Reﬂexive vs. Reﬂective Brain.The reason why people get it wrong is because they “jump to conclusions”using the reﬂexive parts of their brains.
Reﬂexive Brain is effortless, automatic, fast, but can lend itself to errors.Its also the reason why you are alive today. Your ancestors, who learnt to run away at theﬁrst sign of danger, were able to increase their chances of survival until at least they pro-created. If even one of your ancestors had died before pro-creating, you won’t be heretoday. But you are.Reﬂexive brain is VERY useful. But it also leads to mistake.Human Evolution hasn’t kept pace with rapid change since industrialization.
Reﬂective Brain is effortful, reasoned, slow, logical, and less prone to error
Assume today is 27 March 2009 i.e. there are only five days left in thefinancial year ending on 31 March 2009. One of your friends has approached you to advice him on his investments. He presentsyou with the following data about his current portfolio:
In addition, your friend also tells you that during 2008-09, he has already realized short-term capital gains of Rs 27 lacs. He now needs Rs 73 lacs by selling part of his portfolio. Which stocks should he sell?To a man with a hammer everything looks like a nail
This Data is SO boring!How do we make it more interesting?Enter Chief Constable of Gwent, Wales
“People assess the frequency, probability, or likely cause of anevent by the degreeto which instances or occurrences of that event arereadily “available”in memory.”-Daniel Kahneman
“An event that evokes emotions and is vivid, easily imagined, and specific will be more available than an event that is unemotional in nature, bland,difficult to imagine, or vague.”-Daniel Kahneman
What sort ofthings tend to be more available inour minds than others?
People remember vivid imagesWhich is why this presentation is made vivid
a rich and vividrepresentationof the outcome,whether or notit is emotional, reduces the role of probability inthe evaluationof an uncertain prospect.
On Rare Events“I visited Israel several times during a period in which suicide bombings in buses were relatively common—though of course quite rare in absoluteterms. There were altogether 23 bombings between December 2001 and September 2004, which had caused a total of 236 fatalities. The number ofdaily bus riders in Israel was approximately 1.3 million at that time. For any traveler, the risks were tiny, but that was not how the public felt about it.People avoided buses as much as they could, and many travelers spent their time on the bus anxiously scanning their neighbors for packages or bulkyclothes that might hide a bomb. I did not have much occasion to travel on buses, as I was driving a rented car, but I was chagrined to discover that mybehavior was also affected. I found that I did not like to stop next to a bus at a red light, and I drove away more quickly than usual when the lightchanged. I was ashamed of myself, because of course I knew better. I knew that the risk was truly negligible, and that any effect at all on my actionswould assign an inordinately high “decision weight” to a minuscule probability. In fact, I was more likely to be injured in a driving accident than bystopping near a bus. But my avoidance of buses was not motivated by a rational concern for survival. What drove me was the experience of the moment:being next to a bus made me think of bombs, and these thoughts were unpleasant. I was avoiding buses because I wanted to think of something else.”“My experience illustrates how terrorism works and why it is so effective: it induces an availability cascade. An extremely vivid image of death anddamage, constantly reinforced by media attention and frequent conversations, becomes highly accessible, especially if it is associated with a speciﬁcsituation such as the sight of a bus. The emotional arousal is associative, automatic, and uncontrolled, and it produces an impulse for protective action.System 2 may “know” that the probability is low, but this knowledge does not eliminate the self-generated discomfort and the wish to avoid it. System 1cannot be turned off.”
“The emotion is not only disproportionate to the probability, it is alsoinsensitive to the exact level of probability. Suppose that two cities havebeen warned about the presence of suicide bombers. Residents of one cityare told that two bombers are ready to strike. Residents of another city aretold of a single bomber. Their risk is lower by half, but do they feel muchsafer?”
The psychology of high-prize lotteries is similar to the psychology ofterrorism. The thrilling possibility of winning the big prize is shared by thecommunity and reinforced by conversations at work and at home. Buying aticket is immediately rewarded by pleasant fantasies, just as avoiding a buswas immediately rewarded by relief from fear. In both cases, the actualprobability is inconsequential; only possibility matters.
a basic limitation in the ability of our mind to deal with small risks is that we either ignore them altogether or give them far too much weight —nothing in between.Exessive over-reaction vs. Utter neglect.It depends on “availability”Terrorism vs. Climate Change.
“It hasn’t happened for a long time, so it won’t happen”Earthquake and volcano eruptionsLTCMIt can’t happen to me - like the fellow who goes out on a mobike without ahelmet.
“In all my experience, I’ve never been in an accident of any sort worthspeaking 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 anypredicament that threatened to end in disaster of any sort.”- E.J. Smith,1907, Captain, RMS Titanic
How should treat things that have happened before and those that neverhappened before.
The chances of winning are 10% in urn A and 9% in urn B, so making the right choice should be easy, but it is not: about 30%–40% of students choose the urn with the larger number of winning marbles, rather than the urn that provides a better chance ofwinning.The remarkably foolish choices that people make in this situation is called denominator neglect. If your attention is drawn to thewinning marbles, you do not assess the number of non-winning marbles with the same care. Vivid imagery contributes todenominator neglect.When I think of the small urn, I see a single red marble on a vaguely deﬁned background of white marbles. When I think of thelarger urn, I see nine winning red marbles on an indistinct background of white marbles, which creates a more hopeful feeling.The distinctive vividness of the winning marbles increases the decision weight of that event, enhancing the possibility effect.
Physicians response to Surgeon General’s report linking cancer to smoking
probability of a physician smoking is directly related tothe distance of the Her speciality from the lungs!
Before boarding a ﬂight people are prepared to pay more when offered a ﬂightinsurance policy to cover against “terrorism insurance” than for a general policycovering all risks.Clever, psychologically astute insurance companies can use this to manipulate people.
ITS ALL IN THEExtra vivid annual reports of Temptation Foods (a fraudulent company)resulted in seducing many investors.
QIB Placement on 19 Oct 200776,00,000 shares issued at 150 Money raised: Rs 114 cr.
Now that’s Vivid Too!Company under several investigationsMoral of the story is that you should be wary of “story” stocks.use stories to persuade, not be get persuaded by!
Recency Our most recent experience tends to carry more weight in our heads than old experiences.Thats how memory works.
Recent (and also vivid) events.Recency + vividness = lethal combinationAnd if you get this idea right, you’d understand the importance of takingthe opposite view of the crowd when the crowd is obviously wrong.AFTER the event the RISK went DOWN
Purchase of earthquake insurance increases greatly after the occurrence ofan earthquake and declines steadily as the memory of the event fades.Similar behavior has been observed for ﬂoods and food insurance.Notice this combines with VIVIDNESS
We over-react to recent eventsRecency + vividness = lethal combination
The best time to buy is when there is blood in the streets.While I am not a great fan of DCF (more about that later), it is at such times, that thinking interms of DCF makes sense. The value of an asset is equal to the present value of cash ﬂows.So only a change in two variables can change value. If these changes haven’t occurred butprice has crash, this spells OPPORTUNITYBiggest losing days in stock markets typically mean lucrative opportunities to invest.
The human mind is like the human egg. Out of a billion sperms racing towards the egg,only one succeeds in entering and fertilizing it. As soon as the fastest swimming spermenters the egg, the egg immediately shuts down to stop any other sperm from entering.We answer questions which start with the word “why” by grabbing the ﬁrst answer thatcomes to mind.Example: Steel Price Hike, Impact on Auto StocksExplaining Lollapalooza Outcomes: “part of the reason”
“Nothing is more dangerous than an idea, when its the only one you have.” Émile Auguste ChartierIf you want to have good ideas, you should have LOTS of IDEAS
Everyone should get a pack of these wonderful cards:Amazon.com: Creative Whack Pack (9780880793582): Roger Von Oech:Books
The human mind seeks easy answers to thequestions which start with the word “why”
A stock is selling below cash! Why should I buy this stock? Because its cheap!Well, so what? Under what circumstances would this be a mistake?Can you think of three reasons why you could be wrong?You really have to FORCE yourself to come up with 3 reasons which can prove youwrong.Three reasons why buying it would be a mistake1. Fraud2. Value Trap3. Bubble market
“I followed a golden rule, namely that whenever a new observation or thought came across me, which was opposed to my general results, to make a memorandum of it without fail and at once...Charles Darwin is a wonderful example, according to Mr. Munger, to study.
“for I had found by experience that such facts andthoughts were far more aptto escape from the memory than favorable ones.” - Charles Darwin
I Saw it with my OWN eyes!!!Direct ExperiencesWe overweigh direct experience and under-weigh vicarious experience.What we see for ourselves with our own eyes, hear from our own ears, has agreater impact than what we see or hear through othersI saw it with my OWN Eyes!
Direct Experience Vs. Vicarious ExperienceLearning comes from two types of experiences.Direct experience
“What we learn from history, is that we don’t learn from history.” Benjamin DisraeliYou will be required to read these books and be prepared to do a quiz(closed book) on it very soon.Here is your chance to acquire some extremely valuable vicariousexperience...
“We have never seen anything like this,” said analyst Glenn Schorr, who covers the investment banks for UBSAG. “There have been tough situations like Long-Term Capital Management and the crash of 1987, but theproblem here is there is leverage in the securities under the microscope and in the banks that own them. Andto try and unwind it all at once creates a one-way market where there are only sellers, and no buyers.” - WSJ,September 14, 2008But ﬁnancial history is littered with examples after examples of similar situations…This is an example of underweighing vicarious experience.Just because YOU haven’t seen anything like this, does NOT mean its never happened before.
“But I know a man who smoked three packs of cigarettes a day and lived tobe 99!”
If we personally see people who drowned, our assessment of the riskinessof swimming in open waters will be much higher than the correctprobability.
Problem of Silent Evidence You only see the winners!You can’t learn about success by reading these books because they don’t tell you about thecompanies who had same attributes but went belly up.Read “The Halo Effect”http://www.amazon.com/Halo-Effect-Business-Delusions-Managers/dp/0743291263/http://www.britannica.com/bps/additionalcontent/18/25996994/Misunderstanding-the-Nature-of-Company-Performance-THE-HALO-EFFECT-AND-OTHER-BUSINESS-DELUSIONS
Stock Market Prediction Newsletter ScamOne day you receive a newsletter in which you’re offered a free prediction. Reliance Industries would riseby more than 10% during the course of the next month. Coincidentally it does rise by 10%. Nextnewsletter predicts that Reliance will fall by more than 10% in the next month. A month passes and younotice that the second prediction has also come true.
Stock Market Prediction Newsletter Scamsix accurate predictions in a row! a coincidence? “Of course not!” you conclude. “This manhas real predictive powers.”364,500 = 1,21,500x3; 1,21,500=40,500x3; 40,050=13,500; 13,500=4,500x3;4,500=1,500x3; 1,500=500x3.are there “functional equivalents” of this scam?
Insensitivity to Base Rates (Probability unconditioned on featured evidence)Base rate is the probability unconditioned on featural evidence, frequently alsoknown as prior probabilities. For example, if it were the case that 1% of thepublic are "medical professionals" and 99% of the public are not "medicalprofessionals," then the base rates in this case are 1% and 99%, respectively.
“Base rates are boring but are amongst the most illuminating statistics that exist.”100 people - 70 lawyers 30 engineers. When no additional info is provided and asked to guess occupation of randomly selected 10, people use base rates - they say 7are lawyers and 30 are engineers.When worthless data is added - Dick is highly motivated 30 year old man who is well liked by his colleagues people largely ignore the base rate in favor of their “feel” forthe person.From “What Works on Wall Street”When stereotypical info is added e.g. Dick is 30 years old married shows no interest in politics or social issues and likes to spend free time on his many hobbies whichinclude carpentry and math puzzles, people TOTALLY ignore the base rate and bet Dick is an engineer.Base rates are boring - experience is vivid and fun.The only way someone will pay 100 times earnings for a stock is because it has a tremendous “story’. Never mind that the base rate of investing in high P/E stocks ishorrible - the story is too compelling that people throw base rates out of the window.Human nature makes it virtually impossible to forgo the speciﬁc info of an individual case in favor of the results of a great number of cases. we are interested in THISstock and THIS company, not with this CLASS OF STOCKS or this CLASS OF COMPANIES.Large numbers mean nothing to us.But they should
instructing people to “think like a statistician” enhanced the use of base-rate information, while the instruction to “think like a clinician” had the opposite effect.Amos and I originally believed, on the basis of our early evidence, that base-rate information will always be neglectedwhen information about the speciﬁc instance is available, but that conclusion was too strong. Psychologists haveconducted many experiments in which base-rate information is explicitly provided as part of the problem, and many ofthe participants are inﬂuenced by those base rates, although the information about the individual case is almost alwaysweighted more than mere statistics. Norbert Schwarz and his colleagues showed that instructing people to “think like astatistician” enhanced the use of base-rate information, while the instruction to “think like a clinician” had the oppositeeffect.
“Bargains do appear in the stock market recurrently. However, it cannot be said with certainty that a clear-cut bargain investmentwill produce excess investment returns, and it is impossible to predict the pattern, sequence or consistency of investment returns for a particular bargain investment...
“It can only be stated with certainty that repeated investment in numerous groups of bargain securities over very long multi-year periods has produced excess returns.” - The Partners of Tweedy, BrowneYou should use Stories to Inﬂuence OthersBut Think in terms of Base Rates when forming world viewsBuffett on technology - why does he keep away (mostly) - the mortality rate of technology companies(averaged out experience) makes him uncomfortable.He talks about stepping over one foot hurdles vs jumping over ﬁve foot ones.Mortality rates in leveraged stocksMortality rates in airline industry
“What we learn from history, is that we don’t learn from history.” Benjamin Disraeli
Anchoring Bias as a subset of Availability BiasWe need anchorsWhat are the right anchors?What are the wrong anchors?
Two different mechanisms produce anchoring effects— one for each system.Two different mechanisms produce anchoring effects—one for each system. There is a form of anchoring thatoccurs in a deliberate process of adjustment, an operation of System 2. And there is anchoring that occurs bya priming effect, an automatic manifestation of System 1.
Insufficient Adjustment“Start from an anchoring number, assess whether it is too high or too low,and gradually adjust your estimate by mentally “moving” from the anchor.The adjustment typically ends prematurely, because people stop when theyare no longer certain that they should move farther.”
“Amos and I once rigged a wheel of fortune. It was marked from 0 to 100, but we had it built so that it would stop only at 10 or65. We recruited students of the University of Oregon as participants in our experiment. One of us would stand in front of asmall group, spin the wheel, and ask them to write down the number on which the wheel stopped, which of course was either 10or 65. We then asked them two questions: Is the percentage of African nations among UN members larger or smaller than thenumber you just wrote? What is your best guess of the percentage of African nations in the UN? The spin of a wheel of fortune—even one that is not rigged—cannot possibly yield useful information about anything, and the participants in our experimentshould simply have ignored it. But they did not ignore it. The average estimates of those who saw 10 and 65 were 25% and 45%,respectively.”
List Price $83,900Average Appraisal: $75,190- a rise of $7,000
Adjustment is Effortful, System 2 Operation“Nick Epley and Tom Gilovich found evidence that adjustment is a deliberate attempt to ﬁndreasons to move away from the anchor: people who are instructed to shake their head when theyhear the anchor, as if they rejected it, move farther from the anchor, and people who nod theirhead show enhanced anchoring. Epley and Gilovich also conﬁrmed that adjustment is an effortfuloperation. People adjust less (stay closer to the anchor) when their mental resources are depleted,either because their memory is loaded with digits or because they are slightly drunk. Insufficientadjustment is a failure of a weak or lazy System 2.”
Was Saddam Hussain more or less than 155 years old when he died?How old was Saddam Hussain when he died?Ans: 70 years.Did you think of your answer by adjusting down from 155?And yet the absurdly high number still inﬂuenced your estimate.This is the “power of suggestion.”
Primed for Money“Reminders of money produce some troubling effects. Participants in one experiment were shown a list of five words from which they were required toconstruct a four-word phrase that had a money theme (“high a salary desk paying” became “a high-paying salary”). Other primes were much more subtle,including the presence of an irrelevant money-related object in the background, such as a stack of Monopoly money on a table, or a computer with ascreen saver of dollar bills floating in water. Money-primed people become more independent than they would be without the associative trigger. Theypersevered almost twice as long in trying to solve a very difficult problem before they asked the experimenter for help, a crisp demonstration of increasedself-reliance. Money-primed people are also more selfish: they were much less willing to spend time helping another student who pretended to beconfused about an experimental task. When an experimenter clumsily dropped a bunch of pencils on the floor, the participants with money(unconsciously) on their mind picked up fewer pencils. In another experiment in the series, participants were told that they would shortly have a get-acquainted conversation with another person and were asked to set up two chairs while the experimenter left to retrieve that person. Participants primedby money chose to stay much farther apart than their nonprimed peers (118 vs. 80 centimeters). Money-primed undergraduates also showed a greaterpreference for being alone. The general theme of these findings is that the idea of money primes individualism: a reluctance to be involved with others, todepend on others, or to accept demands from others. The psychologist who has done this remarkable research, Kathleen Vohs, has been laudablyrestrained in discussing the implications of her findings, leaving the task to her readers. Her experiments are profound—her findings suggest that living ina culture that surrounds us with reminders of money may shape our behavior and our attitudes in ways that we do not know about and of which we maynot be proud.”
Speaking of Anchors “The firm we wantto acquire sent us their business plan, with the revenue they expect. Weshouldn’t let that number influenceour thinking. Set it aside.”
Speaking of Anchors “Plans are best- case scenarios. Let’s avoidanchoring on plans when we forecast actual outcomes. Thinking about ways the plan could go wrong is one way to do it.”
Speaking of Anchors “The defendant’s lawyers put in a frivolousreference in which they mentioned a ridiculously lowamount of damages, and they got thejudge anchored on it!”
Money lost in wallet.Your wallet had Rs 1,000 and now Rs 100 is missing.You are feeling miserable because you are latching on (anchoring) to moneyin the wallet and not in the bank. If the money in the bank (your wealth) islarge, then this loss is inconsequential.Stop feeling miserable because of wrong anchors in life...
Par value 52 week low All time high Low absolute price Sunk-costs Stock price itselfIts foolish to think a stock is cheap just because its selling below par orbelow 52 week low or is selling at an absolute low price.A stock selling at Rs 5 may be more expensive than one selling at Rs 500.The right anchor to latch on you is value.
Overweighing what can be counted “You’ve got a complex system and it spews out a lot of wonderful numbers that enable you to measure some factors.“But there are other factors that are terribly important, [yet] there’s noprecise numbering you can put to these factors. “You know they’reimportant, but you don’t have the numbers. Well practically everybody (1)overweighs the stuff that can be numbered, because it yields to thestatistical techniques they’re taught in academia. “and (2) doesn’t mix in thehard-to-measure stuff that may be more important. That is a mistake I’vetried all my life to avoid, and I have no regrets for having done that.”
“The first step is to measure what can be easily measured. This is okay as far as it goes. John Bogle“The second step is to disregard that which cannot be measured, or give itan arbitrary quantitative value. This is artiﬁcial and misleading. The thirdstep is to presume that what cannot be measured really is not veryimportant. This is blindness. The fourth step is to say that what cannot bemeasured does not really exist. This is suicide.”
“Not everything that counts can be counted, and not everything that can becounted, counts.” Albert Einstein
Beta does not capture riskBeta is easily calculated but is “precisely wrong.” Keynes said correctly: “Itsbetter to approximately right than to be precisely wrong.”
“Peoplecalculate too much and think too little.”
Antidotes Look for disconfirmingevidence – killing your own ideas
Under-weigh extra-vivid experience and overweigh less vivid experience.Same with recent events; i.e. cool off period after meeting someone veryimpressive and impressionable.“Sleep over it.”
“Remember the lesson: “An idea or a fact is not worth moremerely because it is easilyavailable to you.”