fpa nor cal 2014.ppt

7/22/2019 FPA Nor Cal 2014.Ppt

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This is Your Brain on Stocks:Behavioral Economics,

Neurofinance, Risk Aversion:

Why You Are Not Wired to Make

Intelligent Financial Decisions

Presentation by

Barry Ritholtz

FPA NorCal Conference

May 27, 2014


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Todays Discussion:

1. ReviewInvestor Behavior, noting most common investingerrors;

2. Explore how and why these occur;

3. Learn how you can help prevent your clients from making

these exact same investing errors + hurting themselves


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This is Your Brain.

This is Your Brain on Drugs1987 PSA


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Thisis

your

brain

Your brain weighs 3 pounds, and is 100,000 years old. It is a dynamic, opportunistic, self-organizing system

of systems. MRIs have revealed to Neurologists what our brains looks like when making decisions. We can

observe it 1) in real time; 2) under actual conditions, and 3) in reaction to financial risk/reward stimuli.

Once we begin trading stocks, however, our brains begin to undergo subtle physical change that we can

actually see in the MRIs of Traders . . .


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Thisis

your

brainon

stocks


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1. Herding, Groupthink

2. Optimism Bias

3. Confirmation Bias

4. Expert Opinions

5. Recency Effect

6. Endowment Effect

7. Hindsight Bias

Behavioral Economics Neuro-Finance

How Your Brain Interferes with Your Investing

Risk Aversion

1. Anticipation vs. Rewards

2. Selective Perception/Retention

3. Words vs Images

4. Pattern Recognition

5. Data vs Narrative

6. Cognitive Dissonance

7. Species of Dopamine Addicts

1. Humans dont understand risk

2. What we fear

3. Black Swans

4. What will kill you5. Clients biggest financial Fears

5. What hurts their portfolios


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A brief intro to

BehavioralEconomics


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Source: Kal, Economist

Herding

Mutual of Omaha

Lone Gazelle


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Sources: Ritholtz.com, NYT, McKinsey, Marketwatch

1. Only 5% of Wall StreetRecommendations Are SELLS-NYT, May 15, 2008

2. Why Analysts Keep Telling Investors

to Buy-NYT, February 8, 2009

3. Equity Analysts Too Bullish and

Bearish at the Exact Wrong Times-McKinsey, June 2nd, 2010

4. None of the S&P 1500 have a Wall St.Consensus Sellon them-Robert Powell, Editor, Retirement Weekly, August

2011

It is better for one's reputation to failconventionally than to succeed

unconventionally.

-John Maynard Kyenes

Groupthink


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Sources: IMDB, Wines & Vines

The Sideways Effect

In 2004, Merlot was the best

selling wine in America = 15%of all sales.

Pinot Noir was < 3%

Paul Giamatti (Miles): I amNOT drinking any f&%king

Merlot!

Merlot sales plummeted 35%

and Pinot Noir sales rose more

than a 100%.

This became known as the

Sideways Effect.


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Source: McKinsey & Co.

Analysts have been persistently overoptimistic for the

past 25 years, with [earnings] estimates ranging from 10 to

12 percent a year, compared with actual earnings growth of

6 percent On average, analysts forecasts have been

almost 100 percent too high

-McKinsey study

Analysts: Over-Optimistic GroupThink


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Here, Kitty, Kitty, Kitty

Optimism Bias


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The Math of Active Management is Daunting:

1. Only 20% of active managers (1 in 5) can outperform their benchmarks inany given year;

2.Within that quintile, < half (1 in 10) outperform in 2 out of the next 3 years;3. Only 3% stayed in the top 20% over 5 years (1 in 33)4.Add in costs and fees, less than 1% (1 in 100)manage to outperform (net).

5. What are the odds of picking that that

1-in-100 manager?

Passive vs Active Management

Source: Morningstar, Vanguard


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You are an above average driver

Your kids are better than their kids

You saw the crisis coming

You can pick stocks

You can time markets

Lake Wobegone Effect


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Dunning Kruger Effect: DK is a cognitive bias in which unskilled people make poor

decisions and reach erroneous conclusions, but their incompetence denies them the

metacognitive ability to recognize these mistakes.

Metacognition: The less competent you are at a task, the more likely you are to over-

estimate your ability to accomplish it well. Competence in a given field actually weakens

self-confidence.

This has devastating consequences in the investment world.

Dunning Kruger Effect

Glaser & Weber, University of Mannheim surveyed

investors, asking them recent performance. Most

considered themselves above average. On average,

investors overestimated annual returns by 11.6% per

year. In fact, the lower the actual returns the worse theywere at judging their returns.

The correlation between self ratings and actual

performance is not distinguishable from zero.


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Source: Zweig, Your Money & Your Brain; Grants Interest Rate Observer,

Expert forecasters do no better than the average member

of the public; Statistically, expert predictions are the =random guesses. (Philip Tetlock)

Experts acknowledge future is inherently unknowable are

perceived as being uncertain and therefore less

trustworthy. (Isaiah Berlin: Hedgehog vs Fox)

The more self-confident an expert appears, the worsetheir track record is likely to be. And, the more likely he is

to be believed by TV viewers;

Most famous = least accurate.

Least accurate = most confident

Forecasters who get a single big outlier correct are more

likely to underperform the rest of the time;

The Articulate incompetentsThe Tao Jones (1984) by

Bennett Goodspeed

ExpertForecasting versus Ambiguous Uncertainty


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1. We tend to read that which we

agree with; We avoid that which

disagrees with our preconceived

biases, notions or ideologies;

2. Our biases change the way weperceive objects literally, the way

we see the world.

3. The same biases affect our

memories we retain less of whatwe disagree with . . .

4.Expectations Affect Perception

Selective Perception & Retention

Confirmation Bias


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Source: WSJ

WSJ: 2007 WSJ: 2010

Beware the Recency Effect


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Source: Fortune, Time

Time, June 2005 Fortune, June 2005

What Just Happened vs. What is Going to Happen


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Source: Morgan Housel, Motley Fool


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Obama State of the Union, 2010

One in 10 Americans still cannot find work. Many businesses have shuttered. Home

values have declined. Small towns and rural communities have been hit especially hard.

And for those who'd already known poverty, life has become that much harder. Thisrecession has also compounded the burdens that America's families have been dealing

with for decades -- the burden of working harder and longer for less; of being unable to

save enough to retire or help kids with college.

[Soon after, stocks surged.]

Source: Morgan Housel, Motley Fool


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What does this mean for investors?

We have an Optimism bias (helps our survival).

Our brains are better at processing good news about the future than bad.

Anticipation of financial reward > than actual benefits (Buy Rumor, Sell News)

Gamblers, Alcoholics, Sex Addicts, Junkies, OA, Hyper-Traders =Dopamine High.

A Species of Dopamine Addicts


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A brief intro to

NeuroFinance


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If u cn rd ths


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This animation . . .

. . . is not an animation


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When it absolutely positively

has to deceive your eyes overnight

Source: Federal Express


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No, this was not photoshopped

Source: 11even.net


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We prefer stories to data

Pre-writing, story-telling is how

Humans evolved to share information

We are vulnerable to anecdotes that

mislead or present false conclusions

unsupported by data

Monkeys Love a Narrative


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A brief introduction to

Misunderstanding Risk


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We Are All Going to Die. Heres How.

Shark: A perfectly evolved killing machine, immortalized in Spielbergs 1975 film, Jaws.


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10 People a year are killed by sharks

worldwide

There are other large predators that

each year manage to whittle down a

few off of that 7 billion number:

Humans live on land

Lions? (100)

Elephants (100)

Hippos (500)

Crocodiles (1,000)

Snakes (50,000).

Dogs (25,000) almost all due to rabies.


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Source: Gates Foundation, CDC

The Deadliest Animal in the World

Mosquitoes are the deadliest creature

on earth; Man only comes in second


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Your Risk of Terrorism

2010: 25 U.S. noncombatant

fatalities from terrorism worldwide

2011: Terror related deaths = 8

People who die after being struck

by lightning: 29.

Americans abroad most likely to be

killed in car accidents than any

other reason

Study found 500 additional people

die in cars accidents each year after9/11 due to fear of terrorism. Since

then, double the number of

casualtiesSource: CDC, Mueller & Stewart, Terror, Security, and Money.


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Your Actual Risk

You are

35,079 times more likely to die of heart disease

33,842 times more likely to die of cancer

than a terror attack.Source: CDC


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What are your clients afraid of?

Market Crashes

HyperInflation

Collapse of the

Dollar

Looking foolish


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1987 Crash in Imminent!

Marc Faber: 2014 crash will be worse than 1987sCNBC, April 10, 2014


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Marc Faber Says Stocks Have Likely Peaked for 2009 Bloomberg, 9/25/2009

Faber on Hyperinflation: Not A Matter Of If But When Business Insider, 9/23/2010

'The Bear Market Is Starting' Marc Faber CNBC, August 3, 2011

Faber: The Dollar's Value In The Future Will Be Zero Business Insider, 4/18/ 2011

Marc Faber: We Could Experience A 1987-Style Crash This Year Business Insider,

5/10/2012

Marc Faber: Look out! A 1987-style crash is coming. CNBC, August 8, 2013

2014 crash will be worse than 1987's: Marc Faber CNBC, April 10, 2014

My prediction? In 2015, Faber will predict crash . . .

1987 Crash in Imminent!


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What Really Hurts Portfolios . . .

People fear Black Swans Terrorist attacks,

Sharks, Disasters when its the mundane things

like heart disease, cancer and diabetes that get you

in the end.

Investors fear Black Swans Market Crashes,

Hyper-Inflation, Collapse of the Dollar when its

the mundane things such as fees, expenses, taxes,performance chasing and emotions that lead to poor

investment performance.


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Investor Performance (20 Years)


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Now I understand thesecognitive issues, what can I

do about them?

Avoid making all the usual errors

investors make!


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We have met the

enemy, and he is us.

-Walt Kelly, Pogo, 1971


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Barry L. Ritholtz

Chief Investment Officer,

Ritholtz Wealth Management

90 Park Avenue, 18thfloor

New York, NY 10016

212-455-9122

[email protected]

for more information, please contact

My favorite books on these subjects can be found at

http://www.ritholtz.com/blog/behavioral-books

fpa nor cal 2014.ppt

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