W 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 W 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? 2 3 JP Morgan: Cross-Asset Strategy October 26, 2018 Page James D. Babcock, CFA, CPA, MBA - © Copyright Protected 2018 W 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. 3 5 Müller-Lyer illusion devised by Franz Carl Müller, a German sociologist, in 1889 Page James D. Babcock, CFA, CPA, MBA - © Copyright Protected 2018 W 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. 6 4 Kahneman, Daniel: Thinking, Fast and Slow, 2011. Frrar, Straus and Giroux. Page James D. Babcock, CFA, CPA, MBA - © Copyright Protected 2018 W 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 W 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.