, and also addicting to a certain segment of the population, both financial traders and laypersons, who consider themselves the type who can succeed in such a high pressure, high intensity environment.
While market research and gut feelings have their place in any financial transaction, being able to read human behavior when it comes to money, particularly financial behavior, can be the key between taking yourself or your client to the poor house or down Easy Street.
There is a definitive psychology to trading that must be honed if one is to succeed in this fast paced environment in which split second judgment errors matter. Fear and Greed are two emotions that must absolutely be kept in check to have even a chance for success in a trading environment.
Fear: Fear is perhaps the most crippling of our emotions, whether you’re a financial planner or an investor. The frenetic pace of watching a stock price fall is a very difficult environment for anyone to hold firm to their prescripted plan of action. Fear is a natural reaction to a situation not going the way we think it should. Relying systematically on training, data, and previous experience can definitely reduce the effect of fear to a significant extent.
Greed: Regardless of what Gordon Gecko might have taught us in Wall Street, greed is not a good idea when you’re trading. Just like fear might cause you to panic and sell everything, being greedy can keep you from walking away before a position becomes unfavorable. We sometimes justify this type of behavior by telling ourselves we’re trying to get every last possible dollar on the table for ourselves or for a client, but that is often to cover up simply wanting to boost our own ego and prove how much smarter we are than “the other guys.”
Keeping these emotions in check is largely the work of developing your own set of trading rules, parameters that you never veer away from in order to keep yourself from acting rashly.
Behavioral Causes of the GFCMarch 9th 2017
As incredible as it is to think about, we’re closing in on 10 years since the global financial crisis (GFC) of 2007 – 2008 that saw the housing market collapse lead to an almost complete breakdown of capital markets worldwide. Overnight several banks failed, with the rest forced to admit to a shaken public and a nonplussed federal government that they needed assistance to get back on their feet.
While the banks and many private citizens learned painful lessons during the collapse and ensuing recession, history continues to paint a fascinating picture of what happened to cause the bubble, particularly when it comes to the areas of psychology and behavioral finance.
In 2011, Yale’s Nicholas Barberis penned “Psychology and the Financial Crisis of 2007 - 2008” in which he addressed the crisis from an emotional angle and came up with three root causes:
• Over-extrapolation of past resultants
• Self-inflicted belief manipulation
• Psychological amplification mechanisms
In some ways, that’s a lot of fancy talk for people acting on what their hearts, and often their greed, said as opposed to what their brains were frantically trying to tell them. But doing a deeper dive into the reasons behind such a massive brain freeze is worth exploring, lest they be repeated.
If you’ve ever lived in a booming metropolitan area, you know all about over-extrapolation. Governments will watch populations rise and start planning long-term for more schools, more roads, more everything, only to have to dial those estimates way back when the population eventually slides back to a stable curve.
This is the basic theory that happened in the housing market. Historical data suggested prices were only to keep going up, even though at its root, that type of theory breaks the most fundamental of economic principles - every market and product has a tipping point. Here however, investors believed the date of saturation was a long way off, leading to the aforementioned over-extrapolation. In this bullish market, investors kept buying, assuming prices would go increasingly up thus resulting in an unsustainable price bubble.
Belief manipulation sounds like an euphemism for lying, but it’s more complicated than that because it involves professionals and experts in a field lying to themselves in order to make their shareholders, investors, and companies happier and wealthier, at least until the bottom dropped out. No one wants to be a spoiler when a party is going ahead at full blast and this is pretty much what happened with the professionals too.
The psychological amplification mechanism describes the process by which investors focused solely on home mortgages because they had met with previous success there and they knew, or thought they knew, how the process worked. Barberis broke the mechanism down into two components: Loss aversion and ambiguity aversion.
Loss aversion is fairly simple - if investors have lost money in some particular realm in the past; they are unlikely to return there in the future. Ambiguity aversion is a close cousin; if investors don’t really understand a market, or why it moves up or down, they’ll avoid it. So again, investors stuck with what they knew - home mortgages - and kept funneling all their business that way, eventually dooming themselves and their banks.
A lot of finger pointing got done in the weeks and months after the full financial collapse came to life, but this does not mean that we can absolve ourselves from any personal responsibility to make sound financial decisions.
Mental Accounting Matters
Feb 18th 2017
If you’ve ever saved money away for a purchase be it a new car, a house, a big vacation, or a yacht to sail around the world in, you’ve engaged in mental accounting, that is, the process of separating money into different accounts based on biased criteria such as short-term wants and personal values.
Take the George family, for example. A husband, wife, and two small children who subsist month to month while paying off massive amounts of credit card debt from previous indulgent decisions and living beyond their means. The Georges have now constructed a plan of paying off credit card debt using the Dave Ramsey technique of snowballing, while paying the minimum amount on everything else.
While this is admirable and more financially responsible than a large majority of people, the Georges continue to prioritize certain financial resources for "non-needs"; i.e. a new couch, a tripto Disney World, a new house, even while their credit card debt is still above $30,000, and Mrs. George has student loan payments that have never progressed past the point of paying off accrued interest.
This mind frame is one of the most prominent flaws discovered in the field of behavioral finance.
The science behind the theory is that individuals assign different functions for each stream of revenue, regardless of the fact that the currency is all the same and can be used for the same purpose paying bills, making purchases, etc.
Ironically, one of the biggest errors people make in this category is believing money too important for some categories, to consider using it for something else; thus believing they are making the correct moral decision even when it’s the wrong moral decision. For instance, if the Georges put away $25/week to Mr. George’s retirement IRA, but in doing so they miss a payment on their MasterCard, the accrued interest and fees of that late charge are way more than $25, meaning they’ll end up spending more money on penalties than they would have needed to miss a one time deposit into the IRA and make it up the next week.
The source of revenue often has a lot to do with how people decide what to do with it. For instance, when a relative of Mr. George passes away and leaves him a favorable amount of inheritance money, the couple agree that they each get make one major “splurge” purchase before divvying up the rest to their savings account and to pay bills. But why the splurge?
Those dollars would be far better spent making extra payments on their credit cards or mortgage, because money spent in those areas now will be worth far more down the road. Instead, the Georges treat the inheritance as “found money”, and feel they are entitled to treat themselves, if only a little, with the “reward”.
The bias extends into the investing realm, where investors will often split their resources between a conservative portfolio and a more aggressive one. This often comes from a mindset of wanting to feel “alive” and “risky” with the more aggressive approach, even though the investor inherently knows that the conservative approach is vastly more likely to make consistent gains.The best way to avoid this bias across the board is to learn a veritable word of the day calendar entry known as “fungible”.
Fungible means that money is the same, no matter how it is acquired or how it will be used. That means the $20 you found on the ground outside your apartment is worth the same amount and should be used to the same purchase as the $1,500 paycheck you earn every two weeks which goes to paying bills. By acknowledging both the power and the weight of every dollar we earn, we can cut down on the frivolous purchases and stay more consistently on the path of reaching our financial goals.
Financial Therapy – An Emerging FieldJan 16th 2017
Whilst Financial Therapy might sound like a cute name for a church meeting or a community center event that encourages singles and couples to get good advice on how to handle their finances, it’s a real field that took hold in 2010 with the founding of the Financial Therapy Association (FTA).
You ask, hold on a sec, what’s the difference between Financial Advisors and Financial Therapists? Generally speaking, Financial Advisors look more into how to manage your money to reach financial goals. Conversely, the task of a Financial Therapist is to delve into how to handle the financial problems and mistakes a person or family has already committed, and ones which they tend to repeat over and over again, often without being consciously aware of the pattern.
Much like a traditional therapist, financial therapists are licensed professionals who happen to focus on the financial side of a person’s well‐being, through discussions and observation of cognitive, relational, integrative, emotional, and behavioral thought processes.
Financial therapists generally hear about monetary problems that the rest of the world never knows about ‐ gambling, illicit relationships, substance abuse problems, giving money to family members again and again without any improvement in their station, problems with being a shopaholic, etc.
As seen in many studies Financial Advisors and Planners are often recipients of all these types of confessions, but many are ill‐prepared to deal with the human side of people’s reasons for seeking financial assistance, and end up losing potential customers over this emotional disconnect.
Much like a traditional counsellor, a financial therapist will do a deep dive into a person’s background, including what sort of environment they were brought up in, how their parents dealt with money, what their socio‐economic history has been, and what their education level is.
In many ways, Financial Therapists provide the answers to “why” while Financial Advisors and Planners are answering the question of “how”. A Financial Advisor might tell you to invest a certain percentage of each paycheck into your 401(k) fund in order to retire comfortably at age 65, while a Financial Therapist is more apt to break down the reasons why you keep putting this investment off month after month and provide you hard evidence of just how much you are costing your future self with every delay.
As with any type of therapy, this one also requires one to be comfortable and open‐minded in sharing their deepest concerns, secrets, and desires concerning finances with a therapist. If you are looking for help in this venue, you can check out the member directory of the FTA by visiting www.financialtherapyassociation.org. To find a therapist, start with the FTA’s member directory (financialtherapyassociation.org). Practitioners tend to be mental‐health professionals, social workers, or financial planners.