Are intuition and instinct useful investment tools?

Which of the following portfolios would you buy into?

The one that made over 20% right? You probably want to know what the secret of its success is and whether it can be bestowed on you for a relatively small sum.

Well, sadly, there is no secret. Each portfolio was assigned 10 stocks picked (from a sample of 363 FTSE companies with names begging by A's) by a random number generator. Averages were taken and the results plotted as above. The idea is to show that even with just 26 portfolios there is a massive amount of variance in returns. 

The point to emphasis is that statistically speaking when there are thousands of investors there are bound to be quite a few who have been very succesful purely down to luck.  The difficultly comes in attempting to distinguish between what is caused by luck and what is caused by skill alone.  One reason for this is illusory superiority or that we all think we are better than we actually are. (E.g. over 50% of people think they are above average in terms of intelligence.)

Thus individuals are likely to attribute their success to their own positive attributes and or strategies rather than luck. Conversely, upon failure they are more likely to chalk this up to bad luck than any inherent inability to think.  Which means that even if you believe that this argument works for other people, you will still believe you are special case.

Therefore, I would like to consign to the universe of luck is that based on Gut instinct, feeling, or intuition as opposed to reasoned analysis of the pertinent factors.  Instincts of experts have continually been shown to be a poor judge in a variety of cases none more so than in investing. There are all sorts of ways we are unknowingly led astray from the rational course when we let our intuition take control leading us to sell losing stocks too slowly, sell winners too quickly, trade too much, choose stocks in the media eye and many many more.  There is no doubt that our instinct is a poor investor.

There will be many people out there, confident of their own instincts having had high returns which they will attribute to their impressive intuition. However, given two contrasting explanations for this, luck vs. Gut feeling it is rational to conclude that what is more likely to be the case (luck) is the case unless it can be proved otherwise.  (See Occam’s Razor for justification of this conclusion).

Eurozone Break up? Which experts should we listen to?

It is possible the world will undergo profound changes in the next few years. The recent elections in Greece, won by parties campaigning on an anti-bailout platform have been hailed as marking the beginning of a new era of international relations, finance and politics. However, other commentators argue, equally plausibly that such a break up is neigh on impossible.

So which of these experts should we be listening to?

Well luckily for us a professor called Phillip Tetlock has given some insight into who is more likely to be correct. In his book Expert political judgement Tetlock attempts to create impartial standards for judging predictions. In a twenty year study Tetlock looked at two hundred and eighty four people who made their living commenting on political and economic trends.

In his analysis Tetlock categorises thinkers into two categories (borrowed from Isaiah Berlin); hedgehogs and foxes. Hedgehogs view the world through one distinctive meta-idea (think Karl Marx and class warfare) and view all developments, and predict the future through this distorting prism. Foxes try to understand the world through a variety of different angles, ideas and viewpoints.

While Tetlock found both experts to be relatively useless the foxes' ability to deal with uncertainty enabled them to make more accurate predictions than the hedgehogs that were often blinded by their slavery to their all encompassing idea.

What is perhaps more surprising is that hedgehogs are more likely to be higher profile, better paid and more successful than their fox peers. Hedgehogs are also more certain they are correct and more deluded in their assesment of the effectiveness of their own past predictions.

So, which if any, commentators should we listen to about the euro?

Well, first I guess it is easier to work out who we shouldn't listen to. Take Tim Worstall's column in the Telegraph which states that the way to work out whether the eurozone should exist is through the sole prism of "Robert Mundell's concept of an Optimum Currency Area. Equally, uninsightful are Andrew Alexander in the Daily Mail and Peter Morici of Fox News who both prepare arguments supported by an undying adherence to free-market theories that the Euro was doomed to failure from the start.  Or on the opposing side Barry Eichengreen from The National who can only see the issue through its contrasting path to his lifetime speciality, the gold standard.  These commentators are classic hedgehogs, blinded to the incredible complexity of life by adherence to single ideas or narratives.

Contrastingly, On the fox side of the discipline is an article in Der Spiegel which explores the issues through a combination of political, social and economic schemas. Another is written by Mohamed El-Erian in the FT which argues insightfully that keeping the Euro is possible in some conceivable instances. These are perfect examples of fox thinking, using a broad variety of narratives to look at an incredibly complex problem.

The conclusion then is simple, look for commentators who can deal with uncertainty and complex issues who deal with questions from a wide variety of angles. However, be prepared that the certainty we all crave will not be found in the arms of these sages.

Post IPO stock movements and company names.

Which company is more likely to gain in price shortly after floating?

TIM W.E. SGPS SA or Edwards Group Ltd.

The astute investors among you will tell me, possibly with a rather smug condescending smile, that a comparison is impossible without further information. We would need at least an opening price, financial statements some understanding of the product and its markets.......
 
However, in 2006 two Princeton academics published a paper entitled predicting short term stock fluctuation using processing fluency. This showed a high level of correlation between post-IPO share price and the name of a stock, the easier it was to pronounce the better the share performed after 1 week and 6 months. The effect was no longer statistically significant after a year.

To show this in monetary form they looked at $1,000 invested in the 10 most fluent and disfluently named shares in their study.  The fluent names produced a greater profit at all four points: $112 after 1 day, $118 after 1 week, $277 after 6 months and $333 after 1 year.

It appears that people are judging shares, at least when there is not much other information around, based on name. Why? Well, it comes down to the converging reactions we have when processing more or less difficult to comprehend information. 

The easier words are to comprehend the more familiar they feel. This relaxes us, leading to a more casual approach to thinking and a more trusting demeanour.  Conversely the harder something is to comprehend the less we like it, the more we doubt it and the more thoroughly we think engaging in what dual process theory refers to as system two.

When we read Edwards Group Ltd we are more likely to trust the company, our intuitions and buy. When we read TIM W.E. SGPS SA we are more sceptical and questioning of the share, it doesn't feel right and we don't buy.

So how do we use this to our advantage? Well once we've identified this there are two ways to deal with the situation depending on your intended exposure to risk.

If you are a long term investor attempting to gather constant returns over a long period. Stay away from IPOs; wait until companies have a long history of data to judge their performance by.

If you are happy taking on risk then the approach to take would be to go long easy to read IPOs, selling after a short time frame, you could also hedge exposure to cognitively easy shares by shorting harder to read IPOs.

Best books on Behavioural Economics / Investing

I thought I would create a list of some of the books  etc which have inspired me to write this blog. Instead of writing lengthy reviews for each I've provided a few words of my own to pique your interest and then links to my favourite review if you want to delve deeper. The first 6 are behavioural economics; I’d count the last 4 as behavioural investing.

Economics Related; 1-6

1.) Predictably Irrationality. Dan Ariely.....Good easy to read introduction to some of the ideas of behavioural economics. Review 

2.) Think Fast, and Slow. Daniel Kahneman.....Our mind has two systems for solving problems, one fast, one slow. The fast one uses shortcuts and therefore gets some things wrong.  Review

3.) Future Babble. Dan Gardner....Examines expert forecasts, quite a lot are wrong, explains why they are and why we listen to them anyway.  Review

4.) Being Wrong: Adventures in the Margins of Error. Kathryn Schulz....To err is to be human. Why we get things wrong, hate uncertainty but should embrace it. Review - Bill Clinton on why the tea party should read this book. 

5.) Irrationality. Stuart Sutherland......This book sparked my whole interest in this subject. Written in 1992 it manages to tackle a massive amount of the studies up to that point fitting in references to 160 different psychological experiments in its 242 pages. Review

6.) Arming the Donkeys. Dan Ariely....Ok, this isn't actually a book but it deserves to go in here anyway. In this series of free podcasts (just search in iTunes) Dan talks to researchers at different universities about the work they are doing and its ramifications for everyday life. In particular interest to investors, there is one on Stocks and their names / tickers and how this affects their pricing. Fascinating stuff and short!

Behavioural Investing; 7-10.

7.) The little book of behavioural investing. James Montier......Great starting point for behavioural investing. Explains the mistakes we make and how to stop them. Interview with Author

8.) Unexpected Utility. A good finance blog with a behavioural perspective.

9.) Inefficient Markets: An Introduction to Behavioural Finance. Andrei Shlifer...The book describes and evaluates inefficient markets and shows how behavioural techniques can be used to understand some of the anomalies in the markets. Couldn't find a review of this one!

10.) Behavioural Investing: A Practitioners Guide to Applying Behavioural Finance. James Montier...This is for the more serious reader. (At a whopping £40 it would have to be) If you still haven't had enough after the last three then get this one!

Availability, the Price Pressure Hypothesis and Facebook's IPO.

Do more words start with a K or have a K as the third letter?

The majority of people will answer the former. However, words with a K as third letter are two times more likely to occur in a typical text than those starting with a K. This post will attempt to explain how by understanding this basic heuristic we can better understand our own investing decisions and draw conculsion to what this means for facebook's impending IPO.

The reason we get this question wrong is due to the availability heuristic,  a mechanism humans have embedded in our brains which makes us believe that the ease that things come to our minds is equatable with the probability of that thing occurring. So as it is far easier to think of words beginning with K (King, Kangaroo etc)than those with K as a third letter, our mind tells us, there must be more of those words around.  But we are wrong.....

So, how does this help us?

Retail investors have a massive variety of stocks which they can buy. However, they only have a very small number they can sell (those they own).  The price pressure hypothesis states that due to this dynamic higher level of investor attention to specific stocks results in positive short term price pressure and long run underperformance. This research has been extended to IPOs showing the same findings.

This then is clear evidence of the availability heuristic occurring in markets. Stocks with a peak of interest (measured by google searches in the above referenced paper) go up briefly then underperform in the long run, this trend holds for IPO's. (Obviously this is not the case for all of them, but they are more likely to follow this pattern than not).

Which is all well and good but what can we practically take from these findings?

If we apply the findings to Facebook's much hyped IPO it is clear that this stock is clearly highly available in investors minds. Probably all the more so for those of us who use it on a daily basis. Which should send alarm bells ringing. So people are constantly mentioning facebook making it avaialble, investors cannot sell it therefore they can only buy.
So i would expect to see a flood of retail investors in its early stages, pushing up the price for a short period away from it's equilibrium and leading to long-run underperformance. The next question is for how long will the stock underperform?

Here, i’m a little reluctant to give exact dates (then i could easily be proved wrong and we wouldn’t want that would we). However, If we look at apple we can draw some comparisons which may help.

Apple stock owners are far more likely to own apple products, facebook stock owners will
 more likely to be facebook users. Common sense, right?  However, this means that the investors are likely to have assumed that as they like the product so the market fundamentals must also be good. (Based on the Halo Effect which I will write about in the future.)  This means that as long as the product is highly rated the stock is always destined to overperform, with the big players wary of shorting it due to the long-term over-pricing of the stock.

 In terms of investment strategy the conclusions we can make for ourselves are try to make investments decisions by sticking to sounds maxims to bring long term returns, rather than based on growth projections or your thoughts about a particular product.  Do not let your weak and fallible mind convince you into something where the numbers aren't right.

So conclusions for those looking for long term value: stay away from facebook, sell any apple shares you own.