Monday, October 4, 2010

The Gorilla Suit

Here are five behavioral impediments that contribute to bubbles repeatedly following the same path. By extension, I think it also helps explain why the over and under valuation of assets, even short of a bubble, happens so frequently.

The following are some excerpts from page 4 and 5 of James Montier's white paper: "Was It All Just A Bad Dream? Or, Ten Lessons Not Learnt"

1) Overoptimism
Everyone simply believes that they are less likely than average to have a drinking problem, to get divorced, or to be fired. This tendency to look on the bright side helps to blind us to the dangers posed by predictable surprises.

2) Illusion of Control
This is where we encounter a lot of the pseudoscience of finance, e.g., measures such as Value-At-Risk (VaR). The idea that if we can quantify risk we can control it is one of the great fallacies of modern finance. VaR tells us how much you can expect to lose with a given probability, i.e., the maximum daily loss with a 95% probability. Such risk management techniques are akin to buying a car with an airbag that is guaranteed to work unless you crash!

3) Self-serving Bias
...the innate desire to interpret information and act in ways that are supportive of our own self interests. As Warren Buffett puts it, "Never ask a barber if you need a haircut." If you had been a risk manager in 2006 and suggested that some of the collateralized debt obligations (CDOs) that your bank was working on might have been slightly suspect, you would, of course, have been fired and replaced by a risk manager who was happy to approve the transaction. Whenever lots of people are making lots of money, it is unlikely that they will take a step back and point out the obvious flaws in their actions.

4) Myopia
All too often we find that consequences occurring at a later date tend to have much less bearing on our choices the further into the future they fall. This can be summed up as, "Let us eat and drink, for tomorrow we shall die." Of course, this ignores the fact that on any given day we are roughly 260,000 times more likely to be wrong than right with respect to making it to tomorrow. Saint Augustine’s plea "Lord, make me chaste, but not yet" is pure myopia. One more good year, one more good bonus, and then I promise to go and do something worthwhile with my life, rather than working in finance!

5) Inattentional Blindness
Put bluntly, we simply don't expect to see what we are not looking for. The classic experiment in this field shows a short video clip of two teams playing basketball. One team is dressed in white, the other in black. Participants are asked to count how many times the team in white passes the ball between themselves. Now, halfway through this clip, a man in a gorilla suit walks onto the court, beats his chest, and then walks off. At the end of the clip, participants are asked how many passes there were. The normal range of answers is somewhere between 14 and 17. They are then asked if they saw anything unusual. Nearly 60% fail to spot the gorilla! When the gorilla is mentioned and the tape re-run, most participants say that the clip was switched, and the gorilla wasn't in the first version! People simply get too caught up in the detail of counting the passes. I suspect that something similar happens in finance: investors get caught up in all of the details and the noise, and forget to keep an eye on the big picture.

Check out the entire white paper.


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