FPA Nor Cal 2014.Ppt
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Transcript of 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
for more information, please contact
My favorite books on these subjects can be found at
http://www.ritholtz.com/blog/behavioral-books