Chapter 1: Who Could Design a Brain…

Ø Economics… examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of well being. Thus it is on the one side a study of wealth; and, on the other, and more important side, a part of the study of man (Alfred Marshall, Principles of Economics).

Ø Despite Marshall noble words above, a fundamental feature of the study of man has no place in his classical economics (which concentrated on the study of wealth).

Ø Marshall’s approach was finally dislodged, with great difficulty and after many years of dispute, by the publication in 1936 of his student John Maynard Keynes’s masterwork, The General Theory of Employment, Interest and Money.

Ø Marshall’s approach was finally dislodged, with great difficulty and after years of dispute, by his student John Maynard Keynes’s masterwork, The General Theory of Employment, Interest, and Money.

Ø Capital Ideas (appeared between 1952 and 1973), owe little to Keynes and almost everything to Marshall.

Ø The entire underlying structure of Capital Ideas rests on the overriding assumption: investors have no difficulty in making optimal choices in the bewildering jumble of facts, rumors, discontinuities, vagueness, and black uncertainty that make up the real world around us.

Ø However, the ideal concept of human rationality and the coarse reality of our daily lives has become an increasingly contentious issue which led to the emergence of Behavioral Finance.

Ø Daniel Kahneman: “The failure in the rational model is… in the human brain it requires. Who could design a brain that could perform in the way this model mandates? Every single one of us would have to know and understand everything, completely and at once.”

Ø However, the real issue is this: do the teachings of behavioral Finance lead us to alpha – an excess return on our investments after adjustment for risk?

Ø Kahneman: “Nobody has ever figured out a perfect technique for dealing with uncertainty. Consequently, in making choices and decisions, we tend to overweight certain outcomes relative to uncertain outcomes, even when the uncertain outcomes have a high probability.”

Ø The proponents of Behavioral Finance have drawn heavily on the writings and teachings of Kahneman and Tversky. They have made human quirks like the failure of invariance, framing, and the illusion of validity the core of their confrontation with the assumptions of the rational model that motivates and supports the structure of Capital Ideas.

Ø Kahneman and Tversky defined these kinds of inconsistencies in decision making as “failure of invariance.”

Ø Framing à the passive acceptance of the formulation given (Kahneman).

Ø Invariance cannot be achieved by a finite mind (Kahneman).

Ø Hose money effect à if you have money in your pocket, you will choose the gamble. If you have no money in your pocket, you would rather have the $30 for certain than take the risk of ending up with $21 (Thaler).

Ø House money effect matters in real world. Investors who are already wealthy are willing to take significant risks because they can absorb the losses, while investors with limited means will invest conservatively because of fear they cannot afford to lose the little they have.

Ø Although human beings have extraordinary reasoning power compared with animals, something other than cool analysis and calculation seems to take over when we are faced with difficult choices – even though, on many occasions, we honestly believe we have made a rational decision.

Ø This struggle is especially intense when it comes to decisions involving our wealth. Finance and investment are bets on future outcomes – investing means we pout away money today because we expect to earn a future return on it.

Ø Speaking psychologically, investors have “cognitive difficulties” in their efforts to arrive at profitable decisions.

Ø Yet people who are not so smart frequently become rich. If they are lucky enough to avoid being wiped out immediately, they can survive for a long time and create all kinds of mispricings that scare away more sober investors.

Ø Keynes observes that the market could stay at crazy levels longer than most people could even imagine.

Ø Use of shortcuts (heuristics) in decision making:

n We faced with uncertainty and complexity in investing process.

n But the shortcuts we use to extricate ourselves from these dilemmas lead to inadequate processing of information, or avoiding the use of info entirely and relying on our gut to guide us.

n Many of the problems we encounter in this process of oversimplification and instinctive responses stem from the limits of our imagination (which cause imbalance in our imagination), although sometimes we impose limits we do not have to impose.

n One of the most dangerous of these habits is to believe low-probability events will not happen.

n Due to imbalance of imagination:

u We tend to focus on the short term because the long term is too vague (and anyway, it is not the domain in which we live).

u We extrapolate recent developments into the longer run future without questioning their significance for s constantly changing world.

u We cling to our preconceptions even when the evidence in front of us shows they are outdated.

u We are content being inconsistent because consistency may be too demanding.

u The possibilities of regretting a decision dilutes our ability to make a rational decision in the first place.

u We often make the mistake of heeding what others say when they agree with us, even when they may know les than we do.

u We display a tendency to take greater risks when faced with losses than when faced with gains.

u We make judgments on the basis of small samples of information that are far from representative of the broad generalization on which we want to base our decision, largely because we often have nothing else available.

Ø Impact of heuristics can be costly. Davis research shows that: “In studying the trading activities in a large number of investor accounts at a nationwide discount brokerage house. It is found that with extraordinary frequency, that the stocks these investors sold went on to earn higher returns than the stocks these investors purchased to replace those holdings.”

Ø Overconfidence:

n We display overconfidence in our own beliefs even though our better judgment should recognize the high risks in thinking we know more than the consensus of the people in the marketplace.

n Many of those individuals have more information and understand the situation better than we do.

n Kahneman: “The central characteristic of agents is not that they reason poorly but that they often act intuitively. And the behavior of these agents is not guided by what they are able to compute, but by what they happen to see at a particular moment.”

Ø We are human beings. Financial theory has to take account of that incontestable fact.

Ø Richard Thaler compile a list of “anomalous behaviors” – behaviors that went against the predictions of the standard models in finance.

Ø Kahneman: “I am now quick to reject any description of our work as demonstrating human irrationality. When the occasion arises, I carefully explain that research on heuristics and biases only refutes an unrealistic conception of rationality, which identifies it as comprehensive coherence”

Ø Thaler: “People are not blithering idiots, but they are a long way from hyper-rational automatons”

Ø Nobel Laureate Herbert Simon proposed the concept of “bounded rationality” à people facing an uncertain future aim to reach rational decisions, but they often fail because the demands of the process are too great and the variety of possible outcomes too bewildering.

Ø Fuller and Thaler able to achieve encouraging results from fund management, but the time period may have been too short to reach any strong judgments about what it has been able to accomplish.