Saturday, January 31, 2009

Behavioral Finance in Everyday Life – The Lottery as a Case Study

Is lottery a tax on stupidity or are our flawed psychologies playing another trick on us?

My wife and I usually enjoy strolls around our neighborhood on weekends, especially on sunny winter days. We live in the city and in our last stroll I kept noticing lottery advertisements everywhere as if they were beckoning to me.

Lottery has been deemed a tax on stupidity for a good reason. Every smart and aware consumer knows better than to throw money away on odds smaller than those of getting hit by lightning 3 times in a row.

Still, I couldn't help but buy a ticket. I felt I'd be I'd ignoring all the signals I had received that day calling out to me: buy and ye shall win. After having bought the ticket, for some reason, I'm full of hope and a very strong sensation of confidence in my chances of winning something.

I'm sure many of you have experienced that feeling before as well. Somehow, even though I am aware of the slim odds an unjustifiable feeling of optimism surges and the thoughts of all the things I'm going to do with my soon to be acquired financial independence overwhelm me.

There's a certain bias at work here and as my readers know I love psychological biases. This feeling of elation and of profits to come reminded me something. I usually get the same feeling when I make a stock investment. I simply can't be more certain this particular stock will drive my portfolio to new highs. Where does this conviction come from?

Behavioral finance and hedonic psychology - Daniel Kahneman and Amos Tversky's work

Daniel Kahneman is an Israeli psychologist and Nobel laureate, notable for his work on behavioral finance and hedonic psychology. With Amos Tversky and others, Kahneman established a cognitive basis for common human errors using heuristics and biases, and developed Prospect theory.

Kahneman and Tversky's work on behavioral finance is one of the most interesting and important to anyone who wishes to learn of the limitations of human rationality and the psychological biases that play a key part in our "rational" thinking. Their work is very relevant for investors everywhere as it ties in very tightly to stock market success and failure due to the affects of psychology on us, as investors or traders.

The Representativeness Heuristic – A wrong perception of chance

Would you choose consecutive numbers like 1,2,3,4,5 for the lottery? I'm guessing that you won't. But why not choose these numbers?

1,2,3,4,5 have the same chances of appearing than 2,8,12,23,35 but the last seems much more probable to be the winning numbers due to their randomness. Our minds are programmed in such a way as to correlate order with intention, which is mostly true. Still, there are times when this is obviously false.

The same phenomenon exists in the roulette where the combination red-red-red-black-black-black is thought of as much less likely than black-red-red-black-red-black. We have a certain expectation of nature restoring order to it, offsetting the results.

The Overconfidence effect and Optimism bias

Very common in investors the overconfidence effect is a bias in which people are correct in their judgments far less often than they think they are. For example, for certain types of question, answers that people rate as "99% certain" turn out to be wrong 40% of the time. Overconfidence is one kind of what is called the miscalibration of subjective probabilities.

You really can't get any more optimistically biased than hoping to win the lottery against unbeatable odds.

Apparently the lethal combination of overconfidence and optimism bias is very common and very hard to resist. According to Kahneman and Tversky only seasoned stock market brokers, weatherpersons and dog track analyists have shown some resistance to the effects of these biases.

I'm still hoping to win something but somehow I'm a little less confident in my guesswork. Still, people do win.

If you find judgement under uncertainty and heuristics and biases as interesting as I do please let me know. In the near future I hope to write more on these issues. In the meantime, you may be interested in Kahneman and Tversky's Judgment under Uncertainty: Heuristics and Biases

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Saturday, January 24, 2009

Success: Who Dares Wins?

Following the crowds won't get you there

After a couple of hours spent on a certain report or analysis I usually take 5 minutes to browse through my favorite news and finance sites to update on recent events and financial developments.

This week, to my surprise, a familiar face looked back at me from the home page of one of the most prominent financial websites around. Even more astounding was the fact that this person, once a good friend of mine, was chosen to be one of the most promising entrepreneurs in Europe.

It seems that while a distant and remote individual achieves financial success we somehow calm our envious and frustrated spirits by attributing his or her success to some magical factors unknown to us whether it is family and friends or pure luck.

When someone you're quite familiar with makes it big there are questions that need answering, all emanating from the same frustrating thought: Why him and not me?

The questions of success and financial independence and the way to achieve is perhaps one of the most troubling the minds of all of us, at least in western societies. Many of us spend long days in tiring jobs, feeling stranded and stuck. How do you weave the magic of financial independence?

I can't say I felt great at the moment I read through the article. I was naturally very happy for my friend but my mind quickly strayed off to other directions. Although I lead quite a successful life I've yet to become a success in my eyes.

I consider myself very talented and a great employee but it seems the set of skills I have is destined to leave me fighting to climb-up the corporate ladder, each exhausting step at a time.

To really succeed you need to be a visionary, to be determined enough, to have a certain hunger and to be brave enough to follow your convictions. Naturally these have to be combined with intelligence, marketing and social intelligence, hard work and luck. The combination of these traits and circumstances is obviously rare.

There's no reason to adopt a fatalistic approach. Actually most of us, including me, haven't really tried. I think I speak for many of us when I say we're just too comfortable and not hungry enough. Unfortunately we're caught in a situation we're not happy in but we don't have the courage or conviction to try and change it.

To really succeed, much like in the stock market, one has to avoid the crowds, or leverage them. You can have a pretty good life following the classic examples but in order to really stand out it seems we need to be innovative in some fashion, and dare.

The very appropriate motto of the British SAS or Special Air Service, which is one of the most famed special ops units in the world, is simple and powerful: Who Dares Wins. I, myself, intend to dare a little more.

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Friday, January 16, 2009

Valuation and Risk Measurement Models under Heavy Criticism – What Went Wrong?

Are valuation and risk measurement models as the root of all evil?

In this crisis we witnessed a broken market. Financial institutions relaying on complex financial models for both valuation and risk management suffered heavy losses and saw their methodologies break before their eyes.

Many valuation models and risk models literally stopped functioning and started spewing out numbers that seem to have no real connection with reality and stock market prices.

Many investors and financiers alike are losing faith in what was once held high as the hope of objective decision making based on mathematical calculations. Math and numbers provided a sense of security and scientific aura to many managers who only recently learned of their limitations, the hard way.

It is natural for us to assume complex equations and finance theory applied to the markets is much better than any subjective human judgment made. The model does over-estimate risk or influenced by market psychology. The model is no eager to sell on profit and is essentially not biased by any psychological human weakness.

So what went wrong?

Understanding models

Reality is far too complex to model. At least for us simple minded humans. As a result all models have to make assumptions which simplify reality and enable to model it while still providing powerful insights into the subject matter.

Many simple models are very powerful such as simple economic supply and demand, game-theory prisoner’s dilemma and many many others. The most important thing, then, is to be aware of the assumptions made in the model and draw the model’s limitations as a result.

In order to understand how far these limitations may go I’ll examine too very commonly used financial models: VaR, which is a commonly used risk measurement model and Black and Scholes which is a commonly used valuation model.

VAR and black swans

I’ve recently discussed the question of whether the western financial markets are just a huge Ponzi Scam. Nassim Taleb, author of the Black Swan theory suggests so (read more here: Is the Stock Market a Big Ponzi (Madoff) Scheme?).

So what do black swans have to do with value at risk? Let’s have a look at VaR and its purpose.

Value at Risk is a widely used measure of the risk of loss on a specific portfolio of financial assets. All the financial institutions in the world use VaR in their risk management efforts. For a given portfolio, probability and time horizon, VaR is defined as a threshold value such that the probability that the mark-to-market loss on the portfolio over the given time horizon exceeds this value (Wikipedia)

To put it simply VaR is the amount a certain portfolio might lose on a given probability and length of time.

For example, if a portfolio of stocks has a one-day 5% VaR of $1 million, there is a 5% probability that the portfolio will fall in value by more than $1 million over a one day period (Wikipedia).

When VaR is applied a probability has to be assumed. This is one of the main weaknesses of VaR and is crucial for understanding its limitations. When VaR is calculated a given timeframe and confidence level are assumed. For example I’d like to have a 95% confidence that in a 10 day period I will not lose over $1,000 on my portfolio.

What VaR does is take either historical or expected values for the assets and uses a statistical distribution to calculate the maximum loss on a 95% confidence level.

The problem lies with the remaining 5% which are not modeled and that’s where the black swans come into play. A black swan refers to a large-impact, hard-to-predict, and rare event beyond the realm of normal expectations. That is exactly what that remaining 5% (or 1%) represent. The chances are slim but the impact will be destructive (see sub-prime and credit crisis).

This limitation cannot be avoided. Had one modeled for 100% of occurrences than the Value at Risk would simply be the entire portfolio as there’s always a chance to lose everything.

Black and Scholes Model and non standard times

Another very commonly used model is the Black and Scholes model for option pricing. This model, sometimes under certain adjustments, is considered the gold standard for option pricing.

The model is quite complex and relays on relatively advanced mathematics but as always the model needs to make assumptions on reality which in turn limits it.

The Black and Scholes model is very powerful for option pricing and provides very interesting data on the impact of time, base asset price movements and standard deviation on the price of options.

However, the mighty Black and Scholes model assumes that the stock prices, which are the basic asset for the option, distribute normally (Normal Distribution) and that continues trading exists.

Obviously when the market is broken and trading is slim Black and Scholes simply doesn’t work. Option pricing according to Black and Scholes will usually be ridiculously high.

More complex financial instruments call for more complex valuation models along with more difficult to understand assumptions and limitations. No wonder we got lost in all the numbers.

It’s not that everyone wasn’t aware. There aren’t any better tools out there

I wouldn’t hurry to disparage financiers everywhere. Most of these individuals understand very well the limitations of models and modeling for financial assets. The problem is there aren’t any better tools out there.

Financial institutions have to quantify risk and valuate assets somehow. As such these models are the best solution available next to selling the assets altogether.

The problem stated when models weren’t accompanied with adequate skepticism, conservatism and a good infrastructure that calls for experience and judgment. It’s really not my intention to offer wisdom in hindsight. I’d make the same mistakes myself. That’s just human nature. Let’s make sure we implement these lessons in the future.

As always the industry will overshoot to access conservatism of valuations and extreme risk assessment. The ones that will make money are the ones that will be brave enough to remain calm and sound and apply the common sense we all know to be right but too afraid to apply.

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Image by: scottwills

Monday, January 12, 2009

I Want To Be A Part Of You, New York New York

I Just returned from spending two working weeks in Manhattan, one of mankind's most amazing creations. I'd like to share 7 observations I've had during my visit.

The accomplishments of mankind

Walking around Manhattan I always feel humbled by the achievement represented by this small island. I love the moment the skyline reveals itself as the taxi approaches and the feeling of driving through the streets of Manhattan for yet another time.

There are very few places in the world one can experience mankind's potential realized before one's eyes. Walking amongst the towering skyscrapers of Manhattan is just that.

They say you can recognize a tourist in Manhattan by how their heads are always tilted back. I've been to Manhattan quite a few times but I guess I'm still a tourist since I can't resist looking up at those magnificent buildings.

Makes you feel at home

From my very first visit to Manhattan I felt right at home. I'm a city dweller myself so I might be biased towards cities, although compared to New York City not many cities can claim that title.

It might be the familiar streets I'm used to seeing on the cinema coming to life before my eyes that give the welcome feeling but I doubt that. I think the high degree of accessibility and the cultural and ethnic diversity of the city play a key role.

I've been too many foreign cities and none greets you like NY City. The people may not be the most courteous but they are straightforward, to the point and usually warm towards both tourists and local residents.

You will usually be judged by one standard and that is how much money you have. This is a complement, although nothing at its extreme is good.

Social inequality and the ability to make money

Being in the state of mind I am, and that is an economic, personal finance, state of mind, I can't help but think of the many Manhattanites who can actually afford an apartment to rent or let alone buy.

Apparently there are enough very rich people in this world to populate the many luxury apartments throughout the city. I would probably have to work two lifetimes to start thinking of buying a 3 bedroom apartment in Manhattan. That social difference is amazing.

I understand many of Manhattan's residents are successful foreign individuals. Paradoxically enough the place everyone wants to live in (thus the high demand and prices) probably has a very high number of empty apartments as many of these individuals are usually out on various businesses.

Consumption as a state of mind

Shopping in New York is an entirely different experience. I've been to Macy's at least 5 different times and each and every time I get lost between the various buildings. It takes a certain skill to shop in New York as the vast array of anything and everything is mind blowing.

Floors on floors of clothes, electronics, entertainment and what not will get you dizzy in no time. It is very hard to resist the temptation of such abundance.

You can also better understand consumption as a state of mind. It isn't possible to be happy while so many good things I don't have are available, and relatively cheaply.


When I came to New York I half expected to find amazing sales and empty lines. With recession news pumped all day long and with the financial industry badly hit I really thought I'd see a change.

Well, you can probably understand I found everything to be the same. Lines were there, sales were not. Times Square and Broadway theaters were packed full as they've always been. I heard a show or two are closing but I didn't see any supporting evidence in the field.
Manhattan is obviously more recession proof but I did expect to see some impact on the city.

The sale gambit – Psychology of sales

Shopping is a part of a visit to Manhattan. I'm not a big shopper but since everything is available is such a small area I can't resist shopping for a while as well.

As I've written already I was surprised by the lack of sales but did notice, yet again, the psychology of sales and its effect on us or "the sales gambit" if you'd like.

It seems that no matter what, the size, color and design you like is never on sale. You usually settle for something close to enjoy that "got a great deal" feeling but you also buy another item to justify your visit to the store.

I've visited 3 different department stores only to find this pattern repeat itself over and over again.

Best steak I've ever had and a lesson on brand names

Peter Luger. I've heard that name every visit to New York. Everyone insists it's the best steak in New York and probably the entire USA. I'd be careful in making that assertion but I will contribute to the reputation of Peter Luger and say it's the best steak I've ever had.

More interesting is the location of the restaurant and its ability to attract visitors despite it. The brand of Peter Luger is so strong and well known people actually make the trip to Brooklyn for the experience. It's a 30-40 minute train ride from midtown Manhattan into a not so welcoming neighborhood (though I can't really judge as I don't know the place).

It seems certain brand names, once created, have a sort of inertia that keeps them going, that and the fabulous steak. Still, I don't think such a reputation is easily maintained. They offer the guest an experience, not just a steak. That's the key to their success, in my opinion.