Anchored to Missed Opportunities by Stephen Duneier
In the previous edition of Seeds, I attempted to show that we humans are prone to decision making mistakes and that it’s those mistakes that make it possible for “skill” to exist in our industry. Remove all decisional mistakes made by market participants and your investment performance will be determined purely by chance. Ipso facto, the only way to generate true alpha is to capitalize on the mistakes of others.
Decision theory is the field of study that focuses on decision making, and it is broken into two main categories, normative and descriptive. Normative decision theory is the study of how we should make decisions. It is objective, systematic, and unemotional. It relies heavily on statistical analysis and requires an understanding of probabilities. Descriptive decision theory, on the hand, is the study of how we actually make decisions. There are times when a decision will fall under the domain of both, typically occurring when we are dealing with what is known as a “decision under certainty.” For instance, when faced with the decision as to whether or not we should touch a stove that is red hot, assuming we do not want to burn our hand, very often we will actually make the decision as we should. In our business, it is extremely rare to face a decision under certainty. (Most of them have been prohibited by law.) Instead, we must make “decisions under risk”, which means we have historical data from which to generate probabilities of future outcomes. This is the type of decision we face when forecasting weather, predicting demand for electricity, producing mpg estimates for new cars, and making investment decisions.
What separates a decision made descriptively from one made normatively, can only be described as a mistake. Cognitive scientists prefer the term, cognitive bias, but whichever term you choose, they both reflect systematic errors in judgment, and they tend to occur when we are employing heuristics. Heuristics are simply mental shortcuts, such as intuition, gut feel and rules of thumb. One of the more commonly employed heuristics is known as “Anchoring”.
Anchoring is a popular phenomenon among retailers and negotiators. For the retailer, it provides such a simple, inexpensive way to manipulate customers into spending more. As an example, they will create an anchor by first showing something like an MSRP (manufacturer’s suggested retail price), and then emphasize how far below that price they are willing to sell it to you. In reality, the MSRP is completely arbitrary, created merely to set an anchor by which all transactions will be compared. It is how some people can actually think of shopping in terms of money saved, as opposed to money spent. Good negotiators will often present the first offer, knowing that all discussions from that point forward will be anchored to it, and we rarely adjust very much away from it.
Anchoring can be powerful in far more subtle ways too. Tversky and Kahneman first exposed the effect in a study 42 years ago, when they asked people to estimate “how many African nations are part of the United Nations?” To test the anchoring effect, they first had participants spin a wheel with 100 numbers painted on it. Unbeknownst to participants, the wheel was rigged to land on either 10 or 65. Although you would think that the random number generated by spinning a wheel would have no effect whatsoever on someone’s estimate regarding how many African nations are part of the United Nations, you’d be wrong.
There is a simple formula to quantify the anchoring effect, called the Anchoring Index. To calculate it, you take the difference in the mean response from each group and divide it by the difference between the high anchor and the low. In the case of the Tversky and Kahneman’s experiment, the average answer from those who had the low anchor of 10 was 25, while the average for those who were anchored to 65 was 45. An anchoring index of 36%.
The anchoring effect is evidence of a systematic error in judgment (read: mistake). Given that mistakes are required in order for skill to present itself in investing, we should be using the information gleaned from 60+ years of research that effectively presents a roadmap of psychological vulnerability to predictably irrational decisions. What makes it difficult to create a competitive edge in this area is that we are all inherently vulnerable. No matter how intelligent, experienced or even educated specifically in this area, we are all susceptible to both making the mistakes, and even more importantly, being oblivious to the error as it’s occurring. The only real defense against it is a willingness to accept just how powerful the effect can be and an openness to allowing the evidence to override even the most deeply seated belief.
The reason I mention this right now is because I believe there is a bias being exhibited by even the smartest, most highly educated, experienced and respected people in the investment and policymaking communities, today. It is a mistake caused by the anchoring effect, and true to form, no one seems to be acknowledging its existence, or even contemplating the possibility that something could be amiss. The mistake occurs in the belief that zero means something as it relates to interest rates. That it is in effect a floor, below which it should never go, and if it does, for only a very short time and by a very tiny amount.
This belief is equivalent to an MSRP of markets, unsupported by economic fundamentals or market principles. Yet, so much of what is happening in monetary policy and investment management is being affected by it. If you believe the risk/reward of holding US Treasuries is unattractive here, there’s a good chance you’re experiencing the anchoring effect. If you believe interest rates are too low, you might be experiencing the anchoring effect. If you believe low interest rates didn’t work so we might as well raise them, you are probably experiencing the anchoring effect. If you believe there isn’t plenty of powder left in monetary policy, you might be exhibiting the anchoring effect. If it makes you feel any better, the same mistake is being made by nearly every central banker and economist.
As I argued in Declawing of the Federal Reserve, “What gets lost in conversations about Fed policy is the fact that the Federal Reserve, for all intents and purposes, is in the business of behavior modification. Every tool, from open market operations to the discount rate and even quantitative easing, is meant to alter the behavior patterns of its target audience.” While their mandate is tied to inflation and growth, how they achieve it depends on their ability to alter behaviors. Effectively, they stand as the floodgate between financial assets and the real economy. If too much capital is being invested in the real economy, threatening to push inflation higher than their goal, they will raise the interest rate offered on risk free investments, effectively saying, “why take risk when you can earn attractive returns without it?” On the other hand, when not enough is finding its way into the real economy, threatening growth and/or inflation below the lower end of the targeted range, they will lower the incentive offered to sit in risk free assets. In essence, saying, “you will have to take some risk if you are going to achieve the returns you seek.”
If they aren’t getting the response they want, they just go lower, and lower, and lower. Why should zero be the floor? Why can’t the risk free rate go as deep into negative territory as it does into positive? The reality is, there isn’t any reason. When it is deep in positive territory, it serves to shift capital from the public sector to the private. If owners of capital are deep in risk seeking mode, it will require very high rates to draw them away from the riskier alternatives. On the other hand, if investors are exhibiting extremely risk averse behavior, as we are currently witnessing, then it will require very low rates to push them to take risk. If it requires rates so low that they enter very negative territory to force that action, it will also begin shifting capital from the private to the public sector, thereby rebalancing the imbalance created by the massive bailouts. That too would serve to move policymakers closer to where they want to be, wouldn’t it?
You see, the fundamental issue is that capital continues to flow out of the hands of spenders and into those of the savers. Thanks to income and wealth disparity, every transaction that occurs in the real economy lowers the probability of a future transaction (see the trajectory of the velocity of money), while simultaneously increasing the demand for financial assets. Those who control the overwhelming majority of the world’s wealth are exhibiting extreme levels of risk aversion. Yes, even at zero or negative rates. If they won’t start spending more of their income, and it’s highly unlikely they will (or even can), then policymakers need to push them in that direction. They have two tools to do so. Either they can raise taxes and redistribute that capital through fiscal spending, or they move interest rates deep into negative territory. In so doing, savers will transfer capital to the government which can then be redistributed through fiscal spending into the hands of spenders.
The old argument that negative interest rates are “unsustainable” is true. Eventually, if the owners of capital don’t shift out of financial assets and into the real economy, either by spending or investing in R&D, equipment and/or people, they will run out of capital. But let’s be logical about that. At -50 bps, assuming 100% of the private sector’s funds were invested, it would take 200 years for that to occur. At -5%, it would take 20 years. Of course, by that time, we wouldn’t be talking about onerous government debt overhang anymore. Getting back to the specific issue of zero as an anchor, rather than a valid discrete moment, consider the marginal impact on an investment portfolio. If interest rates shift down 100 bps, from +250 bps to +150 bps, the annual return on a $100 million portfolio will be $1,000,000 less. If interest rates shift down 100 bps, from +50 bps to -50 bps, the annual return on a $100 million portfolio will be $1,000,000 less. Yes, the marginal change is exactly the same.
About the Author For nearly thirty years, Stephen Duneier has applied cognitive science to investment and business management. The result has been the turnaround of numerous institutional trading businesses, career best returns for experienced portfolio managers who have adopted his methods, the development of a $1.25 billion dollar hedge fund and 20.3% average annualized returns as a global macro portfolio manager.
Mr. Duneier teaches graduate courses on Decision Analysis and Behavioral Investing in the College of Engineering at the University of California. His book, AlphaBrain, is due to be published in early 2017 (Wiley & Sons).
Through Bija Advisors' coaching, workshops and publications, he helps the world's most successful and experienced investment managers improve performance by applying proven, proprietary decision-making methods to their own processes.
Stephen Duneier was formerly Global Head of Currency Option Trading at Bank of America, Managing Director in charge of Emerging Markets at AIG International and founding partner of award winning hedge funds, Grant Capital Partners and Bija Capital Management. As a speaker, Stephen has delivered informative and inspirational talks to audiences around the world for more than 20 years on topics including global macro economic themes, how cognitive science can improve performance and the keys to living a more deliberate life. Each is delivered via highly entertaining stories that inevitably lead to further conversation, and ultimately, better results.
His artwork has been featured in international publications and on television programs around the world, is represented by the renowned gallery, Sullivan Goss and earned him more than 50,000 followers across social media. As Commissioner of the League of Professional Educators, Duneier is using cognitive science to alter the landscape of American K-12 education. He received his master's degree in finance and economics from New York University's Stern School of Business.
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