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Truth is investing is more about psychology than anything else! December 22, 2008

Posted by shaferfinancial in Uncategorized.
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Our brain is a wonderful instrument, but it does not work like a computer.  It deals with information and logic in a very different manner.   Our brain takes in so much information every second, that there is no way it can make conscious all that it takes in.  The way it deals with this information is to limit the relevant information.  We can call this framing.  Now here is the key point, this limiting of information is not rational but based on emotional/intuitive aspects.  For example, we defer to authority.  This is called value attribution.  Simply, some stimuli is considered more important than others.  We attribute some characteristics highly, therefore believe the information from this source.  For example, studies have shown that highly drafted basketball players get more playing time than lower drafted players regardless of how they play.  Or that corporate hiring managers hire based on open ended questions (tell me your best and worst quality?, where do you see yourself in five years?, etc.) when it leads to hiring the best liar and actually has  a negative relationship with job success!  A side note on hiring decisions; research has demonstrated that the best hiring matrix is a actual test of the real skills needed on the job (not those psychological tests now given or an interview).


What does this have to do with investing?  Well, it turns out that asking the right questions will frame the investment decisions in a way that allows folks to obtain best results.  But, most people don’t ask the right decisions, even professional money managers.  A common question that frames most folks investment decision is the question of losing one’s money or risk.  Like the hiring managers asking of what one’s best and worst characteristics are, this question also has a negative correlation to success.  The reason is two-fold.  First, risk of loss is such a strong emotional issue, that if allowed it will create the total frame of the decision.  In other words, if this question is the first thing that comes to mind, no other considerations will be allowed to enter the decision making.  Hence, you have people purchasing CDs from banks or insurance products with guarantees.  No amount of pointing out the fallacy of investing and not overcoming inflation and taxes will ever get through, because the frame is about not losing money.

Secondly, investing is about receiving cash flow in exchange for one’s investment dollars.  By framing investments around risk, you miss this valuable point.  Now, I am not saying that risk should not be considered, just that it shouldn’t be the main frame of the decision making process.  Once, there was an experiment done in Washington D.C.subway where a violin prodigy, Joshua Bell, with a Stradivarius entertained the crowd.  He wore a baseball hat and jeans and played one of the most difficult pieces ever written for a violin.  No reaction from the subway crowd, except for one women who recognized him.  Few people even acknowledged his playing.  Here they were getting a 45 minute concert from the best violinist in the world, and no one even stopped for five minutes to listen, or even one minute.  Had there been cameras present or had he worn a formal tuxedo maybe it would have changed, but folks just thought he was one of the many mediocre street performers because of his dress.  This was an example of value attribution.  Had they somehow been told that the world’s best violinist would be playing in the subway that day, do you think the outcome would have been different?  But they took one look at his dress, and assumed he was nothing special regardless of the music coming out of the violin.  

We ignore our senses in that way all the time, just as NBA coaches ignore the data coming from the basketball floor and play players based on their prior draft status, just as hiring managers ignore actual skills and hire based on answering questions nobody is truthful answering.  Getting back to the investment world, no one can accurately assess the future, yet many base their decisions on doing exactly that, ignoring the real data available.  Just as prior draft position is a terrible indicator of present basketball playing skills among NBA players, our predictions about the future is a terrible indicator of the success of any investment. 

We all become better investors when we drop the frames of “lossand “our predictions of the future” and frame the investment decisions around the real data available on cash flow, demand of product, etc.  Of course, this takes a concentrated effort, and even the most experienced investor needs to be reminded of this periodically.



1. Madoff’s fraud; As long as there are passive investors there will be victims « Uncommon Financial Wisdom - December 27, 2008

[…] factors that play into this unfortunate scene.  First, as I pointed out earlier this week is value attribution.  Madoff had this in spades.  A fancy NY City office, Palm Beach residence, the right clothes, […]

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