If you are tempted to answer should I read this book now, or later? "Later" then you should consider reading Chapter 14, "Self-Control, or the Lack of It," first. As humans, we are prone to specific psychological biases—procrastination is a good example—that can cause us to behave in ways that reduce our wealth. These biases also cause us to delay taking actions that would maximize our wealth. Consider the following choices many people have. How many times will they choose the delayed actions?
¦ Should I start contributing to my 401(k) plan now, or later?
¦ Should I invest the extra money that's in my savings account now, or later?
¦ Should I change the bonds and CDs I inherited to stocks now, or later?
In each of these cases, it is better to get the money invested sooner. The longer your money is invested, the larger your portfolio will grow.
However, a bias toward procrastination causes employees to delay making 401(k) pension plan decisions—often losing time and employer contributions. People's bias toward the status quo allows substantial money to build up in savings accounts before it is transferred to investment accounts; therefore they lose the higher returns an investment account offers. We also have a bias toward keeping the securities we inherit instead of investing them in vehicles that are more appropriate to our needs (the endowment effect).
Not only does our psychology cause us to delay some actions, it also can cause us to act too soon, too often, and too badly in some cases. In investing, sometimes we act too soon and sometimes we delay too long. Is this a paradox? Probably, but that is because we are human.
WHY HAVEN'T I HEARD OF THIS BEFORE?
Much of the education for investors originates with the work of financial economists in the nation's universities. However, these financial economists have traditionally dismissed the idea that people's own psychology can work against them when it comes to making good investment decisions. For the past three decades, the field of finance has evolved on two basic assumptions:
¦ People make rational decisions.
¦ People are unbiased in their predictions about the future.
However, psychologists have known for a long time that these are bad assumptions. People often act in a seemingly irrational manner and make predicable errors in their forecasts.
Financial economists are now realizing that investors can be irrational. Indeed, predictable errors by investors can affect the function of the markets. But, most important to you, your reasoning errors affect your investing, and ultimately your wealth!
It is my opinion that you could completely understand all the information in a modern investment text but could still fail as an investor if you let your psychological biases control your decisions. This book
¦ Explains many psychological biases that affect decision making
¦ Shows how these biases can affect your investment decisions
¦ Helps you see how these decisions can reduce your wealth
¦ Teaches you how to recognize and avoid these biases in your own life
The rest of this chapter is dedicated to illustrating that these psychological problems are real. The arguments will be far more convincing if you participate in the demonstrations in the following two sections.
A Simple Illustration
One example of the reasoning mistakes caused by the brain is the visual illusion. Consider the optical illusion in Figure 1.1. Of the two horizontal lines, which looks longer?
In fact, both lines are the same length. Look again. Although you know that the horizontal lines are equal in length, the top line still looks longer. Just knowing about the illusion does not eliminate it. However, if you had to make some decision based on these lines, knowing that it is an illusion would help you avoid a mistake.
The brain does not work like a computer. Instead, it frequently processes information through shortcuts and emotional filters to shorten the analysis time. The decision arrived at through this process is often not the same decision you would make without these filters. I refer to these filters and shortcuts as psychological biases. Knowing about these psychological biases is the first step toward avoiding them. One common problem is overestimating the precision and importance of information. This demonstration illustrates this problem.
Let's face it, investing is difficult. You must make decisions based on information that may be inadequate or inaccurate. Additionally, you must be able to effectively understand and analyze the information. Unfortunately, people make predictable errors in their forecasts.
Consider the 10 questions in Figure I.2.1 Although you probably do not know the answers to these questions, enter a range in which you think the answer lies. Specifically, give your best low guess and your best high guess so that you are 90% sure the answer lies between the two. Don't make the range so wide that the answer is guaranteed to lie within, but also don't make the range too narrow. If you consistently make a range so that you are 90% sure the answer lies within, then you should expect to get 9 of the 10 questions correct.
Enter the range (minimum and maximum) within which you are 90% certain the answer lies.
1. What is the average weight of the adult blue whale, in pounds?
2. In what year was the Mona Lisa painted by Leonardo da Vinci?
3. How many independent countries were there at the end of 2000?
4. What is the air distance, in miles, between Paris, France, and Sydney, Australia?
5. How many bones are in the human body?
6. How many total combatants were killed in World War I?
7. How many books were in the Library of Congress at the end of 2000?
8. How long, in miles, is the Amazon River?
9. How fast does the earth spin (miles per hour) at the equator?
10. How many transistors are in the Pentium III computer processor?
If you have no idea of the answer to a question, then your range should be large in order to be 90% confident. On the other hand, if you think you can give a good educated guess, then you can choose a smaller range and still be 90% confident. Go ahead now—give it your best shot.
Most people miss five or more questions. However, if you are 90% sure of your range, then you should have missed only one. The fact is that we are too certain about our answers, even when we have no information or knowledge about the topic. Even being educated in probability and statistics is no help. Most finance professors miss at least five of the questions too!
This demonstration illustrates that people have difficulty effectively processing and evaluating information.
Now let's check the answers. They are (1) 250,000 pounds; (2) 1513; (3) 191 countries; (4) 10,543 miles; (5) 206 bones; (6) 8.3 million; (7) 18 million; (8) 4,000 miles; (9) 1,044 miles per hour; and (10) 9.5 million. Count your response correct if the answer lies between your low and high guesses. How many did you get right?
Now that I have shown you the difficulty, let's try another one. Since this book relates psychology to investing, consider the following question:
In 1896 the Dow Jones Industrial Average (DJIA) was 40. At the end of 1998, the DJIA was 9,181. The DJIA is a price-weighted average. Dividends are omitted from the index. What would the DJIA average be at the end of 1998 if the dividends were reinvested each year?
Notice that Figure 1.2 has room for your DJIA minimum and maximum guesses. Again, pick a range in which you are 90% sure the answer lies. You should get this one correct. Ready for the answer?
If dividends were reinvested in the DJIA, the average would have been 652,230 at the end of 1998.2 Does this surprise you? It surprises most people. Even after learning that most people set too narrow a range in their predictions, and even after experiencing the problem firsthand, most people continue to make the same mistake!
Long Term Capital Management Hedge Fund Even Nobel prize winners in economics are prone to overestimating the precision of their knowledge. Consider the plight of the hedge fund Long Term Capital Management (LTCM). The partners of the fund included John Meriwether, the famed bond trader from Salomon Brothers; David Mullins, a former vice chairman of the Federal Reserve Board; and Nobel prize winners Myron Scholes and Robert Merton. The firm employed 24 people with Ph.D.s.
The hedge fund began in 1994 and enjoyed stellar returns. In the beginning of 1998, LTCM had $4 billion in equity. It had also borrowed $100 billion to leverage its positions for higher returns. Its original strategy was to find arbitrage opportunities in the bond market. These are low-risk strategies that usually garner low returns. However, since they were so highly leveraged, the low returns were magnified into high returns. After several years of great success, LTCM found fewer arbitrage opportunities. At that point, the hedge fund began entering into riskier positions. The risk was compounded by the high leverage from borrowing.