As markets have evolved over time and financial theories have progressed humans have become increasingly confident in the systems we create and the world we live in. Entire generations of investors have become convinced that markets are stable and efficient. We have come to believe that computer models can accurately predict markets. On the contrary I believe most of the systems we create are highly complex, inefficient and chaotic. The markets are one of the last refuges of natural selection (see here):
“The investment world is the civilized version of natural selection. It cuts to the core of every emotion imaginable. When Joe Schmo goes to work for 25 years straight in an attempt to create a better life for his family and suddenly sees his life’s savings going down the tube because Lehman Bros went bankrupt you can’t possibly expect him to react rationally in such an environment. This is no different than the man whose family is attacked in the middle of the night. Do you expect that man to react rationally when everything he lives for is suddenly in harms way? Do human beings make rational and efficient decisions in chaotic scenarios? Even more important, will 1 million humans working in tandem make efficient decisions all within the same system? No, the majority of them will make highly inefficient decisions. “Mistakes” as we like to call them. We all make them.
If we have learned anything over the course of the greatest mean reversion in stock market history over the last 24 months it is that markets are HIGHLY inefficient. Why? Because the humans that write the algorithms are using flawed theories and the emotions upon which these trades are placed are not psychologically efficient.”
Despite our evolutionary leaps and bounds I believe we are not so far removed from our animal brethren when it comes to survival instincts. When confronted with complex decisions we make mistakes, we panic, we turn to our animal instincts which scream: SURVIVE AT ANY COST. And nowhere is this more apparent than it is in the most complex facets of our lives. Markets are highly complex systems and have become directly tied to important facets of our lives. In many regards it is the last place most human beings should be residing. We are simply not built to deal with such a complex system. Despite our evolutionary progression our survival instincts remain quite primitive.
In an excellent TED video Laurie Santos, a Professor of Psychology at Yale, studies the actions of a simple economy using monkeys and discovers that we are far less sophisticated than we think. This is fascinating on so many different levels. Santos begins by teaching the monkeys how to use a currency to trade for food. She goes on to create a monkey marketplace where the monkeys can exchange coins for food. Her findings are intriguing. She finds that the monkeys don’t like to save. They often steal from one another and from the market salesman. They display greedy tendencies. Sound familiar?
She continues by performing a simple experiment to prove just how irrational humans can be and how our natural instincts can drive us to make irrational decisions when confronted with a complex situation that impacts survival. Pretend you have $1,000. You have two options. In option 1 you can you flip a coin: heads you win $1,000 more, tails you win $0. In option 2 you are given a risk free $500 – a 50% risk free return. According to Santos most people will choose option 2.
In the second experiment she gives you $2,000 and offers you two ways to lose that money. In option 1 you again flip a coin. Heads you risk losing $1,000. Tails you lose $0. In option 2 you can play it safe and lose $500 with certainty. Interestingly, most people choose to flip the coin taking more risk.
In game 1 you max out your gains at $2,000 if you flip the coin, but risk gaining nothing. The risk free decision leaves you with $1,500. In the second game you max out your gains at $2,000 if you flip the coin, but take the risk of losing 50% of your capital. If you choose the risk free path in game 2 you again max out your gains at $1,500 just as you did in game 1. So, the risk free result is the same no matter what, however, when it comes to the option of potentially losing money most people decide to take excessive risk by flipping the coin in game 2. Santos found that the monkeys do the exact same thing! Their survival instinct is to avoid losing something they already have, but in doing so they’re irrationally willing to take excessive risk.
So what’s going on here? Why are we making a poor risk management decision here? Santos says this is due to two biases. The first is our instinct to think in relative terms. We have a difficult time thinking in absolute terms. The second bias is loss aversion. Humans hate losing anything of value they have obtained. So in a misguided attempt to save money we actually take MORE risk at times. Sound familiar? Ever held onto a stock just hoping to break even? Still hanging onto that house you bought in 2006 because you’ve convinced yourself that the market is coming back (it’s not, by the way) and you’ll break even on it? Yes, same exact thing.
Santos concludes that many of our biases that result in poor decisions are no different than the irrational survival related instincts that drive other animals’ decision making processes. Therefore, many of these biases are inherent and very difficult to overcome. But the most important takeaway here is her conclusion. Santos concludes that the best way to overcome our limitations is the simple act of recognizing them. Accept that you know less than you think you do. Accept that you can and will be wrong. Accept that you will make mistakes, learn from them and only then can you actually overcome them. Humans are irrational, therefore markets are irrational, however, that doesn’t mean you have to be the one making irrational decisions.
(The full presentation is attached):