By Craig Mattoli
Our short foray into the psychology of investment design, in part one of the article, should make you aware of the importance of psychology in investment and the investment business. Even elementary economics is based on psychology, but, in the past, the emphasis, in financial writing and investment spiels, has been on rational finance with arithmetic and mathematics. In the end, investment is more about psychology than about numbers. Investment professionals understand psychology and use it as much of the basis for their investment decisions. The financial industry understands it and uses it to design products to sell to the ever-widening investing public. Thus, understanding how people make decisions and react in the investment environment are important lessons for potential investors. Many oft these topics have, now, been covered, classified, and christened, in behavioral finance
To begin, we examine the decision process of normal human beings. Decision-making can be divided into three phases: perception, assimilation, and evaluation. The fact is that, even though people are not perfect rational beings, in reality, they do not even take the time to do the full scope of an analysis of which they are capable. First, they oversimplify. Then, they let emotional factors seep into this simplified analysis. Instead of hard analysis, most people rely on heuristics, or back-of-envelope calculations. In addition, in what is referred to as the reduction of complexity, numbers might be rounded and small differences ignored. Next, mental accounting separates larger problems into components, which might miss the implications of the package. Interestingly, this also relates back to our discussion of framing; mental accounting means that sometimes people will miss favorable frames that are available. A final component in the reduction of complexity is availability: people will focus on information that is readily available and look no deeper. As far as comparing it to past experience, cognitive availability will cause people to attach greater significance to things that they can relate from past experience.
On top of the simplification process, people also ignore information: because there is too much of it, because they do not want to acknowledge certain information, or just because they were expecting different information. Even the order in which information is presented can create biases. In a stream of information, the first piece will prime our thinking, and the last will stick in our minds. In addition, contrast is important. If information is homogeneous, nothing stands out, but one piece of really different information will be contrasted to the rest. For example, a car dealer might, first, show you a junk heap at a certain price, which you reject, outright. Next, the dealer will show you a newer car at a higher price, and you might buy it, simply because it was so much better than the first car that you were shown, even though the second car is not particularly striking. Studies in marketing have shown that the colors that are used in an advertisement can also affect reaction to the ad.
After the process of the reduction of complexity has been completed, and once other details have been swept under the rug, there remains the necessity of making a decision, quickly, particularly in the continuous auction markets of the investment arena. That decision process begins with an anchor, a reference point, and subsequent adjustment, through the inclusion of additional information or from further analysis. Anchors are normally chosen because of their salience. Analysts will use anchors to produce forecasts, and, in turn, market participants will be anchored in those forecasts. Anchoring itself is not the problem in this process. After all, analysis needs a starting point. The flaw is in inadequate subsequent adjustment, as a result of putting too much weight on the initial anchor. As a consequence, forecasts based on anchors will underestimate the possible range of outcomes. Relating that back to numbers finance, the range of possible outcomes, the spread, is related to risk, so, risks are underestimated.
Another problem that seeps into the decision process and distorts it is concerned with representativeness. This concept can result in overestimation. For example, if a coin is flipped ten times and the results are ten heads, the common mistake is to believe that the probability of a tails, on the next flip will be very high, when, in fact, there is still only a 50 percent chance that a tail will result. In addition to this gambler’s fallacy, there are the conjunction fallacy and the conditional probability fallacy. In the case of the former, joint probabilities must be less than or equal to the component probabilities. However, people, due to representativeness, will often consider the conjunction of two probabilities to be greater than the separate probabilities would allow. Thus, it attributes more cause and effect to the concurrence of events than is correct. Ultimately, representativeness can lead one to assume relationships where none exist.
Such mistakes, based on misuse of representativeness, can be embodied in overestimation of both empirical relationships and causal relationships. For example, people might assume that there is a high incidence of HIV in lesbians because there is a high incidence in male homosexuals, when, in reality, the incidence of HIV in lesbians is actually lower than in the heterosexual population. This is an example of empirical misestimating. On the other hand, when we believe that there are patterns in data that may be only fortuitous, we are overestimating causal relationships. If you wish hard for snow, tomorrow, so that classes will be canceled, and it snows, you may believe that you have affected the weather: that is (probably) an overestimation of cause and effect. If you go to a casino and win a bundle of money, you may believe that it was due to your skill, not just some fluke of luck.
Perception itself is a relative thing. For example, standard color vision tests are composed of an aggregation of colored balls on a chart. There are usually numbers or other symbols embedded as patterns in such charts, which the subject is asked to discern. In a color vision test, the symbols are easier to pick out in the first few charts, and it becomes more difficult for a subject to distinguish them as more and more subtle charts are shown. The same is true in acoustical perception. If a bird sings in the forest, it is easy to perceive, but when it is close to a highway or on a busy city street, its voice might be lost in the background noise. Another common example of this sensory relativity that you may have experienced is concerned with the feeling of temperature. When you have frozen fingers, you are supposed to run cold water over them. However, even though the water is cold, it feels warm on your fingers. Thus, perception, in general, is measured against some reference point.
Helson introduced adaption level theory as a psychophysical basis for the study of perceptional relativity. In essence, it states that judgments based on perception are conditioned on previous experience. In that regard, there will be a neutral point, or reference level, in perception. If you stare at a dark gray sheet of paper, then, at lighter gray, your perception will be lighter, if black, darker. In general, perceptions will have such zeroing reference points. That ties in with the cognitive availability and anchoring that we have just discussed. In going from perception to the evaluation process, Kahneman and Tversky have adapted this same basic relativity theory in the prospect theory that they developed as an alternative to utility theory from economics. The price at which an investment asset is purchased (sold short) becomes the zeroing point against which gains and losses are perceived.
In the case of mutual fund managers, the reference point might be the return on the market. More importantly, people will display decreasing marginal sensitivity, as losses or gains move farther and farther away from that reference point, much like in utility theory and prospect theory. Both marginal gains and marginal losses will have less value to investors. Moreover, sensitivity will decrease with time. For example, if there is a choice between receiving $500 in 4 weeks or $520 in 5 weeks, most people will choose the former. If the difference is in 15 weeks or 16 weeks, people will become more indifferent. In addition, reference points can change as time goes on. Perhaps, a position was bought at $50/share, and, 6 months later, the stock price has risen to $75. The $75 might, then, become the new reference point. In that regard, the reference point is not fixed but might vary, depending on both the passage of time and other factors.
If we add the separation effect of mental accounting, the result is that each mental account will have its own point of reference. This means that not only is each position placed into its own mental account with its own reference point, separate from the others, but also that there is a separate overall performance account, in which all of the gains and losses are lumped together. In that regard, positions with small profits might be closed, in order to sit on a loss in another position, so as to preserve the relativity of the overall performance account. Indeed, this reintegration of gains and losses into an overall mental account that masks the loss is due to hedonic editing of accounts whereby an unfavorable event is placed in a more favorable mental light. It also provides another example that shows that people have frame preferences, while traditional finance assumes that there is no such thing. Moreover, another result of this separation and editing is that the loss will be sat on, longer, and may become much larger.
From our discussion we can see that frames are important in shaping people’s perceptions. Sometimes, people miss the best frame, partly due to their reduction of a problem to a simpler problem. Other times, they obscure the proper frame and settle on one that is more appealing. They do not take the time to analyze, and, therefore, they will most likely not take the time to find and bundle packages, themselves. As a result, most people will be happy to be presented with what appears to be an attractive frame. They are eager to find novel investment vehicles, and the financial community is more than happy to oblige. They also tend to overestimate and underestimate. In that regard, as long as the marketing emphasizes the good points, people will, themselves, deemphasize the bad points.
The portfolio, or package, was also one of the mandates of rational finance. Portfolio diversification is a good idea, so, it is also nice to find that the financial industry has created many packages, whether or not they call them packages. Banks have asset portfolios, so, they need to balance that with a proper portfolio of products and services for the liability side. Conglomerates were designed as portfolios of companies. Real estate and oil and gas investment trusts are portfolios of properties. Companies offered securities as a means around bank borrowing. The liquidity and maturity conversion provided by markets are design features of the markets for securities trading. The securities brokerage business was initially designed to generate sales commissions with no risk; since then, additional products and services have been added. Moreover, there has been an overriding mandate from the financial community: the need to diversify and hold a portfolio of securities. There are advisors, fund managers, and fund of fund managers.
Investment in marketable securities allows for maturity conversion, which is a good thing. In that regards, you do not purchase a 30-year maturity bond expecting to hold it until maturity. You can sell it in the market any time and tailor your holding period to your needs and desires. However, people sometimes cannot afford to take a loss, and they sell before the time is right. Other times, they sell too late, holding on as the price goes down.
There are reasons that people might end up waiting too long to react and generating larger loses. The bigger question is why these cycles of the next best newest investment design continue. Therefore, the final portion of our psychological analysis will focus on the psychology or loss and of selective memory of past investment experiences and the like.
Cognitive dissonance arises in all situations that involve choice since after a decision has been made, people will wonder whether or not they have made the right choice. You buy a green car, and, the same day, a friend drops by with the same car in red, and you admire the red car next to your green one and ask yourself: should you have gone with the red. Perhaps, you had a choice of buying shares of XYZ Corp. or ABC Inc., both of which are companies in the same industry, and you decided on ABC. The next day, XYZ is up $1/share, while ABC is down 50¢, and you are overcome with a sense of regret and a question of whether or not you should have bought the XYZ instead. Thus, a prerequisite for dissonance is commitment, which can only obtain in situations that were entered into when there was freedom of choice, in the first place. Even if there was no red car on the lot when you bought your green one, you had a choice of asking if any other colors were available.
In general, people attempt to eliminate internal conflicts by one means or another. It flows from the instinct of self-preservation. In that regard, people will search for avenues to create consonance and to eliminate dissonance, and confirmation bias will result in the illusion of validity. In that losses are felt more deeply than gains of similar magnitude, losses will lead to additional dissonance, which will also encourage a trader to look for confirmation instead of simply reversing his decision and taking a quick loss. Moreover, beyond this sort of selective perception, people may also engage in selective decision-making. As a result, they might continue to purchase a stock that is tanking as another means to attempt to deal with dissonance. That alternative course of action is known as the sunk cost effect.
In addition to the alternatives to reversal, there are other mental roadblocks that keep people from reversing decisions. There is a status quo bias, also known as the endowment effect, which tells us to just stand fast. Another factor is regret aversion. In that regard, people will hesitate to make a decision because they fear that it will be the wrong one, and, then, they will regret it. Again, these types of avoidance can lead to the decision to not take a loss. Regret aversion goes beyond loss aversion, in that people will consider the “what if”, as in what if I sell now and the price of the stock goes back up, tomorrow. After it is all over, people will even reconstruct the past, remembering it in a more favorable light to eliminate dissonance and regret.
In the end, people are so eager to get rich quick, and they think that investing takes no real training. Given our long discussion of how people think, especially when it comes to making a quick killing, it is not surprising that they continually get suckered into get rich quick schemes. The list goes on and dates back as far as recorded time. In the 1990’s, people mistook the race to patch technology for Y2K as an everlasting trend in technology sales. They let analysts (recall which department employs them) and brokers convince them to invest in the internet craze. Companies have used share size as a design tool for years, making their share accessible to a greater population by designing share prices. The futures exchanges took their cue from that, around the turn of this century, by creating mini stock market and other futures to allow all of those self-styled nouveau investors access to futures trading. It was only natural that someone should come up with the idea of mini-bonds in deadbeat mortgages, which has gotten us into the latest financial crisis.
Obscured-frame securities design was much a part of the world’s latest financial crisis. Fannie Mae and Freddy Mac were originally set up in the middle of the 20th century to buy mortgages from banks to free up their capital to make more loans for new home purchase. It was when the U.S. was beginning its ascent to relative affluence. Since mortgages are, typically, long term assets, it is difficult for a bank to turn over old mortgages to make room for new ones. Of course, time goes on and creates a continual need for an outlet for old mortgage investments to make new ones. The answer to that is for the agencies to act as pass-trough functions and package mortgagees into securities to sell in the financial markets.
Securitization is packaging of assets and sale of securities, debt or equity, on those assets. It was first done with debt and equity of companies. Then, it moved on to things like real estate investment, oil and gas properties, and mortgages. Securitization of mortgages, thus, had a history of about a half a century before they became the focal pint of the world’s latest financial crisis. Already, in the late 1990’s, there was a debate among professional traders even about the risk of Fanny’s and Freddy’s securities.
In the beginning of this millennium, a stock market crash, down 80% in the NASDAQ, left people feeling poorer. In turn, interest rates were ushered down to fifty year lows by the Federal Reserve. Banks offered home equity loans. Low interest combined with high ratios of debt to value (sometimes in excess of) to give marginal borrowers money. People began to trade property. I even sold my 18th century estate on the way up that bull cycle in property (having bought it at the bottom of the preceding cycle). That led to securitization of high risk mortgages as a get-rich-quick vehicle package. Also involved in the package were several kinds of swaps (you can read an excerpt from my coming textbook about various types of swaps, on the finance part of our website).
Then, came Lehman Brother with their mini bonds. Even the name of those “mini-bonds” is a misleading frame-obscured moniker for what was really a structured derivative package. Such were not unknown in the OTC institutional markets, but Lehman Brothers made a package with a price that was accessible to the retail investor, especially given the appetite for something new among that hapless horde of nouveau retail investors bored with the latest investment trends and looking for a new gamble.
Like the S&L’s in the 1980’s going haplessly into junk bonds, Lehman, through its BNC Mortgage arm, went too heavily into low-quality mortgages, and, instead of taking a loss and closing down the operation, it securitized them through complicated swap agreements laid off their resulting mini-bonds onto the general public around the world. Maybe it was psychology at Lehman, in facing loss that guided them into their hold and securitize reframing of investment reality. Rather than getting deep into the meaning of a 30 page prospectus for mini-bonds, which is just the latest example of design and marketing, in finance, we refer the reader to our website In Country Analysis page or Google for further specific information. Here, for simplicity, we show a copy of the structure of entities and transactions, for the Hong Kong market, from a report by Freshfields, Bruckhaus and Deringer, below. Note the complication of the diagram. What it really was a complicated, risky investment, obscured by the name mini-bond, which evokes feelings of security. It involved instruments, like interest rate and credit swaps, which are normally outside the price range of a retail buyer, even in the futures markets.
People continue to look for get rich quick schemes in investment, while treating it more like gambling. The finance industry continues to come up with innovative products to feed the hungry horde of new investors, and it does so with psychology, framing, and design, in mind. Then, each time there is a financial crisis, which is about once a decade, those same self-confident self-styled investors run and cry to the government and say that they were tricked and that they just didn’t really understand. The real problem is that grandstanding Congressmen champion them and chastise the perpetrators when, instead, they should let them learn a lesson, so that it does not give them courage to do it again and again.
Do not despair. The latest product is already on the drawing board, as I finish writing this article. Securities firms are, now, looking at packaging cash-out life insurance policies. In many life insurance policies, there is a cash-out option, which many people use, after they retire. Why wait to die for someone else to get the money when it could be used in your retirement years for your own enjoyment. There may be some policies that have a clause and a mechanism to cover that. There are also companies who buy such policies, in an OTC market, worldwide.
The latest designed retail package will then involve buying such policies, which will pay off at the deaths of the sellers, and sell a securitized piece of that with the promise to make payments as the fund receives them. It will be interesting to see where that business is at, a decade from now, or what will have replaced it by then.
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© 2009 Craig Mattoli, CEO, Red Hill Capital Corporation, Delaware, USA, owner, Leona Craig Art, Guangzhou, China: all worldwide rights reserved.