Article from The NY Times Magazine (10/23/11)

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FlyHi
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Article from The NY Times Magazine (10/23/11)

Post by FlyHi » Sat Oct 22, 2011 6:26 pm

Don’t Blink! The Hazards of Confidence
By DANIEL KAHNEMAN


"Most people in the investment business have read Burton Malkiel’s wonderful book “A Random Walk Down Wall Street.” Malkiel’s central idea is that a stock’s price incorporates all the available knowledge about the value of the company and the best predictions about the future of the stock. If some people believe that the price of a stock will be higher tomorrow, they will buy more of it today. This, in turn, will cause its price to rise. If all assets in a market are correctly priced, no one can expect either to gain or to lose by trading.

We now know, however, that the theory is not quite right. Many individual investors lose consistently by trading, an achievement that a dart-throwing chimp could not match. The first demonstration of this startling conclusion was put forward by Terry Odean, a former student of mine who is now a finance professor at the University of California, Berkeley.

Odean analyzed the trading records of 10,000 brokerage accounts of individual investors over a seven-year period, allowing him to identify all instances in which an investor sold one stock and soon afterward bought another stock. By these actions the investor revealed that he (most of the investors were men) had a definite idea about the future of two stocks: he expected the stock that he bought to do better than the one he sold.

To determine whether those appraisals were well founded, Odean compared the returns of the two stocks over the following year. The results were unequivocally bad. On average, the shares investors sold did better than those they bought, by a very substantial margin: 3.3 percentage points per year, in addition to the significant costs of executing the trades. Some individuals did much better, others did much worse, but the large majority of individual investors would have done better by taking a nap rather than by acting on their ideas. In a paper titled “Trading Is Hazardous to Your Wealth,” Odean and his colleague Brad Barber showed that, on average, the most active traders had the poorest results, while those who traded the least earned the highest returns. In another paper, “Boys Will Be Boys,” they reported that men act on their useless ideas significantly more often than women do, and that as a result women achieve better investment results than men.

Of course, there is always someone on the other side of a transaction; in general, it’s a financial institution or professional investor, ready to take advantage of the mistakes that individual traders make. Further research by Barber and Odean has shed light on these mistakes. Individual investors like to lock in their gains; they sell “winners,” stocks whose prices have gone up, and they hang on to their losers. Unfortunately for them, in the short run going forward recent winners tend to do better than recent losers, so individuals sell the wrong stocks. They also buy the wrong stocks. Individual investors predictably flock to stocks in companies that are in the news. Professional investors are more selective in responding to news. These findings provide some justification for the label of “smart money” that finance professionals apply to themselves."

For the whole article: http://www.nytimes.com/2011/10/23/magaz ... f=magazine
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Re: Article from The NY Times Magazine (10/23/11)

Post by larryswedroe » Sun Oct 23, 2011 7:42 am

Yes individuals are "dumb" money, especially in SG and other lottery type investments (stocks in bankruptcy, penny stocks, IPOs). Institutional investors underweight these. So they win by simply avoiding them

And individuals on average do lose whenever they buy or sell, but the problem for institutions is that there are just not enough victims to exploit to generate alpha AFTER COSTS, though Wermers found that they do BEFORE costs (there must be winner on other side of the individuals). Most trading is now done between these institutions.

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Why Bogleheads stay-the-course.

Post by Taylor Larimore » Sun Oct 23, 2011 8:00 am

The writer of the article, Daniel Kahneman, is a Nobel Laureate in economics. He relates a study by Professor Terry Odean which found:
The large majority of individual investors would have done better by taking a nap rather than by acting on their ideas.
This is the primary reason Bogleheads structure a long-term investment plan--then stay-the-course.
"Simplicity is the master key to financial success." -- Jack Bogle

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Re: Article from The NY Times Magazine (10/23/11)

Post by peter71 » Sun Oct 23, 2011 8:05 am

It's also worth noting that the "Trading is Hazardous to Your Wealth" paper was published 11 years ago, looking back at a very different seven year period than the one we've just experienced.

See here for a thoughtful longer term estimate of the dumb money effect as 0.27% per year or less:

http://thefinancebuff.com/dalbar-study- ... iming.html

Best,
Pete

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Re: Article from The NY Times Magazine (10/23/11)

Post by Fallible » Sun Oct 23, 2011 8:19 am

Toward the end of the article, Kahneman also writes of an encounter with an investment firm catering to the wealthy. It was to be mainly a speech to the group, but it turned out to be more of a quick and simple study of what he called the "illusion of skill." The reaction by the firm's top executives to his findings is amazing. (I won't repeat the many graphs on this since the link to the article is already posted.)
John Bogle on his often bumpy road to low-cost indexing: "When a door closes, if you look long enough and hard enough, if you're strong enough, you'll find a window that opens."

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Re: Article from The NY Times Magazine (10/23/11)

Post by yobria » Sun Oct 23, 2011 9:31 am

Great article, I'll certainly be picking up (in the electronic sense) a copy of Kahneman's book.

Next time hear you a simple story involving a free lunch in the stock market (the "P/E 10", The "January Effect", The "Value Effect", etc.), keep these quotes in mind:
We are prone to think that the world is more regular and predictable than it really is, because our memory automatically and continuously maintains a story about what is going on, and because the rules of memory tend to make that story as coherent as possible and to suppress alternatives
The bias toward coherence favors overconfidence. An individual who expresses high confidence probably has a good story, which may or may not be true.
...people come up with coherent stories and confident predictions even when they know little or nothing.
...overconfident professionals sincerely believe they have expertise, act as experts and look like experts. You will have to struggle to remind yourself that they may be in the grip of an illusion.
Nick

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Re: Article from The NY Times Magazine (10/23/11)

Post by FedGuy » Sun Oct 23, 2011 10:32 am

FlyHi wrote:Individual investors like to lock in their gains; they sell “winners,” stocks whose prices have gone up, and they hang on to their losers. Unfortunately for them, in the short run going forward recent winners tend to do better than recent losers, so individuals sell the wrong stocks.
Doesn't this imply that rebalancing is bad? I understand rebalancing to mean selling the assets that have grown to be too large a proportion of your portfolio, and buy those that are now too small a portion of your portfolio. This implies selling the winners and buying the losers, which the excerpt seems to suggest is a losing strategy.

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Re: Article from The NY Times Magazine (10/23/11)

Post by djw » Sun Oct 23, 2011 10:54 am

The men v. women example cited by a poster above reminds me of my experience leading a training exercise called "Desert Survival" on several occasions about 25 years ago. I imagine this exercise is still around today.

I learned several fascinating lessons from witnessing the behavior of several very different groups who participated.

The scenario involves a medium sized plane crash in the middle of a desert in which the pilot is killed and the participants in the group are the sole survivors. As such, they bring to the exercise whatever they happen to know or think they know.

Invariably, the women in the group vote to stay put and await rescue. The men vote to walk out. According to the experts in desert survival who created the exercise, under the particulars of this scenario the CORRECT decision is to stay put. I'll leave out the many, many reasons why I believe that the experts are most often correct, including actual case histories of real incidents, but I was reminded of the clear gender split and the women being smarter than the men. Of course, I saw one or two defectors who split with their gender, but the division was extremely consistent.

The second lesson I learned is that the very first step the group SHOULD have taken, and indeed the directions sort of steered them towards it, was that they should have sat in a circle and gone around at least once before they decided anything. In particular, they should have taken a verbal group skills inventory. Each person should have briefly introduced themselves (it was a group of strangers, not friends or relatives) and answered one question: What can you tell us about your personal life experience and skill set that might be useful for the rest of us to know before we start making decisions about anything?

If the group had done so, they would have learned that some folks had medical skills, some had previously lived in or near deserts, some knew how to start a fire or get water out of a cactus or all sorts of random things that might have been pretty useful to the survival of the group, since survival was the whole point of the exercise...

The exercise required that first each individual fill-out a questionnaire concerning the various items that were salvaged from the crashed plane (parachute, compass, gun, rain gear, etc.) and how they might put those items to good use. The task of the whole group was to answer all of the same questions AS A GROUP. In the process, of course, there was lots of discussion with some people talking a lot and some never speaking at all.

When scoring the exercise, I always discovered that the person who had spoken the LEAST or even NOT AT ALL had done the "best" on the individual questionnaire at the very beginning. As you can already guess, the loud mouths turned out to be the ones who'd earned the "worst" scores!!

Food for thought...
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Re: Article from The NY Times Magazine (10/23/11)

Post by jjustice » Sun Oct 23, 2011 11:52 am

FedGuy wrote:
FlyHi wrote:Individual investors like to lock in their gains; they sell “winners,” stocks whose prices have gone up, and they hang on to their losers. Unfortunately for them, in the short run going forward recent winners tend to do better than recent losers, so individuals sell the wrong stocks.
Doesn't this imply that rebalancing is bad? I understand rebalancing to mean selling the assets that have grown to be too large a proportion of your portfolio, and buy those that are now too small a portion of your portfolio. This implies selling the winners and buying the losers, which the excerpt seems to suggest is a losing strategy.
Rebalancing is usually of asset classes. It is not selling individual stocks that have been winners. The value of rebalancing, other than maintaining a constant risk profile, depends on reversion to means in the relationships among asset classes.
John

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Re: Article from The NY Times Magazine (10/23/11)

Post by VictoriaF » Sun Oct 23, 2011 12:46 pm

djw wrote:The men v. women example cited by a poster above reminds me of my experience leading a training exercise called "Desert Survival" on several occasions about 25 years ago. I imagine this exercise is still around today.
...
Invariably, the women in the group vote to stay put and await rescue. The men vote to walk out. According to the experts in desert survival who created the exercise, under the particulars of this scenario the CORRECT decision is to stay put. I'll leave out the many, many reasons why I believe that the experts are most often correct, including actual case histories of real incidents, but I was reminded of the clear gender split and the women being smarter than the men. Of course, I saw one or two defectors who split with their gender, but the division was extremely consistent.
Thank you, this is an interesting perspective. But before women get a smug feeling that they are better investors and survivors, I'd like to point out that frequently women rely on the male confidence, which could be unwarranted based on Kahneman's research.

In investment situations, a woman may not be inclined to do frequent trading, but she may be inclined to use a financial adviser, who will do trading on her behalf and charge for that. In survival situations, when men decide to move on, women may follow even if they would have preferred to stay put.

Victoria
WINNER of the 2015 Boglehead Contest. | Every joke has a bit of a joke. ... The rest is the truth. (Marat F)

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Re: Article from The NY Times Magazine (10/23/11)

Post by Fallible » Sun Oct 23, 2011 5:02 pm

VictoriaF wrote:
djw wrote:The men v. women example cited by a poster above reminds me of my experience leading a training exercise called "Desert Survival" on several occasions about 25 years ago. I imagine this exercise is still around today.
...
Invariably, the women in the group vote to stay put and await rescue. The men vote to walk out. According to the experts in desert survival who created the exercise, under the particulars of this scenario the CORRECT decision is to stay put. I'll leave out the many, many reasons why I believe that the experts are most often correct, including actual case histories of real incidents, but I was reminded of the clear gender split and the women being smarter than the men. Of course, I saw one or two defectors who split with their gender, but the division was extremely consistent.
Thank you, this is an interesting perspective. But before women get a smug feeling that they are better investors and survivors, I'd like to point out that frequently women rely on the male confidence, which could be unwarranted based on Kahneman's research.

In investment situations, a woman may not be inclined to do frequent trading, but she may be inclined to use a financial adviser, who will do trading on her behalf and charge for that. In survival situations, when men decide to move on, women may follow even if they would have preferred to stay put.

Victoria
I don't think I'll get too smug, considering the many investing mistakes I've made over the years. :(

I suppose we may be getting a little off-topic here, but from studies I've read about gender investing, in general men may tend to be overconfident and too aggressive while women may tend to be too conservative. Either way money can be lost, but I don't recall a conclusion that says which gender comes out ahead, or if they come out even.
:confused
John Bogle on his often bumpy road to low-cost indexing: "When a door closes, if you look long enough and hard enough, if you're strong enough, you'll find a window that opens."

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Re: Article from The NY Times Magazine (10/23/11)

Post by VictoriaF » Sun Oct 23, 2011 6:27 pm

Fallible wrote:I don't think I'll get too smug, considering the many investing mistakes I've made over the years. :(

I suppose we may be getting a little off-topic here, but from studies I've read about gender investing, in general men may tend to be overconfident and too aggressive while women may tend to be too conservative. Either way money can be lost, but I don't recall a conclusion that says which gender comes out ahead, or if they come out even.
:confused
My comment was general, the present company is excluded :-). The OP refers to a paper “Boys Will Be Boys." The title sounds vaguely familiar, but I cannot recall if I have ever read it, and even less so what its conclusions were.

I have observed that many women I know defer to their husbands for financial planning and investing decisions, and if they are not married they seem to "need" a financial adviser. When I tried to explain that all they have to do is to put 50% into TSM and the other 50% into TBM, the logic seemed to be over their heads.

The male propensity to frequent trading is more obvious. They like to discuss which stocks they are buying and selling.

Victoria
WINNER of the 2015 Boglehead Contest. | Every joke has a bit of a joke. ... The rest is the truth. (Marat F)

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Re: Article from The NY Times Magazine (10/23/11)

Post by Opponent Process » Sun Oct 23, 2011 6:42 pm

djw wrote:the CORRECT decision
the other problem here is assuming that 100% of the players are even interested in making the correct decision. males may be more motivated by bravado, controlling their own destiny, etc..investors, too. investing is part entertainment and ego stroking for many. they're willing to pay a price for these elements, and they tend to get their money's worth. they may be willing to pay for a broker friend to talk stocks with. an elderly lady may be willing to pay for someone to pay attention to her and talk to her on the phone. if you look around at human behavior in general, making the logical decision 100% of the time is never really the goal.
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Re: Article from The NY Times Magazine (10/23/11)

Post by frank5 » Sun Oct 23, 2011 7:14 pm

Are you saying people are sheep? :shock:

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Re: Article from The NY Times Magazine (10/23/11)

Post by grok87 » Sun Oct 23, 2011 10:06 pm

VictoriaF wrote:
Fallible wrote:I don't think I'll get too smug, considering the many investing mistakes I've made over the years. :(

I suppose we may be getting a little off-topic here, but from studies I've read about gender investing, in general men may tend to be overconfident and too aggressive while women may tend to be too conservative. Either way money can be lost, but I don't recall a conclusion that says which gender comes out ahead, or if they come out even.
:confused
My comment was general, the present company is excluded :-). The OP refers to a paper “Boys Will Be Boys." The title sounds vaguely familiar, but I cannot recall if I have ever read it, and even less so what its conclusions were.

I have observed that many women I know defer to their husbands for financial planning and investing decisions, and if they are not married they seem to "need" a financial adviser. When I tried to explain that all they have to do is to put 50% into TSM and the other 50% into TBM, the logic seemed to be over their heads.

The male propensity to frequent trading is more obvious. They like to discuss which stocks they are buying and selling.

Victoria
or which bonds...like 30 year TIPs!
still haven't sold mine yet...
:)
RIP Mr. Bogle.

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Re: Article from The NY Times Magazine (10/23/11)

Post by cjking » Mon Oct 24, 2011 5:54 am

This reporting that active traders under-perform, by more than just the effect of costs, prompts me re-tell an anecdote I've posted here before.

Many years ago (in the nineties) I opened (but fortunately did not much use) an account with British spread-betting company IG Index. They allow you to go long or short of virtually an financial product or derivative that's traded on any liquid market anywhere in the world. The company was originally invented (in the seventies) to allow people to trade gold, at a time when it could not legally be directly owned. Do not be confused by the fact that trades were, legally, bets. All this means in practical terms is that any customer profits are not taxed. The company is regulated by the same authority that regulates the derivatives industry, and whereas "bets" in the UK are not usually legally enforceable, trades with spread-betting companies are. The main difference between trading with a spread-betting company and using a normal broker is that the spread-betting company acts as counter-party to all customer trades.

In their customer brochure they said they make their profit by quoting slightly wider spreads than the underlying market, and hedged their net exposure there, so did not care whether customers won or lost individual bets.

At their IPO a few years later, I was interested to note in the small print in the prospectus they said that as far as their capital allowed, they did not in fact hedge customer positions. In effect, knowing that active traders systematicallly underperform, they generated additional profits by taking the other side of whatever customers freely chose to do.

The sheer beauty of this an investment still excites me today.

(Incidentally, I've read that the reason spread-betting profits are not taxable, something the companies use as big selling point, is apparently because the government knows customers are net losers, so making bets taxable would generate net capital losses, which customers could then offset against gains elsewhere.)

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