Tag: active management

INTRODUCTION

Confronting our own mistakes in judgment is painful. It is one reason we rationalize. Rationalization can, however, alter our interpretation of facts and lead to ineffective decisions. Rationalization is one of the powerful unconscious forces that can drive you towards behavioral investing. In this essay we discuss rationalization, motivated reasoning and five simple ideas for greater self-awareness.

WISHFUL THINKING

Rationalization is something we all do. Call it wishful thinking. By either name, it’s the tendency people have to fit perceptions of reality into a mold that is heavily influenced by preferences. Most of us are highly selective in the information we choose to process and how we process it, for emotional rather than analytic reasons.

When it comes to equity investing, wishful thinking can be devastating. It can blind us to undesirable facts without which we are likely to make ineffective decisions. Rationalizing causes us to depend on confirming information and minimize the significance of conflicting information. Since rationalizations come about comfortably and naturally, they often hide from our conscious ability to detect them, let alone manage them.

MOTIVATION MATTERS

One model for understanding how and why we rationalize, called Motivated Reasoning, suggests that the brain works to satisfy two distinct functions simultaneously – analytic thinking and emotional thinking. While analytic thinking strives to achieve the best fit for the data at hand (accuracy), emotional thinking wants to reinforce existing beliefs and diminish conflicting data (directional).

Those directional goals reflect our beliefs, biases and desires. Interplay between accuracy and directional goals can result in radically different reasoning given the same information at different times. Or as Professor Ziva Kunda puts it: “People rely on cognitive processes and representations to arrive at their desired conclusions, but motivation plays a role in determining which of these will be used on a given occasion.”

NOBODY’S FOOL

Rationalization is often misconstrued as an intentional effort to fool ourselves. To the contrary, we are often very sincere in our assessment of our reasons, while rationalizing. Consider the commonly observed behavior from Prospect Theory involving “risk seeking with losses.” A new position is down by 30% a short time after purchase. The manager decides to buy more believing that it is at a bargain price and sure to bounce. Objectively this may represent a shrewd capitalization on an over-beaten stock. On the other hand, it might be another case of taking even greater risks in the hope of ultimately breaking even.

The interaction between facts and unconscious desires is explained by Professor Kunda this way: “People do not seem to be at liberty to conclude whatever they want to conclude merely because they want to. They draw the desired conclusion only if they can muster up the evidence necessary to support it.“

A contributing factor is that we have a strong need to explain why we make our decisions and actions to ourselves and to others. In explaining our reasoning, motivations for self-efficacy and respect, result in our formulating a narrative. The narrative lays out all the facts as a reasonable and compelling story. Our need to feel good about ourselves and be respected by others, however, fills in around the facts until the narrative morphs into more of a fable than an accounting of what transpired.

RATIONALIZING BEHAVIOR

Rationalization underpins many well known behavioral tendencies: Self Attribution, Anchoring, Hindsight Bias, Optimism Bias and overconfidence, to name a few.

Motivated Reasoning can result in our need for a certain conclusion that then shapes how facts are interpreted. The need to explain can lead to narratives that deliver the wrong lessons to our memories. This, in turn, can result in heuristics, beliefs and biases that push us repeatedly and predictably towards ineffective decisions. Or as Artimus Ward once said: “It ain’t so much the things you don’t know that get you in trouble. It’s the things you know that just ain’t so.”

CONCLUSION

Rationalization reflects an internal struggle between interpreting facts and wanting an outcome that coincides with a belief or desire. As a result, the brain converges on a solution that incorporates available information while minimizing negative and maximizing positive feelings.

Rationalization positions us to readily accept facts that support our desire or belief while urging us to hold unfamiliar or unpleasant facts to a higher standard. Unconscious filtering results in a narrative that passes both our conscious scrutiny and that of others whose respect is desired. Ironically, scrutinization of why decisions were made or actions taken actually gives the illusion of being objective. To make matters even more difficult, the more intelligent the person is the better they will be at constructing and presenting a believable narrative.

Tough-minded investment management requires strong doses of introspection. To help in implementing your heightened self-awareness here are five reminders to pin up on your office wall:

The brain tries to see relationships or stories, even when there are none.
The brain forgets and remembers what it wants, in a very biased way.
Narratives, even the most earnest of them, reflect Motivated Reasoning.
Actively search for data that was overlooked or contradicts my theories or beliefs.
How would someone who disagrees with me look at this data?

ENDNOTES

“The Case for Motivated Reasoning”, Psychological Bulletin, the American Psychological Association, November 1990 Vol. 108, No. 3, by Ziva Kunda.
Perspectives on Self-Deception, by Brian P. McLaughlin and Amélie Oksenberg, University of California Press, 1988.
How We Know What Isn’t So: The Fallibility of Human Reason in Everyday Life, by Thomas Gilovich, Simon & Schuster, 1993.
Don’t Believe Everything You Think: The 6 Basic Mistakes We Make in Thinking, by Thomas E. Kida, Prometheus Books 2006.

MICHAEL A. ERVOLINI, AUTHOR

The ideas expressed on this website are developed and/or curated by Michael Ervolini. Mike has spent his entire 35 year + career leading efforts to improve and strengthen active management.

Tags active management, equity management, judgment

Essays

Thesis, Narrative, or Just Another Disappointing Story

Post author By Kyra Spradlin
Post date May 29, 2024

Behavioral Matters: Insights from the application of Behavioral Finance | Issue 9

Written by Michael A. Ervolini

Thesis, Narrative, or Just Another Disappointing Story

“What is most important is not dispelling particular erroneous beliefs, but creating an understanding of how we form erroneous beliefs.”

– Thomas Gilovich

INTRODUCTION

Stocks are often managed on the basis of a thesis. This has come to mean that the manager has a clear expectation of how a stock will add alpha to the portfolio and she can express it in a tight sentence or two. The mere existence of a thesis suggests purpose, conviction and discipline. On the other hand, the dictionary defines thesis as an unproved statement or argument put forward as a premise. Too often the tentative nature of a stock’s thesis is lost, inviting behaviorally motivated decisions that undermine performance. In this essay we examine the nature of the investment thesis and how, lacking sufficient self-awareness, it can be just another disappointing story.

MIND YOUR THESIS

Our unconscious brain plays a dominant role in the decisions we make. Many scientists now believe that the role of our conscious brain, to a large extent, is to create a narrative so that we can understand what our unconscious brain has already decided.

A thesis can, therefore, as easily be the end result of intense research and process or the verbal expression of one or more instinctive judgments. Consequently, the thesis for stock A may be fact based and built entirely from your process while the thesis for stock B might feel comparably formulated but reflect much less discipline. Understanding the veracity of each thesis in your portfolio can help you strengthen your process and improve performance.

SELLING YOUR THESIS

Buying stocks often is a highly disciplined and process driven activity. Not so with selling. Rigorous investigation points to selling as being underdeveloped with regards to research, analysts’ recommendations, capital expenditure and overall industry investment. The short shrift being given to selling, suggested by these signs of inattention, is underscored by the uneasiness exhibited as most managers explain that they are not as confident in their sells as their buys.

Selling is, therefore, more judgmental and thus prone to behavioral influences. One way this can be observed is through thesis drift. For example, a stock might initially be purchased based upon growth at a reasonable price (GARP) but as the price continues to fall it is reclassified and held as a value stock. This change in thesis might in fact be a case of nimble and responsive portfolio management or just another instance of the Disposition Effect.

The Disposition Effect is perhaps the most studied behavior affecting professional equity managers. It states that when choosing positions in the portfolio to sell managers are behaviorally more inclined to sell winners over losers. This behavior can lead to a relatively high turnover of gains in the portfolio and a commensurate longer holding period for losers. Redefining the thesis for a stock, as in the example above, can reflect the unconscious desire to avoid realizing a loss and formulating a narrative to help make that happen.

PAINFUL AVOIDANCE

Thesis drift can also result from cognitive dissonance. A term coined by the social psychologist Leon Festinger in the 1950’s, cognitive dissonance refers to the discomfort we feel when holding on to mutually inconsistent beliefs. In finance, cognitive dissonance commonly involves our sense of self efficacy. We are, after all, smart, trained and capable investors yet we often find ourselves owning a notorious loser. Our unconscious wants desperately for us to feel capable yet there is the not so small matter of this unfortunate position stinking up the portfolio. How we manage this dilemma can impact performance both today and tomorrow.

The self-aware professional confronts such situations by examining his process. His goal is to learn, improve and reduce the chance that the same misadventure will occur again. Others might formulate a narrative for why riding this stock down to the bottom was a reasonable decision. In such instances the self protective mandate of our brain may be initiated before we have even had a moment to think about what happened consciously. Knowing that our unconscious can override introspection is knowledge that can help us learn from the decisions made in 2008 rather than put them behind us too quickly.

CONCLUSION

The thesis under which you hold a stock is only as good as the process under which it was developed. Self-aware investors with rigorous process can rely on thesis to guide as well as explain their buys. When it comes to selling, however, the lack of discipline and process make formulating a sound thesis more challenging. Learning to question the thesis of each position held as thoroughly as that of a new buy is how many managers are preparing for the rebound. The alternative may have you generating a narrative that your clients won’t be happy with.

ENDNOTES

How We Know What Isn’t So: The Fallibility of Human Reason in Everyday Life, by Thomas Gilovich, 1993, Simon and Schuster.
“The Origins of Cognitive Dissonance: Evidence from Children and Monkeys”, by Louisa C. Egan, Laurie R. Santos, and Paul Bloom, Psychological Science, November, 2007.

MICHAEL A. ERVOLINI, AUTHOR

The ideas expressed on this website are developed and/or curated by Michael Ervolini. Mike has spent his entire 35 year + career leading efforts to improve and strengthen active management.

Tags active management, equity management, process

Essays

Stressing Performance

Behavioral Matters: Insights from the application of Behavioral Finance | Issue 8

Written by Michael A. Ervolini

Stressing Performance

“Nothing is more difficult, and therefore more precious, than to be able to decide.”

– Napoleon Bonaparte

INTRODUCTION

No one has to tell you what stress feels like. It is your job to make the tough decisions about which names stay in the portfolio and which go. A burdensome responsibility, even in the best of times. But these are not the best of times. Your normal processes are being wracked by a market slump well outside your career experience combined with outflows that can be unnerving. If you are sensing in yourself a few raw nerve endings, that is only natural. It is one thing to survive stressful times – quite another to excel during them – ask any jet fighter pilot. In this essay we examine the nature of stress, its impact on critical thinking and what top professionals are doing to harness its effects rather than be overwhelmed by them.

FEELING IS BELIEVING

Stress isn’t always a bad thing. After all it is simply a state of heightened emotional and physiological awareness. Athletes, actors, public speakers and others use positive stress to strengthen their performance. Eustress, a term coined by researcher Richard Lazarus, is felt when the demands being placed upon us seem within our ability to handle. Coping with these stresses is exciting and actually heightens our abilities. In other words “getting pumped up” to perform involves harnessing positive stress.

Negative stress or distress, on the other hand, is felt when we are overwhelmed. Fears of failure or feeling out of control are powerful stressors that can severely limit our thinking and actions. During such experiences we are heavily driven by emotions that, while instinctive, are not the instincts that propel us to do our best. Learning what stresses you, and how to better manage these stressors, is all part of professional self awareness.

DR. JEKYLL, MR. HYDE

Stress can change who you are … or at least how you think. A diminished ability to consciously make good decisions is a common reaction to stress. Stress elicits our brain’s primitive protective responses, that old “fight or flight” feeling. These ancient instincts worked well when we needed protection from a marauding Woolly Mammoth, but are generally less helpful when managing modern sources of stress like market volatility or unhappy investors. This instinctive over-ride of conscious decision making limits us to only part of our brain, the part that doesn’t want to think. It prefers action.

Here are a few ways that stress can impede your decision-making.

Narrow framing: Distress causes us to curtail research and investigation prematurely. This rush to be done results in limiting the number of options we consider; emphasizing simplicity and expediency.

Shortened time horizon: Negative stress can push us towards a quick fix, even when that fix may cost us in the future. We just want the pain to stop.

Heuristics: Stress can result in an over reliance on simple rules-of-thumb. When succumbing to the desire to “do something” we might repeatedly apply ineffective solutions rather than reassess.

Negativity: Stressors can weaken our self confidence, lower our creativity and tilt our viewpoint so that more alternatives seem to possess negative outcomes. This “glass mostly empty” approach to decision making often becomes self fulfilling.

STRESS THIS

So how can you benefit from the current market chaos? We recommend building upon your self awareness, discipline and process. In general, good coping skills help us negotiate stressful times. They enable us to increase our sense of self-efficacy and perception of control. According to Dr. Albert Bandura self-efficacy is our sense of competence, our belief in our own abilities. The more capable we feel in any given situation, the less distress. Our sense of control also helps determine if we experience eustress or distress. According to Harry Mills, Ph.D “The perception of being in control (rather than the reality of being in or out of control) is an important buffer of negative stress”. Our sense of competency and control, therefore, act together in determining our personal reactions to stressors.

Self awareness, discipline and process are the tools you possess to strengthen your feelings of self-efficacy and control. The more you understand and believe in what you do at each decision point, the better you can manage stressors. As you learn to harness stress the more your portfolio decisions will reflect your strategy and analytic thinking rather than those unexamined rules-of-thumb hiding in your unconscious.

CONCLUSION

Stress is part of life. Minimizing negative stress is a skill that can be developed. The further you develop self awareness, discipline and process the better you will handle stress and the better the decisions you will be placing in your portfolio.

Managing stress and thinking clearly as markets gyrate around you can have an obvious impact on return. They can also mean the difference between having your portfolio, strategy and processes well positioned for the eventual market rebound or being caught flat-footed while others garner assets.

ENDNOTES

“Judgment and Decision Making Under Stress: An Overview For Emergency Managers”, Journal of Emergency Management, 2008, by Kathleen M. Kowalski-Trakofler.
Making Decisions Under Stress: Implications for Individual and Team Training, American Psychological Association, 2000, edited By Janis A. Cannon-Bowers and Eduardo Salas.
Sitting in the Hot Seat: Leaders and teams for Critical Incident Management, John Wiley & Sons, 1997, by Rhona Flin.
Sources of Power: How People Make Decisions, MIT Press, 1998, by Gary Klein.

MICHAEL A. ERVOLINI, AUTHOR

The ideas expressed on this website are developed and/or curated by Michael Ervolini. Mike has spent his entire 35 year + career leading efforts to improve and strengthen active management.

Tags active management, equity management, process

Essays

Unconscious Deliberation

Behavioral Matters: Insights from the application of Behavioral Finance | Issue 6

Written by Michael A. Ervolini

Unconscious Deliberation

“The idea that conscious deliberation before making a decision is always good is simply one of those illusions consciousness creates for us.”

– Ap Dijksterhuis

INTRODUCTION

Awareness is a double-edged concept. Conscious thinking is essential to successful decision making, up to a point. Strategy, discipline and process are devices that professional investors use to consciously hone their decisions. Objective research, analytic stock scoring and backtesting are some of the tools that strengthen these efforts. But more is going into your buys and sells than you think.

Much of our thinking happens before it hits our consciousness, driving most of our decisions, from the inconsequential to the highly important. And while it may be easier to dismiss the idea of thoughts erupting from the unconscious, we do so at peril to performance. By understanding the relationship between conscious and unconscious thinking, we can harness the latter to strengthen the former.

In this essay we examine the relationship between conscious and unconscious thinking and consider how harnessing the latter can strengthen the former.

JURASSIC MARKET

Cognitive science tells us that ninety five percent of all decisions are made by our auto-pilot, our unconscious. The unconscious brain is so dominant because there are too many stimuli in the world and too many decisions to make consciously. When early man was threatened by a giant raptor he did not make a conscious plan to survive, he just ran. Those who ran fastest from the raptor became our ancestors. The others became dinner. We commonly call such decisions instinct, though they are really part of our unconscious thinking.

Today, the unconscious still makes decisions automatically. Only instead of reacting to a giant raptor it reacts to market volatility, company news and other investment information. Heuristics, Over Confidence and Premature Dismissal are just a few manifestations of unconscious thinking that may lurk among portfolio management instincts. Unmeasured and unmanaged, modern instinctive decisions can lead to being eaten alive by the market — without our understanding what creature ate us.

OF TWO MINDS

The unconscious brain is very powerful and extremely fast. A recent study led by Professor John-Dylan Haynes at the Max Planck Institute for Human Cognitive and Brain Sciences (Leipzig, Germany) using Functional Magnetic Resonance Imaging (FMRI) found that the unconscious brain arrives at decisions 7 to 10 seconds before we are consciously aware that a decision is even needed. Even more striking, the study showed that participants’ conscious decisions could be predicted with 70 percent accuracy by studying their unconscious brain activity. Both findings underscore the power and persistence of unconscious thinking.

Yet the idea of decisions being made or influenced by the unconscious is new to professional investing. Our industry’s traditional dogma includes concepts like, “totally objective,” “completely by the numbers,” and “facts, not emotion.” Nonetheless, companies such as Goldman Sachs, Morgan Stanley and Fidelity Management & Research have behavioral economists on staff today. These leaders are making conscious decisions to manage unconscious decisions.

SOMETIMES LESS THINKING IS SMARTER

Intuitively, people might assume that simple choices are best left to auto-pilot while more complex decisions require more sophisticated thought. Not so. Scientists in The Netherlands have shown that we are generally satisfied with consciously deliberated decisions about simple or very familiar choices. But when it comes to complicated decisions – those with many criteria or that we make infrequently – we are better off following our gut.

An interesting example regards purchasing a house. We often elevate living space or square footage to a top house hunting criterion. Yet, research shows that our lives are rarely affected by a few square feet one way or the other. A terrible commute, on the other hand, can make life hell. And, we often do not even consider this factor carefully when purchasing a house. The researchers believe that our conscious efforts nudge us towards emphasizing square footage because it is familiar and easily measured. Commuting difficulty is, by comparison, less accessible to our conscious deliberation and also harder to quantify. They suggest we might be better off buying the house that feels right over the one that scores highest in our decision matrix.

Decision satisfaction is not the same as portfolio return. But, this research does point out that our unconscious brain can be a powerful ally in helping us arrive at our best decisions.

RECOGNIZING THE UNCONSCIOUS

Evolution has refined the potent and aggressive unconscious that frequently guides our judgment – even when we don’t “think” we are using judgment. Consider this: When 10 stocks are on the buy list, how do you get down to the 4 or 6 you will buy? If you need liquidity to finance a purchase, which stocks do you sell? We all rely on judgment to make professional decisions. That’s no judgment on you… just a fact.

ENDNOTES

The Emotional Brain, Simon & Schuster, 1996, by Joseph Ledoux.
“Unconscious determinants of free decisions in the human brain”, Nature Neuroscience, April 13, 2008, by Chun Siong Soon, Marcel Brass, Hans-Jochen Heinze, and John-Dylan Haynes.
“Deliberation Without Attention”, Science, Vol. 311. no. 5763, February 17, 2006, by Ap Dijksterhuis, Maarten W. Bos, Loran F. Nordgren, and Rick B. van Baaren.
“Get Out of Your Own Way”, Wall Street Journal, June 27, 2008.

MICHAEL A. ERVOLINI, AUTHOR

The ideas expressed on this website are developed and/or curated by Michael Ervolini. Mike has spent his entire 35 year + career leading efforts to improve and strengthen active management.

Tags active management, behaviors, equity management

Essays

Aching Conviction

Post author By Kyra Spradlin
Post date May 29, 2024

Behavioral Matters: Insights from the application of Behavioral Finance | Issue 4

Written by Michael A. Ervolini

Aching Conviction

“Doubt is not a pleasant condition, but certainty is absurd.”

– Voltaire

INTRODUCTION

The term conviction is used universally among professional investors to suggest that rigorous thinking has preceded a buy or sell decision. What is really backing up conviction? Does conviction reflect knowledge and wisdom accumulated over years or is it merely bluster? Understanding the nature of conviction is essential to improving any investment discipline.

BELIEF OR NOT

The dictionary defines conviction as a “fixed or firm belief”. How are beliefs formed? Are people aware of their complete set of beliefs? Can we consciously edit or manage beliefs?

Beliefs are created, stored and managed almost entirely within the unconscious part of the brain, according to modern Cognitive Science. In commenting on beliefs Harvard Psychologist Daniel Gilbert points out that “research suggests that people are typically unaware of the reasons why they are doing what they are doing, but when asked for a reason, they readily supply one.” Hersh Shefrin, the noted Behavioral Economist, suggests “… we like to think that we are thinking, when often we are just really feeling. That goes on all of the time in the investment business …”

The unconscious, and the beliefs residing there, are credited for roughly 95% of all our daily decisions. These unconsciously driven decisions occur and are being implemented well before we are even consciously aware that a decision is required. The lightening fast processing of the unconscious, together with its content being obscured from ready analysis, call in to question our dependence on conviction.

I SELL, THEREFORE I HAVE CONVICTION

Selling is a relatively unstudied aspect of investing. Few managers, if any, know how well their selling works. Yet, sell they must. Some selling is pragmatic — initiated to satisfy outflows. Creating liquidity to fund new buys is among the most commonly cited motivations for selling. Others include invoking a stop-loss, portfolio rebalancing and reacting to news about a company.

But what about strategic selling? Those sells driven purely to achieve enhanced performance. Author and financial writer Jason Zweig says “… I’ve yet to have anyone provide evidence that their sell discipline works. Performance, even above the benchmark, is not proof that your selling is good.“

The absence of objective analysis on selling effectiveness leaves much to chance. To fill the void “Managers and analysts rely on crude heuristics to measure fundamental value …” says Hirsh Shefrin. Less rigorous by their very nature, these efforts are highly susceptible to shortcomings in cognition and biases.

In his highly acclaimed book The Black Swan, Nassim Nicholas Taleb says about conviction “First, we are demonstrably arrogant about what we think we know.” One factor undercutting conviction he explains this way, “much of what we ascribe to skills is an after-the-fact attribution,” which leaves managers with the duel problem of perhaps making behaviorally motivated decisions initially and then rationalizing the decisions afterward. With such an active unconscious protecting us from thinking or feeling badly about ourselves just how can a manager develop bankable conviction?

QUESTION YOUR CONVICTION

Understanding how effective your convictions are requires that you both question them regularly and, perhaps more importantly, measure exactly how well they work. Questioning conviction or judgment on the fly is difficult. It requires that you suspend all of the natural impulses driving you at the moment (those unconscious forces) and take stock of what, other than strategy and discipline, might be propelling your decision. Rigorous measurement, on the other hand, can be approached with greater dispassion and yield elements of self-knowledge that can be capitalized upon and lead to higher performance.

Overconfidence, Anchoring, Belief Perseverance and Self Attribution are a few of the well documented behavioral traps that can become pseudo-conviction. All that stands between you and misplaced conviction is your own disbelief.

ENDNOTES

Stumbling On Happiness, Random House, 2006, by Daniel Gilbert.
Corporate Behavioral Finance, McGraw-Hill, 2007, by Hersh Shefrin.
“Mind Games”, “Welling@Weeden”, an on-line research journal, May 11, 2007, Volume 9, Issue 9, an interview with Jason Zweig.
Your Money and Your Brain, Simon & Schuster, 2007, by Jason Zweig.
The Black Swan – The Impact of the Highly Improbable, Random House, 2007, by Nassim Nicholas Taleb.

MICHAEL A. ERVOLINI, AUTHOR

The ideas expressed on this website are developed and/or curated by Michael Ervolini. Mike has spent his entire 35 year + career leading efforts to improve and strengthen active management.

RESOURCES

MOST POPULAR ESSAYS

JUDGEMENT

WHEN BUYING LOW AND SELLING HIGH DESTROY ALPHA

PROCESS

ACTIVE MANAGEMENT – TAKE DOWN THE WHITE FLAG

BEHAVIORS

WEAK FEEDBACK AND DENIAL ARE KILLING ACTIVE MANAGEMENT

WANT MORE WAYS TO IMPROVE YOUR SKILLS?

Tags active management, behaviors, equity management

Essays

Thanks For The Memories

Post author By Kyra Spradlin
Post date April 23, 2024

Behavioral Matters: Insights from the application of Behavioral Finance | Issue 18

Written by Michael A. Ervolini

Thanks For The Memories

“Memory itself is an internal rumour.”

– George Santayana, Philosopher

INTRODUCTION

The bedrocks of professional investing — experience, judgment, intuition and deliberation — rely heavily on the use of memory. Though it is fundamental to learning and making effective choices, memory is also highly imperfect. While memories are sometimes cherished, they can push you toward investing misadventures. This essay examines how experts look at memory and its potential for generating investing shortfalls.

MOTIVATED MEMORY

Memory is the result of how information is captured, stored and retrieved. Most of what we remember after an experience (visual, auditory, etc.), happens automatically and pretty much involuntarily. Supporting this process the brain chooses to capture information it finds interesting, useful or that stimulates strong feelings. It encodes this information into long-term memory that sits in the unconscious brain. Unavailable for conscious or deliberate probing and review, memories are accessed and reconstructed upon demand, through either willful intent or involuntarily. Emotions affect both the encoding and retrieval of memories. Excitement about a series of great buys or pain from liquidation of deep losers can change how information is perceived, making it more vivid and stickier. Incorrect learning results from the deep encoding of such emotionally charged impressions. If such incorrect learning transforms into a strongly held belief, it can lead to repeated ineffective decisions.

Market turmoil and position volatility can cause stress and a high emotional state. When these emotions are present during the retrieval of memories they can limit the brain’s searching for information or answers, often pushing it toward simple and emotionally soothing solutions, rather than analyzing a more complete set of options.

MAKE MY MEMORY

False memories may help explain why ineffective tendencies creep into otherwise sound investment processes. Researcher Brian Gonsalves studied the formation of false memories using Functional Magnetic Resonance Imaging (FMRI) technology. Participants were shown images of certain objects and accompanying words, with some words matching the objects shown and other words being unrelated. The participants were asked to visualize the image represented by the words not the objects. What they remembered is fascinating. When asked what objects they were shown they tended to remember seeing objects related to the words they visualized, even if a picture of that object was never presented. What happened According to Gonsalves: “Many of the visual images that the subjects were asked to imagine were later misremembered as actually having been seen.” He points out: “A vividly imagined event can leave a memory trace in the brain that’s very similar to that of an experienced event.” Gonsalves and team were able to accurately predict when an imagined image would be remembered as having been seen because highly vivid imaginings stimulate the same part of the brain as do real experiences.

Memories can also be suggested, even impossible ones. Professor Elizabeth Loftus asked adults if they had met Mickey Mouse when they were children. Some were first shown a video of people having fun at Disney World. Recollection of this experience was significantly higher among those who saw the video. Loftus believes that when in a positive emotional state the participants’ old and fragile autobiographical memories were unconsciously rewritten to include a personal experience with Mickey that never happened. To confirm this phenomenon, another group was asked about whether they ever met Bugs Bunny instead of Mickey while at Disney Land. Among those shown the same Disney video, 16% recollected shaking hands with Bugs at Disney land, even though he is not a Disney character, but a Warner Brothers creation. They recalled an event that was not simply unlikely but impossible.

Interestingly, participants in both studies that viewed the video overwhelmingly denied it affected their recollections. Suggesting that not only is memory malleable but internal defenses refuse to accept this proven quality. Loftus concludes: “These studies show that with suggestion and imagination, a significant minority of people can be led to believe that they had experiences that were manufactured, and many of them elaborated upon those false experiences with idiosyncratically produced details.”

THESIS, PROCESS AND DISCIPLINE REMEMBERED

Despite its known flaws, memory remains a primary tool used by managers for learning about their strengths and shortcomings. Other conventional sources of portfolio information like return and attribution help some, but using them to improve is like a golfer playing at night using only the total score for feedback. Whether hitting above or below par, the golfer can’t see where performance is strongest or where it needs refinement.

Over relying on their memories, managers have no choice but to imagine where their alpha comes from. They commonly misidentify which skills are strongest and which need improvement or precisely how to improve. And this leads to missed opportunities regardless of the quintile they are in. Studies of actual portfolios conducted by Cabot show that:

Some strong buyers can and do consistently sell winners prematurely — giving away alpha in the process.
Managers that pick great names often do not feed them sufficiently — reluctant to pay up for a stock on the run.
Selling winners tends to be difficult — they are often held well past their ability to generate excess returns and drag down performance.

Ineffective decisions such as these can start with a faulty memory. These memories then go on to produce flawed beliefs and rules-of-thumb, which then are used to make investment decisions. In addition, critical analysis of skills and process is hampered as recollections reflect motivations as well as facts. You see only what your memories allow and your decisions integrate half-truths as if they were rigorously constructed data.

CONCLUSION

Memory defines who you are and what you think. It is, however, imperfect, fragile and quite capable of making falsehoods seem like facts. Memory recall can range from consistent and complete, to partial and irregular.

As reliable as memories may seem, their flaws can hurt portfolio performance. This can be the result of false memories that tilt decisions toward ineffective choices. Faulty Memories may be the product of weak encoding, retrieval or both. Comparing your treasured recollections to verifiable information is one straightforward antidote to ineffective memories. The alternative may position you as a prisoner of a past that never really happened.

REFERENCES

Brian Gonsalves, Paul J. Reber Darren R. Gitelman Todd B. Parrish Marsel Mesulam and Ken A. Paller, “Neural Evidence That Vivid Imagining Can Lead To False Remembering”, Psychological Science, October2004.
Elizabeth F. Loftus, Kathryn A. Braun and Rhiannon Ellis, “Make My Memory: How Advertising Can Change Our Memories of the Past”, Psychology & Marketing, John Wiley & Sons, Inc, 2002.
Tim R. Holcomb, R. Duane Ireland, R. Michael Holmes, Jr. and Michael A. Hitt, “Architecture of entrepreneurial learning: exploring the link among heuristics, knowledge, and action”, Entrepreneurship: Theory and Practice, Jan, 2009.
“Motivated Reasoning”, A Behavioral Matters essay, April 15, 2009, available at http://www.cabotresearch.com.

MICHAEL A. ERVOLINI, AUTHOR

The ideas expressed on this website are developed and/or curated by Michael Ervolini. Mike has spent his entire 35 year + career leading efforts to improve and strengthen active management.

RESOURCES

MOST POPULAR ESSAYS

JUDGEMENT

THANKS FOR THE

MEMORIES

PROCESS

BEWARE PHANTASTIC INVESTMENTS

BEHAVIORS

INSIDE-OUT

INVESTING

WANT MORE WAYS TO IMPROVE YOUR SKILLS?

The multi-trillion dollar active management industry is predicated on the idea that managers have skill – yet little is known about it – Who has skill? How is it measured? This website is dedicated to finding answers to the questions surrounding skill.

NAVIGATION

Beware Phantastic Investments

Post author By Kyra Spradlin
Post date April 23, 2024

Puts pen to the display. Two stockbrokers in formal clothes works in the office with financial market.

Behavioral Matters: Insights from the application of Behavioral Finance | Issue 17

Written by Michael A. Ervolini

Beware Phantastic Investments

“A good story is more compelling than the search for the truth.”

– Shakespeare, Richard III

INTRODUCTION

By its very nature, investing requires making estimates about future events. These estimates reflect the manager’s analysis of facts combined with imagining likely but unsure outcomes. Imagination is what enables skilled investors to see opportunities ahead of the crowd. It can also excite emotions that make it difficult to distinguish real investment opportunities from “phantastic” ones.

EMOTIONAL INVESTING

The theory of Emotional Finance examines investor tendencies through the lens of Freudian psychoanalysis. Sigmund Freud suggested that thoughts cause people to experience two basic types of feelings, pleasurable or painful. Pleasurable feelings, understandably, are sought out and painful ones are avoided or repressed. According to Freud, the seeking and avoiding all occurs within the unconscious. In addition, he proposed that the mind often holds conflicting emotions about a person, idea or thing simultaneously… like/dislike, love/hate and trust/distrust being common conflicts. Because these conflicting feelings are both strong and unknown to the conscious mind, they affect our beliefs about our relationships with the world. This means investing involves entering into an emotional and unconscious relationship with the assets you own.

Research team Richard Taffler, a professor of finance and investment and David Tuckett, a professor of psychoanalysis, who together developed the theory of Emotional Finance, extend these Freudian concepts into investing. According to Professor Taffler, “People are prone to unrecognized emotions — fears and fantasies — which Freud described as the main components of unconscious mental life and the deep drivers of human judgment.” These unrecognized emotions are often more powerful than either facts or the results of objective analysis, driving investors to oscillate between feelings of hope and fear about their investments.

Taffler and Tuckett are quick to acknowledge the vital contributions that Behavioral Finance has made to the understanding of decision-making under uncertainty. Their concern with the direction of current Behavioral Finance inquiry, however, is that it often tends to focus on the cognitive underpinnings of ineffective judgmental tendencies alone. They argue that cognition and emotion need to be studied together to truly understand investor behavior.

SEPARATING FACT FROM FANTASY

Formulating judgments about, and acting on, information before it is fully priced into the market is how managers add value to investing. Typically, they identify promising candidates (either purely bottom-up or supported with systematic screening) and then choose specific names to own. Ultimately, purchasing an asset requires a commitment — capital, ongoing attention and choosing when to liquidate.

Taffler and Tuckett see the ownership commitment as forming an important emotional relationship with the asset — one that can bring happiness or let you down. They suggest, “When we commit to an investment strategy, we commit to an imagined relationship with consequences — a relationship not unlike a marriage contract.” They go on to say, “Psychoanalysts postulate three principal kinds of imagined emotional relationships, governed by: L (loving), H (hating), and K or -K (knowing or anti-knowing).”

Objective decision-making requires “knowing” the asset — being aware of its potential to please and disappoint and accepting both as a balanced reason for owning it — an integrated view. This reflects the type of unemotional objectivity that is associated with disciplined investing. It grounds manager decisions so that winners are sold as their thesis is achieved and losers are reevaluated and then sold or kept based on their go-forward potential.

Conversely, “anti-knowing” involves splitting potential pain from pleasure. For buys, this amounts to avoiding the unpleasant feelings related to the risk of loss while focusing on the potential pleasure from a gain. This form of relationship makes assets overly attractive while they are performing and then horribly disappointing when their momentum turns. Such abrupt and full throttle reversals between “loving and hating” causes overbuying and overselling as investors gather up pleasure and disgorge pain.

EMOTIONAL NARRATIVES

Assets commonly are chosen because they represent a strong thesis. The thesis is a simple narrative description of all the facts known about the asset plus a judgment of why these facts indicate likely out-performance. Formulating the thesis involves assessing potential risks as well as returns. A fundamental aspect of this process requires managers to contemplate future events whose outcomes are highly uncertain. Contemplating the unknowable produces anxiety for managers, thereby, injecting emotional content into their analyses. These anxieties push buttons within the manager’s unconscious, having the effect of short-circuiting their otherwise disciplined approach to decision-making.

There are two types of anxiety produced by investing, according to Taffler and Tuckett: “… that caused by unavoidable information asymmetries at the moment of decision-making, and that determined by the fact the future is inherently unknowable.” Information asymmetry undermines conviction, niggling away at the manager’s resolve or as the researchers suggest “This judgment creates anxiety. First, there is the fear that the information they have been given by the firm’s management is untrustworthy, second there is the fear that even if the information and their underlying analysis is correct, the rest of the market may never come to share their view.”

While the manager’s unconscious is battling information asymmetry, it is also being harassed by uncertainty about the future. Imagining tomorrow’s outcomes is one thing; betting that they will materialize is quite another. Together, these two sources of uncertainty create anxiety that, as mentioned, is often dealt with by splitting the good feelings (upside) from the bad (downside) — a defense mechanism that calms emotional stress and bolsters conviction while increasing portfolio risk. Although your current processes can guide imagination toward a potentially unique idea, they may offer no protection from the anxieties generated throughout the analysis and ownership of the asset.

YOUR PHANTASTIC!

It always pays to be mindful that an asset is a probabilistic mix of risk and return, with the potential to deliver both pain and pleasure. This integrated perspective can enable investors to manage a thesis more effectively — objectively knowing when to hold their conviction and when to change. When assets are held for reasons rooted more in emotion than reasoned expectation, the unconscious has more control over investment decisions. As positions migrate from gain to loss and back again, these shifts in performance trigger emotions that invoke thoughts about your relationship with the asset, and these thoughts foster further emotions, and so on. The cycle repeats until the unconscious has you cornered — you either love or hate the investment.

When your over excited the tendency is to act emotionally, often running roughshod over any remnants of analytic thinking. This behavior relates to what Taffler and Tuckett have termed a “phantastic object”. The term phantastic object they describe: “… is derived from two ideas. The Freudian concept of object denotes a mental representation, i.e. a symbol of something in our mind but not the actual thing itself. Phantasy is a technical term which psychoanalysts use to describe an individual’s unconscious beliefs and wishes which come from the earliest stages of an infant’s mental development. Thus a phantastic object is a mental representation of something (or someone, or an idea) which fulfills the individual’s deepest desires to have exactly what they want and exactly when they want it.” Relating this to investing, the phantastic object is initially seen as possessing superior qualities, well above the usual investment opportunity, allowing the manager to achieve his emotional goal of delivering exceptional returns with no downside risk. In other words, this opportunity is simply phantastic. But because this impression of the asset is created in part by suppressing thoughts and feelings about its limitations and risks, or what Tuckett and Taffler describe as splitting, its inevitable disappointment gives credence to the lingering doubts stored in the unconscious. What once was loved becomes hated and a hold quickly turns into a sell.

EMOTIONAL FACTOR

In their CFA Monagraph to be published later this year, the research team discusses findings from in-depth interviews conducted by Professor Tuckett with over 50 fund managers from around the globe. One of the many insights from these interviews is the nature of risk, specifically risk felt by managers. When talking about their greatest exposures this group of managers tended to discuss information risk, the future being unpredictable, business risk and career risk. As Professor Taffler explains, “These are very different to conventional measures of risk. Yet these are the real risks managers worry about. So the concept of risk also has a key emotional dimension.”

Taffler and Tuckett see conventional risk models as providing pseudo-defenses against uncertainty. They suggest that the practice of performing regressions against historical relationships can lull individuals in to believing that they know more about the future than is possible. This overoptimism about the future or, conversely, overconfidence about the ability to control uncertainty fascilitates managers in splitting — enabling them to focus on potential gains since the risks feel like they have already been managed. This interpretation of unconscious processing is consistent with Kahneman and Lovallo who found that the mere investigation of uncertainty can lead to an illusion of control and under-appreciation of actual risk. One likely example of this behavior is when managers override portfolio optimizers to retain or pump up the size of favorite positions. These decisions to “go against the science” of the risk models are commonly defended as the manager having a strong intuition about an asset: An alternative explanation is that she is reaching for a phantastic object.

CONCLUSION

Reasoning involves telling stories to yourself. The more objective the stories, the more sound each thesis and investment decision. Thesis formulation relies on making judgments about events whose outcomes are inherently uncertain. These judgments produce anxiety that often has an adverse impact on the assessment of risks as assets are being evaluated.

The new theory of Emotional Finance examines how the unconscious management of anxiety affects investment decisions. It offers additional insights into how unconscious motivations easily erupt into buy and sell decisions. The brain is terribly adept at substituting emotions for facts in order to make a financial decision that feels right. This unconscious means of decision-making represents a constant counterforce to your intended discipline and process. Heightened self-awareness is one way to combat the unconscious forces that drive unintended decisions. You just can’t build fantastic performance owning phantastic objects.

REFERENCES

Richard J. Taffler,., Martin Currie Professor of Finance and Investment, University of Edinburgh. Exclusive interview with Cabot Research, December 23, 2009.
Richard J. Taffler,. and David A. Tuckett, “Emotional Finance: The Role of the Unconscious in Financial Decisions.” Chapter 5 in Behavioral Finance (eds. Kent Baker and John Nofsinger), Wiley 2010.
David Tuckett, “Addressing the Psychology of Financial Markets.” Economics, The Open-Access, Open Assessment E-Journal, vol. 3, 2009-40.
Richard J. Taffler and David Tuckett, “How a State of Mind Abets Market Instability.” The Financial Times, September 21, 2007.
Richard J. Taffler and David Tuckett, “Emotional Finance: Understanding What Drives Investors.” Professional Investor, Autumn, 2007, pp. 18-20.
Daniel Kahneman and Dan Lovallo, “Timid Choices and Bold Forecasts: A Cognitive Perspective on Risk Taking”, Management Science, vol. 39, no. 1, January 1993, pp. 17-31.

ADDITIONAL READING

David Tucket and Richard Taffler, “Phantastic Objects and the Financial Market’s Sense of Reality: A Psychoanalytic Contribution to the Understanding of Stock Market Instability.” International Journal of Psychoanalysis, vol. 89, no. 2, 2008, pp. 389-412.
Arman Eshraghi and Richard Taffler, “Hedge Funds and Unconscious Fantasy.” University of Edinburgh Business School Working Paper, November 26, 2009. Available electronically at: http//ssrn.com/abstract=1522486.

MICHAEL A. ERVOLINI, AUTHOR

The ideas expressed on this website are developed and/or curated by Michael Ervolini. Mike has spent his entire 35 year + career leading efforts to improve and strengthen active management.

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When Buying Low And Selling High Destroy Alpha

Post author By Kyra Spradlin
Post date April 22, 2024

BEHAVIORS

ARTICLE

Article Forthcoming in Journal of Investing | May 2024

Written by Michael A. Ervolini and Andrew R. Tuttle

3 min read

When Buying Low and Selling High Destroy Alpha: Visualizing The Interplay Amongst Judgment, Process, and Prospect Theory

Article Abstract

Evidence of the disposition effect and its negative impacts on equity funds is well established. Many managers continue to sell winners too quickly and hold on to losers too long. Efforts to eliminate these and other behavioral tendencies appear to be limited in their impact. Weak feedback regarding which decisions are helping generate excess returns and which aren’t is a major stumbling block that inhibits such improvement efforts. So too is the resistance to change frequently present when change is unconsciously perceived as more risky than the status quo. This paper argues that the use of newer analytics, in particular the vivid visualizations of manager decisions with individual holdings, can greatly increase the odds that a manager will develop greater self-awareness and actually improve.

Three Key Takeaways:

Confirmation of behavioral tendencies such as the disposition effect have existed for decades. Yet, there is scant evidence that knowledge of these tendencies has impacted equity manager decisions or fund results.

Looming largest amongst the reasons many managers have trouble eliminating behavioral tendencies and improving generally are: the lack of rigorous feedback about which decisions add alpha and which destroy it, and succumbing to emotional needs that are in conflict with learning.

Visualizations reflecting each action taken by a manager on individual holdings, in conjunction with rigorous and granular fund-level analytics, can enable managers to overcome unproductive behavioral tendencies.

MICHAEL A. ERVOLINI, AUTHOR

The ideas expressed on this website are developed and/or curated by Michael Ervolini. Mike has spent his entire 35+ year career leading efforts to improve and strengthen active management.

RESOURCES

Inside-Out Investing

Post author By Kyra Spradlin
Post date April 11, 2024

Human brain over black background. 3D illustration

Behavioral Matters: Insights from the application of Behavioral Finance | Issue 16

Written by Michael A. Ervolini

Inside-Out Investing

“It is the optimistic denial of uncontrollable uncertainty that accounts for managers’ views of themselves as prudent risk takers, and for their rejection of gambling as a model of what they do.”

– Daniel Kahneman

INTRODUCTION

Analysis is fundamental to equity investing. Deep dives require that you apply extensive energy and talent into understanding a company and its ability to deliver excess returns. Yet this activity can awaken behavioral tendencies that short-circuit your analytic processes. Consequently, rigorous analysis can heighten the potential for over optimism at exactly the moment when greater objectivity is needed. This essay examines the importance of calibrating judgements as a critical element of self-awareness and honing investment skill.

THE DEEP DIVE

The greater the opportunity or risk associated with an outcome, the more analysis typically is applied to the decision. Investors commonly employ a process or framework to guide them through the steps of detailed company analysis. Such steps are analogous to what biologists, chemists, physicists and other refer to as the scientific method.

Presented with a challenging decision the problem is first reduced to its major components. These, in turn, are further deconstructed to smaller and smaller components facilitating clear understanding and confident resolution. After gathering and analyzing appropriate data for all subcomponents, the process is reversed and an understanding of the initial question is constructed by assembling your understanding of the components and their relationship to each other.

Done well, deep analysis can lead to rich proprietary insights about a company’s likely performance or intrinsic value. This is the “information advantage” that skilled professionals bring to portfolio management. Intense rigor can also produce over optimistic conclusions — reflecting a run-away process.

MOTIVATION PLEASE

Thinking is more emotional than commonly believed. The cognitive process itself draws upon both the analytic and emotional parts of the brain. Reasoning is a blended outcome of the “best fit” for the data under consideration plus unconscious filtering and shaping of that data to support beliefs, biases or desires within the unconscious. This model of thinking, known as Motivated Reasoning, helps explain why even the most careful experts engage in over optimistic assessments when performing rigorous analyses.

Excessively optimistic forecasts of risky outcomes, according to Professor Kahneman, are linked to “…three main forms of a pervasive optimistic bias” (i) unrealistically positive self-evaluations, (ii) unrealistic optimism about future events and plans, and (iii) an illusion of control.” Rigorous analysis often ignites these unconscious motivations resulting in both narrow framing of the possible outcomes (extreme possibilities are discounted) and higher certainty or success being assigned to each subcomponent evaluated – as if by thoroughly analyzing a risk it has been rendered less risky.

Judgment is further affected when issues are viewed as unique. “The natural way to think about a problem is to bring to bear all one knows about it, with special attention to its unique feature,” says Professor Kahneman. This is precisely the dilemma of thesis management.

INSIDE-OUT

The deep dive reflects what Professor Kahneman terms the “inside view.” This is the view of a situation that is based on judgments applied to specific facts about that situation. Michael Mauboussin, author and Chief Investment Strategist for Legg Mason Capital Management offers a less flattering description: “Inside view are judgments about information gathered; they involve anecdotal evidence and fallacious perceptions.” Yet, inside views are the very cornerstone of the process used by analysts and managers to shape investment decisions.

One technique recommended by both Kahneman and Mauboussin for managing the perils of inside views is to balance them with “outside views.” Outside views are based entirely on facts. They ignore specific attributes of the situation under consideration. Instead, the outside view looks to typical outcomes for similar situations. It accomplishes this through the use of statistics compiled from a group of relevant comparable opportunities.

Consider a company analysis that requires forecasting the expected revenue stream from a drug currently in Phase 3 trials. Formulating such an outcome conventionally involves many steps including: estimating the chances that the trial will be successful, anticipating a likely efficacy for the new drug and then translating this information into estimates of market size, unit demand, cost and price. Each of these seemingly objective judgments will reflect selected experiences in your memory and the belief you have in management’s ability to think strategically and execute effectively — a classic inside view. Approaching the same task using an outside view would begin by identifying like companies that have attempted similar endeavors. Once identified, the results from this group of comparable situations would be analyzed to determine benchmarking information such as: percent success/fail, mean outcome when successful and the standard deviation across results.

Foregoing inside views is not realistic for most investors. Seeing assets that can generate excess returns is, by definition, hunting for uniqueness. Highly skilled investors, however are experts at isolating truly unique characteristics for any opportunity. Then they rigorously analyze these characteristics as appropriate, drawing upon outside view facts to sharpen judgments and spotlight key risks.

CONCLUSION

Rigorous analysis is, in large part, what professional investors rely upon to make buy and sell decisions. This can lead to over optimistic assessments reflecting the shortcomings of inside views. Outside views can be incorporated into the evaluation process, helping calibrate interim steps of your analysis. The take-away for refining your investing is this: inside views may be essential for identifying opportunities that are well reasoned while outside views keep your judgments reasonable.

ENDNOTES

“Timid Choices and Bold Forecasts: A Cognitive Perspective on Risk Taking”, Daniel Kahneman and Dan Lovallo, Management Science, Vol. 38, No. 1, January 1993.
Think Twice: Harnessing the Power of Counterintuition, Michael J. Mauboussin, Harvard Business Press, Fall 2009.
“Motivated Reasoning”, A Behavioral Matters essay, Issue 11, April 15, 2009.

MICHAEL A. ERVOLINI, AUTHOR

The ideas expressed on this website are developed and/or curated by Michael Ervolini. Mike has spent his entire 35 year + career leading efforts to improve and strengthen active management.

RESOURCES

MOST POPULAR ESSAYS

JUDGMENT

THANKS FOR THE

MEMORIES

PROCESS

BEWARE PHANTASTIC INVESTMENTS

BEHAVIORS

INSIDE-OUT

INVESTING