The Psychology of Human

Misjudgment- IV

Bias # 5

Social Proof

Which line on the right do you think is the same size as the line on the left?

http://www.youtube.com/watch?v=iRh5qy09nNw

http://www.youtube.com/watch?v=TYIh4MkcfJA

Safety in Numbers

Video on “safety in numbers”

Birds of a feather flock together...

Evolution programmed “social proof” in us. It gave us a survival advantage...

http://www.youtube.com/watch?v=bBlOX3PaVKs

Social proof most influential under two conditions

Uncertainty and doubt – when people are unsure, when the situation is ambiguous, they are more likely to copy others

Testimonials from “similar others”

Persuasion very effective if it comes from peers

People follow lead of “similar others”

Amazon.com uses data analytics to identify “similar Others”

“SIMILAR OTHERS”

“SIMILAR OTHERS”

“similar Others”

hardwired to herd

Real pain and social pain are felt in the same parts of the brain.

Chandler would make a good investor.

Being a successful investor requires not feeling any social pain by doing something thats very unpopular...

We can get more wiser or more foolish by following the crowd…

When does the wisdom of the crowds becomes madness of the mobs?

There are domains where one is better off relying on the crowd

Wisdom of Crowds as Social Proof

For me, its very useful to quickly zoom into the 10 most emailed articles on NYT.

So, when it comes to reading news in NYT, I rely on the “wisdom of the crowds”

In some domains wisdom of crowds works. In some (like financial markets) it doesn’t.

“If you want to have a better performance than the crowd,

you must do things differently from the crowd.”

But when it comes to investing, you are on a VERY different terrain...

“People are always asking me where is the outlook good, but that’s the wrong question... “The right question is: Where is the outlook the most miserable? I call this the Principle of Maximum Pessimism... “Let me explain how it works. In almost every activity of normal life people try to go where the outlook is the best... “You look for a job in an industry with a good future, or build a factory where prospects are best. But my contention is if you are selecting publicly traded investments, you have to do the opposite... “You’re trying to buy a share at the lowest possible price in relation to what that corporation is worth... “And there is only one reason a share goes to a bargain price: Because other people are selling. There is no other reason... “To get a bargain price, you’ve got to look for where the public is most frightened and pessimistic.”

Reversion to the mean

“You pay a very high price in the stock market for a

cheery consensus.”

“Most managers have very little incentive to make the intelligent-but-with-some-chance-

of-looking-like-an-idiot decision.

“Their personal gain/loss ratio is all too obvious: if an unconventional decision works out well, they get a pat on the back and, if it works out poorly, they get a pink slip. (Failing conventionally is the route to go; as a group, lemmings may have a rotten image, but no individual lemming has ever received bad press...

“John Maynard Keynes said in his masterful The General Theory: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” (Or, to put it in less elegant terms, lemmings as a class may be derided but never does an individual lemming get criticized.)”

Social Proof + Incentive Caused Bias

“Exchange Alley was in a fever of excitement... The company's stock, which had been at a hundred and thirty the previous day, gradually rose to three hundred......and continued to rise with the most astonishing rapidity during the whole time that the bill in its several stages was under discussion. It seemed at that time as if the whole nation had turned stock-jobbers. Exchange Alley was every day blocked up by crowds, and Cornhill was impassable for the number of carriages. Every body came to purchase stock.

The inordinate thirst of gain that had afflicted all ranks of society was not to be slaked even in the South Sea. Other schemes, of the most extravagant kind, were started. The share-lists were speedily filled up, and an enormous traffic carried on in shares, while, of course, every means were resorted to to raise them to an artificial value in the market. Every person interested in the success of the project endeavored to draw a knot of listeners around him…

Exchange Alley was crowded with attentive groups. One rumor alone, asserted with the utmost confidence, had an immediate effect upon the stock. Visions of ingots danced before their eyes. Innumerable joint-stock companies started up everywhere. They soon received the name of Bubbles... Some of these schemes were plausible enough... But they were established merely with the view of raising the shares in the market.

But the most absurd and preposterous of all, and which shewed, more completely than any other, the utter madness of the people, was one started by an unknown adventurer, entitled “A company for carrying on an undertaking of great advantage, but nobody to know what it is.”

"I can calculate the movement of

the stars, but not the

madness of men". - Issac

Newton

500% return in 17 months

Down 80% in 5 years

300% return in 18 months

-92% return in 32 months

1. The speculative public is incorrigible. In financial terms it cannot count beyond 3. It will buy anything, at any price, if there seems to be some "action" in progress. It will fall for any company identified with "franchising," computers, electronics, science, technology, or what have you, when the particular fashion is raging. – BG in The Intelligent Investor.

The speculative public is incorrigible. In financial terms it

cannot count beyond 3. It will buy anything, at any price, if there

seems to be some "action" in progress. It

will fall for any company identified with

"franchising," computers,

electronics, science, technology, or what have you, when the

particular fashion is raging. – Ben Graham

“This is a world inhabited not by people who have to be persuaded to believe but by

people who want an excuse to believe.”- John Kenneth Galbraith

People want to latch on to just about any reason to do what they have already decided to do…

But what about money managers? Why do they behave like sheep? Or rather like zebras?

Ralph Wanger in “A Zebra in Lion Country”

“Zebras have the same problems as institutional portfolio managers. First, both seek profits. For portfolio managers, above-average performance; for zebras, fresh grass... “Secondly, both dislike risk. Portfolio managers can get fired; zebras can get eaten by lions... “Third, both move in herds. They look alike, think alike and stick close together... “If you are a zebra, and live in a herd, the key decision you have to make is where you stand in relation to the rest of the herd…

“When you think that the conditions are safe, the outside of the herd is the best, for there the grass is fresh, while those in the middle see only grass which is half-eaten or trampled down… The aggressive zebras, on the outside of the herd, eat much better…”

“On the other hand – or other hoof – there comes a time when lions approach.”

“The outside zebras end up as lion lunch, and the skinny zebras in the middle of the pack may eat less well but they are still alive…”

“A portfolio manager for an institution such

as a bank’s wealth management

department cannot afford to be an Outside Zebra.

“For him, the optimal strategy is simple: stay in the centre of the herd at all times... “As long as he continues to buy the popular stocks he cannot be faulted. To quote one portfolio manager, “It really doesn't matter a lot to me what happens to Johnson & Johnson as long as everyone has it and we all go down together. But on the other hand, he cannot afford to try for large gains on unfamiliar stocks which would leave him open to criticism if the idea fails…”

“Needless to say, this Inside Zebra philosophy doesn't appeal to us as long-term investors.. We have tried to be Outside Zebras most of the time, and there are plenty of claw marks on us."

Ralph Wanger in “A Zebra in Lion Country”

We are willing to look foolish as long as we don't feel we

have acted foolishly.

A committee is a group of people

who keep minutes and

waste hours - Mark Mobius,

Templeton Funds

My idea of a consensus is to look in the

mirror

Why does this happen?What models explain this?

Why do independent directors no speak against stupid resolutions?

The Bystander Effect

http://www.youtube.com/watch?v=OSsPfbup0ac

Kitty Genovese

Murder of Kitty Genovese - Wikipedia, the free encyclopedia

http://en.wikipedia.org/wiki/Murder_of_Kitty_Genovese

We don’t just copy the actions of others, we also copy their inactions...

The effective saints of civilization…They don’t fall under biases from overinfluence of authority or social proof...

“If fifty million

people say a foolish thing,

it is still a foolish thing.” -Anatole France

Bias # 6

DOPAMINE

frontline: dot con | PBShttp://www.pbs.org/wgbh/pages/frontline/shows/dotcon/

The scene shows how Americans went crazy over dotcoms. It also shows how ecstatic employees of E-Loan felt when their stock options in the company which had just gone public became so valuable that some of them became millionaires.

These are E-Loan employees. The company just listed. It has NO business. It’s office is EMPTY. The market value of the company is $2 billion.

Notice they just had an unexpected pleasant surprise.

We are VERY INTERESTED in studying such people. What happens to them? What is their “state of mind?”

They are so happy, and so foolish (we know this of course with the benefit of hindsight as almost all dotcoms fell by more than 90% post listing).

People were equally ecstatic during Tulipomania, The South Sea Bubble.

People are Most

Credulous when they are most

happy

Walter Bagehot was right. When people are happy, they will believe almost anything. They become extremely suggestible.

We want to know what’s happening inside the brains of very happy people who just made an unexpected killing in the stock market, or won a lottery, or won in the casino...

“This is a world inhabited not by people who have to be persuaded to believe but by

people who want an excuse to believe.”- John Kenneth Galbraith

People want to latch on to just about any reason to do what they have already decided to do…

Galbraith was right.

You should read two of his books - The Great Crash 1929, and A Short History of Financial Euphoria.

“Financial Euphoria”. Nice term. Is it similar to other kinds of euphorias? What other domains exist in which humans experience euphoria?

There is no difference

between a man who just made

a killing in the markets

and a man who is high on cocaine

Doctors cannot tell the difference from fMRI scans between the two.

So we now know that doing drugs and making a killing in the markets are virtually identical.

YouTube - Meth Dopamine Effects

http://www.youtube.com/watch?v=sy-nNQEQ1io

If lab rats are wired up to receive tiny pulses of electrical stimulation in the dopamine centers of the brain when they press a lever, they often begin tapping it nonstop to the exclusion of other activities, including eating and drinking

They would rather starve to death than live without that dopamine surge inside their brains.

The human equivalent of this Lab Rat is there in all of us…

After all, don’t we keep on clicking on link after link on the internet, using the mice of our comps just to get a novelty-induced kick? Internet addiction is like all other addictions…

What are the consequences of internet addiction?

“The thrill of the chase blinded the pursuers to the consequences of the catch.” - Buffett

Addicted gamblers chain themselves to slot machines

“Chains of habit are too light to be felt, until they are too heavy to be broken” - Buffett

Studying the business of gambling and gambling addiction is a great way to learn about human nature.

What I really love is how it gets rationalized…

If you work for a gambling casino as an employee, how would you respond to the idea that gambling is bad for civilization?

Are their functional equivalents of gambling casinos? How about day-trading? Or speculating in derivatives?

Nothing sedates

rationality like large doses of

effortless money

I love this quote. He knows what it must be like to make a lot of money.

What happens to a gambler who through sheer randomness wins the jackpot? What is he going to think? Was it luck? Of course not. He is going to think “his system works.” And then he is going to think “this is just the beginning, and I am on a roll, I can see the future, nothing can stop me - I am the master of the universe.”

For him, this one time-lucky gain would look like the initial cash flow from a growing perpetuity he just created with his “effort.” He will start having “delusions of grandeur,” he will start thinking, “why do I have to even go to my clinic to see my patients and earn only so much, I can do much better by just using my system to get rich.”

What’s going on in the head of this man? Well, his head is practically drowning in a rush of dopamine…

General principle: When your dopamine levels are high, you risk becoming over-confident and foolish.

This is a man in a “HOT STATE”. So were the people who worked for E-Loan at the time they learnt they were paper millionaires. So were the people who thought they had become rich permanently because they owned a very rare and very precious tulip bulb.

Are there any other “HOT STATES?” Yes there are...

Unexpected pleasant surprises make people ecstatic because of the dopamine surge they produce

Getting what you expected produces no dopamine kick

However, an unexpected gain fires up the brain (neurons go from firing 3 times a second to 40 times a second)

If expected reward fails to materialize, dopamine dries up

If you want to make your girl/boy friend really happy, give her/him an expected pleasant surprise -but don’t make a habit of it for then it will cease to be a surprise.

Dopamine system loves novel stimuli. Variety is the spice dope of [market] life

Vivid stock market screens and real time charts offer frequent change (i.e. volatility) and sometimes unexpected good surprises, thereby producing surges of dopamine which results in addiction.

Day traders, like cocaine addicts, are in it more for the dopamine than for the money.

Internet addiction - our lowing attention spans, caused due to distractions...

We love observing fast action because its EXCITING!

“Severe change and exceptional returns usually don't mix.

“Most investors, of course, behave as if just the opposite were true. That is, they usually confer the highest price-earnings ratios on exotic-sounding businesses that hold out the promise of feverish change…”

“That prospect lets investors fantasize [THINK DOPAMINE] about future profitability rather than face today's business realities. For such investor-dreamers, any blind date is preferable to one with the girl next door, no matter how desirable she may be.”

IPOs, New Hot Stocks e.g. dotcoms, Fashion industry, Movie business, Music business, Airline industry

Average person buys more aggressively in response to recent price rises - expectation of further rises

“We make bricks in Texas which use the same

process as in Mesopotamia.” - Munger

Warren Buffett has made most of his money in businesses which you may consider as BORING - Carpets, furniture, insurance, candy, cola…

People who invest in “exciting” businesses - are they doing it for the money or the dope?

Bias # 7

Over-influence of Authority

The Milgram experiment is the most cited experiment in social psychology.

http://www.youtube.com/watch?v=BcvSNg0HZwk

http://www.youtube.com/watch?v=IzTuz0mNlwU

http://www.youtube.com/watch?v=CmFCoo-cU3Y

Psychology textbooks include this experiment in the chapter that deals with conformity or authority. However, something as big as this (a lollapalooza outcome) simply cannot be explained by ONE model. There are other models in force here. Can you identify them?

http://www.youtube.com/watch?v=y6GxIuljT3w

The Milgram experiment has been replicated several times. And every time the results are the same. The majority of the participants go all the way...

http://www.youtube.com/watch?v=CmFCoo-cU3Y

“More Hideous

crimes have been

committed in the name of obedience

than in the name of

rebellion.” - C.P. SNOW

Throughout history, the plea “I was only following orders” has been offered to excuse actions carried out on behalf of orders that were foolish, destructive, or illegal.

The Jonestown Massacre is another much-studied incident in social psychology textbooks.

http://www.youtube.com/watch?v=D7IxGGfpSWk

http://www.youtube.com/watch?v=u9rSN05Pi94

http://www.youtube.com/watch?v=_myD9eXv20U

Again, something as big as this, cannot be explained by one model alone.

http://www.archive.org/details/ptc1978-11-18.flac16

As I write, highly civilized human beings are flying overhead, trying to kill me. They do not feel any enmity against me as an individual, nor I against them. They are ‘only doing their duty’, as the saying goes. Most of them, I have no doubt, are kind-hearted law-abiding men who would never dream of committing murder in private life. - George Orwell.

We are conditioned to blindly accept authority. After all mom is always right isn’t it?

The Hospital Experiment

From Cialdini’s Influence:

Group of researchers, composed of doctors and nurses with connections to three hospitals.

To twenty-two separate nurses’ stations on various surgical, medical, pediatric, and psychiatric wards, one of the researchers made an identical phone call in which he identified himself as a hospital physician and directed the answering nurse to give twenty milligrams of a drug (Astrogen) to a specific ward patient.

(1) The prescription was transmitted by phone, in direct violation of hospital policy. (2) The medication itself was unauthorized; Astrogen had not been cleared for use nor placed on the ward stock list. (3) The prescribed dosage was obviously and dangerously excessive. The medication containers clearly stated that the “maximum daily dose” was only ten milligrams, half of what had been ordered. (4) The directive was given by a man the nurse had never met, seen, or even talked with before on the phone.

Yet, in 95 percent of the instances, the nurses went straightaway to the ward medicine cabinet, where they secured the ordered dosage of Astrogen and started for the patient’s room to administer it. It was at this point that they were stopped by a secret observer, who revealed the nature of the experiment...

Flight Simulator Experiment cited by Charlie Munger:

“You get a pilot and a co-pilot. The pilot is the authority figure. They don’t do this in airplanes, but they’ve done it in simulators. They have the pilot do something where the co-pilot, who's been trained in simulators a long time - he knows he’s not to allow the plane to crash - they have the pilot to do something where an idiot co-pilot would know the plane was going to crash, but the pilot’s doing it, and the co-pilot is sitting there, and the pilot is the authority figure. 25% of the time the plane crashes…”

Mr. Buffett has correctly called stock market as a “semi-psychotic creature given to extremes of elation and despair.”

However, the vast majority of people, and academic finance in particular, treat market prices as correct and give it the respect reserved for authority figures….

Buffett writes the following about Ben Graham’s “Mr. Market” metaphor in his book, “The Intelligent Investor”:

“Ben Graham explained why in Chapter 8 of The Intelligent Investor. There he introduced “Mr. Market,” an obliging fellow who shows up every day to either buy from you or sell to you, whichever you wish. The more manic-depressive this chap is, the greater the opportunities available to the investor. That's true because a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses. It is impossible to see how the availability of such prices can be thought of as increasing the hazards for an investor who is totally free to either ignore the market or exploit its folly.”

By giving too much importance to Mr. Market, most investors make a fundamental mistake of converting their basic strength into a weakness

The Pied Pier of Hamlyn was a very charming authority figure and when he cast his spell, everyone followed. The consequences for following for this blind obedience were not good.

There have been many pied pipers in financial history….

Mr. Harshad Mehta and Mr. Ketan Parikh were two pied pipers India has seen.

No doubt there will be others…

The consequences for people who followed these pied pipers were disastrous.

Remember that it wasn’t just the “gullible” individuals who drowned. There were many institutional “investors” who had the same fate. Indeed, at one point there were funds created with a declared plan to invest “only in the K10 (the top ten favorites of Mr. Ketan Parikh) stocks.”

The funds took in a lot of money. And then drowned...

When evaluating management beware of the authority. You may think they know better, but very often they don’t.

They are just too close to the situation. They often miss the BIG PICTURE, which a mature seasoned security analyst can have.

See “Biased Assimilation and Attitude Polarization.” - People too close to a situation experience noise which mis-influences them.

Keep you skeptical hat on when you meet management. And don’t forget to carry a few pinches of salt...

“Science alone of all the subjects contains within itself the lesson of the danger of belief in the infallibility of the greatest teachers in the preceding generation... Learn from science that you must doubt the experts. As a matter of fact, I can also define science another way: Science is the belief in the ignorance of experts.”- Feynman

“In some disciplines, “expert” is the closest thing to a fraud performing no better than a computer using a simple algorithm.” - Taleb

Be wary of “experts”

http://www.youtube.com/watch?v=v4jt3686C6U

http://www.youtube.com/watch?v=gCMzjJjuxQI

“There are 60,000 economists in the U.S., many of them employed full-time trying to forecast recessions and interest rates, and if they could do it successfully twice in a row, they'd all be millionaires by now...as far as I know, most of them are still gainfully employed, which ought to tell us something.” - Peter Lynch, One Up On Wall Street

We make no attempt to predict how

security markets will behave; successfully

forecasting short term stock price

movements is something we think

neither we nor anyone else can do.

Like a Don Juan or a Casanova, the chartist has an unending series of short affairs with stocks. First there is observation, a watching of the head and shoulders, the neckline, and the shape of the bottom. Flirtation may involve some resistance or some support. As involvement increases, congestion builds. There may be penetration of old tops, or a violation of former lows. These give way to mounting excitement and then climax, followed by the warm afterglow of profit taking. – Burton Malkiel

Burton Malkiel "The market's rise after a period of

reaccumulation is a bullish sign.

Nevertheless, fulcrum characteristics are not yet clearly present and a resistance area exists 40 points higher in the

Dow, so it is clearly premature to say the next leg of the bull

market is up.

“If, in the coming weeks, a test of the lows holds and the market breaks out of its flag, a further rise would be indicated. Should the lows be violated, a continuation of the intermediate term downturn is called for. In view of the current situation, it is a distinct possibility that traders will sit in the wings awaiting a clearer delineation of the trend and the market will move in a narrow trading range." If you ask me exactly what it means, I'm afraid I cannot tell you, but I think the technician probably had the following thing in mind: "If the market does not go up or down, it will remain unchanged."– Burton Malkiel

We believe that short-term forecasts of

stock or bond prices are useless. The

forecasts maytell you a great deal about the forecaster; they tell you nothing

about the future.)

short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from

grown-ups who behave in the market like children.

We have two classes of

forecasters: Those who

don't know – and those who

don't know they don't

know – Galbraith.

We will continue to ignore

political and economic

forecasts, which are an expensive distraction for many investors

and businessmen.

Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%.

But, surprise - none of these blockbuster events made the slightest dent in Ben Graham's investment principles. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices. Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is thefoe of the faddist, but the friend of the fundamentalist.

Social Proof + Authority (predictions by experts),

Tetlock is the fella who demonstrated the lunacy of the idea of most “experts” in social science...

People who make prediction their business— people who appear as experts on television, get quoted in newspaper articles, advise governments and businesses, and participate in punditry roundtables—are no better than the rest of us. When they’re wrong, they’re rarely held accountable, and they rarely admit it, either. They insist that they were just off on timing, or blindsided by an improbable event, or almost right, or wrong for the right reasons.

Required Reading:

http://www.newyorker.com/archive/2005/12/05/051205crbo_books1

“The fox knows many things, but

the hedgehog knows one

big thing.” -Isaiah Berlin

Tetlock borrows a marvelous metaphor from Isaiah Berlin.

A Hedgehog knows how to curl itself into a ball to escape its enemies. That’s all he knows. A fox on the other hand has many more models in his head...

Berlin divides writers and thinkers into two categories: hedgehogs, who view the world through the lens of a single defining idea...

...and foxes who draw on a wide variety of experiences and for whom the world cannot be boiled down to a single idea.

Follow Single Doctrine Avoid Ideology

One Big Idea Lots of Ideas (multi-disciplinary)

Cling on to their One Big IdeaFlexible Mind (Know how to

deal with surprise)

Confirmation Bias No Confirmation Bias

Overconfident Doubtful

Articulate Not very Articulate

Poor predictive ability, but occasionally bang on target

Better Predictors

http://en.wikipedia.org/wiki/The_Hedgehog_and_the_Fox

http://www.longnow.org/seminars/02007/jan/26/why-foxes-are-better-forecasters-than-hedgehogs/

http://www.youtube.com/watch?v=gUkbdjetlY8

Here is an example of a hedgehog…

When they’re wrong, they’re rarely held accountable, and they rarely admit it, either. They insist that they were just off on timing, or blindsided by an improbable event, or almost right, or wrong for the right reasons.

http://www.youtube.com/watch?v=ayGcF8dnTV0

http://www.youtube.com/watch?v=IaO69CF5mbY

Feynman, clearly was a fox - full of doubt, and never certain about almost anything...

Fox or Hedgehog?

How to Spot them?

Tetlock:

“Count how often they press the brakes on trains of thought. Foxes often qualify their arguments with "however" and "perhaps," while hedgehogs build up momentum with "moreover" and "all the more so." Foxes are not as entertaining as hedgehogs. But enduring a little tedium is worth it if you want realistic odds on possible futures.”

“Listen to yourself talk to yourself. If you're being swept away with enthusiasm for some particular course of action, take a deep breath and ask: Can I see anything wrong with this? And if you can't, start worrying; you are about to go over a cliff.”

Thank you