behavioral finance

The wise Yogi Berra once said that, “Baseball is 90% mental; the other half is physical”. Aside from a Hall of Fame career, Berra is best known for his entertaining “Yogi-isms”. Despite Yogi’s questionable math, baseball is indeed mental. Coincidentally, it was Berra’s teammate who invented one of baseball’s most mental tools.

Yogi Berra’s fellow Yankee catcher, Elston Howard, created the batting doughnut. Everybody from Little Leaguers to Mike Trout has used one. The premise is simple; warm up with a heavy bat in order to swing your regular bat faster. Except research has shown that, if anything, batting doughnuts may slow down swings.

But batting doughnut use persists. Former Minnesota Twins batting coach, Joe Vavra, explains that, “hitters need to do whatever helps them feel confident. The on-deck circle is like a mental hitting chamber”.

Whether they realize it or not, MLB players are leveraging a psychological phenomenon known as the contrast effect to boost their confidence.

The contrast effect impacts our perception of new information based upon exposure to prior information. Said differently, everything is relative.

One of the oldest examples of the contrast effect is an experiment involving three buckets of water. Bucket 1 contains ice cold water. Bucket 2 contains hot water. Bucket 3 contains room temperature water. Experimenters place opposite hands into the cold and hot buckets for a length of time. Then they take both hands out and place them into the room temperature bucket. The same temperature induces different sensations based upon each hand’s prior environment.

The same bat can feel heavy or light
The same temperature can feel hot or cold
The same account balance can feel thrilling or nauseating

As investors, we endlessly contrast our current vantage point with those from our past. Depending on the framing we choose, this can either be psychological torture or a confidence boost. As Ben Carlson has correctly observed, the best way to win any argument about the markets is to change the time horizon so it suits your stance.

For example, if you have a diversified investment portfolio, there’s a good chance it’s currently not worth as much as it was at some point last year. However, there’s also a good chance that it’s worth far more than it was three years ago.

By tweaking the variables of “compared to what” and “since when”, we can make any investment strategy look like it’s working or not.

This is part of what makes successful investing so tough. The same portfolio balance can simultaneously please and disappoint us. Then we have to balance those conflicting emotions and decide how to proceed. No wonder things get messy.

Investing evokes a broad range of emotions. When we feel ourselves drifting towards the extremes of the fear/greed spectrum, we should consider whether the contrast effect has been weaponized against us. This is one of our best defense mechanisms against being emotionally hijacked into poor investment decisions.

There are two sides to every story. Or, when it comes to the 1950 film, Rashomon, four sides.

After its surprise Golden Lion victory at the 1951 Venice Film Festival, Rashomon took the world by storm. The small Japanese film was created by the now-revered director and screenwriter, Akira Kurosawa.

Rashomon is a mystery about the unsolved murder of a samurai. During the film, we see four eye-witness accounts of the crime. The reason Rashomon was such a hit is because all four accounts tell conflicting versions of what occurred.

Each account seems accurate based upon how its narrator perceived the incident. However, it’s clear that the eye-witnesses are presenting themselves favorably, rendering their stories equally unreliable.

At the time, Kurosawa’s blatant disregard for the literary convention of a single, reliable narrator was groundbreaking. Adding to its already innovative style, the film ends without closure. The mystery is never solved. This drove audiences wild.

Fast forward to today, and Rashomon’s format has been adapted by countless TV shows and movies. The film has even surpassed its own cinematic acclaim. Since Rashomon burst onto the scene, when differing narratives describe the same event, the film’s title is often invoked as an expression of the phenomenon itself. The “Rashomon Effect” appears in law, psychology, and philosophy.

The Rashomon Effect also transpires in finance.

It is not uncommon to hear differing narratives attempt to explain daily market moves. And as we’ve learned lately, the more volatile the environment, the higher the volume of opinions.

Just in the last few months, we’ve seen daily market moves ascribed to: Trade Wars, a Trade Truce, the Fed, the yield curve, Brexit, a government shutdown, economic strength, economic weakness, the Death Cross, the Santa Claus Rally.

Don’t believe me? These headlines appeared a week apart:

It’s like our own little version of Rashomon. Every explanation for a market movement can seem plausible based upon somebody’s perception of it. But are any of them true?

It’s not so much that all of these explanations are wrong or that all of these explanations are right. It’s that they’re versions of what happened from different perspectives. Unfortunately for investors, that isn’t very satisfying.

When we can’t figure out who killed the samurai, it’s entertaining. When we can’t understand the swings in our retirement account balance, not so much.

The truth is that there aren’t definitive explanations for why the stock market does what it does. There never will be. However, human nature doesn’t seem to be compatible with this fact. As long as the human desire for certitude exists, so will the narratives. They scratch an itch, and that certainly has value.

There’s no harm in consuming market narratives as long as we remember that most of them fall into the category of interesting, but not actionable.

Prepare for a hot take: the earth is a sphere.

Now that I’ve lost all the flat-earthers, let me continue. Since the earth is a sphere, we cannot perfectly map its surface. Despite this, we’ve persisted in translating our three-dimensional world onto a variety of two-dimensional surfaces.

We don’t really have a choice. In order to navigate larger areas, we must shrink, shift, and warp details into digestible formats. Sometimes, this creates discrepancies.

For instance, check out this image that shows the relation between a Mercator map projection and the true size of each country:

And this one, that shows how understated that makes the size of Africa:

This isn’t to say that all maps are bunk or that their creators are disingenuous. Maps are subjective. Maps are abstractions. Maps tell us as much about their their makers as they do about reality.

The most important thing we can understand about a map is what it was designed for. This gives us a clue as to whether it will be useful to us or not.

This principle rings true for investors, as well.

The most important thing we can understand about market information is what it was designed for.

Short term market information was not designed to benefit the long term investor. In fact, you could make the case that this information often does more harm than good. It seems exactly backwards that the least relevant market information is normally the most readily accessible to us. But for whatever reason, we’ve been convinced that daily, monthly, or quarterly investment performance is a good way to track long term success.

I understand that, added together, days, weeks, and months become our long term reality. However, this still seems like an informational mismatch considering that, as Cullen Roche describes in this post, stocks are inherently long duration assets. When short-term feedback loops get applied to long duration assets, mistakes are sure to be made. 

Most of us would be better off receiving market information in a format like this:

What we see is all there is, and when all we see is short term information, it’s easy to get sucked in. Viewing short term information in the context of the bigger picture would be a helpful improvement for most.

But whether we look at daily market returns or rolling ten year performance, the numbers are the numbers. It’s what we do with them that matters.

The right feedback loop should keep you informed enough to know, but not enough to go insane. This is subjective, and finding that balance is easier said than done. The interval at which we seek feedback probably says as much about us as it does about reality.

The good news is that we’re in control. The bad news is that we’re in control.

It’s a blessing and a curse: we’re the cartographers; we make our own maps. Choose your feedback loop wisely. 

In the movie A Quiet Place, the story follows the Abbott family. The Abbotts live in a post-apocalyptic world that has been decimated by extraterrestrial creatures who hunt by sound. As we quickly learn in the first few minutes of the film, the family’s survival is dependent upon silence. Anybody who makes even the slightest noise is promptly attacked by the aliens.

To give you an idea of just how silent this film is: the first half hour contains no spoken dialogue. The tension created by this silence is captivating. I found myself anxious and filled with dread each time a character did something that might make a sound. The anticipation of noise and the understanding of its consequences had me on the edge of my seat. Every sound, no matter how faint, seemed like it could end the Abbotts.

A Quiet Place brilliantly leverages the power of silence. This contrast effect is often referred to in art as the use of negative space. Negative space speaks to the idea that the absence of something can have as much of an impact as its presence.

• In a photograph, the area surrounding the main subject is negative space
• In a song, that dramatic pause at just the right moment is negative space
• In A Quiet Place, the silence is negative space.

For investors, rising prices are negative space.

The contrast between rising and falling prices creates the same tension I felt watching A Quiet Place. As the market rises, we’re constantly bracing for the next crash. This mindset has been especially prevalent of late with all the talk surrounding the “longest bull market ever”. The longer it’s been since the last crash, the greater the anticipation builds.

This constant anticipation of doomsday creates a paradoxical environment where the higher the market climbs, the more anxiety and dread we feel. It’s why every dip in the market legitimately feels like it could be the top. The perma-bears know this, and will convincingly use the contrast effect to warn you for the hundredth time since 2009 that, “we’re due”.

It’s true that this bull run cannot last forever. Eventually there will be a top before we descend into the next bear market. But how will we know in the moment whether it’s the real deal or a false alarm? Is there any value in predicting sixteen of the last two bear markets? Will there be commemorative plaques for those who nail the top?

If your financial plan’s success is dependent upon calling the top of this market cycle, then you’re right to be worried. Trying to time the market is a terrific way to erode your investment returns into the dirt. Bear markets are an inevitable part of investing, so having a financial plan and investment portfolio that can get you through them (psychologically and monetarily) is vital.

You cannot watch a baseball game these days without hearing about a batter’s launch angle. Launch angle is the measurement of a batted ball’s vertical trajectory.

Since 2015, hitters have begun optimizing their swings for the ideal launch angle (25-35 degrees). This is because research has shown that balls hit within that range are more likely to result in impactful hits.

According to an article from Sports Illustrated comparing 2015 stats to 2017, batters hit 3,023 fewer ground balls, 3,157 more fly balls, and 1,196 more home runs in 2017. Some believe that the “launch angle revolution” helped contribute to the record 6,105 home runs seen during the 2017 season.

As more hitters have become launch angle disciples, pitchers have responded in kind. In 2018, they’re throwing fewer balls that lend themselves to hitters’ uppercut swings, like sinkers and low pitches. Instead, more pitchers are throwing curveballs and fastballs up in the strikezone.

The results of this counter-adjustment have yet to be fully quantified, but speak to an important point: in highly competitive fields, today’s edges often become tomorrow’s table stakes. We see this all the time in sports, as well as investing.

Winton CEO, David Harding, recently made a profound distinction in an article explaining his $30 billion investment management firm’s decision to rely less on trend following signals: “People always say to me: ‘This is what works.’ I say: ‘Worked’.”

Anything successful that can be easily and painlessly replicated will. Additionally, suckers don’t like to stay suckers, so they tend to make counter-adjustments when they find out they’re being taken advantage of. This is how edges get reduced to table stakes.

When large amounts of money are involved, I’d bet on any “unfair advantage” becoming table stakes (or useless) sooner rather than later. This is especially true in a hyper-competitive field like investing. Charley Ellis describes this phenomenon well:

“If you go back, 50 years ago there might have been 5,000 people involved in active investing. Now there are at least a million involved. And they’re smart. Well educated. They’ve all got exactly the same tools. Computers, access to the internet, Bloomberg terminals, and they’ve all got access to the same information because the SEC requires public companies to give everybody all the information they give to anybody.”

The idea of having an informational or analytical edge today is a pipe dream for almost all of us. There are too many intelligent people, all working with the same information, for an edge like that to last. However, less desirable edges stand a fighting chance because they come with a cost. A good indication of how enduring an edge will be is how uncomfortable it is to capitalize on.

Jim O’Shaughnessy was recently on the Bespoke Podcast with George Pearkes. He made an excellent comment about their own and many other successful investment strategies that might seem counterintuitive:

“You can scream from the roof tops what the secret sauce is and it doesn’t matter because people simply either won’t do it or will do it incorrectly.”

In a world where informational and analytical edges are fleeting, behavioral edges are the most important advantage available to us. Having a behavioral edge over other investors is far easier said than done. The reason this edge exists is because it’s uncomfortable, counter-intuitive, and sometimes downright painful. It means relentlessly following a financial plan and its corresponding investment portfolio, even when it feels wrong.

As I see it, there are two options: constantly and consistently find today’s edges before they become tomorrow’s table stakes or behave better. One seems far more realistic to me, but we each have to reach that conclusion on our own.

Creating a portfolio without making an investment policy statement means failing to acknowledge that investing is an emotional endeavor. 

For those of you who don’t know what an investment policy statement is, let me begin with a story:

In Homer’s epic, The Odyssey, the hero Ulysses must sail past the Sirens to reach his home. Sirens are monsters who pretend to be beautiful women with amazing voices. They frequently lure sailors off course and kill them. Ulysses is forewarned of the test that lies ahead for him and his crew, and formulates a plan.

His men stuff their ears with beeswax so they cannot be tempted by the Sirens’ song. Ulysses is desperate to hear the infamous song, but realizes that it is likely to cost him and the crew their lives. His compromise is to have his men tie him to the ship’s mast, and promise not to release him under any circumstances.

The Sirens and their song are just as alluring as anticipated. Ulysses is enamored by their charm. Despite his relentless struggle to be released, the crew fulfills their promise. Ulysses is left tied to the mast and the crew rows them to safety.

By recognizing during calmer times that he might later react poorly, Ulysses was able to create a framework to ensure that chaos did not prevail. In modern times, we sometimes call decisions like these Ulysses contracts.

An investment policy statement is a good example of a Ulysses contract. It clearly defines what investments are for, when the money is likely to be needed, and what the guiding principles will be in the interim. An investment policy statement is the embodiment of a calm, rational you who will need to remind a hysterical, irrational you what your priorities are at some point in the future.

Creating an investment policy statement involves a bit of an ego check. We’re essentially admitting that we’re going to lose our minds at some point in the future. However, recognizing that behavior is likely to be a huge component of future investment success or failure is simply realistic.

The tricky part is that an investment policy statement, or any Ulysses style contract for that matter, is worthless without the acknowledgement that its existence is necessary. If we don’t actually believe our future behavior might be an issue, it’s highly unlikely we’ll abide by any guidelines we create.

It’s very easy to give lip service to the idea that investor behavior matters, but it’s another thing entirely to recognize that it’s personally applicable. Investor return statistics refer to us, not them. Earning market returns is no walk in the park. If it were, then everybody would do it with ease. There’s no shame in setting some guiding principles for yourself at the outset of your journey.

The mere existence of an investment policy statement isn’t magic. As Annie Duke wrote in her excellent book, Thinking in Bets: “In most situations, you can’t make a pre-commitment that’s 100% tamper-proof. The hurdles aren’t necessarily high, but they nevertheless create a decision-interrupt that may prompt us to do the bit of time travel necessary to reduce emotion and encourage perspective and rationality in the decision.” 

When push comes to shove, we can always override an investment policy statement. That’s why creating an IPS is only the half of the equation. We have to believe in the reason for its creation to give it real value. This is easier said than done. However, I’m certain that it beats making emotionally charged decisions with your money in the heat of the moment.