Example 1: Wasteful Education In 2007, I began a five year research project wherein I attempted to understand what is truly ailing the K-12 education system in America. I’m happy to share my findings and proposed solution, but not here. Instead, I’d like to share the story of something I discovered along the way that is relevant to the topic of this edition.
While touring an elementary school in South Florida, I passed a classroom that caught my attention. The door was open, but lights were off. I flipped them on to discover a room filled from wall-to-wall and floor-to-ceiling with nothing but desks and chairs. When I asked the principal about the display, she explained the rationale behind it. Turns out, every year the school gets a budget. Well, actually not a budget, but rather many budgets. Among them is one for teacher salaries, one for textbooks, one for maintenance, and yes, one for furniture. If the principal comes in under budget on say, school furniture one year, she can’t apply the savings to something she might need more of at that moment, like maybe a new coat of paint for the gymnasium. If she doesn’t spend the furniture budget that year, the money remains in the county coffers. Here is where it gets really interesting though. If she comes in under budget for furniture this year, there is a high probability they will reduce her furniture budget for next year. So, rather than risk having her budget reduced for anything in any given year, she will continue to buy furniture with her furniture budget even if it means shoving it into an empty classroom or using the facilities budget to build a shed out back to store it all until it can be fully depreciated and thrown away.
I know, I know. You’re befuddled by the waste and stupidity of the education system. If you’re anything like I was when I stared into the abyss of that classroom, you’re probably shaking your head, mouth agape, wondering how it’s possible that things like this still go on. However, if you think about it, given the system as it exists, her logic is actually unassailable. Given her constraints and how she is assessed, would you behave differently?
Truth is, over those five years I found episode after episode of similar situations and amazingly, every single time, the people in charge were as frustrated with the state of the education system as you and I. Even more incredible, when I would meet their bosses and their bosses’ bosses they all had a similar story to share. Each had a pet peeve about the system that caused them to make decisions that could be perceived as irrational to those on the outside, but made sense to them given the constraints.
No doubt, by now you’re ready to tear the hair out of your head, prepared to march straight down to your school board to either raise hell or take a position on the board so that you can singlehandedly straighten out these knuckleheads. Before you do, you might want to continue reading, because very shortly, I will argue that the same cognitive flaw responsible for this colossal error in judgement among the leadership in education is also responsible for a systematic error in judgement exhibited by nearly all institutional money managers (traders and allocators alike), and yes, it probably applies to you too.
Example 2: Drunken Economics Back in 1998, behavioral economist Richard Thaler teamed up with Eldar Shafir to learn about the thought process among wine enthusiasts. They asked subscribers of Orley Ashenfelter’s newsletter, Liquid Assets, the following question: Suppose you bought a case of a good 1982 Bordeaux in the futures market for $20 a bottle. The wine now sells at auction for $75 per bottle. You have decided to drink a bottle. Which of the following best captures your feeling of the cost to you of drinking this bottle?
$20 plus interest
-$55 (I drank a $75 bottle for which I only paid $20)
Interestingly, respondents were fairly evenly dispersed with the percentages for each answer being 30%, 18%, 7%, 20% and 25%, respectively. Put another way, in the mind of more than half the respondents, drinking the wine either cost them nothing or it actually saved them money. The researchers found the results so fascinating, they followed up a year later with a related experiment. Their findings were later published in a paper with the very literal title, “Invest Now, Drink Later, Spend Never.” It should be noted, the great majority of respondents were people whom most would consider to be financially sophisticated individuals, including many professional investment managers and economists.
Example 3: Bet the House On the back of Kahneman and Tversky’s Prospect Theory paper, Thaler conducted a study in 1990 to see how decisions are affected by prior outcomes, namely gains and losses. In it, MBA students gambled with real money and were given the following three problems. (The percentage of students choosing each option is provided in brackets.)
Problem 1: You have just won $30. Now choose between:
A 50% chance to gain $9 and a 50% chance to lose $9. [70%]
No further gain or loss. [30%]
Problem 2: You have just lost $30. Now choose between:
A 50% chance to gain $9 and a 50% chance to lose $9. [40%]
No further gain or loss. [60%]
Problem 3: You have just lost $30. Now choose between:
A 33% chance to gain $30 and a 67% chance to gain nothing. [60%]
A sure $10. [40%]
As it happens, MBA students are really no different than the typical gambler at a Las Vegas casino. Gamblers who are up money often create a separate mental account for “house money”, which is somehow distinct from the rest of their wealth. It’s a phenomenon aptly named the house money effect, because the casino is often referred to as the house and so when gamblers are up money at the casino, they tend to think of those winnings as the house’s money. Many gamblers will even go so far as to physically separate their money from the house’s money, putting one in the left pocket and the other in the right.
What is significant about Thaler’s study, along with many others that came before and after, is not so much that a separate mental account is created, but that the money in these two accounts are actually treated differently. As the results above show, gamblers playing with house money exhibit a greater propensity for risk. Those who were experiencing losses tended toward risk aversion, unless the gamble offered a chance to break even. In other words, the very assessment of a bet’s risk/reward is affected by whether one is betting with “their” money or the “house’s”.
Example 4: Half Off James is a global macro portfolio manager with 20 years of experience. He purchased a one-touch option on the S&P Index with a barrier at 2000 for 10% of a $1m payout. For those unfamiliar with one-touch options, worry not. For the purposes of this example all you need understand is that James has bet the S&P Index will “touch”, i.e. trade at, the 2000 level at some point between the day he purchased the option and the day it expires. If it trades at 2000 during that time frame, he gets 100% of the payout or $1 million. If it does not touch, he gets nothing in return for the $100,000 premium he paid up front. Based on the payoff profile, it’d be fair to assume the chances of it touching 2000 are low.
Two weeks later, the S&P Index jumps up and the option is now worth 20% or $200,000. James decides to unwind half the position in order to “recoup” his initial investment of $100,000, thereby leaving only the house’s money at risk.
Well done, James. That’s a very wise decision which serves as evidence of your ability to remain disciplined. A decision that would be applauded by even the most experienced traders. After all, it’s an age old strategy that has been passed down from generation to generation.
Unfortunately, it’s also irrational.
Conclusions Truth is, there is absolutely no difference between what James did and what gamblers in Las Vegas do on a daily basis. James created a mental account which differentiated between his money and the house’s money. There are numerous issues to consider here.
Firstly, money is fungible, which means there is no difference between money in your left pocket and money in your right, money earmarked for furniture and money earmarked for textbooks, $75 in your bank account and a bottle of wine that you can sell today for $75. As for James, all $200,000 is money to do with as he pleases.
I know what you’re thinking. The risk/reward has changed and so too should his assessment of the trade’s value. I wholeheartedly agree, so long as it is assessed based on the merit of the trade itself. The issue though, is that the doubling of James’ original investment is purely a function of where he bought it (10%) and what it’s valued at today (20%), neither of which are inherently relevant to either market fundamentals or technical indicators. The only relevance “20%” has is that it creates an opportunity for him to put his initial investment of $100,000 cash back into his account while creating a separate mental account for the $100,000 he still has at risk.
To reiterate, the problem isn’t simply that mental accounting has occurred, but that the two accounts are actually treated differently. Having “pocketed” the original investment and now playing with the house’s money means the gambler, err, I mean trader will be more risk tolerant with the remaining position. This is inconsistent with the tenets of expected utility theory. In other words, it is irrational.
Beyond that, what Thaler and others have proven is that this generally accepted strategy of taking off enough of a position in order to cover your initial investment wasn’t the result of decades of experience or wisdom being passed down from generation to generation, but rather flawed intuition shared by MBA students, gamblers and experienced investors alike. As a result of simply being repeated time and again by market participants, the wisdom behind it is rarely questioned, even though it should be.
Ultimately, the goal for all decision makers is to be objective. If your assessment of one bet with one set of characteristics and one set of outcome probabilities is affected by whether the money you are betting with has come out of your left pocket or your right, you are not being objective. You are making a mistake. The common thread which ties all of the examples above together is that the law of fungibility has been broken, leading to irrational decisions and typically poor results. In the education example, formal barriers in the form of segregated budgets created the inefficiencies that frustrate you and me. For the wine enthusiasts, because the current value of $75 hadn’t been realized (ie converted to cash), it was difficult for them to see the fungibility of that money, and therefore the true cost of the wine they were drinking. Fundamentally, there is really no difference between the MBA students in example 3 and James in example 4. In both cases (and that of the typical gambler), the law of fungibility was broken when the distinction was made between their own and the house’s money. Even though it may feel right and make intuitive sense, fundamentally it is as irrational as ordering more furniture to be stacked in an empty classroom.
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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 in the College of Engineering, as well as Behavioral Investing, at the University of California. His new 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 60,000 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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