Do You Love Your Investments Too Much?

I must admit that I have never fallen in love with an investment. Yet per the summary of an article in International Journal of Psychoanalysis (hat tip 2ubh, investors are prone to "emotional inflation" similar to what people experience in romantic relationships.

But the piece leaves key questions unanswered: do depressives or paranoid schizoids make better investors? Are hair-trigger traders and bears quietly suffering from an inability to form normal attachments to their holdings?

From UCL (University College London):

Investors get carried away with excitement and wishful ‘phantasies’ as the stock market soars, suppressing negative emotions which would otherwise warn them of the high risk of what they are doing, according to a new study led by UCL (University College London). Economic models fail to factor in the emotions and unconscious mental life that drive human behaviour in conditions where the future is uncertain says the study, which argues that banks and financial institutions should be as wary of ‘emotional inflation’ as they are fiscal inflation.

The paper, published in this month’s issue of the International Journal of Psychoanalysis, explores how unconscious mental life should be integrated into economic decision-making models, where emotions and ‘phantasies’ – unconscious desires, drives and motives – are among the driving forces behind market bubbles and bursts.

Visiting Professor David Tuckett, UCL Psychoanalysis Unit, says: “Feelings and unconscious ‘phantasies’ are important; it is not simply a question of being rational when trading. The market is dominated by rational and intelligent professionals, but the most attractive investments involve guesses about an uncertain future and uncertainty creates feelings. When there are exciting new investments whose outcome is unsure, the most professional investors can get caught up in the ‘everybody else is doing it, so should I’ wave which leads first to underestimating, and then after panic and the burst of a bubble, to overestimating the risks of an investment.

“Market investors’ relationships to their assets and shares are akin to love-hate relationships with our partners. Just as in a relationship where the future is unexpected, as the market fluctuates you have to be prepared to suffer uncertainty and anxiety and go through good times and bad times with your shares. You can adopt one of two frames of mind. In one, the depressive, individuals can be aware of their love and hate and gradually learn to trust and bear anxiety. In the other, the paranoid schizoid, the anxiety is not tolerated and has to be detached, so the object of love is idealised while its potential for disappointment is ‘split’ off and made unconscious.

“What happens in a bubble is that investors detach themselves from anxiety and lose touch with being cautious. More or less rationalised wishful thinking then allows them to take on much more risk than they actually realise, something about which they feel ashamed and persecuted, but rarely genuinely guilty, when a bubble bursts. Again, like falling in idealised love, at first you notice only the best qualities of your beloved, but when everything becomes real you become deflated and it is the flaws and problems that persecute you and which you blame.

“Lack of understanding of the vital role of emotion in decision-making, and the typical practices of financial institutions, make it difficult to contain emotional inflation and excessive risk-taking, particularly if it is innovative. Those who join a new and growing venture are rewarded and those who stay out are punished. Institutions and individuals don’t want to miss out and regulators are wary of stifling innovation. If other investors are doing it, clients might say ‘why aren’t you doing it too, because they’re making more money than we are’.”

How the Prisoner's Dilemma and Unintended Consequences are Accelerating the Credit Crisis

Two readers wrote to me concerning phenomena we've mentioned upon occasion in the expanding credit crunch, and it seemed a good opportunity to discuss them longer form.

There are two separate, but related threads: we are now seeing a lot of "every man for himself" behavior (liquidity hoarding is one of many examples) that seem rational (or at least defensible) on an individual basis, but are destructive to the financial system as a whole. The second is that, per Richard Bookstaber, our financial system is "tightly coupled" and in tightly coupled systems, risk reduction measures (which too often look at risks in isolation) will typically have the perverse effect of increasing risks. As he explained:

Tight coupling is a term I have borrowed from systems engineering. A tightly coupled process progresses from one stage to the next with no opportunity to intervene. If things are moving out of control, you can’t pull an emergency lever and stop the process while a committee convenes to analyze the situation. Examples of tightly coupled processes include a space shuttle launch, a nuclear power plant moving toward criticality and even something as prosaic as bread baking.

In financial markets tight coupling comes from the feedback between mechanistic trading, price changes and subsequent trading based on the price changes. The mechanistic trading can result from a computer-based program or contractual requirements to reduce leverage when things turn bad.

Eugene Linden, who has written extensively on animal behavior as well as markets, gave this observation:

The problem facing the credit markets right now is yet another iteration of the "prisoner's dilemma" from game theory, at least in the sense that participants know that if everybody takes the stance of "every man for himself" the markets will crater, but they also know that if they rush for the exits there's a chance that they will get out the door relatively unscathed. Studies of the problem suggest that the more anonymous the context, the more likely that players will adopt "every man for himself," and, of course there's nothing more anonymous than markets. Nature has a long time to work out solutions for problems, and it turns out that a number of animals have converged on the same optimal solution that game theorists have worked out. It's called "tit for tat," and it simply means that if someone extends trust to you reciprocate that trust, and if not, not. The best example comes from vampire bats. When a bat is short on blood it will call on a copain for a sip, and if its bat buddy does the right thing, then the thirsty bat will reciprocate at some point in the future when the tables are turned.

It is wonderfully perverse that vampire bats are more community-minded than Wall Street.

The problem now is, save perhaps within the dealer community itself, many players deal with each other on an anonymous, one-off, or transactional basis. So the opportunity to discipline bad behavior is diminished considerably (but ironically, one of the big factors behind Bears' demise was anger in the community that it had behaved badly both in the LTCM crisis by being the only firm called by the Fed who refused to participate, and its reluctance to shore up its failed hedge funds last June).

Now consider how this conspires with the second element, the perverse outcomes that result from trying to reduce risk in a tightly coupled system. We had written about these examples of efforts to fix the housing/credit crunch backfiring. I'll start with the first, which is that aggressive cuts at the short end of the yield curve initially did nothing to lower long-term rates, which are the basis for pricing most mortgages; the later cuts have steepened the curve, making matters worse.

Reader Lune came to similar observations independently and put them together well, so we'll continue with her list:

We've already seen the law of unintended consequences so far:

1) Congress raises conforming limits on Fannie/Freddie to help unfreeze the mortgage market. Result: agency spreads skyrocket, bringing down Bear and a host of hedge funds. Mortgage markets still remain frozen.

2) Fed opens TSLF to unfreeze mortgage market. Result: Carlyle goes bankrupt as people rapidly arbitrage the difference between holding MBS in firms that can and can't access the new credit facility. Mortgage markets remain frozen.

Now we have 3) Fed opens TSLF to broker-dealers. Given the track record of our esteemed Fed so far, I shudder to think what the unintended consequences of this one will be, and I'm disturbed that it's very likely that no one has thought about that while running around in a panic shooting from the hip at any shadow that comes up. Anyway, here's my speculation...

The Fed is already close to tapping its full balance sheet. The trigger for the collapse of the past few weeks has been the rise of agency spreads, which is the cause not the effect of all the implosions we've seen so far. So to stop the panic, the Fed would have to intervene in the agency market. But it's remaining reserves of ~$400bil is tiny compared to the amount of debt out there. Furthermore, even a full faith govt. guarantee is unlikely to stop the rise in premiums (witness Ginnie Mae debt, where spreads are increasing even with a govt. guarantee). This is partially because of panic, and partially because agency debt will have fundamentally different behavior when it includes all the extra debt Congress is talking about stuffing it with. So with that uncertainty and unpredictability, it's no wonder spreads are increasing.

As the spreads continue to claim more casualties, more firms will line up for funding (when do hedge funds get to drink directly from the punch bowl? At this rate, probably in a week or two), and the Fed, unable to say no, will have to start issuing treasuries to expand its balance sheet. Within a matter of a month or two, the Fed will find itself with a trillion or so dollars of impaired debt in a "repo" that can't ever be recalled (some because the counterparty's balance sheet is still too weak, others because the counterparty has gone BK). The ultimate casualty? The Fed itself, unable to lower interest rates below 0%, facing default on collateral on its hands, and counterparties (central banks) unwilling to trust the Fed to manage the dollar any longer.

Oh yeah, and mortgage markets will still be frozen.

And she continued later with another possible unintended result:

I'm wondering: if the demise of Carlyle and BSC was hastened because they were firms that couldn't access Fed money and thus were foreclosed by firms that could, what will happen Monday? I'm thinking hedge funds, unable to access the Fed directly, will be eaten alive by the IBs.

Why? Because I'm figuring they'll find it safer to shut down hedge funds, take their collateral and convert it into Treasuries, even at the usual Fed haircut, rather than deal with the prolonged uncertainty and volatility of working with their hedge fund clients for an orderly unwind of their positions.

When there was no choice but to choose option #2, plenty of IBs bent over backward to try to keep the hedgies afloat, lest the market collapse. But now, better to shut them down, stuff the Fed with the remaining crap, and sleep better at night knowing your collateral is now in Treasuries rather than illiquid and opaque hedge fund positions. Which IB out there wouldn't be willing to convert their whole CDS position into treasuries even at a 50% discount (especially since with a repo, if the CDSes don't default, you'll get them back at par when the storm has settled)?

Altogether plausible. Let's hope this is not what come to pass.

How to Look Generous on the Cheap

A very useful holiday shopping advisory from Eliezer Yudkowsky at Overcoming Bias. Bottom line: you get more credit from buying the top item in cheapie categories than by buying low to moderate priced items in more exclusive types of goods. But the reaction also depends on whether the recipient is able to evaluate what they have received.

From Overcoming Bias:

With the expensive part of the Hallowthankmas season now approaching, a question must be looming large in our readers' minds:

"Dear Overcoming Bias, are there biases I can exploit to be seen as generous without actually spending lots of money?"

I'm glad to report the answer is yes! According to Hsee (1998) - in a paper entitled "Less is better: When low-value options are valued more highly than high-value options" - if you buy someone a $45 scarf, you are more likely to be seen as generous than if you buy them a $55 coat.

This is a special case of a more general phenomenon. An earlier experiment, Hsee (1996), asked subjects how much they would be willing to pay for a second-hand music dictionary:

Dictionary A, from 1993, with 10,000 entries, in like-new condition.
Dictionary B, from 1993, with 20,000 entries, with a torn cover and otherwise in like-new condition.
The gotcha was that some subjects saw both dictionaries side-by-side, while other subjects only saw one dictionary...

Subjects who saw only one of these options were willing to pay an average of $24 for Dictionary A and an average of $20 for Dictionary B. Subjects who saw both options, side-by-side, were willing to pay $27 for Dictionary B and $19 for Dictionary A.

Of course, the number of entries in a dictionary is more important than whether it has a torn cover, at least if you ever plan on using it for anything. But if you're only presented with a single dictionary, and it has 20,000 entries, the number 20,000 doesn't mean very much. Is it a little? A lot? Who knows? It's non-evaluable. The torn cover, on the other hand - that stands out. That has a definite affective valence: namely, bad.

Seen side-by-side, though, the number of entries goes from non-evaluable to evaluable, because there are two compatible quantities to be compared. And, once the number of entries becomes evaluable, that facet swamps the importance of the torn cover....

What does this suggest for your holiday shopping? That if you spend $400 on a 16GB iPod Touch, your recipient sees the most expensive MP3 player. If you spend $400 on a Nintendo Wii, your recipient sees the least expensive game machine. Which is better value for the money? Ah, but that question only makes sense if you see the two side-by-side. You'll think about them side-by-side while you're shopping, but the recipient will only see what they get.

If you have a fixed amount of money to spend - and your goal is to be seen as generous, rather than to actually help the recipient - you'll be better off deliberately not shopping for value. Decide how much money you want to spend on impressing the recipient, then find the most worthless object which costs exactly that amount. The cheaper the class of objects, the more expensive a particular object will appear, given that you spend a fixed amount. Which is more memorable, a $25 skirt or a $25 candle?

Gives a whole new meaning to the Japanese custom of buying $50 melons, doesn't it? You look at that and shake your head and say "What is it with the Japanese?". And yet they get to be perceived as incredibly generous, spendthrift even, while spending only $50. You could spend $200 on a fancy dinner and not appear as wealthy as you can by spending $50 on a melon. If only there was a custom of gifting $25 toothpicks or $10 dust specks; they could get away with spending even less.

PS: If you actually use this trick, I want to know what you bought.

"Why Debunking Myths Can Backfire"

An excellent post, courtesy Mark Thoma at Economist's View, from FactCheck.org, on why its efforts to correct the record are too often counterproductive. In essence, if ideas are falsely linked (say "Saddam Hussein" and "Al Queda"), further discussion preserves the false association.

The entire post is very much worth reading; it's a primer on how the Big Lie works. And it offers at least one prescription: it is important to strike out against an inaccuracy as fast as possible before the pattern gels in the public psyche.

But otherwise, the article gives an image of people who for the most part are hopelessly suggestible. And while that is no doubt true, the article failed to note that the degree of gullibility varies by culture. In my limited frame of reference, it correlates with respect for authority. Australians, who are exceedingly egalitarian, are highly critical readers of the press and often question what they are told. Americans, despite our individualistic self-image, are deferential towards people in power and too often simply consume media information. Japanese (except the highly placed insides who know better) are even more trusting of their information sources.

From FactCheck.org:

Have you heard about how Al Gore claimed to have invented the Internet? What about how Iraq was responsible for the attacks on the World Trade Center? Or maybe the one about how George W. Bush has the lowest IQ of any U.S. president ever? Chances are pretty good that you might even believe one (or more) of these claims. And yet all three are false. At FactCheck.org our stock in trade is debunking these sorts of false or misleading political claims, so when the Washington Post told us that we might just be making things worse, it really made us stop and think.

A Sept. 4 article in the Post discussed several recent studies that all seemed to point to the same conclusion: Debunking myths can backfire because people tend to remember the myth but forget what the debunker said about it. As Hebrew University psychologist Ruth Mayo explained to the Post, “If you think 9/11 and Iraq, this is your association, this is what comes in your mind. Even if you say it is not true, you will eventually have this connection with Saddam Hussein and 9/11.” That leaves myth busters like us with a quandary: Could we, by exposing political malarkey, just be cementing it in voters’ minds? Are we contributing to the problem we hope to solve?

Possibly. Yet we think that what we do is still necessary. And we think the facts back us up.

The Post story wasn’t all that surprising to those who follow the findings of cognitive science research, which tells us much of our thinking happens just below the level of consciousness. The more times we hear two particular bits of information associated, for example, the more likely it is that we’ll recall those bits of information. This is how we learn multiplication tables – and why we still know the Big Mac jingle.

Our brains also take some surprising shortcuts. In a study published in the Journal of Personality and Social Psychology, Virginia Tech psychologist Kimberlee Weaver shows that the more easily we recall something the more likely we are to think of it as being true. It’s a useful shortcut since, typically, easily recalled information really is true. But combine this rule with the brain’s tendency to better remember bits of information that are repeated frequently, and we can run into trouble: We’re likely to believe anything we hear repeated frequently enough. At FactCheck.org we’ve noted how political spin-masters exploit this tendency ruthlessly, repeating dubious or false claims endlessly until, in the minds of many voters, they become true. Making matters worse, a study by Hebrew University's Mayo shows that people often forget “denial tags.” Thus many people who hear the phrase “Iraq does not possess WMDs” will remember “Iraq” and “possess WMDs” while forgetting the “does not” part.

The counter to this requires an understanding of how it is that the brain forms beliefs.

In 1641, French philosopher René Descartes suggested that the act of understanding an idea comes first; we accept the idea only after evaluating whether or not it rings true. Thirty-six years later, the Dutch philosopher Baruch de Spinoza offered a very different account of belief formation. Spinoza proposed that understanding and believing happen simultaneously. We might come to reject something we held to be true after considering it more carefully, but belief happens prior to the examination. On Spinoza’s model, the brain forms beliefs automatically. Rejecting a belief requires a conscious act.

Unfortunately, not everyone bothers to examine the ideas they encounter. On the Cartesian model, that failure results in neither belief nor disbelief. But on the Spinozan model we end up with a lot of unexamined (and often false) convictions.

One might rightly wonder how a 17th-century philosophical dispute could possibly be relevant to modern myth-busting. Interestingly, though, Harvard psychologist Daniel T. Gilbert designed a series of experiments aimed specifically at determining whether Descartes or Spinoza got it right. Gilbert’s verdict: Spinoza is the winner. People who fail to carry through the evaluation process are likely to believe whatever statements they read. Gilbert concludes that “[p]eople do have the power to assent, to reject, and to suspend their judgment, but only after they have believed the information to which they have been exposed.”

Gilbert’s studies show that, initially at least, we do believe everything we hear. But it’s equally obvious that we reject many of those beliefs, sometimes very quickly and other times only after considerable work. We may not be skeptical by nature, but we can nonetheless learn to be skeptical. Iowa State’s Gary Wells has shown that social interaction with those who have correct information is often sufficient to counter false views. Indeed, a study published in the Journal of Applied Psychology by the University of Southern California’s Peter Kim shows that meeting a charge (regardless of its truth or falsity) with silence increases the chances that others will believe the claim. Giving false claims a free pass, in other words, is more likely to result in false beliefs (a notion with which 2004 presidential candidate John Kerry, who didn’t immediately respond to accusations by a group called Swift Boat Veterans for Truth about his Vietnam record, is all too familiar).

So, yes, a big ad budget often trumps the truth, but that doesn’t mean we should go slumping off in existential despair. You see, the Spinozan model shows that we will believe whatever we hear only if the process of evaluating those beliefs is somehow short-circuited. Humans are not helpless automatons in the face of massive propaganda. We may initially believe whatever we hear, but we are fully capable of evaluating and rejecting beliefs that turn out not to be accurate. Our brains don’t do this naturally; maintaining a healthy skeptical attitude requires some conscious effort on our part. It also requires a basic understanding of logic – and it requires accurate information. That’s where this Web site comes in.

If busting myths has some bad consequences, allowing false information to flow unchecked is far worse. Facts are essential if we are to overcome our brain’s tendency to believe everything it hears. As a species, we’re still pretty new to that whole process. Aristotle invented logic just 2,500 years ago – a mere blink of the eye when compared with the 200,000 years we Homo sapiens relied on our brain’s reflex responses to avoid being eaten by lions. We still have a long way to go. Throw in a tsunami of ads and Internet bluster and the path gets even harder, which is why we’re delighted to find new allies at PolitiFact.com and the Washington Post’s FactChecker. We’ll continue to bring you the facts. And you can continue to use them wisely.

A Tip on Making Better Group Decisions

Since I assume many readers work in large organizations, I pass this post from Eliezer Yudkowsky at the Overcoming Bias blog as one of those rare bits of practical advice that isn't overwhelmingly difficult to implement and can make a real difference in the quality of outcomes:

From pp. 55-56 of Robyn Dawes's Rational Choice in an Uncertain World. Bolding added.

Norman R. F. Maier noted that when a group faces a problem, the natural tendency of its members is to propose possible solutions as they begin to discuss the problem. Consequently, the group interaction focuses on the merits and problems of the proposed solutions, people become emotionally attached to the ones they have suggested, and superior solutions are not suggested. Maier enacted an edict to enhance group problem solving: "Do not propose solutions until the problem has been discussed as thoroughly as possible without suggesting any." It is easy to show that this edict works in contexts where there are objectively defined good solutions to problems.

Maier devised the following "role playing" experiment to demonstrate his point. Three employees of differing ability work on an assembly line. They rotate among three jobs that require different levels of ability, because the most able - who is also the most dominant - is strongly motivated to avoid boredom. In contrast, the least able worker, aware that he does not perform the more difficult jobs as well as the other two, has agreed to rotation because of the dominance of his able co-worker. An "efficiency expert" notes that if the most able employee were given the most difficult task and the least able the least difficult, productivity could be improved by 20%, and the expert recommends that the employees stop rotating. The three employees and the a fourth person designated to play the role of foreman are asked to discuss the expert's recommendation. Some role-playing groups are given Maier's edict not to discuss solutions until having discussed the problem thoroughly, while others are not. Those who are not given the edict immediately begin to argue about the importance of productivity versus worker autonomy and the avoidance of boredom. Groups presented with the edict have a much higher probability of arriving at the solution that the two more able workers rotate, while the least able one sticks to the least demanding job - a solution that yields a 19% increase in productivity.

I have often used this edict with groups I have led - particularly when they face a very tough problem, which is when group members are most apt to propose solutions immediately. While I have no objective criterion on which to judge the quality of the problem solving of the groups, Maier's edict appears to foster better solutions to problems......

This echoes the principle of the bottom line, that the effectiveness of our decisions is determined only by whatever evidence and processing we did in first arriving at our decisions - after you write the bottom line, it is too late to write more reasons above. If you make your decision very early on, it will, in fact, be based on very little thought, no matter how many amazing arguments you come up with afterward.

And consider furthermore that We Change Our Minds Less Often Than We Think: 24 people assigned an average 66% probability to the future choice thought more probable, but only 1 in 24 actually chose the option thought less probable. Once you can guess what your answer will be, you have probably already decided. If you can guess your answer half a second after hearing the question, then you have half a second in which to be intelligent. It's not a lot of time.

I differ a bit with Yudkowsky on last point, about changing our minds. In the study he cites, the participants had to state their guesses. As Robert Cialdini pointed out in his classic Influence,, people have a strong need to appear consistent. Once they voice an opinion, or even an inclination, they are loath to reverse themselves.

This research suggests a corollary: avoid if at all possible discussing where you are coming out on an investigation until you are done with your research. Otherwise, you may wind up shutting down your own thinking by revealing possible recommendations too early.