4. Reflexive vs. Reflective Brain.
The reason why people get it wrong is because they “jump to conclusions”
using the reflexive parts of their brains.
5. Reflexive Brain is effortless, automatic, fast, but can lend itself to errors.
Its also the reason why you are alive today. Your ancestors, who learnt to run away at the
first sign of danger, were able to increase their chances of survival until at least they pro-
created. If even one of your ancestors had died before pro-creating, you won’t be here
today. But you are.
Reflexive brain is VERY useful. But it also leads to mistake.
Human Evolution hasn’t kept pace with rapid change since industrialization.
6. Reflective Brain is effortful, reasoned, slow, logical, and less prone to error
8. Assume today is 27 March
2009 i.e. there are only
five days left in the
financial year ending on 31
March 2009. One of your
friends has approached you
to advice him on his
investments. He presents
you with the following data
about his current
portfolio:
9. In addition, your friend also tells you that
during 2008-09, he has already realized short-term
capital gains of Rs 27 lacs. He now needs Rs 73
lacs by selling part of his portfolio. Which
stocks should he sell?
To a man with a hammer everything looks like a nail
10.
11.
12.
13. This Data is SO boring!
How do we make it more interesting?
Enter Chief Constable of Gwent, Wales
16. Approximately 3,000 people died in september 11 attacks.
An additional 1,500 died due to increased ROAD Travel because of
dread risk.
17. What caused the dread risk?
The extraordinarily vivid images of the disasters caused mass fear of flying.
Key word here is VIVID. But there is a general principle at work here. What is
it?
21. Human brains tends to drift into
working with what’s easily
available to it.
The human brain tends to drift into working with
what’s easily available to it.
27. “People assess the
frequency,
probability, or
likely cause of an
event by the degree
to which instances
or occurrences of
that event are
readily “available”
in memory.”-Daniel
Kahneman
28. “An event that
evokes emotions
and is vivid, easily
imagined, and
specific will be
more available
than an event that
is unemotional in
nature, bland,
difficult to imagine,
or vague.”-Daniel
Kahneman
31. a rich and vivid
representation
of the outcome,
whether or not
it is emotional,
reduces the
role of
probability in
the evaluation
of an uncertain
prospect.
32. On Rare Events
“I visited Israel several times during a period in which suicide bombings in buses were relatively common—though of course quite rare in absolute
terms. There were altogether 23 bombings between December 2001 and September 2004, which had caused a total of 236 fatalities. The number of
daily bus riders in Israel was approximately 1.3 million at that time. For any traveler, the risks were tiny, but that was not how the public felt about it.
People avoided buses as much as they could, and many travelers spent their time on the bus anxiously scanning their neighbors for packages or bulky
clothes that might hide a bomb. I did not have much occasion to travel on buses, as I was driving a rented car, but I was chagrined to discover that my
behavior was also affected. I found that I did not like to stop next to a bus at a red light, and I drove away more quickly than usual when the light
changed. I was ashamed of myself, because of course I knew better. I knew that the risk was truly negligible, and that any effect at all on my actions
would assign an inordinately high “decision weight” to a minuscule probability. In fact, I was more likely to be injured in a driving accident than by
stopping near a bus. But my avoidance of buses was not motivated by a rational concern for survival. What drove me was the experience of the moment:
being next to a bus made me think of bombs, and these thoughts were unpleasant. I was avoiding buses because I wanted to think of something else.”
“My experience illustrates how terrorism works and why it is so effective: it induces an availability cascade. An extremely vivid image of death and
damage, constantly reinforced by media attention and frequent conversations, becomes highly accessible, especially if it is associated with a specific
situation such as the sight of a bus. The emotional arousal is associative, automatic, and uncontrolled, and it produces an impulse for protective action.
System 2 may “know” that the probability is low, but this knowledge does not eliminate the self-generated discomfort and the wish to avoid it. System 1
cannot be turned off.”
33. “The emotion is not only disproportionate to the probability, it is also
insensitive to the exact level of probability. Suppose that two cities have
been warned about the presence of suicide bombers. Residents of one city
are told that two bombers are ready to strike. Residents of another city are
told of a single bomber. Their risk is lower by half, but do they feel much
safer?”
34. The psychology of high-prize lotteries is similar to the psychology of
terrorism. The thrilling possibility of winning the big prize is shared by the
community and reinforced by conversations at work and at home. Buying a
ticket is immediately rewarded by pleasant fantasies, just as avoiding a bus
was immediately rewarded by relief from fear. In both cases, the actual
probability is inconsequential; only possibility matters.
35. a basic
limitation in
the ability of
our mind to
deal with small
risks is that we
either ignore
them
altogether or
give them far
too much weight
—nothing in
between.
Exessive over-reaction vs. Utter neglect.
It depends on “availability”
Terrorism vs. Climate Change.
36. “It hasn’t happened for a long time, so it won’t happen”
Earthquake and volcano eruptions
LTCM
It can’t happen to me - like the fellow who goes out on a mobike without a
helmet.
37. “In all my experience, I’ve never been in an accident of any sort worth
speaking about. I have seen but one vessel in distress in all my years at sea.
“I never saw a wreck and have never been wrecked nor was I ever in any
predicament that threatened to end in disaster of any sort.”- E.J. Smith,
1907, Captain, RMS Titanic
38. How should treat things that have happened before and those that never
happened before.
39. The chances of winning are 10% in urn A and 9% in urn B, so making the right choice should be easy, but it is not: about 30%–
40% of students choose the urn with the larger number of winning marbles, rather than the urn that provides a better chance of
winning.
The remarkably foolish choices that people make in this situation is called denominator neglect. If your attention is drawn to the
winning marbles, you do not assess the number of non-winning marbles with the same care. Vivid imagery contributes to
denominator neglect.
When I think of the small urn, I see a single red marble on a vaguely defined background of white marbles. When I think of the
larger urn, I see nine winning red marbles on an indistinct background of white marbles, which creates a more hopeful feeling.
The distinctive vividness of the winning marbles increases the decision weight of that event, enhancing the possibility effect.
42. probability
of a
physician
smoking is
directly
related to
the distance
of the Her
speciality
from the
lungs!
43. Before boarding a flight people are prepared to pay more when offered a flight
insurance policy to cover against “terrorism insurance” than for a general policy
covering all risks.
Clever, psychologically astute insurance companies can use this to manipulate people.
44. ITS ALL IN THE
Extra vivid annual reports of Temptation Foods (a fraudulent company)
resulted in seducing many investors.
45. QIB Placement on 19 Oct 2007
76,00,000 shares issued at 150
Money raised: Rs 114 cr.
51. Now that’s Vivid Too!
Company under several investigations
Moral of the story is that you should be wary of “story” stocks.
use stories to persuade, not be get persuaded by!
52. Recency
Our most recent experience tends
to carry more weight in our heads
than old experiences.
Thats how memory works.
53. Recent (and also vivid) events.
Recency + vividness = lethal combination
And if you get this idea right, you’d understand the importance of taking
the opposite view of the crowd when the crowd is obviously wrong.
AFTER the event the RISK went DOWN
54. Purchase of earthquake insurance increases greatly after the occurrence of
an earthquake and declines steadily as the memory of the event fades.
Similar behavior has been observed for floods and food insurance.
Notice this combines with VIVIDNESS
55. We over-react to recent events
Recency + vividness = lethal combination
56. The best time to buy is when there is blood in the streets.
While I am not a great fan of DCF (more about that later), it is at such times, that thinking in
terms of DCF makes sense. The value of an asset is equal to the present value of cash flows.
So only a change in two variables can change value. If these changes haven’t occurred but
price has crash, this spells OPPORTUNITY
Biggest losing days in stock markets typically mean lucrative opportunities to invest.
58. The human mind is like the human egg. Out of a billion sperms racing towards the egg,
only one succeeds in entering and fertilizing it. As soon as the fastest swimming sperm
enters the egg, the egg immediately shuts down to stop any other sperm from entering.
We answer questions which start with the word “why” by grabbing the first answer that
comes to mind.
Example: Steel Price Hike, Impact on Auto Stocks
Explaining Lollapalooza Outcomes: “part of the reason”
59. “Nothing is
more
dangerous
than an idea,
when it's the
only one you
have.”
Émile Auguste Chartier
If you want to have good ideas, you should have LOTS of IDEAS
60. Everyone should get a pack of these wonderful cards:
Amazon.com: Creative Whack Pack (9780880793582): Roger Von Oech:
Books
61. The human mind
seeks easy
answers to the
questions which
start with the
word “why”
62. A stock is selling below cash!
Why should I buy this stock?
Because its cheap!
Well, so what? Under what circumstances would this be a mistake?
Can you think of three reasons why you could be wrong?
You really have to FORCE yourself to come up with 3 reasons which can prove you
wrong.
Three reasons why buying it would be a mistake
1. Fraud
2. Value Trap
3. Bubble market
63. “I followed a
golden rule,
namely that
whenever a
new
observation or
thought came
across me,
which was
opposed to my
general
results, to
make a
memorandum
of it without
fail and at
once...
Charles Darwin is a wonderful example, according to Mr. Munger, to study.
64. “for I had
found by
experience
that such
facts and
thoughts were
far more apt
to escape from
the memory
than
favorable
ones.” -
Charles
Darwin
65. I Saw it
with my
OWN
eyes!!!
Direct Experiences
We overweigh direct experience and under-weigh vicarious experience.
What we see for ourselves with our own eyes, hear from our own ears, has a
greater impact than what we see or hear through others
I saw it with my OWN Eyes!
66. Direct Experience
Vs.
Vicarious Experience
Learning comes from two types of experiences.
Direct experience
73. “What we learn from history, is
that we don’t learn from
history.” Benjamin Disraeli
You will be required to read these books and be prepared to do a quiz
(closed book) on it very soon.
Here is your chance to acquire some extremely valuable vicarious
experience...
74. “We have never seen anything like this,” said analyst Glenn Schorr, who covers the investment banks for UBS
AG. “There have been tough situations like Long-Term Capital Management and the crash of 1987, but the
problem here is there is leverage in the securities under the microscope and in the banks that own them. And
to try and unwind it all at once creates a one-way market where there are only sellers, and no buyers.” - WSJ,
September 14, 2008
But financial history is littered with examples after examples of similar situations…
This is an example of underweighing vicarious experience.
Just because YOU haven’t seen anything like this, does NOT mean its never happened before.
75. “But I know a man who smoked three packs of cigarettes a day and lived to
be 99!”
76. If we personally see people who drowned, our assessment of the riskiness
of swimming in open waters will be much higher than the correct
probability.
77. Problem of Silent Evidence
You only see the winners!
You can’t learn about success by reading these books because they don’t tell you about the
companies who had same attributes but went belly up.
Read “The Halo Effect”
http://www.amazon.com/Halo-Effect-Business-Delusions-Managers/dp/0743291263/
http://www.britannica.com/bps/additionalcontent/18/25996994/Misunderstanding-the-
Nature-of-Company-Performance-THE-HALO-EFFECT-AND-OTHER-BUSINESS-DELUSIONS
78. Stock Market
Prediction Newsletter
Scam
One day you receive a newsletter in which you’re offered a free prediction. Reliance Industries would rise
by more than 10% during the course of the next month. Coincidentally it does rise by 10%. Next
newsletter predicts that Reliance will fall by more than 10% in the next month. A month passes and you
notice that the second prediction has also come true.
79. Stock Market
Prediction Newsletter
Scam
six accurate predictions in a row! a coincidence? “Of course not!” you conclude. “This man
has real predictive powers.”
364,500 = 1,21,500x3; 1,21,500=40,500x3; 40,050=13,500; 13,500=4,500x3;
4,500=1,500x3; 1,500=500x3.
are there “functional equivalents” of this scam?
80. Insensitivity
to Base Rates
(Probability
unconditioned
on featured
evidence)
Base rate is the probability unconditioned on featural evidence, frequently also
known as prior probabilities. For example, if it were the case that 1% of the
public are "medical professionals" and 99% of the public are not "medical
professionals," then the base rates in this case are 1% and 99%, respectively.
81. “Base rates are boring but are amongst the most illuminating statistics that exist.”
100 people - 70 lawyers 30 engineers. When no additional info is provided and asked to guess occupation of randomly selected 10, people use base rates - they say 7
are lawyers and 30 are engineers.
When worthless data is added - Dick is highly motivated 30 year old man who is well liked by his colleagues people largely ignore the base rate in favor of their “feel” for
the person.
From “What Works on Wall Street”
When stereotypical info is added e.g. Dick is 30 years old married shows no interest in politics or social issues and likes to spend free time on his many hobbies which
include carpentry and math puzzles, people TOTALLY ignore the base rate and bet Dick is an engineer.
Base rates are boring - experience is vivid and fun.
The only way someone will pay 100 times earnings for a stock is because it has a tremendous “story’. Never mind that the base rate of investing in high P/E stocks is
horrible - the story is too compelling that people throw base rates out of the window.
Human nature makes it virtually impossible to forgo the specific info of an individual case in favor of the results of a great number of cases. we are interested in THIS
stock and THIS company, not with this CLASS OF STOCKS or this CLASS OF COMPANIES.
Large numbers mean nothing to us.
But they should
82. instructing
people to “think
like a
statistician”
enhanced the
use of base-rate
information,
while the
instruction to
“think like a
clinician” had
the opposite
effect.
Amos and I originally believed, on the basis of our early evidence, that base-rate information will always be neglected
when information about the specific instance is available, but that conclusion was too strong. Psychologists have
conducted many experiments in which base-rate information is explicitly provided as part of the problem, and many of
the participants are influenced by those base rates, although the information about the individual case is almost always
weighted more than mere statistics. Norbert Schwarz and his colleagues showed that instructing people to “think like a
statistician” enhanced the use of base-rate information, while the instruction to “think like a clinician” had the opposite
effect.
83. “Bargains do appear in the stock market
recurrently. However, it cannot be said with
certainty that a clear-cut bargain investment
will produce excess investment returns, and it is
impossible to predict the pattern, sequence or
consistency of investment returns for a
particular bargain investment...
84. “It can only be stated with certainty
that repeated investment in numerous
groups of bargain securities over
very long multi-year periods has
produced excess returns.” - The
Partners of Tweedy, Browne
You should use Stories to Influence Others
But Think in terms of Base Rates when forming world views
Buffett on technology - why does he keep away (mostly) - the mortality rate of technology companies
(averaged out experience) makes him uncomfortable.
He talks about stepping over one foot hurdles vs jumping over five foot ones.
Mortality rates in leveraged stocks
Mortality rates in airline industry
85. “What we learn from history, is
that we don’t learn from
history.” Benjamin Disraeli
86. Anchoring Bias as a subset of Availability Bias
We need anchors
What are the right anchors?
What are the wrong anchors?
89. Two
different
mechanisms
produce
anchoring
effects—
one for each
system.
Two different mechanisms produce anchoring effects—one for each system. There is a form of anchoring that
occurs in a deliberate process of adjustment, an operation of System 2. And there is anchoring that occurs by
a priming effect, an automatic manifestation of System 1.
90. Insufficient
Adjustment
“Start from an anchoring number, assess whether it is too high or too low,
and gradually adjust your estimate by mentally “moving” from the anchor.
The adjustment typically ends prematurely, because people stop when they
are no longer certain that they should move farther.”
91. “Amos and I once rigged a wheel of fortune. It was marked from 0 to 100, but we had it built so that it would stop only at 10 or
65. We recruited students of the University of Oregon as participants in our experiment. One of us would stand in front of a
small group, spin the wheel, and ask them to write down the number on which the wheel stopped, which of course was either 10
or 65. We then asked them two questions: Is the percentage of African nations among UN members larger or smaller than the
number you just wrote? What is your best guess of the percentage of African nations in the UN? The spin of a wheel of fortune—
even one that is not rigged—cannot possibly yield useful information about anything, and the participants in our experiment
should simply have ignored it. But they did not ignore it. The average estimates of those who saw 10 and 65 were 25% and 45%,
respectively.”
94. Adjustment is
Effortful,
System 2
Operation
“Nick Epley and Tom Gilovich found evidence that adjustment is a deliberate attempt to find
reasons to move away from the anchor: people who are instructed to shake their head when they
hear the anchor, as if they rejected it, move farther from the anchor, and people who nod their
head show enhanced anchoring. Epley and Gilovich also confirmed that adjustment is an effortful
operation. People adjust less (stay closer to the anchor) when their mental resources are depleted,
either because their memory is loaded with digits or because they are slightly drunk. Insufficient
adjustment is a failure of a weak or lazy System 2.”
96. Was Saddam Hussain more or less than 155 years old when he died?
How old was Saddam Hussain when he died?
Ans: 70 years.
Did you think of your answer by adjusting down from 155?
And yet the absurdly high number still influenced your estimate.
This is the “power of suggestion.”
99. Primed for Money
“Reminders of money produce some troubling effects. Participants in one experiment were shown a list of five words from which they were required to
construct a four-word phrase that had a money theme (“high a salary desk paying” became “a high-paying salary”). Other primes were much more subtle,
including the presence of an irrelevant money-related object in the background, such as a stack of Monopoly money on a table, or a computer with a
screen saver of dollar bills floating in water. Money-primed people become more independent than they would be without the associative trigger. They
persevered almost twice as long in trying to solve a very difficult problem before they asked the experimenter for help, a crisp demonstration of increased
self-reliance. Money-primed people are also more selfish: they were much less willing to spend time helping another student who pretended to be
confused about an experimental task. When an experimenter clumsily dropped a bunch of pencils on the floor, the participants with money
(unconsciously) on their mind picked up fewer pencils. In another experiment in the series, participants were told that they would shortly have a get-
acquainted conversation with another person and were asked to set up two chairs while the experimenter left to retrieve that person. Participants primed
by money chose to stay much farther apart than their nonprimed peers (118 vs. 80 centimeters). Money-primed undergraduates also showed a greater
preference for being alone. The general theme of these findings is that the idea of money primes individualism: a reluctance to be involved with others, to
depend on others, or to accept demands from others. The psychologist who has done this remarkable research, Kathleen Vohs, has been laudably
restrained in discussing the implications of her findings, leaving the task to her readers. Her experiments are profound—her findings suggest that living in
a culture that surrounds us with reminders of money may shape our behavior and our attitudes in ways that we do not know about and of which we may
not be proud.”
100. Speaking of
Anchors
“The firm we want
to acquire sent us
their business
plan, with the
revenue they
expect. We
shouldn’t let that
number influence
our thinking. Set it
aside.”
101. Speaking of
Anchors
“Plans are best-
case scenarios.
Let’s avoid
anchoring on plans
when we forecast
actual outcomes.
Thinking about
ways the plan
could go wrong is
one way to do it.”
102. Speaking of
Anchors
“The defendant’s
lawyers put in a
frivolous
reference in which
they mentioned a
ridiculously low
amount of damages,
and they got the
judge anchored on
it!”
103. Money lost in wallet.
Your wallet had Rs 1,000 and now Rs 100 is missing.
You are feeling miserable because you are latching on (anchoring) to money
in the wallet and not in the bank. If the money in the bank (your wealth) is
large, then this loss is inconsequential.
Stop feeling miserable because of wrong anchors in life...
104. Par value
52 week low
All time high
Low absolute price
Sunk-costs
Stock price itself
Its foolish to think a stock is cheap just because its selling below par or
below 52 week low or is selling at an absolute low price.
A stock selling at Rs 5 may be more expensive than one selling at Rs 500.
The right anchor to latch on you is value.
105. Overweighing what can be counted
“You’ve got a complex system and it spews out
a lot of wonderful numbers that enable you to
measure some factors.
“But there are other factors that are terribly important, [yet] there’s no
precise numbering you can put to these factors. “You know they’re
important, but you don’t have the numbers. Well practically everybody (1)
overweighs the stuff that can be numbered, because it yields to the
statistical techniques they’re taught in academia. “and (2) doesn’t mix in the
hard-to-measure stuff that may be more important. That is a mistake I’ve
tried all my life to avoid, and I have no regrets for having done that.”
106. “The first step
is to measure
what can be
easily
measured. This
is okay as far
as it goes.
John Bogle
“The second step is to disregard that which cannot be measured, or give it
an arbitrary quantitative value. This is artificial and misleading. The third
step is to presume that what cannot be measured really is not very
important. This is blindness. The fourth step is to say that what cannot be
measured does not really exist. This is suicide.”
107. “Not everything
that counts can
be counted, and
not everything
that can be
counted, counts.”
Albert Einstein
108. Beta does not capture risk
Beta is easily calculated but is “precisely wrong.” Keynes said correctly: “Its
better to approximately right than to be precisely wrong.”
110. Antidotes
Look for
disconfirming
evidence – killing
your own ideas
111. Under-weigh
extra-vivid
experience and
overweigh less
vivid experience.
Same with recent events; i.e. cool off period after meeting someone very
impressive and impressionable.
“Sleep over it.”
112. “Remember the
lesson: “An idea
or a fact is not
worth more
merely because it
is easily
available to you.”
