The Psy-Fi Blog

The Cherry Coke Effect?

noreply@blogger.com (timarr) — Mon, 13 May 2013 06:00:00 +0000

Hunger Games

If you want a favorable decision from a judge pray that you get a hearing early in the day or straight after lunch. In similar fashion you shouldn’t be making investment decisions on an empty stomach. In the parlance, such arbiters of justice and seekers after profit are suffering from ego depletion; although we might perhaps just say that they’re hungry.

Anyway, ego depletion seems to have a real effect on our ability to make important decisions: we’re more likely to be decoyed, to procrastinate and to compromise over our decisions when we’re low in energy. So this explains why Warren Buffett is such a good investor; it must be down to his addiction to Cherry Coke. Surely?

Ego Depletion

David McRaney has produced a great summary of the history of ego depletion on his website, You Are Not So Smart. As he relates, the research studies of Roy Baumeister and colleagues (see, for example: Ego Depletion: Is the Active Self a Limited Resource?, no guesses to the answer) revealed that there seems to be a psychic cost associated with self-denial and self-control: we have limited reservoirs of the stuff and the harder we have to work to resist temptation the more these reserves are depleted:

“These results point to a potentially serious constraint on the human capacity for control (including self-control) and deliberate decision making. “

The weird thing about this is that it isn’t some special state that we get ourselves into, it’s simply what happens in everyday life. Force yourself to concentrate on some mind-numbingly boring task, like everyday work, and you’ll find it harder to resist the call of the candy bar. And it may well be that it’s the candy bar that’s crucial to managing to continue to self-regulate.

Parole Lottery

As McRaney notes, in Extraneous Factors in Judicial Decisions the researchers, Shai Danziger, Jonathan Levav and Liora Avnaim-Pesso showed that the percentage of favourable rulings during a parole session drops from 65% to virtually zero as sessions proceed. Following a break for food the positive decision rate jumps back to 65%:

“We have presented evidence suggesting that when judges make repeated rulings, they show an increased tendency to rule in favor of the status quo. This tendency can be overcome by taking a break to eat a meal, consistent with previous research demonstrating the effects of a short rest, positive mood, and glucose on mental resource replenishment”

In fact, any kind of positive reinforcement seems to reduce issues with depletion of cognitive resources, but low glucose levels is one area where researchers are focussing their attention, as higher brain functions seem to require a lot of fuelling. In deference to this, recent research by Michael Kuhn, Peter Kuhn and Marie Claire Villeval has examined how our ability to defer income is affected by cognitive load. As you might expect, if participants were fed glucose drinks they were able to control their propensity to spend more effectively.

On the other hand, it turned out that if they were given a sugar free drink they were also able to defer their spending, which rather knocks the idea that glucose is a key factor in ego depletion. In fact it rather looks like this is indicating that the reward mechanism of the dopamine system to cutting in to boost the individuals’ egos and replenish their reserves of won’t power (see: Curiouser and Curiouser: Incentives Through The Looking Glass) . In fact, to confuse even more, people who had undertaken complex prior tasks also were able to show better self-control, which the researchers put down to an “attention/focussing” effect, essentially a priming mechanism for the complex stuff that lay ahead (see: To Boldly Go: Risk and the Prime Directive).

Which sort of indicates how hard these experiments are to get right, although not how difficult it is to construct elaborate explanations for why they go wrong.

Depleting Fast and Slow

Another rich area of psychological explanation for this type of behavior arises out of the separation between so-called System 1 and System 2 choice mechanisms. Anyone who’s read Daniel Kahneman’s Thinking Fast and Slow will be familiar with the concept – System 1 (Fast) handles intuitive thinking while System 2 (Slow) handles deliberative thinking. System 2 is better for those tricky situations that need careful consideration but we’re not always too good at recognising this and often misapply System 1 where System 2 would be better used. In investment we’re rarely better off using System 1.

In Deciding Without Resources the researchers looked at the impact of resource depletion on our propensity to use System 1 over System 2, even in situations where the latter would produce better results. As you might expect from the foregoing discussion:

“Specifically, we demonstrate that resource depletion enhances the role of intuitive System 1 influences by impairing the effortful and deliberate overriding role of System 2.”

Anastasiya Pocheptsova, On Amir, Ravi Dhar and Roy F. Baumeister’s results are particularly interesting because they identify a number of specific effects of this type of resource depletion:

“We find that resource depletion increases the share of reference-dependent choices, decreases the compromise effect, magnifies the attraction effect, and increases choice deferral”

So let’s unpick this. Reference-dependent choices are relative to specific reference points – anchors – and trigger our loss aversion anxieties (see: Anchoring: The Mother of Behavioral Biases). While investment decisions should be made solely on the basis of the current valuation we all too often rely on other factors. The attraction effect issue is the one we looked at in Birds, Bees and the Decoy Effect – the inclusion of extraneous options can influence our choices. Being depleted makes us more likely to suffer from this problem. Choice deferral is simply a grand way of referring to procrastination – and resource depletion makes us more likely to avoid making a decision and carrying on looking (see: Retirees, Procrastinate at Your Peril).

Mashed-up Behavior

This is a right old mash-up of behavioral finance, spanning a whole range of different factors. And there’s more. We’ve previously looked at the idea of mindfulness as a mechanism for preventing us making stupid financial decisions (see: Mindfulness), but constant mindfulness itself would potentially lead to cognitive depletion, making us more likely to make bad decisions. Well, there’s not a great deal of research on the topic but in Mindfulness Meditation Counteracts Self-Control Depletion the researchers Malte Friese, Claude Messner and Yves Schaffner find that … well, you can probably figure that out for yourselves.

In general we’d expect most intelligent investment decisions to be made by people exercising System 2, yet we know that paying constant attention is likely to deplete our cognitive resources. If a spot of meditation or a quick swig of Cherry Coke helps us make better decisions then so be it. After all, it should be our money at stake, not our egos.

Ego depletion, cognitive depletion, attraction effect and choice deferral added to The Big List of Behavioral Biases.

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Thatcherism: The Irony of Economics

noreply@blogger.com (timarr) — Thu, 18 Apr 2013 06:00:00 +0000

Nuance-onomics

We’ve previously looked at some of the evidence that suggests Studying Economics Makes You Mean. The general idea is that learning about the market economy and the benefits of natural selection tends to make us less generous and less empathetic towards the travails of others.

However, like so much research quoted here this only offers up part of the story. It’s possible that we’re looking at a false correlation – it may be that it’s not studying economics that makes you a nasty grasping son-of-a-bitch but that you study economics because you already are one. And, as usual, the truth is, at best, nuanced.

Ad-hoc-onomics

One thing is sure about studying economics: it’s not easy. It’s an ad-hoc mixture of social theory, mathematics and physics with a bunch of psychology thrown in for good measure. No half-way intelligent person ever took the subject for an easy ride. So we know to start with that there’s an element of self-selection about economics students.

In fact, anyone who’s worked in industry for any length of time will know that there’s an general acceptance of the profit maximizing principle amongst executives. This is almost a given, really, because how else would they ever be able to justify their behavior? And when Raymond Gorman and James Kehr followed up a study by Daniel Kahneman, Jack Knetsch and Richard Thaler on this topic this is exactly the result that they found. So, for instance, senior executives endorse pay cuts more often than people lower down the corporate ranking.

To investigate whether or not this type of principle is self-selecting rather than learned Giam Pietro Cipriani, Diego Lubian and Angelo Zago carried out a neat little study of students at the University of Verona. In Natural Born Economists? they examined the difference in behavior between economics and non-economics students both at the beginning of their university careers and at the end. Their findings were unequivocal:

“Comparing economics from other students at the same university, we find evidence of a clear selection effect: from the outset economics students differ from others in their tendency to maximize profits and in their view of the market mechanism.”

Thus: economists are born not made. In fact, the non-economics students appear to show clear selection bias against a market based system.

Optimal and Not

Nonetheless, the researchers do seem to show some evidence that behavior is not just predetermined and that some learning takes place. Which is good in that it indicates a university education may not be entirely pointless. Generally, though, there’s a slight tendency amongst economics students to fall back to market mechanisms even when there are wider issues of social responsibility or fairness.

In fact, given the world’s creeping addiction to financialization this is not insignificant as we saw in Screwed: Fictional Profits, False Accounting and Financialization. Real world problems are rarely simple and an ideological commitment to market-driven solutions will tend to create obscure solutions which ignore wider social issues. Economics may lead to the optimal outcome in terms of the allocation of scarce resources, but the social impact may be widespread and long-lasting.

Riotous Assembly

A case in point is the recent debate in the UK triggered by the death of Margaret Thatcher. While her supporters celebrate her staunch defence of the individual and celebration of the free-market economy her detractors criticise the unfairness and social upheaval that her policies caused. Although as a great many of her critics weren't born in the 1970’s and didn't experience the three day week, power cuts, rubbish piled up in the streets and mass labor unrest at first hand you've got to reckon that many of them just like a good party, preferably with a riot thrown in …

The hint that education can cause some impact on economic thinking is one that was followed up by Bryan McCannon and Jeffrey Peterson in Does Economics Education Affect Behavior? They were particularly interested in capturing the self-selection effect, what economists, largely to confuse the lay public, call “endogenity”.

Public Goods

The experiment involved a public goods game (see Games People Play), in which participants secretly contribute money into a public pot which is then multiplied by some factor and the “public good payoff” is then distributed to all. The best outcome is for everyone to contribute all of their cash, but oddly economic theory predicts exactly the opposite – that no one will contribute anything. Bizarrely, if you run the math, this is the optimal outcome because any rational person will always get the best outcome by adding nothing: this is the Nash equilibrium:

“The Public Goods Game is selected because it precisely provides a tradeoff between personal wealth-maximizing choices (which some refer to as selfish or shirking behavior, i.e. free riding) and group wealth-maximizing decisions. Thus, it is an ideal environment to assess the impact on decision making.”

The results are intriguing:

“Those who choose to study economics tend to be those who are more willing to make group wealth maximizing decisions. As economics training increases, private wealth maximizing behavior becomes more prevalent.”

In essence, more economics education will tend to make people less public-spirited and more likely to decrease their contributions to the public pot. Which suggests quite clearly that people don’t take economics because they’re mean but become mean because they take economics.

Reflexive Economics

OK, this is not as clear-cut as it seems and anyway it’s arguable about whether the outcome is desirable or not. Our economics students are clearly better able to make good financial decisions about their futures (see: Financial Education Doesn't Work, Freedom of Financial Choice is a Myth and Experience, Rare Events and Risky Choice) and that’s no bad thing in a world in which we’re all largely responsible for ourselves. Of course, this change is partly because of a lessening of the social safety net that governments and employers used to offer, which is happening in part because of the greater influence of economics on policy. Like so much in the world of finance this is reflexivity in action.

However, this does rather raise the question about how influential we should allow economists to be in setting policy, and certainly argues for ensuring that decision-making should never simply be delegated to the most financially optimal outcome.

Individual Economics

And this is as applicable to us as individuals as it is to corporations and governments. Saving a few hundred dollars now for a better retirement may be the economically optimal decision, but if that few hundred dollars was instead spent on a day out for your spouse it may make the difference between a retirement shared or a retirement alone.

No economic decision is ever taken in isolation from the social environment. Everyone should get an economics education; but no one should get an economics education without a balanced instruction in sociology. These ideas change lives and en-masse are altering our world; so let’s try and ensure they’re based on something more than theories about the optimal allocation of resources.

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Where Two Strangers Never Meet: Self-Serving Bias

noreply@blogger.com (timarr) — Thu, 28 Mar 2013 06:47:00 +0000

"If you can meet with Triumph and Disaster, and treat those two strangers just the same"

IF ... Rudyard Kipling

Problematic Pronouns

We all probably know someone who believes that their successes are entirely down to their own levels of skill and whose failures are someone else’s fault. To some extent most of us will meet them in the mirror each morning. This is self-serving bias in action. As Donelson Forsyth explains it:

“Those told they failed attribute performance to such external factors as bad luck, task difficulty, or the interference of others, and those told they succeeded point to the causal significance of such internal factors as ability and effort.”

Now, what do you think will happen to a corporation if you put someone with a bad case of self-serving bias in charge? Beware the CEO with a bad case of the personal pronouns, that’s what I say. And let's not talk about global warming.

Driven To Fail

Apocryphally most drivers believe that they’re above average, a statistical impossibility. In fact, as Ola Svenson showed in Are We All Less Risky And More Skilful Than Our Fellow Drivers? it appears to be a rare apocryphal "fact" which happens to be true:

“In the US sample 93% believed themselves to be more skillful drivers than the median driver and 69% of the Swedish drivers shared this belief in relation to their comparison group. “

Generally we have an unduly positive image of ourselves, and we gravitate towards activities at which we’re naturally good, rather than those which we’re bad at; which reinforces our self-perception. Self-serving bias (otherwise known as self-serving attribution bias, or SAB) would seem to arise quite naturally from this bias to the positive. And, frankly, given all the crap we have to put up with most of the time if we don’t believe in ourselves we’d probably drown in misery.

Normal, Sad and Dangerous To Know

Unfortunately a perfectly natural bias to the positive gets taken to the extreme in some people and people with a bad case of self-serving bias are quite dangerous to be around. One piece of research, by Theo Offerman, Hurting Hurts More Than Helping Helps, suggests that people with a positive self-image will respond less favorably to someone being nice to them than you might expect:

“After all, someone as nice as yourself deserves to be treated well.”

But, of course, this effect is reversed if someone is nasty to you. In fact subjects are much more likely to reciprocate an intentionally hurtful action than an intentionally helpful one. And the key is intentionality – people with a strong positive self-image really, really don’t like being mistreated.

Believing in Yourself

Of course, if most people are afflicted by self-serving bias then most investors will also be, and the tendency to attribute our investing successes to skill and our failures to the incompetence of management or some other ethereal force has long been attested to. For instance, in Investor Psychology and Market Under- and Overreactions the authors note:

“The confidence of the investor in our model grows when public information is in agreement with his information, but it does not fall commensurately when public information contradicts his private information. The psychological evidence indicates that people tend to credit themselves for past success, and blame external factors for failure”.

Applied to stock market trading this has several disconcerting implications, because if we believe our triumphs are the outcome of our own efforts and our failures the result of unavoidable external interventions we’re never going to learn – we’re blocking our own feedback paths, and feedback is critical to improving investment performance (see: Depressed Investors Don't Need Feedback. Everyone Else Does). We would expect such beliefs to tend to lead to overtrading and as we’ve seen overtrading leads to underperformance. However, the implications go beyond this, as Simon Gervais and Terrance Odean point out in Learning to be Overconfident:

“In times when aggregate success is greater than usual, overconfidence will be higher … In many markets returns will be a trader’s metric of success. Traders who attribute returns from general market increases to their own acumen will become overconfident and therefore trade more actively. Therefore we would predict that periods of market increases will tend to be followed by periods of increased aggregate trading.”

Shocking, ain't it?

CEO SAB

Of course, this result is intuitively obvious. Fortunately, given that human intuition is about as reliable a guide as a compass in a cyclotron, there’s some empirical evidence to support the idea. Most interestingly the model goes on to suggest that we’re more overconfident early in our investing lifetimes – experience does reduce this effect, as we saw confirmed in Investor Decisions - Experience Is Still Not Enough (But It Helps A Bit).

However, behavioral biases don’t stop at one level, they afflict us all, no matter what position we hold. Just as self-serving bias impacts us in ordinary life and as investors it will also afflict us at work. And when your job happens to be as a chief executive of a major corporation this can have consequences for more than you and your immediate family.

In a neat study, Managers’ Self-Serving Attribution Bias and Corporate Financial Policies, Feng Li looks at how and when CEO’s use the personal pronoun “I” in 10-K filings. The finding is unsurprising at one level – when times are good executives are quick to promote themselves, and when times are not so good they’re rather more likely to retreat to use of the third-person. Heads I win, tales they lose. However, the implications are rather graver than the sloping of well padded corporate shoulders. Let me quote at length:

“Consistent with this argument, managers with more SAB [self-serving bias] are more likely to issue forward-looking statements and make earnings forecasts, the tone (e.g., positive versus negative) of their forward-looking discussions has smaller variation, and their earnings forecasts tend to be overly optimistic. Firms whose managers have more SAB have higher investment-cash flow sensitivity and experience more negative market reactions around acquisition announcements. These firms also tend to have higher leverage, rely more on long-term debt financing, are more likely to repurchase stocks, and are less likely to issue dividends.”

On a slightly more positive note Andy Kim in Self-Serving Attribution Bias and CEO Turnover suggests that CEO’s with bad cases of self-serving attribution bias are more likely to get fired. Even the market response to these executives appearing on CNBC is generally negative, so not all media exposure is bad.

Climatic Penury

From all of which we can roughly conclude that people who aren’t very good at accepting the blame are not good for us personally or as investors. However, because this is an all-encompassing bias it can appear in all sorts of places: we even find this in national attitudes to who should bear the costs of mitigating climate change – a difference that appears to mirror the current impasse in negotiations, and probably reflects the impact of self-serving bias on the negotiators.

Of course, we can’t attribute all of the woes of the world to self-serving bias, but the idea that what’s good for us is fair, that our successes are always the result of our innate skill and that our failures are inevitably caused by evil outside intervention is a dangerous one for investors. For us the proper state is to be egoless; willing to recognize that triumph and disaster are strangers we should treat just the same.

In investing, as in life, dogmatic persistence with a particular approach is a good thing right up until it isn’t. Very many very rich people have got that way by believing in themselves and ignoring feedback – but unfortunately these are just the ultimate result of survival bias. If everyone gambles constantly someone will fluke a fortune. Following these “successes” is a one-way ticket to penury. Better take the long reflexive way home. You may not end up filthy rich, but at least you won’t end your days chasing hubcaps for a crust.

Self-serving bias, self-serving attribution bias added to The Big List of Behavioral Biases.

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Free Zeitgeist

noreply@blogger.com (timarr) — Sat, 23 Mar 2013 09:14:00 +0000

As the Eurozone undergoes another trial by stupidity and markets edge ever higher in the face of uncertainty and confusion, my publisher has kindly put The Zeitgeist Investor on free offer for the weekend. If any Kindle owners out there haven't already picked up a copy now is the time to do so. Because, of course, there's nothing new in the markets, it's just that we don't live long enough to remember.

Read More >> The Zeitgeist Investor

Curiouser and Curiouser: Incentives Through the Looking Glass

noreply@blogger.com (timarr) — Tue, 12 Mar 2013 07:00:00 +0000

Demotivated by Design

The world is full of schemes aiming to incentivize us; we’re spurred on to achieve new targets and scale new heights by the carrot of lucre-based incentivization schemes designed to appeal to our selfish natures. Which is not surprising because we live in a society characterised by a belief that we’re all out for what we can get, wheeling and dealing in our own self-interest, forever trying to get the maximum reward for the minimum effort.

Which is like determining that 5 is the square root of 17. Anyone who truly believes that money is the main motivation for most of our behavior is someone whose belief system needs to be carefully inspected with one of those devices used for stirring septic tanks. Worse still, financial incentive schemes may actually miss the point by undermining our most cherishable quality: curiosity makes the man, even if it flattens the feline.

Moral Prices

We’ve previously seen that financial incentives may have the curious effect of reducing a person’s natural inclination to engage in some behavior or other. So, for instance, in Money Can't Buy You Happiness Swiss people who were reluctantly willing to put up with a waste plant on their doorstep out of their simple good natures suddenly went cold on the idea when offered money to meet what they’d previously regarded as their civic duties.

Or consider the study A Fine is a Price by Uri Gneezy and Aldo Rustichini where fining people for turning up late to pick their kids up from kindergarten actually increased the number of late arrivals. The researchers suggest that introducing a financial penalty removed the moral obligation to arrive on time; a financial transaction is not the same as a moral one.

This underlying natural inclination to behave morally is known in the jargon as intrinsic motivation (see When Incentives Go Bad) and its disappearance under the influence of financial incentives is known variously as the undermining effect or the overjustification effect or even the mouth-numbing motivation crowding out effect.

Duped by Dopamine

Researchers have now found a neural mechanism to explain the effect, whatever the damn thing's called. Kou Murayamaa, Madoka Matsumoto, Keise Izuma, and Kenji Matsumoto in Neural Basis of the Undermining Effect of Monetary Reward on Intrinsic Motivation discovered that introducing performance based rewards on an interesting task actually reduced performance and, in particular, showed a decrease in activity in certain brain areas implicated in reward based processing – specifically one needed to prepare for mental processing and another implicated in the dopamine reward system: and we’ve met the dopamine reward system before, in Craving a High: Trading on Dopamine.

The idea that financial incentives can remove a person’s natural intrinsic motivation to engage in a high value task is a bit depressing if you’re particularly wedded to the idea that financial incentives are the solution to all ills. It’s probably closer to the truth to argue that they’re an easy answer to a difficult problem, and that most people are sufficiently self-interested not to argue with the prospect of extra money that they may get simply by getting lucky.

Curiosity Killed

However, perhaps the most depressing thing about this study is not that financial incentives don’t work but that they undermine peoples’ natural tendency to involve themselves in stuff that interests them. Because if there’s one quality that should define a human being above all others it’s curiosity – someone who is no longer interested in the world around them is someone who’s not really engaged with life and it’s a depressing thought that many of us end up trapped in circumstances that mean we carry on with the same old grind purely because of financial circumstances.

Of course a study showing that intrinsic motivation is reduced in the presence of financial rewards is not the same as one that says that it’s increased in the presence of simple curiosity. However, such a idea exists, something known as the information-gap theory, hypothesised by George Loewenstein in The Psychology of Curiosity: A Review and Reinterpretation:

“The proposed theory views curiosity as occurring when an individual’s informational reference point becomes elevated in a certain domain, drawing attention to an information gap. Curiosity is the feeling of deprivation that results from an awareness of that gap”.

Burning Bright

As Loewenstein points out, this may not explain all aspects of curiosity, but it’s an interesting approach and one that’s now been investigated using the same sort of neural analysis as in the previous study. In The Wick in the Candle of Learning Loewenstein and colleagues have shown that:

“Subjects spend more scarce resources (either limited tokens, or waiting time) to find out answers when they are more curious. The fMRI also showed that curiosity increases activity in memory areas when subjects guess incorrectly, which suggests that curiosity may enhance memory for surprising new information. This prediction about memory enhancement is confirmed in a behavioral study— higher curiosity in the initial session is correlated with better recall of surprising answers 10 days later.”

And are you curious about which brain area is implicated in this information gap theory? Well, it’s that darned reward modulating dopamine system again. Indeed, enhanced curiosity about a particular subject was also correlated to the ability of experimental participants to recall answers to questions that interested them, suggesting that this mechanism is implicated in general learning.

Uncertainly Curious

As the study carefully points out this is almost certainly not the final word on curiosity – there are wide range of complicating effects which haven’t been teased out – but it’s certainly part of the answer. In a world saturated by information, much of which is irrelevant, it certainly raises issues about how we choose what to be curious about.

The theory, and the evidence, also argues that uncertainty is initially correlated with curiosity:

“The fact that curiosity increases with uncertainty (up to a point), suggests that a small amount of knowledge can pique curiosity and prime the hunger for knowledge, much as an olfactory or visual stimulus can prime a hunger for food, which might suggest ways for educators to ignite the wick in the candle of learning.”

Beyond a certain point, though, increasing uncertainty leads to declining curiosity. We know that peaks in uncertainty in financial markets are linked to a wide range of generally poor behavioral traits: perhaps beyond a given point it just gets too difficult to integrate new information with old, such that curiosity is overwhelmed by novelty. After all, how many of us had experienced the nightmare of irrational markets at their worst before 2008?

Neuroeconomic Stimulation

Linking curiosity and financial incentives to intrinsic motivation and both to our dopamine modulating systems, while showing that different levels of curiosity are invoked by increasing uncertainty offers us a neat story but one that’s probably only a pastiche of the truth. Nonetheless, even glimpsing a path from brain structures to individual behavior to behavioral economics is a step forward, and a small triumph for neuroeconomics.

But broadly speaking if you want to motivate them stimulate their interest. Only don’t overstimulate them, because they’ll probably start behaving less rationally than you’d want: truly this is incentives through the looking glass. Which is curious, is it not?

The undermining effect, the overjustification effect and the motivation crowding out effect added to The Big List of Behavioral Biases.

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