Money Illusion – “A Dollar Today > A Dollar Tomorrow”

Money illusion refers to the tendency of individual investors to think of investment returns only in terms of nominal value. The term was coined by the economist John Maynard Keynes in his early twentieth century writings.

Nominal value only uses current market value without taking into account the past and future effects that inflation has on the purchasing power of an investment. The alternative is to use real value, which is the value after accounting for the effects of inflation.

Imagine you purchase a bond for $100 that pays an annual 5% rate of interest. You begin the year with $100 and will finish the year with $105. However, the $5, or 5%, you received is the nominal interest rate and does not account for the effects of inflation. Whenever interest rates are quoted, they refer to the nominal rate of interest, unless it is stated otherwise.

If the inflation rate was 3% for that year, then a $100 item that you could purchase at the beginning of the year would cost $103 by the end of the year. If you take into account the effects of inflation, then the $100 bond has earned a real return of only 2%.

Money illusion can influence your perception of which outcome is most beneficial to select. You will tend to choose a 4% nominal investment return in an environment of 2% inflation, over a 2% real investment return, even though the real returns of the two alternatives are equivalent. You believe that the 4% quoted interest rate has to be more attractive because it appears to be greater.

A dollar today is worth more than a dollar tomorrow and they are both worth much more than the value of a dollar in forty years. Inflation erodes the future purchasing power of your investments. This erosion is deceiving to most individual investors because it occurs slowly and compounds over time.

A proxy for the rate of inflation in Canada is shown by the monthly price change in the consumer price index (CPI). This index calculates changes in the cost of a fixed basket of consumer items that includes food, shelter, furniture, clothing, transportation and recreation.

In the forty year period from 1970 to 2010 the average annual inflation rate was 4.45%. A $100 investment in 1970 had to increase to $570 by 2010 just to maintain the same real value.1.

You need to overcome the effects of money illusion in order to understand how inflation affects the real purchasing power of your investments over long time horizons.

1. Bank of Canada http://www.bankofcanada.ca/en/rates/inflation_calc.html

Framing – Half Full or Half Empty?

Imagine that I am holding a glass that is partially filled with water. Is it half full or half empty? Either answer is acceptable because they can both be perceived as being correct.

I am still holding the same half-filled glass, but I now tell you I just drank some of it. Is it half full or half empty? Most individuals will now answer the question with half empty because they have a mind’s eye picture of me drinking some of the water.

I am still holding the same glass, but I now tell you I just filled it from the faucet. Is it half full or half empty? The answer to the question now becomes half full because you have a mind’s eye picture of me adding some of the water.

Framing refers to how the method in which information is presented can influence your decisions. As a result, the choices that you make are influenced significantly by the way problems are framed. Framing decision problems in a positive way generally results in less risky choices. While negative framing of problems tends to result in riskier choices.

The most widely cited study of decision framing was called the Asian Disease and was completed by Tversky and Kahneman (1981). It demonstrated that individuals systematically reverse their choices when the same problem was presented in different ways.

In financial markets, corporations commonly rely on a positive framing effect when they announce a stock split. A stock split is a corporate action in which a company’s existing shares are divided into multiple shares. Two-for-one is the most common form of a stock split. For example, a company with 500 shares currently trading at $10 per share will issue 500 additional shares, bringing the total to 1000 shares, which should result in the stock price trading at a revised $5 per share.

This price decline should occur because, although the number of shares outstanding has increased, the total dollar value capitalization of the shares and the underlying financial condition of the company remains the same as the pre-split value. There was no additional investment value added as a result of the split.In a study (Garcia de Andoain 2009) that evaluated the effectiveness of corporate stock split announcements, it was shown that “after an announcement of an upcoming split, share prices increased, which was caused by investors that reacted favourably to the announcement by buying more shares”.

The announcement of a stock split frames the perception that investors have about the shares in a positive way, since they will now have more of the investment. Ironically, a stock split can result in increased trading costs for individual investors when they buy and sell the corporation’s shares in the marketplace. This occurs because trading costs are frequently based solely on the number of shares traded, rather than the value.

Framing can also influence how you view data presentations. If you are told that “35 times out of 100 an investment strategy fails” this tends to have a more negative frame than being told “65% of the time this strategy is successful”. Therefore, if you are told that “35 times out of 100 an investment strategy fails” your decision choice is likely to be affected by both your more accurate understanding of the odds calculation of the data, but also by the negative frame in which it was presented.

The next time a financial advisor presents a data sequence to you as an evidence for accepting a risky decision, try reversing the format of the presentation and the frame that is being used, so that you truly have an accurate understanding of the choice.

Why You Hope That Stock Will Come Back

Risk aversion refers to an individual investor’s preference to choose an investment with a more certain, but possibly lower, expected outcome compared to an investment with an uncertain outcome. Individuals often choose investments with low but guaranteed interest rates, rather than investments that have the potential for higher returns, which also come with the chance of declining below the initial purchase cost.

Loss aversion results from the preference of most individuals to strongly prefer avoiding losses to acquiring gains. This occurs because your brain evaluates the emotional impact of losses and gains differently, with losses producing an impact that is more powerful than gains.

Imagine that you have the good fortune of finding $50 on the sidewalk. You place the bill into your pocket and walk to a store that is located in the next block. Once inside the store, you reach into your pocket to pay for a purchase and discover that the bill is gone. Somehow it fell out of your pocket. How would you feel?

Chances are that you would berate yourself over losing the found $50, because the loss has a more powerful feeling even though the true economic impact to you is $0.
Loss aversion explains the reluctance of individual investors to sell investments that will result in a loss.

Imagine that within your investment account you purchase two securities. If you are like most investors, these initial purchase costs will now become your continuing reference points for the success of your investment decisions. One security appreciates and one security declines. You now need to make a withdrawal from the account, so you will have to sell one security to raise the funds. You do not have any new information about either security that may influence your opinion of the future prices of the two securities. Which one would you sell?

Most individual investors would choose to sell the security with the gain, even though the transaction will produce a capital gain that will require a future tax payment. The most rational decision would be to sell the security with the loss, since no tax would be owed and the capital loss can be carried forward indefinitely for tax purposes.

Prospect theory explains this tendency for individual investors to hold on to losing stocks and sell winning stocks. The theory was developed by Kahneman and Tversky in 1979 and resulted in the researchers being awarded the Nobel Prize in economics in 2002. The theory describes how individuals make choices in circumstances where they have to decide between alternatives that involve risk.

The theory builds on the basis of risk and loss aversion, by which individuals value gains and losses differently, and shows that individuals also base their decisions on perceived gains rather than perceived losses. As a result, if you are given two equal choices, one expressed in terms of possible gains and the other in possible losses, you will choose the former, even if it provides the same monetary result.

Individuals tend to decide between which outcomes they see as basically identical, and then set these outcomes as reference points from which they consider lower outcomes as losses and larger ones as gains.

Consider an example where you are presented with $10,000 and then given two choices:

The first choice involves accepting a sure loss of $7500.
The second choice involves accepting a bet that has a 75% chance you will lose $10,000 or a 25% chance you will lose nothing.
Which choice would you prefer?

The probability outcome of both choices is a loss $7500, but most individuals select the second choice. Why? Because they do not like the feeling of losing and the second choice offers a chance that they won’t have to experience the emotional pain of a loss.

The implication of Prospect Theory is that individual investors do not assess risky choices following the principals of rationality. Rather, in assessing such choices, they do not focus on the levels of the final wealth they can attain, but instead view gains and losses relative to some reference point, which may vary from situation to situation.
To the detriment of individual investors, they are willing to assume a higher level of risk in order to avoid the emotional pain of loss. Unfortunately, many securities decline for valid reasons and never recover in price, so there is frequently a financial price to pay for not wanting to feel regret.

 

When Are Stocks Like Hotdogs?

Herding refers to the phenomenon of how individuals, who are acting independently, can sometimes unintentionally act together as a group.

Herding behaviours are common in your everyday decisions. Imagine you are walking down the street and you approach two hot dog vendors. Neither has a line of people waiting to order, so at random you choose one of the vendors. Soon another two individuals stroll down the street in search of a place to eat and they see you at one vendor, while the other vendor still does not have a customer. On the assumption that having customers makes one vendor a better choice, they join the line with you. Another passerby sees that one vendor is doing more business than the other, processes the same information and then joins the growing line, while the other vendor sits idle.

Financial market history is littered with examples of investments that begin as new ideas, then become fads, which turn into bubbles and inevitably into busts: Tulip mania in Holland in the 17th century, the South Sea Island bubble of the 18th century, the U.S. stock market boom of the 1920s, the internet and technology investment boom of the 1980s and, more recently, the residential real estate bubble that occurred in many developed economies in late 2000s. These episodes are often cited as examples of herding behaviour.

Herd behaviour has the potential to increase financial market volatility because in many financial market environments, individual investors are influenced by the decisions of other investors, resulting in them all herding towards the same investments. Suppose that 100 potential investors each make their own independent judgments about the potential profitability of investing in a particular stock. Only 20 of the investors believe that this is likely to be a profitable investment at the current price, while the other 80 believe that it is not worthwhile.

This is the same type of environment in which real financial markets function, as buyers and sellers of securities always having differing opinions regarding the same security. When you want to purchase a stock, someone must be willing to sell it.

Each investor is the only one who knows their own estimate of the profitability of an investment. They have no way of ascertaining the judgments of the other investors or whether a majority have decided to purchase the stock. However, if these investors did share their knowledge about the estimate of the potential profitability of investment, they would collectively decide that investing in the stock is not a good idea (80 ‘against’ vs. 20 ‘for’).

Imagine that these 100 investors do not all make their investment decisions at exactly the same moment. Instead, the first few investors that decide to act are the 20 investors who believe that this will be a profitable investment, and so they purchase the stock. Several of the investors who choose not to invest in the stock notice the increase in the buying activity and the resulting increase in the price of the stock, so they reverse their original decision and also purchase the stock, thinking that there must have been something wrong with their original opinion of value. In turn, this begins a cascading effect that results in most of the remaining individuals reversing their original decisions and now purchasing the stock as they use the same flawed decision-making process.

Once all the investors have finished purchasing the stock, the buying volume is finished and the price begins to decline. Some of the original 20 investors that purchased the stock early have made a profit, so they begin to sell. Other investors notice the change of direction in the stock price and they join the sellers.

Herd behaviour that can arise from informational differences:

• The actions and judgments of investors that appear early can be crucial in determining which way the majority will decide.
• The decision that investors herd on may well be incorrect.
• With the arrival of new information, investors may eventually reverse their initial decisions, starting a herd in the opposite direction.

When making your investment decisions, always remember that there is not always wisdom in joining the crowd.

Shortcuts to Ruin

Shortcuts to Ruin

“Buy low, sell high” is likely the most widely quoted financial market truth of all time. It makes so much sense, yet it is one of the most difficult tasks to repeat successfully in financial markets. The fundamental assumption of your investment decision making is grounded in the belief that you will rationally make a choice that leads to the highest possible financial gain.

But is this assumption always correct?

In order to speed up our decision making all humans utilize shortcuts or rules of thumb, which we use to draw inferences and make decisions from the information we receive. These shortcuts are called heuristics. In many circumstances, these shortcuts are close to being correct, but they also frequently result in some decisions being repetitively wrong. The result is that we are all susceptible to particular types of decision making errors because of our heuristic biases.

The most common heuristic biases are described below. Can you see how these biases may have affected your past investment decisions?

 
Availability Bias – “Trade the News”

You will predict the frequency of an event, based on how easily the occurrence of a previous similar event can be remembered. If you can remember it quickly, then you believe that it must be important. Therefore, recent events tend to have a greater impact on your decisions than past events and, consequently, recent news is viewed as more important than previous news.

Most individual investors rely on some type of media reports for a large amount of the information they receive regarding financial markets and investments. The financial media tends to report some types of information frequently because they view it as newsworthy. You will often view more frequently reported information as important and allow it to influence your investment decision making, rather than objectively weighing its relevance.

Representativeness Bias – “I Will Wait For a Correction to Buy”

You will regularly make judgments by relying on stereotypes. While this process may be correct in some circumstances, it can be very misleading in others.

Imagine that you purchase a stock and then watch its price increase for 10 consecutive trading days. What should you do: sell or hold?

You may believe that you should sell the stock since it cannot possibly rise in price for an 11th consecutive day. Or can it?

Imagine that you purchase a stock and then watch its price decline for 10 consecutive trading days. What should you do: sell or hold?

You may believe that you should continue to hold the stock; since it has fallen for so many days in a row any further decline is unlikely. Or is it?

In both these regularly occurring financial market scenarios, representativeness bias is present and has an influence on your investment decision making process. The fact that a stock has advanced or declined in any previous trading session does not have any bearing on whether it is more likely to reverse direction during the next trading session. Although you should know that this fact is correct, you struggle to overcome the influence of the past on your decisions about tomorrow.

Hindsight Bias – “I Knew It Would Double!”

You are inclined to see events that have already occurred as being more predictable than they actually were before they took place. You also tend to remember your predictions of future events as having been more accurate than they were, especially in the cases where those predictions turn out to be correct. Once you learn what occurred, you look back and believe that you knew all along that the result was going to happen. This encourages you to view financial markets as being more predictable than they actually are.

Hindsight bias develops as you detect new information. Your brain immediately processes the information by incorporating it into what you already understand. This revised understanding then becomes the benchmark from which future information will be evaluated. This process limits your ability to go back in time to objectively assess your state of knowledge at the precise moment that a past event occurred.

Overconfidence Bias – “I Always Make Money”

You tend to hold an overly favourable view of your own abilities. As a result, you are overconfident in the reliability of your own judgments to a much greater degree than should be expected based on facts alone. For this reason, you tend to be surprised by an outcome more frequently than you would anticipate.

We all tend to think that we are better than our peers. In survey responses individuals consistently rate themselves as being above average when they are asked to compare their abilities to a group. Being overconfident is not necessarily a bad personality trait, as it can boost your self-esteem and give you courage to try new things. However, the drawback is that it also leads to overestimating your chances of success or underestimating risks. It leads you to believe that you can control or influence outcomes, when in reality you cannot.

Overconfidence bias causes you to become too assured about your own judgments and not adequately consider the opinions of others. This false belief in your superior judgment is also linked to a perception that your investment decisions will be less volatile and risky than may actually be the case.