Psychology 01 (Nov 08 - Jan 14)

[millionairemind]

MW,

Yes, I agree. Tks for the note on the dividend reinvestment. In US, they call it DRIP (Dividend Re-Investment Plan). This is where the compound interest takes full effect.

Hope 2009 will be a HUAT HUAT year for you and everybody else.

2009 should be a better year. It can't get any worse liao lah.. what's there left to sell??

Cheers,
mm

[millionairemind]

Behavioral Finance: Key Concepts - Prospect Theory
By Albert Phung

Key Concept No.8: Prospect Theory
Traditionally, it is believed the net effect of the gains and losses involved with each choice are combined to present an overall evaluation of whether a choice is desirable. Academics tend to use "utility" to describe enjoyment and contend that we prefer instances that maximize our utility.

However, research has found that we don't actually process information in such a rational way. In 1979, Kahneman and Tversky presented an idea called prospect theory, which contends that people value gains and losses differently, and, as such, will base decisions on perceived gains rather than perceived losses. Thus, if a person were given two equal choices, one expressed in terms of possible gains and the other in possible losses, people would choose the former - even when they achieve the same economic end result.

According to prospect theory, losses have more emotional impact than an equivalent amount of gains. For example, in a traditional way of thinking, the amount of utility gained from receiving $50 should be equal to a situation in which you gained $100 and then lost $50. In both situations, the end result is a net gain of $50.

However, despite the fact that you still end up with a $50 gain in either case, most people view a single gain of $50 more favorably than gaining $100 and then losing $50.

Evidence for Irrational Behavior
Kahneman and Tversky conducted a series of studies in which subjects answered questions that involved making judgments between two monetary decisions that involved prospective losses and gains. For example, the following questions were used in their study:

1. You have $1,000 and you must pick one of the following choices:
Choice A: You have a 50% chance of gaining $1,000, and a 50% chance of gaining $0.
Choice B: You have a 100% chance of gaining $500.
2. You have $2,000 and you must pick one of the following choices:
Choice A: You have a 50% chance of losing $1,000, and 50% of losing $0.
Choice B: You have a 100% chance of losing $500.


If the subjects had answered logically, they would pick either "A" or "B" in both situations. (People choosing "B" would be more risk adverse than those choosing "A"). However, the results of this study showed that an overwhelming majority of people chose "B" for question 1 and "A" for question 2. The implication is that people are willing to settle for a reasonable level of gains (even if they have a reasonable chance of earning more), but are willing to engage in risk-seeking behaviors where they can limit their losses. In other words, losses are weighted more heavily than an equivalent amount of gains.

It is key to note that not everyone would have a value function that looks exactly like this; this is the general trend. The most evident feature is how a loss creates a greater feeling of pain compared to the joy created by an equivalent gain. For example, the absolute joy felt in finding $50 is a lot less than the absolute pain caused by losing $50.

Consequently, when multiple gain/loss events happen, each event is valued separately and then combined to create a cumulative feeling. For example, according to the value function, if you find $50, but then lose it soon after, this would cause an overall effect of -40 units of utility (finding the $50 causes +10 points of utility (joy), but losing the $50 causes -50 points of utility (pain). To most of us, this makes sense: it is a fair bet that you'd be kicking yourself over losing the $50 that you just found.

Financial Relevance
The prospect theory can be used to explain quite a few illogical financial behaviors. For example, there are people who do not wish to put their money in the bank to earn interest or who refuse to work overtime because they don't want to pay more taxes. Although these people would benefit financially from the additional after-tax income, prospect theory suggests that the benefit (or utility gained) from the extra money is not enough to overcome the feelings of loss incurred by paying taxes.

Prospect theory also explains the occurrence of the disposition effect, which is the tendency for investors to hold on to losing stocks for too long and sell winning stocks too soon. The most logical course of action would be to hold on to winning stocks in order to further gains and to sell losing stocks in order to prevent escalating losses.

When it comes to selling winning stocks prematurely, consider Kahneman and Tversky's study in which people were willing to settle for a lower guaranteed gain of $500 compared to choosing a riskier option that either yields a gain of $1,000 or $0. This explains why investors realize the gains of winning stocks too soon: in each situation, both the subjects in the study and investors seek to cash in on the amount of gains that have already been guaranteed. This represents typical risk-averse behavior.

The flip side of the coin is investors that hold on to losing stocks for too long. Like the study's subjects, investors are willing to assume a higher level of risk in order to avoid the negative utility of a prospective loss. Unfortunately, many of the losing stocks never recover, and the losses incurred continued to mount, with often disastrous results.

mm comments - from what I have read on behavioral finance, the pleasure that investors get from gains must be at least 1.5 times more than the losses for it to be equal. This means that investors often loathe to take the loss, and is the chief reason Y many ppe. hold on to losing positions for way too long. Investors/traders often justify to themselves that they invest for the long term, even though the company that they are holding on to is a dud.

[millionairemind]

Psychology
The price of prejudice
Jan 15th 2009
From The Economist print edition

It’s what you do that counts—not what you say you’d do

NOBODY likes to admit an uncomfortable truth about himself, especially when charged issues such as race, sex, age and even supersized waistlines come into play. That makes the task of the behavioural scientist a difficult one. Not only may participants in a study be lying to those running a test, but they may also, fundamentally, be lying to themselves.

Prising the lid off human assumptions and hidden biases thus requires clever tools. One of the most widely deployed, known as the implicit-association test, measures how quickly people associate words describing facial characteristics with different types of faces that display those characteristics. When such characteristics are favourable—“laughter” or “joy”, for example—it often takes someone longer to match them with faces that they may, unconsciously, view unfavourably (old, if the participant is young, or non-white if he is white). This procedure thus picks up biases that the participants say they are not aware of having.
Click here

Whether these small differences in what are essentially artificial tasks really reflect day-to-day actions and choices was, until recently, untested. But that has changed. In a paper to be published next month in Social Cognition, a group of researchers led by Eugene Caruso of the University of Chicago report their use of a technique called conjoint analysis, which they have adopted from the field of market research and adapted to study implicit biases in more realistic situations.

Conjoint analysis, they think, lets them quantify what has been dubbed the “stereotype tax”—the price that the person doing the stereotyping pays for his preconceived notions. In two studies, they turn their new tool loose on questions of the perception of weight and sex.
Know thyself not

Conjoint analysis asks participants to evaluate a series of products that vary in several important attributes, such as televisions of various screen sizes, brands and prices. By varying these attributes in a systematic way market researchers can measure with reasonable precision how much each trait is worth. They can then calculate how big a premium people are willing to pay in one attribute (price) to get what they want in another (a larger screen).

In their first study, Dr Caruso and his team recruited 101 students and asked them to imagine they were taking part in a team trivia game with a cash prize. Each student was presented with profiles of potential team-mates and asked to rate them on their desirability.

The putative team-mates varied in several ways. Three of these were meant to correlate with success at trivia: educational level, IQ and previous experience with the game. In addition, each profile had a photo which showed whether the team-mate was slim or fat. After rating the profiles, the participants were asked to say how important they thought each attribute was in their decisions.

Not surprisingly, they reported that weight was the least important factor in their choice. However, their actual decisions revealed that no other attribute counted more heavily. In fact, they were willing to sacrifice quite a bit to have a thin team-mate. They would trade 11 IQ points—about 50% of the range of IQs available—for a colleague who was suitably slender.

In a second study the team asked another group, this time of students who were about to graduate, to consider hypothetical job opportunities at consulting firms. The positions varied in starting salary, location, holiday time and the sex of the potential boss.

When it came to salary, location and holiday, the students’ decisions matched their stated preferences. However, the boss’s sex turned out to be far more important than they said it was (this was true whether a student was male or female). In effect, they were willing to pay a 22% tax on their starting salary to have a male boss.
A black and white answer

A recent paper in Science adds further fuel to the notion that implicit biases and inaccurate self-perceptions do indeed exist and need further study. A team led by Kerry Kawakami from York University in Canada conducted an experiment to try to understand how racism persisted despite most people roundly condemning it.

Dr Kawakami, too, used students. She recruited 120 who identified themselves as not being black, and then divided them into two equal groups. Members of one group were brought, one by one, into a waiting room with two other “students”, one black and one white, who were, in fact, in on the experiment.

As they waited, the black “student” stepped out of the room to retrieve a mobile phone, gently bumping the knee of the white “student” on the way out. Then, one of three things happened: either the incident passed without comment; or the white “student” remarked “Typical, I hate it when black people do that”; or he sniped “Clumsy nigger”. At this point, the study master returned and administered a test meant to measure emotional state. Finally, the study participant was asked to choose one of the two “students” as a partner for a subsequent test.

The other group was treated slightly differently. Participants were not actually brought into the waiting room but were asked to imagine themselves there, either by reading a description of what happened or by watching a videotaped version of the proceedings.

Both those who read what had happened and those who witnessed it on television thought they would be much more upset in the cases involving racist comments than the one involving no comment at all. However, those who had actually been in the waiting room showed little distress in any of the three cases.

In addition, a majority of those imagining the encounter predicted that they would not pick the racist student as their partner. However, those who were actually present in the room showed no tendency to shun the white student, even when he had been rude about the black one. People, it seems, are rather more prejudiced than they think they are.

[winston]

It's Good to Know: The Smell of Fear

University of Dusseldorf researchers have found that when people are fearful or anxious their bodies release a chemical that others respond to - at least, subconsciously.

Volunteers were hooked up to brain scanners. They were then asked to sniff cotton pads taken straight from the armpits of a group of students. Pads were taken just before the students were about to take an important exam, and then again while they worked out on exercise bikes.

Based on smell, the sniffers could not tell the difference between the pre-exam "panic" sweat and the sweat that had been generated during exercise. But the brain scans showed that when they sniffed the pre-exam sweat, it stimulated a part of the brain that triggers empathy - essentially making the anxiety contagious.

The researchers believe this automatic sensory reaction may have evolved in humans to speed up the spread of fear within a group that's in some sort of danger. As a result, it would jumpstart a flight to safety.

(Source: New Scientist)

[mojo_]

Humans prefer cockiness to expertise

New Scientist
10 June 2009 by Peter Aldhous

EVER wondered why the pundits who failed to predict the current economic crisis are still being paid for their opinions? It's a consequence of the way human psychology works in a free market, according to a study of how people's self-confidence affects the way others respond to their advice.

The research, by Don Moore of Carnegie Mellon University in Pittsburgh, Pennsylvania, shows that we prefer advice from a confident source, even to the point that we are willing to forgive a poor track record. Moore argues that in competitive situations, this can drive those offering advice to increasingly exaggerate how sure they are. And it spells bad news for scientists who try to be honest about gaps in their knowledge.

In Moore's experiment, volunteers were given cash for correctly guessing the weight of people from their photographs. In each of the eight rounds of the study, the guessers bought advice from one of four other volunteers. The guessers could see in advance how confident each of these advisers was (see table), but not which weights they had opted for.

From the start, the more confident advisers found more buyers for their advice, and this caused the advisers to give answers that were more and more precise as the game progressed. This escalation in precision disappeared when guessers simply had to choose whether or not to buy the advice of a single adviser. In the later rounds, guessers tended to avoid advisers who had been wrong previously, but this effect was more than outweighed by the bias towards confidence.

The findings add weight to the idea that if offering expert opinion is your stock-in-trade, it pays to appear confident. Describing his work at an Association for Psychological Science meeting in San Francisco last month, Moore said that following the advice of the most confident person often makes sense, as there is evidence that precision and expertise do tend to go hand in hand. For example, people give a narrower range of answers when asked about subjects with which they are more familiar (Organizational Behavior and Human Decision Processes, vol 107, p 179).

There are times, however, when this link breaks down. With complex but politicised subjects such as global warming, for example, scientific experts who stress uncertainties lose out to activists or lobbyists with a more emphatic message.

So if honest advice risks being ignored, what is a responsible scientific adviser to do? "It's an excellent question, and I'm not sure that I have a great answer," says Moore.

[winston]

WHY DOES THE MARKET KEEP GOING UP?

This is a question that confounds those on the sidelines and aggravates the bears to no end. Many attribute it to some sort of bank or government engineered conspiracy theory. Others say it is simply performance chasing by large money managers.

Personally, I find the answer in the psychological. When you break market transactions down to their simplest point it really all comes down to psychology. The transaction price point occurs at an agreed upon price where one party succumbs to the demands of the other (to oversimplify things). In other words, one party has a greater need to achieve a certain price on the buy side or sell side. This is all due to psychology.

This was best seen during the last year. 12 months ago sellers were desperate to get out of stocks. The buyers were in an obvious position of power where they could actually drop their bids or hold out altogether. Today’s market environment is very much the opposite. The sellers are in a position of power because there is no great need to sell.

The buyers on the other hand, are in a position of fear caused by the idea that they might miss out on future price appreciation. There is no dire reason to sell therefore the buyers simply overpower the sellers on a daily basis and this drives prices higher.

This is all being compounded by the fact that we are coming off such a massive psychological imbalance earlier this year. This is classic overshooting in a mean reversion process. The following image represents price action around the business cycle.

The blue line represents the mean. As the economy expands investors tend to overshoot to the upside. The inverse occurs in a recession. What we saw in March was a classic case of panic fear that resulted in a massive overshoot to the downside. My March 8th bottom call had very little to do with changing fundamentals and everything to do with a panic overshoot.

Admittedly, the timing was remarkably lucky, but the approach was not. I was simply playing off the idea that stocks and emotions had overshot far too much to the downside.

http://pragcap.com/why-does-the-market-keep-going-up

[millionairemind]

Taken from the book SWAY.

Why would a Harvard MBA student pay $204 for a $20 bill?
Irrational Behavior Happens to the Best of Us.

Why would a Harvard MBA student pay $204 for a $20 bill?

Harvard Business School professor, Max Bazerman found a fail proof way to take money from Harvard MBA students. On the first day of his negotiations class, he waves a $20 bill in the air and declares he will be auctioning it off. There are only two rules to the auction: First all bids must be in $1 increments and, second the winner will walk away with the bill, but the runner-up must honor his or her bid leaving the situation empty handed.

As Professor Bazerman begins the auction, the MBA Harvard students are at the edge of their seats- anxious to make a cheap $20. The auction rapidly takes off as as hands are flying up throughout the classroom. Within no time the bid is up to $10 and climbing, around the $12 to $16 students notice the trend and the volume of bidding falls out completely till there are two bidders left.

Now one would think this shouldn't get too out of hand; these are intelligent business students that are going to change the world. However, neither wants to be out $16. So it goes on to $21, $22, $23, $50, $100 the record is $204.

Lesson? Loss aversion is a powerful force to recon with, as it beckons irrational behavior, be it in a classroom auction or when making important decisions such as choosing a college. By gauging your commitment and controlling your anxiety, you can prevent this from fogging up your decision-making perception!

[kennynah]

the winner will walk away with the bill, but the runner-up must honor his or her bid leaving the situation empty handed.

must pay attention to this game rule... the winner doesn;t pay for the auction...the runner up pays but gets nothing...

so, i think this story is suspicious..becos, what's stopping another person from bidding $205...afterall, the person who bidded $204 will have to pay for the $20bill that goes to the $205 bidder...and if there was a $205 bid...there will be a $206, 207,208, ....1000000000000000000000000000000000000010 bid...time permitting..

[Aspellian]

the winner will walk away with the bill, but the runner-up must honor his or her bid leaving the situation empty handed.

must pay attention to this game rule... the winner doesn;t pay for the auction...the runner up pays but gets nothing...

so, i think this story is suspicious..becos, what's stopping another person from bidding $205...afterall, the person who bidded $204 will have to pay for the $20bill that goes to the $205 bidder...and if there was a $205 bid...there will be a $206, 207,208, ....1000000000000000000000000000000000000010 bid...time permitting..

makes you wonder why the person who bidded $203 (and lost the bid) stopped bidding??

[iam802]

Maybe there is a time limit to it (eg. Professor control the auction time...nobody knows when it ends)

In fact, I have a version of Monopoly that has auction in it as well. And we will bid for a land, driving up the price, and keep pushing it till the auction time is almost up. My kid will end up burning a lot of cash during the auction.

She will ultimately find herself unable to pay me when she steps onto my properties next

Pretty much like the market , isn't it?