“Apophenia?” - “Bias” and “Heuristics?”

What is “Apophenia?” - “Bias” and “Heuristics?”

Executive Summary

Biases and heuristics. Two important concepts that form part of our decision-making process. They can be very effective, but they can also be deleterious when they cause cognitive illusions, resulting in disastrous investment decisions.

Bias is defined as an inclination, feeling or opinion that is pre-conceived and unreasoned. Meanwhile, heuristic (a term popularized by the economist, Herbert Simon1) can be described as an aid to problem-solving by trial-and-error. It is also known as a “rule-of-thumb” – not a theoretically sound solution but one that seems to generally work.

The human mind relies on them daily – mostly unconsciously – to make decisions: from simple acts, such as deciding which route to take to get to work, to complex tasks such as investing. Their effects on the latter has developed into a new field of academic study called behavioral finance in a bid to better understand the cognitive process behind investment decisions.

The significance of this new academic field of human decision-making is evidenced by the October 9th, 2017 award of the 2017 Nobel Memorial Prize in Economic Sciences to Richard Thaler of the University of Chicago for his contribution to behavioral economics. In addition to advancing many new ideas, Thaler was also a student of the 2002 Nobel prize winner in Economics, Daniel Kahneman (a professional psychologist) upon whom many of the concepts in this paper were developed. 2

Source: Google Images – copyright free.

1 1 Harvard Business Review: From Economics Man To Behavioural Economist, May 2015. 2 Many of the concepts herein were popularized by the recent Michael Lewis book called: “The Undoing Project.” Page James D. Babcock, CFA, CPA, MBA - © Copyright Protected 2018

What is “Apophenia?” - “Bias” and “Heuristics?”

This paper seeks to identify and thereby raise awareness of investment dangers, or pitfalls, stemming from systematic human cognitive illusion errors. Part 1 outlines human evolution of the mind and how that led to a reliance on bias and heuristics.

Part 2 identifies specific common cognitive illusions and illustrates how understanding their causes can be used to circumvent investment errors in “risk assets” (equities, commodities, corporate bonds and currencies). This part will have an emphasis on the work and book of Daniel Kahneman, “Thinking, Fast and Slow.”

Part 1 – “Recognize Your Illusion”

Introduction

Many debates on Wall Street center around two issues: stage of the economic/investments cycle and asset valuations. Market uncertainty is currently (October, 2018) elevated due to the late point of the cycle.

Consider the following from a recent issue of The J.P. Morgan View regarding the YTD returns of various global assets: The longer-term perspective is jarring: the percentage of asset classes that have generated positive returns this year (2018) is only 20%, a share that has never been so low outside of the 1970s stagflation episodes and the Global Financial Crises.3

J.P. Morgan View goes on to present: “Explanations for this misery abound, but the three most sensible ones are”: 1) The global economy and US earnings have reached a major turning point; 2) The Fed is committing its habitual policy mistake by overtightening; and 3) After the pre-Lehman experience with complacency, markets will overreact late-cycle to even minor changes in fundamentals.

The J.P. Morgan View concludes: “We tend to favor the third notion over the others.” That conclusion suggests a collective bias and heuristic. In other words, have we all collectively been staring at a cognitive illusion (an Availability Cascade, as will be later discussed) and failed to identify it?

3 JP Morgan: Cross-Asset Strategy October 26, 2018 Page James D. Babcock, CFA, CPA, MBA - © Copyright Protected 2018

What is “Apophenia?” - “Bias” and “Heuristics?”

Recognizing Cognitive Illusions: Which Line Is Longer?5 • Cognitive illusions are the mental counterpart of optical illusions to vision.

• Cognitive illusions are caused by bias and heuristics.

• Optical and cognitive illusions are not easily eliminated.

• Even awareness of illusions does not eliminate them but, at least, allows them to be managed. Source: Google Images – copyright free.

Against this backdrop, I believe it is important to focus investor attention on the field of behavioral finance and outline common errors and cognitive traps to which we, as humans, are prone to succumb. I believe this could help make us better investors and improve our active management decision making.

Human Evolution of the Mind

Source: Google Images – copyright free.

5 Müller-Lyer illusion devised by Franz Carl Müller, a German sociologist, in 1889 Page James D. Babcock, CFA, CPA, MBA - © Copyright Protected 2018

What is “Apophenia?” - “Bias” and “Heuristics?”

Percent of Human Evolution Event Year Years Ago Existence Human split from Hominidae - 6,000,000 100% (Great Ape family)

Hunter/Gatherer Phase (6mm years ago to - 99.83333% 10,000 years ago)

Agricultural Revolution - 10,000 0.16667%

Industrial Revolution 1800 215 0.00362%

Digital Revolution 1960 55 0.00095%

Internet Became Mainstream 2000 15 0.00028%

De Waal, Frans: Our Inner Ape, 2005, page 15.

99.8% Of Human Evolution as Hunter/Gatherer

According to Charles Darwin’s theory of evolution by natural selection, the human mind evolved to function optimally as hunter/gatherer. The original goal was simple – to improve the chances of species survival - the brain evolved to respond to its perceptions of opportunities or threats. This entailed scanning the environment to secure food, identify shelter, ensure reproduction and avoid harm. The evolution process also included economizing on calories to equilibrate the body size/function with available nutrition.

The work of Nobel laureate Daniel Kahneman provides a useful way of understanding how the human mind evolved, and crucially, how it works. He introduced the world to “Fast Thinking and Slow Thinking” - two separate cognitive processes that are best understood as mental division of labor, helping us to optimize performance while minimizing effort6. The table below offers a quick explanation of Kahneman’s theory.

4 6 Kahneman, Daniel: Thinking, Fast and Slow, 2011. Frrar, Straus and Giroux.

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What is “Apophenia?” - “Bias” and “Heuristics?”

Fast Thinking Slow Thinking • Scans environment and compares sensory • Operates systematically and deliberately stimuli to memories, seeking a match. (Logical Analysis): - Unfamiliar/complex decisions, • Searches for somewhat close memory - Logic, match - if none – transfers stimuli - Probability, evaluation to Slow Thinking System. - Mathematical problem solving.

• Default mode (intuition) - works • Only activated when Fast Thinking fails to automatically and very quickly with find a somewhat close memory match. minimal energy - “Fight or Flight.” • Requires much more energy – only used • Brain spends most of its time in Fast when economically efficient. Thinking mode. • Understands how Fast Thinking might be • When used in uncertainty and risk, prone misled and takes steps to prevent errors to predictable errors. Errors of (when Slow Thinking System is alert to mismatching. them).

• Fast Thinking feels like something that • Slow Thinking feels like something I DO, passively happens TO ME. actively.

• CANNOT be turned off – this is what • HARD to turn-on and to maintain creates cognitive allusions – Process works activated - consumes lots of energy; must automatically and we are not consciously be used sparingly and tends to over-rely aware of it. on Fast Thinking (it’s lazy).

Source: Kahneman, Daniel: Thinking, Fast and Slow, 2011. Frrar, Straus and Giroux.

Fast Thinking was used by the Hunter/Gatherer to scan the environment for opportunity (food and mating) and to avoid danger. It works quickly without conscience awareness. However, Fast Thinking is prone to a dramatically high rate of error, when applied in the modern digital age.

Since the Fast Thinking System was designed for the Hunter/Gatherer, the error rate (at that time) was low enough assure survival of the human species. For example, if a Hunter/Gatherer spotted what appeared to be a source of food and the Fast Thinking matched it as an affirmation (when, in

fact, it was a predator) the Hunter/Gatherer might not survive. This error would result in the demise

5 Page James D. Babcock, CFA, CPA, MBA - © Copyright Protected 2018

What is “Apophenia?” - “Bias” and “Heuristics?” of that particular individual. However, the low level of error rate would not imperil the entire human species.

The low error rate and high success rate of Fast Thinking would result in a few Hunter/Gatherer individual deaths but would help the species to thrive. Unfortunately, this same Fast Thinking operation, which had an acceptable error rate for Hunter/Gatherers, has a much, much higher error rate when used in the field of modern investment management.

Meanwhile, Slow Thinking is called upon to process experiences that Fast Thinking cannot (e.g., changes in the environment, new observations/experiences and complex thinking). Slow Thinking, as its name implies, is slower and much more accurate. However, it requires more energy, which explains the human brain’s natural preference to defer to Fast Thinking (to conserve energy/calories).

In summary, these two separate processes were designed for efficiency in an environment of Hunter/Gatherers. However, its Fast Thinking reliance on heuristics and biases can create predictable and repeated (cognitive illusion) errors – especially in modern, digital age, investment decision- making.

Part 2 – “Use Your Illusion”

Applying Behavioral Finance to Investment Management Controlling Fast Thinking, Emphasizing Slow Thinking’s Decision-Making Element

Investment decisions are between uncertain options – outcomes that cannot be known in advance. The options represent: 1) A range of possible outcomes (i.e., security valuations) and 2) Probability of each outcome.

Logic would prescribe that investors use their Slow Thinking System and rely on quantitative metrics and/or algorithmic models as the basis for decisions. Intuition (i.e., Fast Thinking) should not factor in the decision-making process and therefore should be controlled.

Example tools to consciously engage Slow Thinking: Computer-based screening of securities; Fundamental financial models for each security; and Relative value comparison rankings (e.g., graph bonds based on Credit Spread and Leverage).

Another critical example is an “Expected Value Decision Tree.” This is a table listing each outcome, valuing each outcome and assessing the respective probabilities of each outcome, using a weighted

average principle:

6 Page James D. Babcock, CFA, CPA, MBA - © Copyright Protected 2018

What is “Apophenia?” - “Bias” and “Heuristics?”

Source: Google Images – copyright free.

Investors should also “Time-shift” to combat their urge to use Fast Thinking. Market volatility and directionality are typically elevated around release of new information (e.g., quarterly earnings). Investors should develop an array of outcomes before the event (e.g., beat, met, or missed) and establish trading decision rules for each (e.g., sell, nothing, or buy). This will enable investors to act on their (pre-set) Slow Thinking rules as soon as the news is out, while others are still trying to reach a decision using the error-prone Fast Thinking System.

Use of these quantitative tools, ensures more profitable investing through use of the ‘Slow Thinking System’.

Overcoming Cognitive Illusions – Examples

Below, are highlighted several common cognitive illusions identified by prominent behavioral finance experts and how they can be managed within the context of investment management. Much of it could sound intuitive, or obvious. However, it is surprising how we, unconsciously, all fall into these traps. 1) Managing Over- Confidence

Overconfidence, according to David Kahneman, “is built so deeply into the structure of the mind that you couldn’t change it without changing many other things.” 7

7 Guardian: Daniel Kahneman: “What Would I Eliminate If I Had A Magic Wand?”, July 18, 2015 Page James D. Babcock, CFA, CPA, MBA - © Copyright Protected 2018

What is “Apophenia?” - “Bias” and “Heuristics?”

The following exercises are based on the ideas that Kahneman and Riepe proposed in 19989:

First, write down your best forecast where the S&P 500 will be one month from today. Next, pick a high value, such that you are 97.5% sure that the S&P 500 a month from today will be lower than your “high value.” Then, pick a low value, such that you are 97.5% sure that the S&P 500 a month from today will be higher than your “low value.” You have now determined your 95% subjective confidence interval for the value of the S&P 500 one month from today. Finally, do this same monthly exercise enough times to establish a sample set.

Assuming you are not over-confident, the actual S&P 500 should encounter approximately 2.5% of high and 2.5% of low surprises [(100-95)/2] compared to your subjective confidence interval. In 95% of cases, the true value should fall inside your confidence interval. Individuals who set confidence intervals that satisfy this are said to be well-calibrated in their judgments of probability. Unfortunately, very few people are well-calibrated.

In most cases the surprise is well above or below 2.5%. According to Kahneman and Riepe, research shows that there exists a “highly systematic bias in subjective confidence intervals” (i.e., over- confidence). Interestingly, the authors highlighted that two specific groups of professionals have been found to be well-calibrated: meteorologists and race-track handicappers – this is due to three dominant characteristics of their trade:

• They face highly similar problems every day (low uncertainty); • They make explicitly probabilistic predictions; and • They obtain swift and precise feedback on the outcomes (frequently recalibrate their forecasts to actual results).

Crucially, these conditions are not satisfied in the investment market.

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9 Journal of Portfolio Management: Aspects of Investor Psychology: 1998 Page James D. Babcock, CFA, CPA, MBA - © Copyright Protected 2018

What is “Apophenia?” - “Bias” and “Heuristics?”

This finding is also consistent with scores of academic research which show that most people tend to overestimate their own abilities (75% of drivers think they are above average drivers).10 Such over-confidence bias can cause one to overestimate one’s knowledge, underestimate risks and exaggerate one’s ability to control events.

How to Manage It:

➢ Investors should be aware that they are prone to overconfidence and should keep track of past instances when they acted overconfident. This would temper the natural inclination to remember only successes. It is also important to not let others project their own over-confidence unto you.

➢ Tempting as it may be, it makes sense to resist the urge to be optimistic about your investment decisions. Engage with the Slow Thinking System and consider what could go wrong, as well as the “unknowable unknowns”.

2) Over-Reaction to Chance Events (Pattern Recognition)

Which of the following sequences is more likely to occur when a fair coin is tossed?

Sequence A Sequence B Heads Heads Heads Tails Heads Heads Tails Tails Tails Heads

Tails Tails

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9 10Journal of Applied Social Psychology: I Am a Better Driver Than You Think, July 19, 2013.

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What is “Apophenia?” - “Bias” and “Heuristics?”

In truth, the two sequences are equally likely to occur. However, one of the sequences “appears” to be random, while the other “appears” to be systematic. Most people erroneously believe Sequence B is more likely to be random than Sequence A.

According to Professor Steven Novella, Academic Neurologist at Yale School of Medicine:11

The ability to see patterns, even abstract patterns, is one of the human brain’s greatest strengths. It gives us a lot of our ability to problem-solve, the ability to see the commonality among different things, but it’s also potentially one of our greatest weaknesses…if we’re not aware that that’s how our brain works.

The brain seeks patterns to fit the stimuli. The brain is trying to make a new perceived pattern fit to patterns with which it’s already familiar. (i.e., Fast Thinking).

Prof. Novella also cites, as another example, the ability (especially among children in the summer) to see shapes in randomly passing cloud formations.

Most investors are too quick to perceive causal regularity in random events (Fast Think) which can cause them to perceive trends where none exists and to make investment decisions based on these illusions.

How to Manage It:

➢ Ask yourself whether you have real reasons to believe that you know more than the market.

➢ Before making an active decision, consider the possibility that patterns are based on random factors and list the reasons patterns should be systematic before making the investment.

➢ Be aware of statistical probabilities. Do not rely on intuition (Fast Thinking).

3) Loss Aversion

Consider the following question:

Would you prefer to find a $100 bill, or lose a $100 bill?

11 Novella, Steven: Your Deceptive Mind: A scientific Guide to Critical Thinking Skills, The Great Courses, 2012 Page James D. Babcock, CFA, CPA, MBA - © Copyright Protected 2018

What is “Apophenia?” - “Bias” and “Heuristics?”

The answer is obvious – everyone would prefer to gain $100 than lose money. Now consider the following question:

Which is a more intense experience: finding a $100 bill or losing a $100 bill?

Therein lies the premise of “Prospect Theory” 12, which explores how individuals value gains and losses and how that can inform/affect one’s decisions. The pain of losses is more acute than the joy of gains, as is summarized in the exhibit below. The value ‘A’ has been set as a neutral outcome, which is called the reference point. The reference point is often equal to the status quo (e.g., the current state of wealth).

Source: Google Images – copyright free.

Notice that the function is steeper for Losses than for Gains. In other words, one experiences more intense pain for Losses when compared with the joy that one experiences from Gains – even if the amount of from gains and losses involved are the same. In the Exhibit, a Gain of ‘x’ is perceived to have a Joy Value of ‘B’ while a Loss of ‘x’ is perceived to suffer a Pain Value of ‘C’ (larger than B). If the values for ‘x’ are the same, the “Loss aversion ratio” is about 2.0-2.5x of losses to gains (‘C’ divided by ‘B’).

How to Manage It:

➢ Some individuals may be more loss-averse than others (at the 2.5x end of the range). It is therefore important to assess your own sense of risk aversion as well as others’ and factor them in when discussing investments.

➢ Be aware that the “risk asset” investment market tends to be highly Loss Averse (analysts can lose their jobs for making recommendations that lead to noticeable investor losses but are seldom penalized for missing out on opportunities which could have led to gains.).

12 Kahneman, Daniel and Tversky, Amos: Prospect Theory: An Analysis of Decision Under Risk: 1979 in Econometrica. Page James D. Babcock, CFA, CPA, MBA - © Copyright Protected 2018

What is “Apophenia?” - “Bias” and “Heuristics?”

➢ Use Expected Value Decision Trees (discussed earlier) to arrive at conclusions. The use of tables can minimize Loss Aversion bias and supports an objective probably weighing of the outcomes.

4) Realizing Gains and Delaying Losses –

Anchoring, Dispositional Effect And Accounting Gains/Losses

Assume an investor needs to raise cash to pay his/her annual federal tax under-withholding. Also, assume this investor has decided to sell one of two owned stocks to raise the cash – one that has gone up from the purchase price and the other that has gone down. Odean 13 studied trade records for 10,000 individual investors and concludes that: “investors demonstrate a significant preference for selling winners and holding losers…it leads to lower returns.”

As this simple example illustrates, investors tend to be very aware of the price at which they bought an investment and will likely use the purchase prices as a reference point (Anchor). Thus, the initial price determines (for the investor) whether selling the investment now will yield a gain or a loss.

According to author Tim Richards:14

If we can delay accepting a loss, we can pretend it’s not real and avoid challenging our beliefs about our innate investing ability. We also sell our winners for a similar reason, because it locks in the “win.” Loss aversion and the dispositional effect reveal yet another fundamental human deviation from rationality. Technically, the price we happen to buy a stock at is no more meaningful that any other price the stock ever trades at.

Investors are biased in the sense that they tend to gravitate towards crystalizing accounting gains and avoid crystalizing accounting losses.

How to Manage It:

➢ Loss is an important aspect of risk for most investors, but loss is a relative term. Many investors calculate gains/losses compared to purchase price (accounting gains/losses) rather than compared to future prices (economic gains/losses). Determine clearly your reference point from which a gain or loss will be calculated and understand why that is so.

12 13 Odean, Terrance: “Are Investors Reluctant to Realize Their Losses?”, 1998. 14 Richards, Tim: Investing Psychology, 2014. Wiley. Page James D. Babcock, CFA, CPA, MBA - © Copyright Protected 2018

What is “Apophenia?” - “Bias” and “Heuristics?”

➢ Before a purchase decision is made, consider the conditions under which a subsequent sale would be made. Set a target sale price and stick to it (or establish “stop loss” and “take profits” triggers).

5) Hindsight Bias and Regret

Memory can be a funny thing. While we might believe our memory to be accurate and unbiased, the study of psychology – specifically the areas of false memories and reconstructive memory – suggests otherwise. Memory recall is subject to distortion.

For example: Back in early June 2016, did you expect UK voters to choose to leave the European Union?

Do you recall your probability estimate for the UK to vote to “Leave” (i.e., for Brexit) on June 23, one day before the momentous event?

If you can recall accurately, then you are in a minority. Psychological evidence indicates that people can rarely reconstruct, after the fact, their probability estimate of an event before it occurred.

Hindsight bias errors are pernicious in three ways:

1) They promote over-confidence (see the earlier example of “Over-confidence” in this paper) by creating the illusion that the world is predictable.

2) Turn reasonable investments into foolish mistakes: - After an investment dropped in value, its fall appears to have been inevitable. - Why didn’t the investor sell it earlier? - It also places investment jobs at risk for having not seen the “obvious” (in hindsight).

3) Regret makes losing subjectively hurt more (see the earlier example of “Loss Aversion” in this paper): - Losing feels worse if investors believe they should have anticipated poor performance. - Losing doesn’t feel as bad - if investors believe the failure could not have been predicted (if we were perfectly rational investors, there would be no feeling at all, just probabilities).

Those prone to regret are likely to blame others for mistakes. Combination of hindsight bias and 13 regret creates a powerful toxin.

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What is “Apophenia?” - “Bias” and “Heuristics?”

How to Manage It:

➢ Hindsight is a crucial element of investor regret and is a Fast Think illusion. Be wary and review hindsight with Slow Thinking.

➢ Document your decision process before the event. This permits you to recall (after the event) your thinking process (before the event).

➢ Objective factors should receive greater weight (e.g., investment horizon, liquidity, volatility, risk premium) as opposed to emotional factors (e.g., loss aversion, irrational fear and propensity for regret).

➢ Regret Diversification: a larger series of smaller position sizes; rather than fewer large position sizes, helps to “diversify” regret of loss away from any one position.

6) Availability Cascades

Availability cascades – a concept developed by Timur Kuran and Cass Sunstein – are based on the “availability heuristic,” a mental shortcut whereby the perceived likelihood of a reported event is tied to the ease with which it can be recalled (Fast Thinking).15

Cognitive psychologists have demonstrated the faster an event can be recalled and the higher the lucidity of the recollection (Availability), the more confident the individual becomes of the authenticity of the purported event. 17 Once again, this is a cognitive illusion that can have a major deleterious impact on investment decisions. The more one hears the assertion of an event in a self- reinforcing feed-back loop (Cascade) the greater the Availability.

Interestingly, according to Kuran and Sunstein, the combination of informational and reputational motives can play an amplifying role:

14 15 Stanford Law Review: Availability Cascades and Risk Regulation, 1999. 17 Kahneman, Daniel and Tversky, Amos: Availability: A heuristic for judging frequency and probability, 1973. Page James D. Babcock, CFA, CPA, MBA - © Copyright Protected 2018

What is “Apophenia?” - “Bias” and “Heuristics?”

Individuals endorse the illusion by learning from the apparent beliefs of others and by distorting their own public responses in the interest of maintaining their own social acceptance, by others. This further reinforces and amplifies the Cascade.

Availability Cascades can also result in mass delusions. Kuran and Suinstein detailed several examples in their 1999 paper, Availability Cascades & Risk Regulations. Two examples:

Love Canal Love Canal was a government housing development that had reportedly suffered chemical contamination. The event attracted widespread media coverage and political debate. Thus, US Congress established a $14 billion fund to clean up the affected sites. Later, several studies found that there was little to no evidence of environmental contamination at the sites at all, leading Kuran and Sunstein to conclude that $14 billion of public resources had been wasted.

Dow at 36,000 Closer to the investment markets, a book called: “Dow 36,000” was published in 1999, shortly before the dotcom bubble burst. In hindsight, few would disagree that the bubble was amplified by the media (including this book), which induced an informational positive feedback loop. The book predicted the Dow Jones Industrial Average would hit 36,000 points by 2003/4. The prediction did not come true, but demonstrates the power of self-fulfilling prophecy of a media induced positive feedback loop.

How to Manage It:

➢ Remain aware that investment opinions of others can be misinformed and deceptive. Insofar as investors appreciate the issue, they will be aware that public opinion and media attention can be both misinformed and deceptive.

➢ Investors must have the fortitude to withstand social pressure and conventional wisdom.

7) Rumors Do you recall the April 23, 2013 Associated Press (“AP”) report that Barak Obama had been injured in a White House explosion? This rumor was tweeted by an AP hacker, sending stocks plunging. The tweet was sent to 2mm AP followers and was re-tweeted 1,500 times.

Shakespeare warned, in Henry IV Part 2 about rumors: The personified “Rumor” actor begins the prolog wearing a costume covered with images of tongues (see the

accompanying Rolling Stones logo). “Rumor” introduces itself and provides a lesson for investors. With a grim challenge, “Rumor” brags:

1) “Open your ears.” Page James D. Babcock, CFA, CPA, MBA - © Copyright Protected 2018

What is “Apophenia?” - “Bias” and “Heuristics?”

2) “I continually tell lies, stuffing ears with falsehoods.”

3) “Guesswork, suspicion and speculation make them seem sound.”

4) Crowds (including theater-going audiences) are always quick to believe such rumors.

Shakespeare’s lesson suggests: + Rumors can be wrong, dangerous and misleading.

+ False, good news - is worse than hearing the truth (even if the truth is bad).

+ People themselves, (the crowd) cause rumors to be passed along.

Psychological explanation for rumors:

1. People spread rumors when there’s uncertainty.

2. People spread rumors when they feel anxiety. Spreading rumors can make them feel better by turning uncertainty into “facts.”

3. People spread rumors when information is important.

4. People spread rumors when they believe the information.

5. People spread rumors when it helps their self-image.

6. People spread rumors when it helps their social status.

How to Manage It: ➢ Do NOT rush into rumor induced trading mistakes using Fast Think. Do your homework – consider details (e.g., company issued 10K’s and Q’s) – with Slow Thinking.

➢ Assess plausibility of the rumor (i.e., probability) and rely on a Decision Tree (discussed earlier in this paper).

➢ Think skeptically about the source of the rumor. Does the source stand to benefit from false rumors (improved self-image or higher social status or stands to benefit financially – “Talking their book.”)

What is “Apophenia?” - “Bias” and “Heuristics?”

8) Halo (Horn) Delusion

Recall April 11, 2009 when Contestant #43212 appeared on Britain’s Got Talent?

When Susan Boyle appeared, she said she aspired to become a professional singer. She sang “I Dreamed a Dream” from Les Misérables and was watched by over 100 million viewers. Program judge, Amanda Holden, said her performance was “the biggest wake- up call ever!” The Halo (Horn) effect is to evaluate and judge a person, company or product based on one quality or attribute, and extrapolate the all other characteristics from that one quality. This bias can have a devastating effect on first impressions we have of people and investments. The Halo Delusion is what brand building is all about – creating Halos so that consumers and investor are more likely to think favorably of a company and its management team. Company’s invest in huge, professional Public Relations budgets to present management with Halo’s at on their earnings conference calls and at conference presentations.

It’s not so much the result of conscious distortions - as it is a natural tendency to make judgments about things that are abstract and ambiguous on the bases of other things that are salient and “seemingly” objective. Since gathering valid and objective data is hard work, people tend to default to the Halo/Horns Delusion.

Examples include: 1) Physical attributes contributing to perceptions of professional/investment potential for success; 2) Studies have shown that to evaluate a job candidate or management team, more accurately, insist that assessments be made without knowledge of the applicants school or photograph.

In a famous step to control the Halo Delusion, the NY Metropolitan opera successfully improved its method of auditions by having the candidate perform, unseen, from behind a screen.

How to Manage It:

➢ Be conscious of your own judgements (use Slow Thinking rather than Fast).

➢ Give your first impressions a second chance. Review your first impressions and reject those that are not objective.

➢ Ask someone you know well, their first impression of you, and reflect on the response.

➢ Avoid preferring management teams that are similar to you, just because of the similarity (grew- 17 up near you, went to same school, have same hobbies, etc.).

What is “Apophenia?” - “Bias” and “Heuristics?”

9) Categorical Thinking

Notice the difference between the “stylized” rainbow and the “real” rainbow? The stylized image depicts the mind’s Fast-Think impression - clear and distinct categories of colors. The real image depicts the colors residing on the electromagnetic spectrum as frequencies of varying energy waves. The waves smoothly flow on a continuum through the band of visible light.

The human mind is a categorization machine!

Dr. Robert Sapolsky, professor of biology and neurology at Stanford University lectured: 1) Arbitrary boundaries on a continua can be helpful to memory – placing facts into clearly demarcated and labeled buckets (e.g., “yellow”). 2) However, people are at risk of forgetting the boundaries are arbitrary and place way too much importance on the boundaries themselves. 3) When you think categorically, you have trouble seeing how similar different things are. 4) You risk paying too much attention to the boundaries and less attention to

the big picture and you may miss overlap. In investing, if faced with the following two options: 1) Stock forecasted a 4% return with 4% volatility and 2) Bond forecasted a 6% return with 2% volatility; one would be at risk to select the Stock because historically the “Stock” category has returned more than the “Bond” category. Risk of this type of strict categorization can also occur in bond rating categories (i.e., IG vs. HY ratings).

Categorical thinking can be dangerous in 4 important ways: 1) “Compressing” category members - treating them as if they are more alike than they are; 2) “Amplifying,” or exaggerating differences between categories; 3) “Discriminating” by favoring certain categories; and 4) “Fossilizing” the arbitrary categorical structure as if it were static.

How to Manage It: ➢ Be aware of arbitrary categories and ask: 1) Are categories valid? 2) Are categories useful (serve a purpose)?

➢ Develop the capability to analyze data continuously.

➢ Audit your decision-making by being less “black and white” and consider shades of grey.

➢ Schedule regular “defossilization” reviews to be more aware of the continua nature of the real- 18

What is “Apophenia?” - “Bias” and “Heuristics?”

Conclusion

For 99.833% of human existence, people lived in the Hunter/Gatherer phase of evolution and the human mind was designed for optimal performance during this Hunter/Gatherer period. However, decision making skills – based on biases and heuristics – that served us well during the Hunter/Gather period do not always work in the modern society due to cognitive illusions. Modern investment decisions are made in an environment that is highly complex, characterized by uncertainty, risk and rapid change. Investors who make investment decisions based on experience/intuition (Fast Thinking) can lead to systematic errors of judgment and ultimately, losses.

Many active investment managers struggle to beat their benchmarks, partially because they are not aware: • Of the existence of cognitive illusions, and • That they are making active investment decisions, based on illusions.

In this paper, I have described the development and nature of mental biases and heuristics. I have also explained how to recognize the resulting cognitive illusions and how to manage them.

Most importantly, it is a skill set that can be applied to other aspects of life, beyond investment management.

How to Manage It:

The most important concept throughout this paper is to be aware of the innate and unconscious biases and heuristics of the human mind during investment decision making. Lack of awareness frequently leads to cognitive illusions and disastrous investments decisions.

What is “Apophenia?” - “Bias” and “Heuristics?”

REFERENCES

Odean, Terrance: “Are Investors Reluctant to Realize Their Losses?”, 1998 in The Journal of Finance.

Kahneman, Daniel: Thinking, Fast and Slow, 2011. Farrar, Straus and Giroux.

Kahneman, Daniel and Riepe, Mark: Aspects of Investor Psychology, 1998 in Journal of Portfolio Management.

Kahneman, Daniel and Tversky, Amos: Availability: A heuristic for judging frequency and probability: 1973 in Cognitive Psychology.

Kahneman, Daniel and Tversky, Amos: Judgment Under Uncertainty: Heuristics and Biases: 1974 in Science.

Kahneman, Daniel and Tversky, Amos: Prospect Theory: An Analysis of Decision Under Risk: 1979 in Econometrica.

Normand, John, J.P. Morgan: “Cross-Asset Strategy,” October 26, 2018.

Kuran, Timur and Sunstein, Cass R.: Availability Cascades and Risk Regulation, 1999. Stanford Law Review.

Lewis, Michael: The Undoing Project, 2017.

Novella, Steven: Your Deceptive Mind: A scientific Guide to Critical Thinking Skills, The Great Courses, 2012.

Richards, Tim: Investing Psychology, 2014. Wiley.

Thaler, Richard H.: Misbehaving, 2015. W.W. Morton & Co.

Thaler, Richard H and Sunstein, Cass R.: Nudge: Improving Decisions About Health, Wealth, and Happiness, 2008. Yale University Press.

De Waal, Frans: Our Inner Ape, 2005.

What is “Apophenia?” - “Bias” and “Heuristics?”

JAMES (“JIM”) D. BABCOCK, CFA, CPA, MBA

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GLOBAL MULTI-ASSET PORTFOLIO MANAGER WITH LIQUID ALTERNATIVES EXPERTISE

GLOBAL HIGH YIELD/BANK LOANS, CREDIT DERIVATIVES, CLO, CORP. BOND, EMERGING

MARKET BONDS, PRIVATE-LENDING, EQUITIES, ASSET ALLOCATION, STRATEGY, STRUCTURE,

PM, RESEARCH, TRADING • Expert at generating performance in various asset classes and market conditions, with low volatility.

• Highly skilled at outperforming through network of collaborators using motivation and team- work.

• Passion for investing, outperforming markets and working with people. Self-knowledge, empathetic, curious, collaborative, trustworthy, competitive and resilient.

Jim is a highly accomplished financial asset manager and advisor with over 20 years investments experience. Jim currently serves as a Managing Director and Portfolio Manager for a Multi-Asset; Absolute Return; Liquid Alternative fund for Manulife Asset Management in Toronto.

His earlier experience includes nearly a decade as Global Head of High Yield and Bank Loans, and Portfolio Manager at APG Asset Management (Second largest global pension manager for 7 European funds and €402Bn in total AUM).

He also has extensive experience managing Global bond investments (including private placement new issues and work-outs) at: Abbey National Treasury in London, Putnam Investments in Boston and