Book of Value

The Fine Art of Investing Wisely

Anurag Sharma

• Publisher: Columbia Business School Publishing
• Year: 2016
• eBook ISBN: 9780231541695
• Topic: Personal Development
• Subtopic: Finance

Financial markets are noisy and full of half-baked opinions, innuendo, and misinformation. With deep insights about investor psychology, Book of Value shows how to apply tools of business analysis to sort through the deceptions and self-deceptions in financial markets. Anurag Sharma joins philosophy with practical know-how to launch an integrated approach to building high-performance stock portfolios.

Investors at all skill levels should learn to be mindful of their psychological biases so they may better frame investment choices. Book of Value teaches novices that investing is not a game of luck but a skill—and it teaches the emotional and analytical tools necessary to play it well. Intermediate investors learn how to effectively control emotions when investing and think strategically about their investment program. Advanced investors see the formalization of what they already know intuitively: that the philosopher's methods for seeking truth can be profitably applied to make smart investments. A groundbreaking guide full of lasting value, Book of Value should be on the shelf of anyone who takes investing seriously.

PART ONE

Illusion

CHAPTER ONE

Opinions and Beliefs

CONSIDER THIS SIMPLE experiment. Each of four cards on a table has a letter on one side and a number on the other, but you can only see what is on the side facing up. What you see are two letters and two numbers:

A 4 D 7

Suppose the rule governing these cards is that if a card has a vowel on one side, it has an even number on the other side. Which two cards would you turn over to find out whether the rule is true?

If you’re like most people, you’ll turn over cards A and 4; in doing so, also like most people, you will have made the incorrect choice. And the error you made is one of the most common as revealed from hundreds of years of thinking about human reasoning, now known as confirmation bias.¹

What you did was to try to confirm the rule that the cards with a vowel on one side will have an even number on the other side. Turning over A is an obvious choice, as being a vowel it can clearly falsify the rule if an odd number turns up on the other side. An even number on the other side of A would validate the rule, but you would not know whether the rule holds in all cases. But what is on the other side of 4 is not actually relevant. If you find a vowel behind 4, you will have confirmed the rule but would still not be able to declare that the rule is true; if there is a consonant behind 4, you have not violated the rule (the rule doesn’t say that a consonant can’t have an even number on the other side). So, turning over 4 gives you no useful information.

The correct response to the task is to turn over card A and card 7, both of which can show the rule to be false. The difference between cards 4 and 7 is that only the latter can provide disconfirming evidence. People turn over card 4 because our natural inclination is to want to confirm the rule.

This experiment was first devised by psychologist Peter Cathcart Wason in 1966, and over the years it has been repeated innumerable times by experimental psychologists trying to understand how people reason. Although the many variations of the experiment have yielded a range of results, one of the key insights gained is that confirmation bias is pervasive in human reasoning. People have a tenacious inclination to confirm seemingly correct rules, and whatever they already believe, no matter why they hold those beliefs or where their beliefs come from.

Beliefs and Their Persistence

Since beliefs play such an important role in how we choose, it is useful to consider that beliefs are propositional attitudes in the sense that people appear always to be tending toward some views on how the world works or ought to work, on what is or is not or ought to be or ought not to be.

History books are filled with examples of highly intelligent people holding beliefs that in hindsight appear to be patently ridiculous. For a millennium, those practicing medicine persisted in bleeding and purging patients even though the curative effects were few and painful death a more likely outcome. As Nickerson notes in a review, even when presented with evidence to the contrary, Galileo believed that tides were created not by the pull of the moon but by the “irregular” motion of the earth.² In fact, whole fields of scientists, presumably some of the most educated in society, have often clung to a theory despite the existence of rapidly developing evidence to the contrary. Nickerson notes that, in spite of numerous observations that contradicted it, Ptolemy’s earth-centric view of the cosmos persisted among the keenest minds for more than a thousand years. Scientists of the day strongly opposed the heliocentric model that sought to replace it, discarding evidence that was not consistent with their idea that the earth was the center of the universe.

Beliefs have a tenacious hold on people, who often stubbornly resist even the most compelling counterevidence. It is now well understood that people with well-formed beliefs distort the selection, evaluation, and interpretation of data so as to justify their views. Especially when information is ambiguous, people with strong beliefs selectively co-opt the evidence for support. Such co-optation is not necessarily irrational, as people have been shown to use facile logic and complex reasoning to contort evidence to reinforce their preferential positions.

Belief persistence is not simply a malady of a bygone era. The modern world offers plenty of examples of how simple ideas take hold of the mind. In studies about how doctors make diagnoses, researchers have noted that the thesis about a patient’s illness is often made early in the process. This initial thesis then guides the acquisition and interpretation of subsequent information and often constrains the range of options or alternative hypotheses considered. Faulty diagnoses, in other words, are usually the result of a persistence of belief that is formed early in the process of evaluation.³

The same phenomenon has been observed in studies of jurors.⁴ Researchers have found that jurors often form initial impressions during or even before a trial begins, based on superficial cues such as the defendant’s demeanor. They then selectively seek evidence to support that impression. In modern policy circles, many in the European Union believe that austerity is indispensable for economic recovery in troubled countries such as Greece and Spain. Their beliefs, perhaps based on a misreading of historical experiences, are such that they continue to ignore contrary evidence and arguments that rather than helping, severe austerity depresses the economies of affected countries even further, making them unable to meet the demands of creditors.

Whatever their source and content, a particularly interesting feature of beliefs is that they can form quickly, and often on the most tenuous grounds. Modern psychological studies have shown that even when presented with data with which to make decisions, people usually rely on information that already exists in their minds, is easily recalled, or is readily obtained from sources nearby. In general, people also give more weight to information that is obtained first. This tendency to quickly form opinions based on only readily available information, and then to selectively seek and creatively use subsequent information to support initial opinions, is called the primacy effect. Francis Bacon made this observation centuries ago, noting that the first conclusion colors everything that follows and pulls all later information toward it. In other words, we see what we believe.

Belief Persistence Among Investors

The primacy effect, belief persistence, and confirmation bias strongly influence what choices we make and how we make them. These deeply psychological dispositions interfere with both the acquisition and interpretation of information, and they do so without our even knowing it, subtly but powerfully shaping our thoughts and choices.

For investors whose success depends on making good choices about where to invest their money and where not to do so, such psychological hindrances can be costly. Taken to the extreme, mistakes induced by poor thinking can be disastrous; pulled into an investment on a hunch, a belief-enhancing cycle can induce an increasing commitment of resources until all is lost.

Another problem is that these interferences occur irrespective of whether the beliefs are true. Even though the examples above emphasize errors in judgment, confirmation bias operates equally strongly even when beliefs are based upon well-conceived standards or objective criteria. When caught in a confirmation cycle, lightly held beliefs and opinions that are legitimately grounded in some verifiable facts may become much stronger than is warranted. Strong beliefs can be built on hints of truth as easily as beliefs that have absolutely no basis in fact. We can easily stretch a little truth to absurd levels, out of all proportion to available evidence.

During the tech bubbles of the 1990s, the emergence of the Internet created legitimate opportunities for new business models and profit possibilities. Data traffic online started growing rapidly, at one point at the rate of 100 percent in only 90 days. This rate of growth then became a mantra that was repeated for the next several years, even though such a high level of growth was discernible for only a short time. As is now widely known, the little truth about the web, extrapolated to the extreme, contributed to one of the most rapid rises in asset prices ever seen.

Researchers have argued that self-deception is all too common among investors and makes them vulnerable to predatory exploitation by shrewd firms and institutions.⁵ Research also shows that, perhaps because of confirmation bias, individual investors are overconfident, trade excessively, and tend to have poor investment performance.⁶

The formation and persistence of beliefs occurs not only at the level of the individual, but also on large scale where entire populations become consumed by it. How errors in belief can gain mass appeal, sometimes quickly and sometimes persistently, is an exciting area of inquiry that I will review briefly in the next chapter. For now, consider what Charles Mackay wrote as far back as 1841:⁷

In the reading of history of nations, we find that, like individuals, they have their whims and their peculiarities; their seasons of excitement and recklessness, when they care not what they do. We find that whole communities suddenly fix their minds upon one object, and go mad in its pursuit; that millions of people become simultaneously impressed with one delusion, and run after it, till their attention is caught by some new folly more captivating than the first. We see one nation suddenly seized, from its highest to its lowest members, with a fierce desire for military glory; another as suddenly becoming crazed upon a religious scruple; and neither of them recovering its senses until it has shed rivers of blood and sowed a harvest of groans and tears, to be reaped by its posterity.

Students of financial history are, of course, familiar with financial manias that have periodically wreaked havoc in the lives of millions.⁸ History books are filled with such memorable events as the tulip craze, the Mississippi scheme, and the South Sea Bubble—and now the tech mania and the housing bubble. From the periodic stock market booms and busts of the last century to the recent housing market crisis in our own times, we are well acquainted with what confirmation bias, combined with other human frailties, can do to us.

Investors Are Human

Modern psychologists have uncovered a plethora of systematic biases that appear to be as much a part of human heritage as anything else. In addition to belief persistence and confirmation bias, there is a tendency for people to be overconfident about their own abilities and to be too optimistic about the outcomes of their actions. Similarly, people tend, on the one hand, to overreact to chance events and, on the other, to think that they could have predicted that which has already occurred.

Of course, entire treatises exist about the biases and visceral drivers that influence our choices; I will touch upon some of these insights in the pages that follow. My intent is to highlight that the utility-maximizing rational investor is a caricature of theory; perfect rationality, even if we know what that means, holds only for normative models. The idea that markets are efficient and that broad diversification accomplished under the dictates of modern portfolio theory is the answer to their unpredictability is as entrenched now as Ptolemy’s earth-centric theories once were. The sooner we acknowledge that we are biologically and psychologically predisposed to make poor choices, and that markets are more unpredictable than they are efficient, the better able we will be to accommodate our vulnerabilities when making investments and building investment programs.

In the following chapter, I show how individual errors and poorly thought-out choices aggregate into mass delusions. In later chapters, I develop the techniques of manipulation, the “dark arts” I call them, that are practiced upon us while we go about our daily lives as consumers, voters, and investors—even as we hold the illusion that we are independent thinkers free of all and sundry influences.

CHAPTER TWO

Correlation of Errors

ON FRIDAY, OCTOBER 24, 2008, panic gripped the financial markets. The Chicago Board Options Exchange (CBOE) volatility index (VIX),¹ also known as the Fear Index, reached an all-time high during trading that day. Having remained under 30 for most of the preceding year, and since its inception in 1990 having hovered between 10 and 20, the Index suddenly began climbing in early September, quickly surpassing the previous historical high of 44, and, on October 24, exploded to 89. The fear reflected in the VIX was clearly evident in the panic selling in the stock market.

In just one month, the market as a whole, as measured by the S&P 500 Index, dropped 26 percent and wiped out more than $2 trillion of equity investment in large publicly traded firms.

The economic news had been growing increasingly worse since the summer, but the speed of the market crash caught even the professionals by surprise. The newspapers were replete with stories about savvy institutions and big brokerage houses losing tens of billions of dollars and more. Many companies saw their market values plummet like a rock dropped from on high, and scores of people saw their life savings disappear in what seemed like the blink of an eye.

The remarkable thing about the sudden panic in the financial markets was that just a few years earlier, the sentiment had been quite the opposite. The S&P 500 Index had reached a historical high of 1,552 in October of the previous year, and the housing market had been booming for several years. The aggregate Case–Shiller Index of housing prices had risen from 125 in January 2002 to a peak of 251 in May 2006, at a rate two and a half times the rate of growth for the preceding four years. The euphoria that had been building for the previous half-dozen years was, in the fall of 2008, quickly and suddenly replaced by panic. Along with the decline in the stock market, housing prices plummeted, too: the Case–Shiller Index plunged more than 15 percent in one year.

Clearly, the euphoria and panic of the first decade of the century were not without precedence. Yet, unlike many others that are usually confined to a region, this particular upheaval was global. Instant news and rapid globalization had so connected the markets globally that what previously would have been somewhat contained now quickly spread throughout the world.

For the month of October through day 24, as the stock market indexes dropped precipitously in the United States, stock indexes around the world saw similar or worse losses. Brazil was down 48 percent, Peru 42 percent, Great Britain 31 percent, Germany 35 percent, Japan 23 percent, South Korea 46 percent, and India 36 percent.²

All the stock markets globally had been riding high barely one year earlier; now it seemed as if people the world over were experiencing a collective panic attack. As I revised this chapter in June 2015, both the S&P 500 Index (2,105) and NASDAQ (5,095) were at new historical highs. A few months later, in February 2016, panic seemed to be setting in once again.

Booms and busts have been with us as long as there have been markets, and in some ways even longer. In spite of the best efforts to contain them, such cycles have persisted in their unpredictability. It is understandable, therefore, that many theories seek to explain why economies and markets go to excesses in both directions. These theories are mostly technical in nature and thrive in such explanations as aggregate demand, money supply, interest rates, debt, and inventory. For the most part, they imagine the economy to be a machine, as if the fix is in pushing this button or pulling that lever.

The technical explanations force us to question why the aggregate demand explodes or crashes, the money supply goes astray, debt gets to excess, or inventories get bloated. Why do such mishaps happen with such speed and surprise even the savviest of investors?

There are few answers to these questions, in part because the technical reasons don’t quite reflect real, ground-level human feelings and emotion; they miss the larger human story at play in such periodic but unpredictable swings. Technical explanations miss the crucial point that economic activity is not an island unto itself; life outside the realm of dry theory influences what happens in the markets.

Participants in the markets are, after all, human. We are the same species that routinely creates flash riots and long-enduring movements, street disturbances and convulsive revolutions. We are the same psycho-biological beings whose collective follies are entertainingly catalogued by many authors such as, more than 150 years ago, Charles Mackay.

Although the world of finance provides a fascinating and highly visible example of collective mood swings, it is but one instance of multitudes acting as though in unison. Both in finance and beyond, the combined fears and hopes of millions take on a life of their own, answerable to no one, relentlessly moving to extremes in any given direction until their eventual, often forceful, dissolution.

In order to understand what happens in the financial markets, therefore, it is instructive to look to the larger human experiences in which we, the people, participate through mass actions. Below, I briefly discuss two examples of mass follies for insights into some of the emotional propellants that may also be at the root of behavior in financial markets.

The Atkins Diet

Consider the Atkins Diet craze that swept across the United States a few years before the market crash of late 2008. As is well known, obesity and its related ills have long concerned Americans, prompting a never-ending search for cures and quick fixes that would magically help people lose weight. As a result, different approaches to dieting have been in the American lexicon for more than a hundred years. Tod...

Table of contents

• Cover 
• Title Page
• Copyright
• Dedication
• Contents 
• Preface
• Acknowledgments
• Prologue: A Short History of Investing
• Introduction: Noise
• Part One. Illusion
• Part Two. Verity
• Part Three. Foundations
• Part Four. Diligence
• Part Five. Policy
• Conclusion: Noise Control
• Notes
• Bibliography
• Index