I love Barry Ritholtz. I had the great fortune to meet and spend some time with him at the recent Agora Financial conference, and to get to know him a bit over dinner and drinks at the Vancouver Art Museum.

He’s a very smart guy, CEO and Director of Equity Research at Fusion IQ (an online quantitative research firm), a super investor and former money manager (he used to manage over $5 billion in client assets), and a gentleman and nice guy to boot.

AND, to top it all off, we are kindred spirits—he is one of the few knowledgeable financial folks out there who talk as much about the importance of mastering your mind and how to become a better investor as they do about telling you which new stock you need to add to your portfolio right now, before you miss the boat on all that coming upside!

Barry has a great blog called The Big Picture and writes a weekly column for the Washington Post, among his other long list of accomplishments.

I subscribe to The Big Picture and love it—I am now an avid fan!

But those aren’t even my favorite things about Barry…

My absolute favorite thing is that he is all of the above and he is hilarious! (and thankfully a great speaker—a winning combination!)

His talk at the Agora Financial conference was hands-down my favorite, because he conveyed a ton of useful, practical information in a completely fun way—if you get the chance to hear him speak live sometime I highly recommend it.

I try to bring you the “best of the best” from the conferences I attend, and I’ve been promising you my write-up of Barry’s talk for weeks now (cough, it might even be a month…), so let me jump right in—here is Barry Ritholz on How to Master Your Mind…I hope you enjoy it, and please let me know what you think in the comments!

This is Your Brain on Stocks: Behavioral Economics, Neuro-Science, and Faulty Financial Decision-Making

Barry is a former trader and successful money manager and has a fascination with research and behavioral economics.

A few years back he decided to move completely into research and to look into the question, “why do investors and traders do the things they do?”

(Something yours truly is extremely interested in, too, and feels is crucial to your success as an investor! You need to learn not only to master your money, but also, and almost more importantly, to master your mind.)

Anyway, once you get interested in behavioral economics you can find all kinds of examples of why people do the things they do.

Barry found this late-80’s public service ad (I bet you remember it…):

This is your brain on drugs

This is your brain, this is your brain on drugs…

Now somebody thought that this would make people stop doing drugs…but as Barry said, all it ended up doing was sending a bunch of stoners to Denny’s to get eggs (“Dude, let’s get the grand slam!”).   🙂

Barry approaches stock trading the same way—he wants to know how our brain operates in the face of actual investing and trading; hence his emphasis on behavioral economics.

And thanks to technology, we now know a lot more about our brains and how they operate than any group of people ever before in the history of mankind.

Our brains weigh 3 lbs. and are 100,000 years old, and as a result of millions of years of evolution coming to a beautiful honed point over the past 100,000 years, the brain can be described as a dynamic, opportunistic, self-organizing system of systems that controls the neural system, the cardio system, the digestive system, and much more.

Thanks to MRI’s, we can see our brain in real time working to make decisions, and from our perspective as investors and speculators and traders, we can see how our brains are affected by financial risk and reward.

Barry has found that traders’ and investors’ brains actually begin to change over their investing career, which can be seen in the MRI’s of beginning investors who have begun to trade stocks:

Homer Simpson: Your Brain on Stocks

This is your brain… This is your brain on stocks!

(It’s a subtle difference…)   🙂

But seriously, we tend to make terrible decisions in the face of prospective financial risk and reward, so Barry of course wanted to know why that happens, and in particular, what mistakes we make as investors.

It turns out that we apparently are simply not built for investing!

There are two fields that cover this in depth:

1) Behavioral economics: how your actual behavior is affected by the process of risk and reward and the possibility of making money, and

2) Neuro-finance: a more granular look at the chemistry and the actual reactions within the brain…how the biomechanics work.

Barry discussed several key behaviors that affect us as investors:

Herding and Groupthink:

I’m sure you are familiar with this—we talk about this often here on Kung Fu Finance and we all know the dangers of being a sheeple.

Barry used to watch Mutual of Omaha’s Wild Kingdom as a kid (OK I admit he lost me here…I seem to remember that being the most boring show on earth, but then again, back when we were kids there were only 4 channels so you didn’t get much choice!).

But when watching this show, you would see a thunderous herd of some 100,000 wild gazelles running across the African savannah…and then the camera would focus in on one gazelle who had drifted away from the herd and you just knew what was going to happen next.

That was lunch for the next lion, cheetah, or jackal to come along, and the lesson our brains learned was, “stay with the group! There is safety in numbers!”

Wall St. has learned this, investors have learned this, and that is why we are lemmings and tend to move in groups.

Barry Cartoon

Groupthink at its finest…(from the Economist, courtesy of Barry Ritholtz)

This reminds me of the childhood game of telephone, where you whisper a secret to the person sitting next to you, and by the time it has made it around the circle it’s a completely different secret altogether.

John Maynard Keynes famously said “it is better for one’s reputation to fail conventionally than to succeed unconventionally”, which is why Wall St. engages in so much groupthink—anyone who puts their neck out on the chopping block gets it cut off.

Barry brought out some statistics to support this that are astonishing:

  • Only 5% of Wall St. recommendations are sells. (New York Times, May 2008)
  • Equity analysts too bullish and too bearish at the exact wrong times. (McKinsey, June 2, 2010)
  • NONE of the S&P 1500 have a Wall St. consensus sell on them (RetirementWeekly, August 2011) (that means the average rating is a sell, and the S&P1500 is made up of the Smallcap 600, Midcap 400, and S&P 500)

Optimism bias:

We all think our investments are going to work out…that this is going to be a good trade, a good date, a good marriage…it’s built into us and into most species here on Earth.

Metacognition:

Two psychologists, Dunning and Kruger, discovered that people who aren’t particularly good at a particular skill set actually have more confidence than those who are more competent…part of that incompetency is the lack of ability to understand their own skill set (they don’t know what they don’t know).

I learned about this in media training last week—they discussed the four stages of learning:

  1. Unconscious incompetence (you suck, but don’t realize just how bad you are)
  2. Conscious incompetence (you suddenly realize just how much you DON’T know)
  3. Conscious competence (you’re competent, but you have to work at it and think about everything you do)
  4. Unconscious competence (you’re so good at the skill it becomes a reflex—you don’t need to think about it)

And what Barry found that is interesting is that the more competent you are at a given skill set, the lower your self-confidence can be.

For example if you are learning to golf and swinging and whacking balls, you probably have no idea just how bad your swing is—if you’re hitting the ball in the air in a reasonably straight direction you’re probably feeling pretty good about yourself.

However, if you are a pro, you are aware when your elbow is off by 2mm or if you hold it just a bit too high from where it should be—you are conscious of all of the little errors that are outside the realm of amateurs, which can lower your self-confidence because you focus on all of the flaws in your swing.

Ultimately, this makes you a better golfer or investor, but first you need that level of self-awareness.

Expert Forecasting vs. Ambiguous Uncertainty:

Barry then brought up so-called “expert” forecasting vs. ambiguous uncertainty, and how the more confident an expert sounds, the more likely we are to believe them.

Barry has done a lot of TV and said he is astonished at the lack of competency of so many people on TV, but there is a belief by the viewing public that if you are on TV, you must know what you are talking about.

Barry asserts this is not true, and had a data point that it’s been proven that expert forecasters do no better than the general public as a whole at predicting economic events.

However, the more specific and confident an expert sounds, the more likely viewers are going to believe him or her.

The confident (or ego-laden…) expert will announce something like: “By December 2014, the DOW will be 36,500!”

But the true expert will stay, “Look, I don’t know what’s going to happen a year from now, but the probability of a recession is 40%. Now I’m not going to tell you there’s going to be a recession for sure, or that it’s going to start next Thursday, but all of these economic data points suggest that a recession is very possible over the next 12 months.”

But viewers hate that.

They would rather have erroneous certainty than ambiguous uncertainty.

Barry said this has been in our brains for millenia, from when the Neanderthals came over wielding spears and one group said, “what should we do? I don’t know, maybe we should send out a party or something to them and see what they want…?”

Whereas another group said confidently, “Let’s get some sticks and stones and beat the crap out of these people!” and everyone said “YEAH!” and followed.

Now who knows what happened…maybe that group got slaughtered, maybe they didn’t…but everybody likes that certitude instead of nuance and ambiguity.

Experts who acknowledge the future as inherently unknowable are perceived as uncertain and wishy-washy and are given less credibility and trustworthiness by the viewer.

But studies show that the more self-confident an expert sounds, the worse their track record is likely to be!

Barry said he didn’t want to mention any names…but he did bring up two examples:

1. Nouriel Roubini

Here’s a guy who said we’re going to see a collapse in 2003 because of the currency, and then 2004 it was going to be employment, and then 2005…and he finally borrowed Josh Rosner’s derivative analysis and in 2008 was finally right, but Barry doesn’t perceive him as being right either before or since.

2. Abby Joseph Cohen

Abby Joseph Cohen was the most beloved technology strategist at Goldman Sachs…she was bullish in ’98, ’99, and 2000, and defended her bullish technology call in 2000 by saying, “well, we told investors to pull 5% off the table in technology.”

(Really? 5%? Well, the NASDAQ fell 81%…what about the other 76%?)

So, in sum, the more confident the expert appears, the more likely the crowd will believe them…(but will also most probably get hosed).

Confirmation Bias:

Someone asked Barry what the hardest part is about his job, and he had a very interesting answer.

He said,

“Finding people to read whom he disagrees with, but whom he still respects their methodology and their process.”

He said it’s really easy to find somebody who disagrees with your investment thesis and then as you are reading their report, on page 1 or 1 1/2, you’re like, “oh, this guy’s a jerk, he obviously doesn’t know what he’s talking about, he’s so wrong!”

It’s painful to read something that disagrees with your investment thesis because we seek out things that we agree with and that tell us “how smart we are”.

Look at Internet usage and at the political sites that people visit:

  • People on the right go to Drudge and Fox News
  • People on the left go to MSNBC and Huffington Post

Politically, they are simply reading what they want to read—there’s no information, no intellect, no challenge…

It’s “tell me what I want to hear”, not “tell me what I should know”.

This has a huge impact in investing.

This also affects our memories (we retain much less of what we are unhappy about) and from an investing perspective we do the same thing—we tend to remember our winners and forget our losers.

Barry said he used to regularly sit down with traders to discuss their portfolios and performance back when he was a money manager. His team would tell him, “I just don’t understand! My numbers are so bad, but I have all these winners!”

Barry would say, “Let’s take a look…well, yes, Apple, that’s great, but that’s your 19th largest position and you bought it at $500…your biggest position is Lehman (and that sucked) and oh lookie here, your next biggest position is Enron…When you look at the weighted average of your holdings…your top 10 positions are either flat or negative, and that’s why your portfolio stinks.”

Ouch.

The math doesn’t lie, but your memory does.

Recency Effect:

We put much more weight on events that have happened recently than on things that happened previously, even though they are the same series of events.

He gave a lot of great examples, but one that stood out for me was the infamous non-farm payroll data.

(I covered my opinion of the vast majority of statistics last week in Lies, Damn Lies, and Statistics… and apparently Barry and I agree on this!)

The non-farm payroll numbers come out every month with huge fanfare and music playing…they are trotted out as the most important data point of the month.

Barry broke this down:

In the US, there are 150 million people in the labor pool, most of whom are working full-time.

Each month, 4 million of them are going to leave their jobs—they’re going to retire, drop dead, or go elsewhere (take another position).

So we start with about 150 million and cut it down to about 4 million in flux, and of those 4 million about 150,000 is the net change. Of course there are seasonal adjustments, adjustments for companies coming into creation or going out of creation…

But essentially, from a 150 million person pool, we get all excited about 100,000 – 150,000 net change.

He asserted us to do the math on that…it’s .001 or 0.1% (150,000 / 150,000,000 * 100 = 0.1%).

Plus, that 150,000 net change is subject to revisions over the next 30 days as more data comes in, plus is subject to big benchmarking every year as we discover new things about the census we didn’t already know, and then every few years there is a major overhaul.

So that little teeny-tiny number of nonfarm payroll is essentially a pretty meaningless statistic.

But on CNBC, there is the ticker in the corner in hundredths of a second, like it’s the Olympics and some guy is going to sprint across the tape…

“Countdown to the non-farm payroll!”

Now the overall trend, the series of numbers, matters.

We of course care about whether the line is going from the bottom left to the top right, whether things are moving in the right direction, whether we are flat, or whether employment is collapsing.

That trend is very important.

But any given month? It’s without any statistical value by itself.

—————————–

What do you think about these Master Your Mind behaviors? I know I personally need to guard against many of them, particularly the confirmation and optimism biases. Which ones are your Achilles heels? Please let me know in the comments!

Barry gave another great talk on the Top Ten Mistakes Investors Make and how to fix them at the conference, so if there is interest I will report on that, too.

I’m off to another conference tomorrow, where I’m very excited to be finally meeting some of you in person! More soon…

To your financial success,

— Kung Fu Girl

P.S. Hopefully this works…you can see Barry’s entire presentation below, as he made his slides available on Scribd! Enjoy!

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