The Psychology of
Human Misjudgment-V

Video on Dopamine

Dopamine
(Chemical Dependency)
A hormone and neurotransmitter
(http://en.wikipedia.org/wiki/Dopamine)

Less than 1/1000th of 1% of
the 100 billion neurons in your
produce dopamine

Dopamine has disproportionate power
Unlike other neurons, its not like a light
bulb

Dopamine shoots forth bursts-like
fireworks, spraying energy throughout that
part of brain which converts motivations
into decisions and actions.
In less than 1/20th of a second

Cocaine causes dopamine increase
resulting addictive pleasure.
Operant Conditioning: It feels so
good, I want more more more!!!

Neuroecono
mics: There
is no
difference
between a
man who
who just
made a
killing in the
markets and
a man who
is high on
cocaine

Dot Con Video Clip - Dope Addicts?

Getting
what you
expected
produces
no
dopamine
kick

However, an
unexpected
gain fires up
the brain
(neurons go
from firing 3
times a
second to
40 times a
second)

If expected
reward fails
to
materialize,
dopamine
dries up

Unexpected pleasant surprises make
people ecstatic because of the dopamine
surge they produce

If lab rats are wired up to receive tiny pulses of
electrical stimulation in the dopamine centers
of the brain when they press a lever...

...they often begin tapping it nonstop to the
exclusion of other activities, including eating and
drinking...

They would rather starve to death than live
without that dopamine surge inside their
brains.

The human equivalent of this Lab Rat is
there in all of us...

Scene from Requiem for a Dream

Dopamine
system
loves novel
stimuli.
Glamor
stocks

Variety is the
spice dope of
[market] life
IPOs
New Hot
Stocks e.g.
dotcoms

“Severe change and exceptional
returns usually don't mix. Most
investors, of course, behave as if just
the opposite were true...

“That is, they usually confer the
highest price-earnings ratios on
exotic-sounding businesses that hold
out the promise of feverish change...

“That prospect lets
investors fantasize
[THINK DOPAMINE]
about future profitability
rather than face today's
business realities. For
such investor-dreamers,
any blind date is
preferable to one with
the girl next door, no
matter how desirable
she may be.”

“We make bricks in Texas which use the
same process as in Mesopotamia.” -
Charlie Munger

Just like in video games, vivid stock market screens
and real time charts offer frequent change (i.e.
volatility) and sometimes unexpected good
surprises, thereby producing surges of dopamine
which results in addiction

Average
person buys
more
aggressively in
response to
recent price
rises -
expectation of
further rises

Dopamine release increases and fires
up reflexive system crowding out
reflective thought.

“Investment success will not be
produced by arcane formulae,
computer programs or signals flashed
by the price behavior of stocks and
markets....

... Rather an investor will succeed by
coupling good business judgement
with an ability to insulate his thoughts
and behavior from the super
contagious emotions that swirl about
the marketplace.”

Monetary gains have narcotic power

Addicted gamblers
chain themselves to
slot machines
Using adult diapers

“People are most credulous when they are
most happy”- Walter Bagehot
They become extremely suggestible and
will believe almost anything

A person in a manic state is impulsive, turbocharged
with euphoria, often unable to sleep, and endowed with
a grand ability to “perceive” the underlying significance
of everything around him

I am on a roll- I can see the future, nothing
can stop me - I am the master of the universe

Elevated levels of dopamine of a man in a
hot state makes him overconfident.

One-time gains start looking like
perpetuities, luck becomes skill, and “early
retirement” is just around the corner...

Over Optimism &
Over Confidence

Video on Influence of Arousal
Elevated levels of dopamine of a man in a hot state
makes him overconfident.

Normal human
tendency
90% of drivers think
that they are better
than average drivers

Why do people buy lottery tickets? Or
indulge in day trading?

74% of investors in a survey said
that their own funds will
consistently outperform the
market
Reality? Only a handful actually do

Only 37% of managers believe
that mergers create value for
buyers. But when it came to their
own mergers and acquisitions,
58% said their deals will create
value

Video Clip of Mr. Buffett on LTCM
Leverage is where overconfidence can be found

1. We are arrogant about
what we know-
Arrogance
2. We are over-confident
of our predictive
abilities- Predictions

Arrogance about what we know

Take a room full of people
Randomly pick a number e.g. sales
of books during september, size of
the Mississippi river etc.

Ask each person in the room to
independently estimate a range of
possible values for that number
set in such a way that they have a
98% probability of being right.

e.g. I am 98% confident that the
population of Japan is between 20
million and 50 million.

We can draw inferences about human nature
by counting how many people guessed wrong.
It should not be much higher than 2 people
out of 100.
Note: the subjects are free to set their range
as wide as possible.

You are not trying to gauge their
knowledge but rather their evaluation
of their own knowledge

The 2% error rate turns out to be
between 15% and 30%!

We can be wrong about ourselves
by a factor of 15 times!

It does not matter whether subjects
are Harvard Business School
students, doctors, lawyers etc.

Overoptimism in Predictions

Our track record in making
predictions is very bad
The future is very unpredictable

Oil at $140?

Oil at $10?

The value of ONGC when Oil is
at $10 will be VASTLY different
from its value when its at $140

“It’s stupid the way people extrapolate the
past- and not slightly stupid, but massively
stupid.”

“For years the financial services
have been making stock-market
forecasts without anyone taking this
activity very seriously. Like someone
else in the field they are sometimes
right and sometimes wrong.
Wherever possible, they hedge their
opinions so as to avoid the risk of
being proved completely wrong...

“(There is a well developed art of
Delphic phrasing that adjusts itself
successfully to whatever the future
brings.) In our view – perhaps a
prejudiced one – this segment of their
work has no real significance except for
the light it throws on human nature in
the securities markets. Nearly everyone
interested in common stocks wants to
be told by someone else what he thinks
the market is going to do.The demand
being there, it must be supplied.”

“The market's rise after a period of
reaccumulation is a bullish sign.
Nevertheless, fulcrum
characteristics are not yet clearly
present and a resistance area exists
40 points higher in the Dow, so it is
clearly premature to say the next
leg of the bull market is up...

“If, in the coming weeks, a test of
the lows holds and the market
breaks out of its flag, a further rise
would be indicated. Should the lows
be violated, a continuation of the
intermediate term downturn is
called for...

“In view of the current situation, it is
a distinct possibility that traders will
sit in the wings awaiting a clearer
delineation of the trend and the
market will move in a narrow
trading range."

“If you ask me exactly what it
means, I'm afraid I cannot tell you,
but I think the technician probably
had the following thing in mind: "If
the market does not go up or
down, it will remain unchanged."-
Burton Malkiel in “A Random Walk
Down Wall Street”

“Like a Don Juan or a Casanova, the chartist has
an unending series of short affairs with stocks.
First there is observation, a watching of the head
and shoulders, the neckline, and the shape of the
bottom. Flirtation may involve some resistance or
some support. As involvement increases,
congestion builds. There may be penetration of
old tops, or a violation of former lows. These give
way to mounting excitement and then climax,
followed by the warm afterglow of profit taking.”
- Burton Malkiel

“We do not have an opinion about
where the stock market, interest
rates, or business activity will be a
year from now.We've long felt that
the only value of stock forecasts is
to make fortune tellers look good.
We believe that short-term market
forecasts are poison and should be
kept locked up in a safe place,
away from children and also from
grown-ups who behave in the
market like children.”

“If I taught a course in
investments, my final
exam would be to value
this Internet stock.

“And if they came up
with an answer, they'd
flunk. And if they came
up with a blank sheet
of paper, I'd probably
give them a B.

“And if they said how
the hell could you ask
something so dumb? I’d
give them an A.”

“There are two
classes of
forecasters:Those
who don't know
and those who
don't know they
don't know.” John Galbraith

I have never seen a research report
which says:
“The value of this is 1,000 if this happens
and 50 if something else happens, and I
have no clue what will happen.”
Importance of Plausible Range of Values

Financial modelers use scenario
analysis and then apply subjective
probabilities to each scenario to
arrive at the “expected value”

That’s the functional equivalent of
the statistician who drowned in
water which was, on average, only 4
feet deep!

He forgot that the RANGE of depth
was between 2 feet and 10 feet!

“Variability matters e.g. if you go on a trip
and I tell you the temperature will be 30
degrees with an expected error rate of 20
degrees, you’d take a different set of
clothes than in the situation where I told
you that the expected error rate is 5
degrees.”

Nassim Taleb
“The worst case scenario is often more
consequential than the forecast itself.”

Worst Case Scenarios

Two very
different
(System 1 i.e
reflexive)
reactions to
worst case
scenarios

“Available” worst
case-scenarios results
in ignorance of
frequency and
overweighing of
magnitude.
Consequence:
Excessive
Overreaction

“Available” worst case-scenarios results
in ignorance of frequency and
overweighing of magnitude.
What is most “available?”
Personal vs.Vicarious experience
Recency
Vividness
e.g. Terrorism vs Climate Change

Immediately after a horrible scenario
(e.g. terrorist attack, major market
crash), people’s perception of risk goes
through a major change.

If worst case scenario
is “unavailable” there
is a tendency to
assume that the
frequency is as good
as zero
Consequence: Utter
Neglect
e.g. Terrorism vs Climate
Change

“It hasn’t happened for a
long time, so it won’t
happen”
Earthquake and volcano
eruptions
LTCM
“It can’t happen to me!”
Cognitive Dissonance and
Psychological Denial

“In all my
experience, I’ve
never been in
an accident of
any sort worth
speaking about.
I have seen but
one vessel in
distress in all my
years at sea...

“I never saw a
wreck and have
never been wrecked
nor was I ever in
any predicament
that threatened to
end in disaster of
any sort.”- E.J.
Smith, 1907,
Captain, RMS
Titanic

The Dangers of Excel Models

How to Value a Bond, or a
Business using Microsoft
Excel?

Definition of value is very precise:
Present value of future cash flows

The sheer number of
assumptions in a valuation model
are mind boggling

How do we calculate future cash
flows?
By using financial forecasting tools like
Microsoft Excel
Extrapolation, ignorance of
diseconomies of scale, ignorance of
competition, regulation.

Where does the cost of capital
come from?
It comes from CAPM

Minor changes in inputs can make
a vast difference in the final
valuation number

In some cases, most of the value is
comprised in cash flows which will
occur several years from now
So we have to worry about
forecast degradation

Increasing the discount factor is
not the way to do it!

“I don’t think you can
stick numbers on a highly
speculative business
where the whole industry
is going to change in 5
years and have it mean Warren Buffett
anything.

“If you say, “I am going to
stick an extra 6% on the
interest rate to allow for
that” I think that’s
nonsense. It may look
mathematical, but its
mathematical gibberish in
Warren Buffett
my view. . .”

P/E Multiples in a high growth
business are extremely sensitive
to growth rates
What happened to Infosys?

Underneath all the precision of the
formulae lies the imperfect man
For example...

“What you find in practice,
of course – the test used by
most CEOs – is that the cost
of capital is about ¼ of 1%
below the return promised
by any deal that the CEO Warren Buffett
wants to do!”

Thats why Excel Models can be
used to rationalize almost any
desired behavior!
Enter Animal Spirits

“The combination of precise
formulas with highly
imprecise assumptions can
be used to establish, or rather
to justify, practically any value
one wishes, however high, for
a really outstanding
Benjamin Graham
company.”

“Any business craving of
the leader, however
foolish, will be quickly
supported by detailed
rate-of-return and
Warren Buffett strategic studies
prepared by his troops.”

Man is not a rational
animal; rather man is a
rationalizing one…

And Excel is a beautiful tool which
helps him do just that!
You don’t even need “Goal Seek”
function because its already built
into the human user!

“People calculate too much and think
too little.”

Overoptimism arising out of
misunderstanding of causal chains

Causal Chains
A chain is only as strong as its weakest link
Or is it?

Airline business vs. Dominant FMCG

Why are airline businesses “accidents
waiting to happen?”
Why is it the same for any highly
leveraged businesses, or a business
which needs access to outside capital
markets?

Businesses which depend on the
kindness of strangers

The Expected Value Frame of Mind

“Take the probability times the amount
of possible loss from the probability of
gain times the amount of possible gain.
that is what we are trying to do. its
imperfect, but that's what it is all about.”

Frequency-Magnitude
The expected value frame of mind
Tendency to focus on frequencies or
magnitudes but not expected values

“If its not worth doing at all its not worth
doing well.” - Charlie Munger

Frequency-Magnitude
Taleb’s Bleed strategy
Being wrong most of the times! (e.g.
venture cap)
What about that CNBC Interview?

Denominator Blindness

Perseverance, Optimism and Luck

Michael Jordan Commercial (Link)
26 times I’ve been entrusted to
I’ve failedthat isand over, and
And over, why, I succeed
I’ve missed more thangames
I’ve lost almost 300 shot.
take the game-winning 9,000
over again in my life
shots inmissed
And my career

“You only have to get rich once- Warren Buffett

Position Sizing and Overoptimism

Kelly Criteria Link

Scene from 21 - Counting Cards in Blackjack

Scene from 21 - Counting Cards in Blackjack

“It is not given to human beings to have such
talent that they can just know everything
about everything all the time. But it is given
to human beings who work hard at it – who
look and sift the world for a mispriced bet –
that they can occasionally find one.

“And the wise ones bet heavily
when the world offers them that
opportunity. They bet big when they
have odds. And the rest of the time,
they don't. It's just that simple.”

“Our experience tends to confirm a long-
held notion that being prepared, on a few
occasions in a lifetime, to act promptly in
scale, in doing some simple and logical
thing, will often dramatically improve the
financial results of that lifetime.

“A few major opportunities, clearly
recognizable as such, will usually come to
one who continuously searches and waits,
with a curious mind, loving diagnosis
involving multiple variables.

“And then all that is required is a
willingness to bet heavily when the odds
are extremely favorable, using resources
available as a result of prudence and
patience in the past.

“Opportunity comes, but it doesn’t come
often so seize it when it does come.”

Look, If you Had
One Shot
One Opportunity
To Seize Everything You
Ever Wanted
One Moment
Would you Capture it?
Or Just Let It Slip?
Eminem agrees

Outliers, Unpredictability, and Luck

“Along the hilly slopes of the bell curve, most
values - the data points that track whatever is
being measured- are clustered around the middle.
The average value is also the most common value.

“The points along the far extremes of the curve
contribute very little statistically. If 100 random
people gather in a room and the world's tallest man
walks in, the average height doesn't change much.

“But if Bill Gates walks in, the average net worth rises
dramatically. Height follows the bell curve in its
distribution.Wealth does not: It follows an asymmetric, L-
shaped pattern known as a “power law,” where most
values are below average and a few far above. In the
realm of the power law, rare and extreme events
dominate the action.”- David Shaywitz (Link)

Link

“There’s a place he calls Mediocristan.
This was where early humans lived. Most
events happened within a narrow range of
probabilities – within the bell-curve
distribution still taught to statistics students.
But we don’t live there any more.

“We live in Extremistan, where black swans
proliferate, winners tend to take all and the rest
get nothing – there’s Bill Gates, Steve Jobs and a
lot of software writers living in a garage, there’s
Domingo and a thousand opera singers working
in Starbucks.

“He points out, chillingly, that banks make
money from two sources.They take interest
on our current accounts and charge us for
services.This is easy, safe money.

“But they also take risks, big risks, with the whole
panoply of loans, mortgages, derivatives and any
other weird scam they can dream up. “Banks have
never made a penny out of this, not a penny.They do
well for a while and then lose it all in a big crash.” -
Profile of Nassim Taleb in Sunday Times (Link)

Link

Link

Link

Why is Reliable Hit Prediction Impossible?

“When people tend to like what other
people like, differences in popularity are
subject to what is called “cumulative
advantage,” or the “rich get richer” effect.
This means that if one object happens to
be slightly more popular than another at
just the right point, it will tend to become
more popular still...
Darwin’s Theory of Evolution

“As a result, even tiny, random fluctuations
can blow up, generating potentially
enormous long-run differences among even
indistinguishable competitors...

“Thus, if history were to be somehow rerun
many times, seemingly identical universes
with the same set of competitors and the
same overall market tastes would quickly
generate different winners: Madonna would
have been popular in this world, but in
some other version of history, she would be
a nobody, and someone we have never
heard of would be in her place.”

Parallel Universes

Web-based experiment.
More than 14,000 participants registered
at Music Lab
(www.musiclab.columbia.edu), and were
asked to listen to, rate and, if they chose,
download songs by bands they had never
heard of.

Some of the participants saw only the
names of the songs and bands, while others
also saw how many times the songs had
been downloaded by previous participants.
This second group — “social influence”
condition — was further split into eight
parallel “worlds” such that participants
could see the prior downloads of people
only in their own world.

All the artists in all the worlds started out
identically, with zero downloads — but
because the different worlds were kept
separate, they subsequently evolved
independently of one another.
Darwin’s Theory of Evolution

In all the social-influence worlds, the most
popular songs were much more popular
(and the least popular songs were less
popular) than in the independent condition.
Winner takes all tendency

At the same time, however, the particular
songs that became hits were different in
different worlds, just as cumulative-
advantage theory would predict. Introducing
social influence into human decision
making, in other words, didn’t just make the
hits bigger; it also made them more
unpredictable.

Thank You