“The study of the psychology of misjudgment is every bit as valuable as the thoughtful analysis of a balance sheet. Possibly more so.” -- Robert Hagstrom
As Robert Hagstrom built his latticework of mental models in “Investing: The Last Liberal Art,” he was inspired by Charlie Munger (Trades, Portfolio), the partner of Warren Buffett (Trades, Portfolio) and an investing legend in his own right.
It was Munger’s thesis that he makes and made better investing decisions by expanding his thinking beyond financial models. In creating his own latticework, Hagstrom has delved into physics (the concept of equilibrium), biology (the concept of evolution) and sociology (complex adaptive systems) so far.
Next on his list is the social science of psychology, “Psychology studies how the human mind works. At first glance it may seem far removed from the world of investing, a world of impersonal balance sheets and income statements, especially since the very mention of psychology so frequently calls up an image of a tortured soul stretched out on the therapist’s couch.”
Hagstrom added that dealing with mental dysfunction is only one small part of the field. More broadly speaking, it is concerned with the processes of thinking and knowing, as well as controlling emotions. In chapter five, the author introduced several psychological concepts that led to a better understand of people and their interactions with stock markets.
He started with Daniel Kahneman and Amos Tversky, whose work led to the science of behavioral finance. The discipline’s goal is to figure out market efficiencies using psychological theories. Among the papers they produced was one titled, “Prospect Theory: an Analysis of Decision under Risk.”
In the paper, Kahneman and Tversky challenged what had been until then the conventional thinking on decision making: utility theory. Popularized by John von Neumann and Oskar Morgenstern, utility theory argued that individuals should not care about the choices with which they are presented because they care only about outcomes.
But, Kahneman and Tversky had done research showing that the way in which the alternatives are framed can make big differences in the conclusions reached by individuals. Hagstrom summarized, “What Kahneman and Tversky were able to prove is that people do not look just at the final level of wealth but rather at the incremental gains and losses that contribute to this wealth.”
Out of this came the concept that individuals are loss averse; they hate losses more than they like gains of the same size. In fact, they found that people would need a potential gain of two and a half times more to match their fear of a loss.
Building on these ideas, Richard Thaler and Shlomo Benartzi connected loss aversion directly with the stock market. Their most important work is in a groundbreaking article titled, “Myopic Loss Aversion and the Equity Risk Premium Puzzle.”
Myopic loss refers to the shortfalls that occur when investors focus on short-term results to the exclusion of a long-term perspective. Equity risk premium refers to the difference available by investing in the stock market rather than in a risk-free security such as 10-year Treasury bonds.
Thaler and Benartzi went on to do research based on a comment from Paul Samuelson. They discovered that the longer an investor owned an asset, the more attractive it became. However, that only holds true if the asset is not frequently evaluated. For example, the more you focus on your short-term returns, the more your returns will suffer. So, “myopic loss aversion” is the combination of loss aversion and the frequency with which an investment is measured.
This idea hit home with Hagstrom:
“In my opinion, the single greatest psychological obstacle that prevents investors from doing well in the stock market is myopic loss aversion. In my twenty-eight years in the investment business, I have observed firsthand the difficulty investors, portfolio managers, consultants, and committee members of large institutional funds have with internalizing losses (loss aversion), made all the more painful by tabulating losses on a frequent basis (myopic loss aversion).”
He went on to note that “the one individual who has mastered myopic loss aversion is also the world’s greatest investor—Warren Buffett.”
Further, Buffett also considers himself a businessman, and he expects the value of his companies to continue rising as long as their economics keep advancing steadily. Hagstrom added, “[Buffett] does not need the market’s affirmation to convince him of this. As he often states, 'I don’t need a stock price to tell me what I already know about value.'”
For psychological insight, Hagstrom also discussed the work of Fischer Black, a professor of finance before joining Goldman Sachs. Along with Myron Scholes and Robert Merton, he developed the Black Scholes options pricing formula. His presidential speech to the American Finance Association in 1986 addressed the issue of “noise.”
The presentation was a challenge to the widespread idea that stock prices are rational. According to Black, there is more than pure information in the air -- there is also noise which leads to confusion. That causes investor confusion, making price information less reliable and effective.
Hagstrom asked, “Is there a solution for noise in the market?” The answer, he noted, is to know the economic fundamentals of securities. This allows an investor to correctly know when prices rise above or fall below intrinsic values.
He also called upon the wisdom of Munger, who warned against taking mental shortcuts. Munger uses what he called a two-track analysis, “First, what are the factors that really govern the interests involved, rationally considered? And second, what are the subconscious influences where the brain at a subconscious level is automatically doing these things—which by and large are useful, but often misfunction.”
Hagstrom closed the chapter with these words:
“What all investors need to internalize is that they are often unaware of their bad decisions. To fully understand the markets and investing, we now know we have to understand our own irrationalities. The study of the psychology of misjudgment is every bit as valuable as the thoughtful analysis of a balance sheet. Possibly more so.”
Read more here:Â
Learning to Think Like Charlie: Sociology and BubblesÂ
Learning to Think Like Charlie: Biology and EvolutionÂ
Learning to Think Like Charlie: Physics and EquilibriumÂ
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