Hidden Drivers

[MUSIC PLAYING] Yes. As mentioned, my route to this field came, I imagine, a very different way than yours developed. I am trained as a counseling psychologist. But I made a discovery about halfway through my doctoral program. And this discovery absolutely changed my life. I discovered that, unlike my colleagues in the counseling psychology program, I really didn't like working with people who had emotional issues. [LAUGHTER] Oh yeah-- yeah, it was a problem. [LAUGHTER] You know, I mean, god bless the people who do that work. It's wonderful work. But I found it was very draining for me. And I thought to myself, look, I want to be a psychologist. I want to help people with their problems. But I've got to find a rational population that I can work with. [LAUGHTER] So now I work with investors. [LAUGHTER] And it's the truth. You can probably appreciate the irony of my career path, right-- especially if you take a look at your client reactions, right? There's nothing more emotional than the relationship people have with their money. And there's nothing less rational. And so what I've determined over the-- and another discovery, really, over the past 15 years I've been doing this is that there's an awful lot of overlap between what a psychologist does and what it is financial professionals do as well. So a few things I'd just like to mention before we dig in, just to set the stage-- this presentation is called "Hidden Drivers: How Emotions Subvert our Investing Decisions and What We Can Do About It." It's going to be a bit of a change of pace, I think, from the rest of the curricula. It's not going to be overly technical. It's going to ask some questions and try to provide some practical strategies you can do to get a handle on your emotions and your investing. You know, behavioral finance-- raise your hand if you'd say you have a working knowledge of what behavioral finance is. Oh, yeah-- well, naturally, an audience like this, most every hand is going to go up. There's really two ways to think about behavioral finance application. One is macro application-- how does it apply to markets, exploitable opportunities in the markets? How do you make decisions and find value? The other one is a micro application, that we take a look at individual decision making, and team decision making, and how we might be able to do it better. And that's where this presentation is going to lie. One other thing-- I picked this up earlier today. They did some really fine work here. My presentation was not designed to dovetail with this, but I'm going to work in a lot of the material from this into my presentation where I can. Because I think it points to some really wise and important trends in the field. I mean, I'm the shrink here. So I can tell you, you're not paranoid. People are out to get you-- [LAUGHTER] --OK? Your industry-- I truly believe this-- it's really under siege on multiple fronts-- through regulation, through some movements, through the do-it-yourself robo movement, which I could speak for hours on, by the way. And so I think that some of the concepts in this book and a need to adjust to that environment is crucial for success and the survival of the business in a healthy way. All right, please allow me to introduce myself. Yeah, not much more to say about this except I am a gambling expert. I'm not particularly good at it, but I know a lot about it. [LAUGHTER] So if you want to sit at a poker table with me, probably be just fine. FRANK MURTHA: There's a difference between being a good poker player and a successful poker player. And the factor is who you're playing with. [LAUGHTER] So this absolutely makes a huge difference. I wrote a book. I may mention it. It's really designed for the layperson, the average investor. I co-founded MarketPsych, which, to my knowledge, remains the first behavioral finance consultancy in North America, back in 2001. I like to say, I was country before country was cool. [LAUGHTER] Nobody knew what I was talking about when I started talking about this. And I am a shrink by training. Now let's do a brief psychological exercise right here in this room. It's approximately 2:20, which means that we're all digesting our lunch, and we could probably use just a little bit of brain food to get us going. You may be familiar with this test. What I'd like you to do is to name the color of the word you see. The letters are in a different color than typical. And I want you to name the color you see. And what I'd like you to do is verbalize that answer quickly and loudly. Ready? Here we go. AUDIENCE: Blue. FRANK MURTHA: Good-- you're quick. [LAUGHTER] AUDIENCE: Red. FRANK MURTHA: Good, all right. AUDIENCE: Green. FRANK MURTHA: I like it. AUDIENCE: Yellow. FRANK MURTHA: Beautiful. AUDIENCE Red. [INTERPOSING VOICES] FRANK MURTHA: OK. That's a curveball. You guys fallowed off. That's what you're supposed to do with a curveball. Wait for your pitch, right? Here we go. AUDIENCE Blue. FRANK MURTHA: Faster, louder-- here we go. AUDIENCE: Green. FRANK MURTHA: Good. AUDIENCE Yellow. [INTERPOSING VOICES] AUDIENCE Oh! FRANK MURTHA: OK, that's all right. [INTERPOSING VOICES] FRANK MURTHA: Good. AUDIENCE Blue. FRANK MURTHA: Ah, nice-- uh-huh. AUDIENCE Oh, yeah. We got it now. [INTERPOSING VOICES] FRANK MURTHA: Fuchsia, magenta-- uh, I got to change this slide. I get too many answers. Green, red, OK. [LAUGHTER] Woo! Nothing wakes you up faster than a five by eight Gary Busey's grill on a screen right in front of you there. In fact, that's a little too intense. I'm going to just do that right now. OK, what we did right here is a psychological test called the Stroop test, which some of you may be familiar with. It tests automatic functioning in the brain with non-automatic functions, and where they intersect, and our ability to distinguish those processes. It's often used to see individuals who have cognitive impairment, because it lies at the anterior cingulate. The anterior cingulate is right in the middle of our brains. It actually is part of the connection between our left and our right. You may notice this slide. It's got two paths on it. And I like it for a number of reasons. And the reason why I think I like it best is if you wanted to make a new path in your brain, you would do so the same way you would make a new path in nature, all right? You would start by walking in an area where there is no path. There would just be green grass. But the more you walked it, the grass would wear away. And you'd have a path that you see there. There would be a dirt road. And you'd have a way to get from point A to point B. And of course, when you stop walking a path in nature or in your brain, we know what happens. It closes up on us, OK? What we actually did just now it was an exercise in neuroplasticity-- building a different path. Look-- the fact of the matter is, almost all psychological experiments are a form of practical joke, OK? They really are. You have to fool people in order to make the things work. And it's no different with the Stroop test. It may feel that way to you. But yeah, at first it was difficult to recognize, and distinguish, and disentangle the processes. But by the end, people were fast, loud, clear, and they were doing it right, OK? You were actually making a new path, and walking, and wearing away the grass. I also think it calls to mind how easy it is for us to rely on shortcuts and habits, right? It takes conscious effort to disentangle those habits. And I think that our automatic functions, the ones that we default to, a lot of times get us in trouble. I think it also makes a good analogy for emotions. Emotions creep into the process. We're not aware that it's creeped into the process. But it subverts our decision making. And we have to find ways to basically tease it out, meet it separately, and then we can make optimal decisions for ourselves and for our clients. Just to speak a little bit more on the agenda, I'm going to talk some about individual biases. And actually, in addition to being a geeky psychologist who plays poker, I also make short films. So I've got a couple of short films that I've put together, which hopefully will illuminate the concepts. We'll talk about the biases. We're gonna talk about emotions-- how they affect our investing, what we can do about it-- emotional market reactions. Talking about-- this is a little bit of the macro. I always like to throw in a little bit of the macro so that, you know, it's not overly focused just on the micro application. Then emotional biases in teams-- how these emotions and biases play themselves out when we're working with our colleagues. And then lastly, a little bit of neuroplasticity-- what we can do to rewire our brains. All right, there are any number-- behavioral finance has produced a litany of behavioral biases, all the little quirky things that people do to get themselves in trouble. It's often very interesting. But I think sometimes it really remains the equivalent of parlor tricks for investing. What we want to do is pay attention to what we can do differently to overcome them and to spot where emotions get involved, because that's when we tend to get in trouble. Here's five-- confirmation bias, anchoring, the endowment effect, mean reversion, and herding. Let's take a look first at the confirmation bias, which is really a mainstream term now, I think. I think almost everybody is sort of familiar with the confirmation bias. It is simply the unconscious tendency to seek and believe data that support already held positions and to discount data that do not. I made a little series of films with a pair of traders. And one of them is about the confirmation bias. We'll check that one out, and then we'll discuss it. [VIDEO PLAYBACK] - Hi, Jim. - Hi, Eddie. - Say, I heard about that earnings announcement for Green Nano Cyber Tech Corporation. It's a good thing you hit your stop loss before that conference call today. That was a nightmare. Eddie, please tell me that you got stopped out before that conference call today. - Well, that stop loss was always more of a suggestion than anything else. - So you still own Green Nano Cyber Tech? - I have $25k still invested. And I've decided to take a more long-term approach. I'm going to ride this thing out. - Eddie, I listened to that conference call too. They said they would no longer provide guidance going forward. It was a distraction. And they said that their margins were getting squeezed. - Not squeezed, constricted. There's a difference. - They also mentioned that they were losing market share to a host of new competitors. - Competition brings out the best in people. - And didn't they also say that they were recalling their latest product because it caused fires, emitted a dangerous level of radiation, and somehow caused a rare form of adult onset scoliosis that scientists did not previously know even existed? - They mentioned a couple of glitches. - And near the end, didn't the CEO announce that he would be starring in a brand new reality series in which he sailed his 100-foot yacht around the world using only a crew of Las Vegas strippers? - The man's an eccentric. Most geniuses are. - So let me see if I understand your position. Green Nano Cyber Tech Corporation was never intended to be a long-term investment. They have more red flags than a Communist Party parade. And the person in charge would rather star in the Erotic Adventures of Ferdinand Magellan than actually fix the problems. You still want to keep your money invested? - Well, it does help diversify my portfolio. - Yes. If your other positions are quality companies, I suppose owning a giant piece of crap is a form of diversification. - Look, Jim, this company is truly visionary. And it's already down too far to sell. I don't really have a choice at this point. - You could choose to admit that you made a mistake. - And who said anything about making a mistake? [END PLAYBACK] FRANK MURTHA: OK. [LAUGHTER] All right, it is a little the lighter side of the confirmation bias, right? We know how it gets us in trouble. I'm not always sure we know why. What can we do about it? For first of all, candidly assess your standard of proof, right? Your standard of proof-- when you hear an argument that supports what you're saying, it's sort of like somebody complimenting your kid. You're like, yeah, thanks, that's so true. But when you hear something that runs afoul of it and maybe challenges you, we tend to have this-- well, wait a minute. I don't buy that. And we'll probably see that later on in this presentation, to be honest with you. Assess your standard of proof. Keep it conscious. And also seek out the best case against your analysis. A MarketPsych aphorism, if that's the right word-- until you can articulate the best argument against your position, you're not ready to take that position, right? And because of the confirmation bias, we often don't do that. One other thing about the confirmation bias, because it's a great example of a bias-- it's cognitive. But is it? Why is there a confirmation bias at all? Why should there be this bias to believe what we already believe? Because emotions-- because being wrong is unpleasant. Being wrong feels bad. It bruises us on some level. It creates a little bit of pain. It creates cognitive dissonance, all right? The ability to recognize when maybe our ego is creeping into the process and to separate that out the same way you do with the Stroop test, it's important. It's a strainer that allows us to make better decisions. All right, anchoring-- It's actually kind of similar to the confirmation bias. It's the tendency to use previously encountered numbers as unwarranted baselines or benchmarks in our analysis. It's a powerful one. I mean, we see the advertising industry has known this for years by the way. And one of my favorite examples, if you get suckered into it-- you know, you drive past the gas station. And it says that gas is $2.299. It's actually 99% of the way to being $2.30. But what do we say the gas is? Oh, it's $2.29. The hell it is-- $2.30, right? It's anchoring. It's a very pervasive, very powerful force. And particularly in our field-- your field-- it creeps in without our knowledge. What can you do about anchoring? Actively seek out the way stories have changed. A lot of what this boils down to is resisting these-- honestly, these biases are like gravity, right? You know gravity? It's going on right now. It's happening to us. We're not aware of it. We don't think about gravity. But it actually takes effort for me to raise my arm. Because if I don't have an effort, it drops to the floor. That's what gravity does. All these biases, they need to be brought into our consciousness and actively resisted. Because they weigh us down without our knowledge. Actively seek out. Consciously expand the scope of possible or likely outcomes. One of the problems with anchoring that doesn't get fully appreciated is that it causes us to narrow the scope of possibilities. The recent election, I think, probably explains that that can happen outside of the realm of investing, OK? People didn't see that coming. They got anchored to numbers, and they weren't able to expand the scope. I mention I enjoy poker and gambling for a lot of reasons, which I will discuss more. Bonus points-- who can tell me who this is? It's an obscure question, I grant you. Her name is Annette Obrestad. She's a brilliant poker player. She's from Norway. And she created a controversy, because she started winning tournaments at the age of 15 online, which I believe is probably too young to actually be doing it. Here's one of the things about Annette Obrestad, which is absolutely fascinating. And it made her a legend. She's really a savant. She videotaped this. She played in a 180-seat tournament online of Texas Hold'em. And you know what she did? She taped paper on her screen. So she played the entire tournament without seeing any of her cards. Because the cards always pop up on your monitor in the exact same place. She just covered them. She won, OK? Highly impressive. How? Reading her opponents, bluffing, playing position, doing all of these things. It's a great example, I think, of the ability to employ analysis that does not factor in the past anchors. You know, the cards you get dealt are like an anchor sometimes. They provide useful information sometimes, but we get stuck on them. If you can find ways-- and I believe the gentleman's name is [? Kathrik ?] who presented earlier. In the same way that he said, OK, pop quiz. Here's three different possibilities. I'm not going to tell you who they are. The ability to strip out the anchors and sometimes bring our colleagues in to have a look at things without those distortions-- we're seeing it clear eyes for the first time-- it's a great tool to use in analysis. Sometimes is very useful to bring other people in. Otherwise it's pretty tough to do on our own. So there's anchoring. OK, the endowment effect-- this is the unconscious tendency to overvalue that which we own and to form a greater attachment to it. I'm going to refer to Jim and Eddie again. A lot of times, it can play itself out in non-financial ways. It plays itself out in relationships. Let's have a look at the endowment effect. Roll the clip. [VIDEO PLAYBACK] - Why do you keep saying I should read the book, MarketPsych? - Because it will help you make better investing decisions. - I don't see why I need help. - Eddie, you have an investing problem. You get so attached to your stocks that you can never bring yourself to sell them. And so you end up staying with them too long and getting hurt. - I believe in buy and hold. What's so wrong with that? - You don't just buy and hold. You buy and cling. - I do not cling to my stocks. - Eddie, you cling like a Velcro koala bear with separation anxiety. You are Corporal Clinger. Static electricity is jealous of your ability to cling. - What is wrong with holding stocks for the long term? - Nothing, but it depends on the stock. Think of it this way. Stock relationships are like romantic relationships. Some are just bad, and you need to get out right away. Some are good, but they eventually run their course. There are precious few that you want to be with for the rest of your life. But they have to be very special. - Why are you telling me this? - Because you treat all relationships like they were meant to last forever. You never consider the conditions that would cause you to end the relationship. Since you can never break with your stocks, they are forced to break up with you. It's not just stocks. The same thing happened with you and Cathy. - Not true. Cathy didn't dump me. She had to relocate for work. - To the island of Tahiti? - Yes, Tahiti. - Eddie, she she's an accountant and a damn good one-- for an office furniture company. - Right. What is your point? - Just go to MarketPsych.com, Eddie-- please. [END PLAYBACK] FRANK MURTHA: OK-- forming an irrational over-attachment to things. Here's a concept I'd like you to consider. I think it's important. When we invest in a stock, when we invest in any position-- it could be money, but it's even just our time and effort-- we invest more than our money. We invest a little part of ourselves. This hidden investment provides a hidden return, an emotional return, EROI, that secretly factors in our decision process. And at times, it can overwhelm it, OK? Consider what happens when your positions go up and your call's right. Well, you get compensated financially, of course. But you also get compensated in other ways that are emotional. And there's almost a form of emotional arbitrage that can be had there. We need to disentangle these processes. What can we do about the endowment effect? Recognize the emotional attachments we have to companies we invest in. Now this is going to happen for different reasons. It could be, like, your favorite call or something about the company that you like a lot. It could be a relationship you have with the management at that company that drives you. It could be one that you started covering when you were very early in your career, so it's a real long standing relationship that you have. Also bear in mind this. When we make a call that is different, or unique, that distinguishes us from other people, there's going to be a disproportional emotional investment. There has to be, otherwise people wouldn't be sticking their neck out. People wouldn't be distinguishing themselves. There's risk in that sometimes. And being able to recognize that those positions are going to be most at risk for the attachment that we have and therefore most immune to new, good, disputing data, that's something for us to factor in. All right, here's one. And it involves an analogy that has to do with optical processing as well as just cognitive processing. It's called the mean reversion bias. Is the tendency to overrate how quickly trends will revert to historical averages and norms. Most everything I've told you affects everybody, but it mainly affects laypersons. As professionals, you have training. You have experience that enables you to resist these more than what most people. Believe it or not, this is one of the biases that has been shown to affect professionals in the field basically at the same rate as it does people. The mean reversion bias-- a roulette wheel is a good example. I learned about the mean reversion bias as a student on spring break in the Bahamas, which has gambling. And I went to a roulette wheel. And it's the classic example. It came up black a whole bunch of times, and I was betting a certain way. My bet size, the position size that we recommend, was consistent until I noticed that it kept coming up black. And I was like, well, this is ridiculous. It's got to come up red sooner or later. So I changed my position sizes, and I got wiped out rather quickly, OK? Because, of course, that past information-- it's irrelevant. I've always thought the gambling industry is brilliant and evil. You ever sat at roulette table? You know that panel of past results that come up? It's completely irrelevant. It shows all the past numbers. It has no effect on anything that's going to happen, OK? But it's a useful tool. It gets people to make decisions. The other thing I want to point out is this. That's a picture of Derek Jeter. Does anybody here happen to know Derek Jeter's lifetime batting average? Any Yankees fans? Who wants to take a guess? Just throw it out there. AUDIENCE 300. FRANK MURTHA: 300? AUDIENCE 305. FRANK MURTHA: You know, you guys are pretty close. He's a 310 lifetime hitter, Jeter. For the purposes of this example, I'll make it 300-- just whatever. Here's the here's the problem. If Derek Jeter has a horrible first half and at the all-star break, he is hitting 200. And we know-- we have a mountain of data. It all tells us Derek's a 300 hitter. And he's hitting 200 halfway through the season. Our mind is going to naturally gravitate towards another number. What's it going to hit [? soon? ?] 400, right? And it's very difficult to overcome. So most people, if you had to estimate, will say, well, 400's kind of crazy. He's not Ted Williams. Maybe we'll say Derrick it's 330 the rest the way, 350. But what's actually the best guess at what Derek Jeter's going to hit the rest of the way? AUDIENCE 300. FRANK MURTHA: 300. He's a 300 hitter, OK? This is where it creeps in it. There's many examples of this with strategists in the market. One that's particularly particularly illuminating-- in the year 2000, people were talking about the historic 9% return on equities in the markets, broadly speaking. 2000, the S&P returned negative 9%. So the best and brightest from the different firms, Barron's polled them and said, what's the consensus market forecast? And they said, well, for 2001, we're going to see 18.7%. That's when it came out to. It happens to be twice that 9%. Well, the market lost another 15%-- I believe 15%. So what happened? What did people say for 2002? Well, now we really need to see that reversion to the mean. So people actually played that card even harder. 23% is what the [? average-- ?] can you imagine that, predicting 23% market returns now? Whew. But they did. And these were really, really smart, learned people. What did the market return? Negative 22%. [LAUGHTER] OK? We need to really resist this universally felt experience to want things to snap back a little faster than they do, recognizing the natural tendency towards over corrections in earnings and market movements. We are beholden to it. Consciously fight gravity. Make sure we're factoring in the things we need to-- and distinguishing between the types of data that we use to make these decisions-- what's irrelevant versus what's really meaningful, what's temporary versus what's permanent, OK? Ah, the distinction bias-- this is this is a neat one-- the tendency for two options to look more distinctive, that is different, when they are evaluated together as opposed to when they are compared separately. This is an optical illusion. Everybody I have shown this to thinks that it's BS. I can assure you, I thought it was BS too until what I did was take a real close look at it and determine it. Take a look at A and B. You see those two squares? One says A. One says B. Which is darker, A or B? AUDIENCE A. FRANK MURTHA: A. I mean, it looks like A, right? In fact, they are the same. I'll go back one. It looks for anybody-- any normal-- I mean, this is universal. It looks like one's darker than the other one, right? I can assure you, look it up on your own if you want to. They are actually the same. I had to do this, because I'm obsessive. I blocked off my entire screen and just put, like, a little sliver. And I went, damn, they're right, OK? Why do I point this out? Because this optical illusion, it works on the same principle as a cognitive illusion, OK? The distinction bias-- whenever you're going to compare two things at the same time, it draws attention to the differences. When you compare them sequentially or separately, they look much more similar-- so maintaining an awareness of that. Comparing sector wide analysis in which perhaps we're looking to take a look at similarities in a sector versus company-specific analysis-- one of the ways that I think this actually plays out in a pretty practical level, you're making presentations. You're writing reports, OK? You're trying to communicate your analysis to other people. When you want to emphasize distinctions, use the distinction bias. Make sure they're side by side, compared as much as possible, and you will have a greater impact on emphasizing those differences on a screen-- you name it, OK? And if you want to emphasize that less and talk about how things are more the same, do it the other way, OK? Low hanging fruit in terms of the ability to use the distinction bias in our favor in order to have a more powerful influence. OK, herding-- this is the unconscious pressure to conform to the opinions of the majority. We've all heard this. Let's take a look. Jim and Eddie, they will eliminate hurting with an analogy that I think is quite fitting. [VIDEO PLAYBACK] - Eddie, you would really benefit from reading the book MarketPsych. - Why? - Because it does a great job of explaining how to overcome peer pressure in your investing. - What does peer pressure have to do with investing? - Everything. Think of the investing community as your peer group. What ultimately moves the price of a stock is its attractiveness in the eyes of your peers. - Right. - But some members of a peer group have more influence than others. Let's call them the smart money. - OK. - The smart money like a stock, so they buy it. Others in the group see this happening and follow suit, pushing the price higher. - Right. - The price appreciation makes the stock even more attractive, so new waves of followers buy in. Now the stock becomes quote unquote a water cooler stock. - OK. - But there is a problem. By the time the stock reaches the water cooler, the trend has become overextended. - I see. - The smart money is long gone. The only people still in it are the followers who find themselves holding an overpriced stock that no one can justify buying any more. The price suddenly collapses, causing massive losses for the trend followers. And it's all caused by the natural pressure to like what other people like. So you see, the market is quite literally peer pressure. - So you're saying the stock market is like junior high? - Yes. - And I'm like a follower doing what the cool kids are doing? - Exactly. - I hope you were not implying that I was uncool in junior high. - That was not my intention. - Because I was a very cool in junior high. I was respected for my intelligence and wisdom. - Those are very admirable qualities. - My points in charisma were off the charts. - Points in charisma? Wait, what? - And I had like a million hit points. I was a total bad-ass super wizard. - Eddie, are you talking about yourself or a Dungeons and Dragons character? - Not character-- alter ego. - OK. I'm just going to go ahead and forget I ever heard that. But regardless, you should read the book MarketPsych. - I had a pet dragon named Esteban. [END PLAYBACK] FRANK MURTHA: OK. But we talk about herding-- it's a relevant concept. It's a good way of looking at it. Herding in nature, the reason why animals go herd-- it's a safety-- it's a survival instinct. And I think it's true for investors too, OK-- for ourselves perhaps, for the lay person. But I think we don't need to look to the animal kingdom to get an accurate version of what's going on-- peer pressure. And I want you to consider what a definition of peer pressure is. It's the influence that a peer group exerts that encourages others to change their attitudes, their values, their behaviors in order to conform. The market is quite literally a form of peer pressure. Everybody who's investing, they're your peers. They're investing peers. And when they like something, it causes other people to like it. It causes it to increase in value in other people's eyes quite literally, and vice versa, OK? I don't know if you grew up with this one. I heard this growing up. And if all your friends jumped off a bridge, would you do that too? And the fact of the matter is, the only real honest answer to that is yeah, probably. [LAUGHTER] OK? And if all your friends jumped into solar energy stocks, would you do that too? [LAUGHTER] Most people would, OK? So let's talk about this. This is a classic. You know, I'm not going to get into it. It's another practical joke psychology experiment. The single one corresponds to the length of which letter-- A, B, or C? [INTERPOSING VOICES] FRANK MURTHA: C, right. In this experiment, they used plants around the table. And they got 70% of people to say that it wasn't C, OK? Why? Lots of different reasons. People thought, gee, I must be crazy. Everybody thinks it's C. And other people just didn't like going against the crowd, because it felt uncomfortable, all right? Even when we know better, this is something that's going on. Psychologists have known this for years. Peer pressure-- let's talk about this for a second. Because it affects all of us. And it affects, I think, people in your work in different ways. Who are your peers? Who are the ones who are putting pressure on you to conform? The market, other analysts, clients, companies you cover, right-- all of these different ones. If this were a workshop format, we would spend a lot of time digging into these concepts and the ways in which different types of peers we have put pressure on us to change our opinions, OK? At this point, I would only say, whether you're on the sell side or the buy side, the particular role that you have with an organization is going to affect it. It shapes opinion. And it drives a need for safety a lot of times as well. So how do you overcome peer pressure? What's the key to overcoming this? Well, the way you overcome social pressure in investing is the same way you overcame it growing up when you were perhaps an awkward 15-year-old who was wearing spectacles and below average height, OK? You overcame it by developing a stronger sense of who you are, a confidence in your own identity that lets you resist what you see other people doing, OK? What does that look like-- building investor identity, a professional identity? Weaknesses. What are your vulnerabilities? Acknowledging them. Your strengths-- what do you do really well? What are your goals, your values? In this book, they talk about motivations. It's a big part of your identity. What is it that drives you and motivates you? Personality being another one-- when we build this and have a stronger sense of it, what it enables us to do is act with confidence in the face of other people-- headwinds, tailwinds, people disagreeing with us-- so we can make the calls that are true to who we are and not unduly emphasized by these other factors that will creep in and subvert what is our expert individual analysis. Personality-- I won't go too far into this. But we have free personality tests at our site. You may find them illuminating. Feel free to avail yourselves of them. Here's the thing. Biases really become important when they affect our emotions, right? The confirmation bias isn't too bad except when it plays into our ego a little bit. We all have these emotional drivers, emotional needs. They sometimes compete with the financial ones, making objective decisions financially. All right, emotions-- loss aversion. And are investors loss averse? In a way, they are. Nobody wants to lose money, all right? Are people risk-averse? Well, yeah. I mean, certainly. But here's the thing about loss aversion and risk aversion. If you've ever been in Vegas, or in a poker game, or perhaps managed a portfolio, and you're up big, you can lose money and not really mind it. You can indulge yourself. Look, I'm up 70% for the year. I can play a little looser right now-- indulge myself and see if I can hit some home runs. You only start to stop that behavior when it starts to pinch again, right? With risk aversion, people think we're risk averse. But here's something that behavioral finance has determined. When positions are down, people will seek out risk just to avoid that loss, all right? They will actually wind up taking more risk because the thought of losing money is a very painful one. But what about this? What about pain aversion? That's the key. People avoid not loss per se, but the awful feeling that comes from experiencing the loss, what the consequences are emotionally for us and in our wallets, OK-- but mainly emotionally. How does this play itself out in investing? Loss aversion, pain aversion-- a lot of times what will happen is people will sell their winners too quickly. I call that clipping the flowers. Locking in a when too early, OK-- we do that. Investors do that. Holding losers too long-- I call that watering the weeds, all right? You can see what happens with this very destructive dynamic. What happens systematically to most people's portfolios, which is why they really need your help-- most investors will completely corkscrew their own portfolios-- is that systematically, they eliminate the best positions in order to get gains. Then they can't buy them back. But they hold onto and maintain all of those lousy positions. And you get at the end a portfolio that is like a garden with nothing but weeds in it. They just collect, all right? Some of us can still see the remnants of those weeds down around zero. And it's worth like $5. You're not going to make a transaction based on a $5 position. So they're constant reminders of ugly garden syndrome. It's all about pain avoidance, all right? So when it comes to analysis, we have financial needs. These are the objective things that we're supposed to be doing that are rational, our purpose, to provide useful analysis of companies and sectors, to provide accurate earnings projections, to provide valuable recommendations for investor actions-- buying, holding, et cetera. But what are the emotional needs? And where do they compete to be safe? No shame in that-- it's a universal need. And sometimes, it can get in the way. Some of the research referred to in here talks about that. To establish or protect one's reputation, right? Very important. To preserve important relationships, right-- it would be wonderful if that was not a consideration. But point of fact, it is. To feel smart, good, and competent about one's self-- look, we just want to feel good about ourselves. It's probably the most underrated factor. Everybody wants to do their job well and feel like they're doing the right thing, right? It's awfully hard to do that sometimes when people are pushing you to make these decisions that aren't quite what you want to do. So I almost think of it like a filtration system that we need to help us screen out the desire to meet the emotional needs and instead to focus on the financial needs and our jobs the best way we can. Thought-provoking questions-- what are the most painful aspects of your work? What are the things that keep you up at night, right? When you boil it down, those are the things that are going to be competing with our best judgment. All right, a brief word-- whenever we're talking about emotions, we're always making decisions and acting decisions in an emotional environment. And we can never escape it. I think of it almost like the snooze button, all right? Now if you want to go jogging at six o'clock in the morning, you're in one set of emotional circumstances. You're sincerely motivated. You're going to wake up early. You're going to do this. So you set the alarm. But then when six o'clock rolls around, you're in a different set of emotional circumstances. And so a lot of times what people do is hit the snooze button. It's the most insidious invention ever. The only purpose of a snooze button is to actually subvert the purpose of the device. [LAUGHTER] That's the only thing it does. But we put it on there, because it's so human, right? That's why risk tolerance questionnaires really underperform. You ask a person in an office in one set of emotional circumstances how they're going to feel-- oh, yeah. I can handle risk. What happens when the bullets start flying? Very different. They're forced to act upon that in a different set of emotional circumstances. OK, the problem with competitiveness-- boy, I think when they talk about phi, what are the what are the benchmarks and the underlying motivations? I think there's this natural tendency to want to outperform, to beat, to be competitive. It's often really destructive. And here's the thing. If you're a competitive person, being a competitive person really may serve you well when you're in a tennis match-- all right, you're in a tennis match. You never give up. You dive for a ball. You're just totally into it. You fight to the last point. That's wonderful. You do this an investing, and you're in serious trouble, all right? It's always too early to quit. Never quit, and you'll never lose, all right? Here's the thing. One of the toughest things we need to do is to find a way to invest our money without investing our ego so when the time comes to make a decision, we can make a decision and go, you know what? I'm cutting my losses. I'm changing my opinion. Because we're not tied to it. We're not anchored to it, right? The problem with competitiveness-- and I think it starts, frankly, to have a culture that supports that in your place business. All right, I've noticed that I am moving through this less quickly than is optimal. I'm going to just touch on emotional market reactions for a moment. Because we're talking about a macro application, which is not my forte. We've all seen charts like this. My colleague at MarketPsych does a brilliant job of analyzing the psychological cycle of markets and how to exploit the opportunities. Basically, it boils down to two things. Something happens, and there's either an overreaction, which is exploitable, or there is an under-reaction, and it is exploitable. Now when it comes to equities analysis and things, it's one thing to make projections on earnings. You know, you have data. You can analyze that data-- cash flow, revenue, sales, all kinds of things you can [? make out. ?] When it comes to price targets, I have always felt like it is a very unfair task. Because now you have to factor in not just objective numbers, but human behavior. Because that's what's going to ultimately drive the price, all right? Nonetheless, there are sometimes exploitable opportunities. One of them is through anchoring, all right? There's an earnings surprise to the upside. Market consensus is biased towards the downside. If the factor is permanent-- this is the key-- versus temporary, it produces, according to our research, an exploitable opportunity. Because there's been under-reaction, OK? We have plenty of examples on our web site, so we won't get into it. Overreaction-- this often happens because of what's called a representative bias, all right? Past disappointments for a company. Here's the consensus. It's a dog. It's always been a dog. It's always going to be a dog. Everybody hates the stock. But when the substantive changes to the company are permanent, not temporary, it's an exploitable overreaction opportunity. OK, most of us work with colleagues in some form as part of the team. Most people talk about how to build good teams. This is a guide to build a lousy team. This is a guide to building a dysfunctional investment committee. It's a four-phase thing. I'll go through it. One, establishing the culture-- OK, social pressure creates a climate that suppresses disagreement and avoids conflict. Sounds nice, but the cultural norm makes disagreement at once more important and less likely, OK? So in an effort to have everybody get along, here's what happens. Here's the problem with investing teams and groups. It amplifies all the biases I talked about. It makes them geometrically worse, OK? So now the team dynamic amplifies, for example, the confirmation bias so that we're going to start gravitating even more towards supportive data and lowering our standard of belief. Inevitably, there is conflict. It's natural. But that frustration leads to disagreement in which critiques of ideas and analysis are now interpreted as critiques of individuals, because they're running afoul of the culture, which, again, is meant to be a good culture. There's also the opposite, but that's not this example. Now team members become more defensive. They start escalating commitment to their opinions, further amplifying the confirmation bias. It's a vicious cycle, right? You've probably seen this with some people. If you've ever gotten into an argument with somebody, and you're sort of attacked, and you take something personally, it makes you dig in that much more. Now we've got phase four. Now we've achieved dysfunction within the team. Team members start serving those emotional needs, that big E. They want to be right. They want to save face. They want to win-- over the financial needs, which involve making the best possible decisions. Now regardless of whether or not the call you make or the position you take makes money or loses money, it creates an ongoing issue with the team. People will vow not to disagree anymore, vow not to share ideas, because they don't want to get them shot down. They seek to pay back people in kind. I remember when Larry torpedoed that call I made. I can't wait for Larry to raise his. I'm going to poke every hole in it. People start politicking for their own ideas in private. They seek to build coalitions on the team. They stretch the facts. And maybe they spin the data, sometimes sincerely and without their knowledge, just to support their own positions. They start feeling the need to redeem themselves. They want to swing for the fences. They start rooting against team members. I have worked with groups and teams in which they have described just this nasty scenario playing itself out, where you can't allow yourself to be wrong anymore. And it's all because of bias amplification and the emotional dynamics of teams. It calls to mind the need-- well, you know what it calls to mind? I used to work with kids, all right? I used to work with emotionally behaviorally disturbed kids, little seven-year-olds, OK? And I would do this work with them. And they'd be in part of a group. And I'd leave. And they'd make some progress feeling a little better about themselves. And part of the reason I got out of that business-- put those kids in the car. And I remember them driving out. We had a long parking lot out of this place I worked. And I could see the parents and the kids screaming at each other before they ever got out of the parking lot. And I thought to myself, oh my goodness. They just undid an hour's worth of work on the way out of the parking lot, OK? There's a lot of reasons why I think this plays in. But-- wow-- just thinking about that's bringing me back. It's really important to recognize the damage that gets done when this happens, OK? It's not always easily repaired. So the stage four dysfunction-- here's some suggestions. Groups and team biases-- beware of bias amplification. That's one. Actively seek out the motivation. That's a common theme here. Here's one. People say, let's assign a devil's advocate. Don't do that. Because you know what happens when you assign a devil's advocate? They begin to look like the devil after a while, all right? [LAUGHTER] Even though somebody may be playing a role, maybe it's a role they're born to play, but after a while, it's going to engender some resentment. Make it a team effort to look at the other side of the story. Focus on critiques of the trade or the analysis, not on the person, avoiding inflammatory language, and ensure all members interests are aligned, all right? That anecdote I told you about the kids, it just calls to mind this-- if there's not top-down culture that has people's values aligned using phi-- new word, I learned it today-- using phi-- it's going to be really hard to maintain these things. So going forward, it's going to be a concept that's going to be, I think, increasingly important, especially with the field in the state that it's in right now with so many people looking to attack it. But I always feel a little bit funny. Because, you know, I worked with kids. And now I work with people who are part of a bigger system and a bigger culture. That culture is not going to support the proper actions. It puts people in a real tough decision. So it's really that the people at the top that it needs to trickle down from. All right, let's talk a little bit about neuroplasticity. Who here knows Brent Steenbergen? He's one of my favorite guys in this business. He works a lot with traders, but his wisdom is applicable to all sorts of jobs in the financial world. He has some insights into what it takes to be better at our work. And I'd like to share with you. We change for the better not by motivating ourselves or trying to talk ourselves into thinking and behaving differently, but by absorbing new life experience. Do you wish to become a more patient professional? You can write in your journal. You can attach sticky notes on your screen. But ultimately, you will become a more patient professional when you experience yourself as a more patient person. I will explain what that means. That means using your non-professional life to cultivate that quality, placing yourself in roles that push you to be the patient person you wish to become. Here's the thing about this. And it's true wisdom. Psychology for years thought that change, neuroplasticity, making these new thoughts and habits come from a process internally. You think different thoughts. I'm good enough, I'm smart enough. Doggone it, people like me. And you think this. [LAUGHTER] And then it causes you to feel something different, which enables you to behave differently. No, that really doesn't work-- not really, all right? What they found is if you want to make behavior change, it's almost the opposite. You actually have to start engaging in the behavior first. Take a little bit of leap. And after you experience some success, all right-- being more patient, being more courageous, being more resilient, whatever that quality is, you do that. You experience it. And that allows you to have thoughts that you can actually believe. Then you believe these things about yourself. You experience yourself doing these things. And that's how you create change. He has lots of examples of how this can work. One of my favorite is poker. I'm going to tell you why. The way people play at a poker table will reflect the way they invest, and their investor biases, and their investor emotions, all right? The risks you take, the traps you fall into, they will play themselves out. It's a great tool for becoming better at your work. So there's all kinds of self-analysis we could do. I talked about emotions creating a distorted lens of things. Getting perspective, whether that perspective is with distance, removing ourselves, or simply getting different angles-- this I'm using as an analogy, because it fits. Depth perception-- if you want depth perception and see things, you have to be able to see it from different angles. And that means inviting different opinions into your process. Otherwise you're leaving yourself open for, well, the inability to perceive depth. We've all been in situations where depth perception has led to a bruise of some kind-- a baseball in the face in my case, all right? To avoid that, we need to get that perspective. Take the other angles. All right, here's one-- poker table's an example. This can be a very frustrating profession. Because you can do every darn thing right, get an outcome you don't like, and that seems to be the thing that anybody cares about. The process was right. You played your hand beautifully. You got the right position sizes. You made the right follow-up bets. You made the right calls. All the analysis was spot on, and then somebody turned over spade, spade, made a flush, beat your position, and you lose a lot of money. And the same thing can happen when it comes to the analysis of equities, all right? You talk to all the right people. You do all of these things. And earnings fall short. You do everything right. You do nine things right. You do one thing wrong. And all anybody cares about is the one thing you didn't actually have any control over, all right? It reminds me of the serenity prayer. Now the wisdom-- the part would be the serenity to accept the things that we cannot change, the courage to change the things that we can, and the wisdom to know the difference. Let's take a look at the wisdom of that for a moment. What we need to do is Institute reward systems-- preferably, this is on an organizational level. We're talking about motivations, right-- the hidden drivers, the hidden motivators, all right? When a company and a culture supports that, it goes an awful long way. Because it rewards the proper behavior. All too often, we're not in a position like that. So I invite you, even on an individual level, to reward yourself with a behavioral plan that says, look, I'm going to the following five things. And I'm going to do them right. And as long as I'm doing that, I'm going to feel OK, feel good, and give myself a little bit of reward to encourage that. When it becomes cultural, you've got a winning organization. Left versus right brain-- I will grant you, this is a bit of an over-simplification. But it's a useful simplification. It takes different skills to be good at the work that you do. I mean, I think of the left brain-- this is the data analysis part-- as being a little bit like technical analysis. Technical analysis, it's just the quantification of human behavior. They don't need to know why. They just need to know what is-- patterns, charts, things like that. There's a role for that. But there's also a role for the narrative, the story, and appreciation of that, all right? That's what the right brain comes in. That's the left hand or the creative part of us. I look at fundamental analysis as being a little bit of both. You need to be able to analyze, and quantify, and put together data, synthesize data. But you also have to have an appreciation of the narrative in the story that goes with it, OK? You need to be creative. So how do we forge these stronger connections, build up both aspects that are critical to our work? There's lots of tests out there that will build neural pathways in your brain, all right? The Stroop test is one. You can go to a web site and find more. Here's just-- honestly, I challenge you to do this. It's a challenge. When you're brushing your teeth tonight, when you're eating, later on writing, try using your off hand. In the same way that the Stroop test is forcing you to do things, you will actually force your brain to do something different, OK? MODERATOR: Can we jump into questions? FRANK MURTHA: Yeah. Yeah, I'm sorry. I"m going right to the end, aren't I? New languages are good too. MODERATOR: Terrific. FRANK MURTHA: Yeah. Any questions-- I'm going to be sticking around too. MODERATOR: Yeah, so I've got a couple of questions here. So let me see if we can get them in. FRANK MURTHA: For what it's worth, if we don't have time, I would be happy to respond with an email to whoever submitted a question. I don't want your questions to go unheard, because I like to hear myself talk, OK? MODERATOR: OK, thank you. FRANK MURTHA: Yep. MODERATOR: A question here-- I believe I'll go trading programs are now programming in some typical behavioral responses with the markets. Do you have any observations or comments? FRANK MURTHA: Except to say-- perhaps. I know that people are trying to do that. But it's kind of the old observer effect. They're actually writing the story as they're doing it. They may think that they're just doing this objective, outside thing that's going to take advantage. But by rewriting the rules that way, you're actually creating imbalances that I think are unsustainable in the long run. I mean, if everybody's-- there's this big movement towards, like, passive investment. What's going to happen when everybody goes passive? It's not going to work. There's going to be increased need for active management. And I think that these factors balance themselves out. So short-term, sure, there may be some ways to quantify that. My colleague-- his work is to identify signals, behavioral biases. But I think that if you're not changing with the times, you're going to find yourself with some pretty big losses down the road. MODERATOR: Terrific. Two questions along the same line-- what practical things can market professionals do to overcome our hidden emotional drivers? And the other question similar, is education alone sufficient to counter these psychological traps? FRANK MURTHA: I'll field the second one first. The answer-- and it's a fair question. Is education enough? My answer is no. If education were enough to change behavior, kids would eat their vegetables. [LAUGHTER] Teenagers wouldn't smoke. And everybody would be making money on the stock market. It doesn't happen. It is not enough in and of itself. The first part of your question asked, what are things people do? MODERATOR: Yep, practical things they can do. FRANK MURTHA: Practical things-- I honestly think involving an outsider-- it doesn't have to be a professional coach. It could be a peer. But touching base with somebody who's able to show you a mirror of what you're doing goes an awful long way. Involving another person in the process of trying to create those change and overcoming your emotion. And doing the work it takes to recognize that, you know what? I'm holding on to this position, because I'm going to feel really bad if I don't-- and making sure you're rewarding yourself for the process, and recognizing, whether it's poker or investors, great poker players lay down great hands. The same is true with investors and analysts-- the ability to recognize that something's changed. It was great. It's not anymore. And reward yourself for that. And recognize, hey, that's what's going to make me great-- MODERATOR: Fair enough, yep. FRANK MURTHA: --you know, admitting a mistake. MODERATOR: One quick last question-- why is bias always a negative term? Can it be wisdom? FRANK MURTHA: That's very zen. [LAUGHTER] You know what? MODERATOR: Good way to end. FRANK MURTHA: Yeah, it as a good way to end. It's a great question. I do think that bias tends to be considered negative. I think it's more of a distortion. And the ability to recognize that distortion in the way we're looking at things-- a natural tendency-- if we just used the word tendency instead of bias, it would feel very different. It's just a tendency, all right? We can have good tendencies too. And some of these-- the distinction bias, mental accounting-- there's other ones-- absolutely, they're not narrowly negative. The key is to be aware of them. And once you're aware of them, sometimes you can actually use them to exploit opportunities. MODERATOR: Thank you. Thanks for giving us some insight. [MUSIC PLAYING] SPEAKER 3: Copyright 2017, CFA Institute, all rights reserved. This program is designed to give accurate and authoritative information in regards to the subject matter covered. It is distributed with the understanding that CFA Institute is not engaged in rendering legal, accounting, tax, investment, or other expert advice. If legal advice or other expert assistance is required, the services of a competent professional should be sought.