investor psychology

Animal Spirits and Mr. Market

Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits—a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.”

— John M. Keynes.,The General Theory of Employment, Interest and Money (1936)

Jamie just found out that his favorite entertainer is coming to his city this coming weekend. Excited, he quickly checks the price online$200 per ticket. “That’s a bit much,” he thinks to himself. “Even for Queen B.”

Later that evening, he meets his friend Sally and complains about how disappointingly expensive the tickets are. To his surprise, Sally pulls out two tickets for the concert and places them in his hands. “For you and your date,” she says.

Dumbfounded, Jamie gives Sally a big hug and tells her that she is undoubtedly the best friend ever.

What’s wrong with this story?

Well, for one thing, you may be quick to point out that Beyonce tickets are well worth $200, or that people should take more time before declaring each-other as best friends (the author is inclined to agree with both).

But there is something else going on here. Why was Jamie was willing to go to the concert only when he got tickets from Sally, and not when he had to buy the tickets himself?

On the one hand, his behaviour seems perfectly natural. But if you look closely, it’s actually illogical. In either scenario, the ticket cost to Jamie is the same; he either has to pay $200 per ticket, or he has to decide not to sell his “free tickets” for $200 apiece. Either way, the true cost of going to the concert is the same. By going to the concert, he is effectively paying $200 per ticket because his opportunity costwhat we would have gained had he sold the ticketsis $200 per ticket. [1]

We shouldn’t be too hard on Jamie, though, since most people (especially Beyonce fans) would have done the same. But whenever someone tells you “I got these tickets for free!”, gently remind them that what they really mean is “I got the illusion of getting free tickets when really I am paying the same price as everyone else!” On second thought, maybe it’s better to let them enjoy the illusion…

My reason for telling this story is to make the point that seemingly rational choices are often less rational than they appear.

The human mind, as brilliant as it can be, is riddled with blind spots. If you look up “cognitive biases” on Wikipedia—and I encourage you to do so—you will see that there are almost 200 well-known traps that we routinely fall into. Not because we are stupid, but because of how we are wired. To put this in perspective, there are about as many documented blind spots causing us to make systematically irrational choices as there are countries in the United Nations. And this vast community of blind-spots is headquartered right between your ears.

“The Cognitive Biases Codex”, designed by John Manoogian, maps our many mental blindspots

Psychologists are one group of people who would have no difficulty accepting the limitations of the human mind. In fact, highlighting such limitations has proven very useful in allowing us to understand the mechanisms of the human brain.

Economists, on the other hand, have traditionally had a much more optimistic view of the mind, with many economic models resting on the assumption that humans are rational economic agents. That is, that we can be relied upon to make systematically rational decisions. Concepts like “Rational Expectations Theory” and the “Efficient Market Hypothesis” have dominated the academic literature in economics and finance, and are a common presence in most business schools today.

The vast gulf in professional opinion between the fields of psychology and economics has never made much sense to me. After all, what is economics if not the application of psychology to economic life? It seems to me that psychology should be to economics what the natural sciences are to engineering. How could economics possibly rest on any other foundation?

Thankfully, psychologists and economics have done some fruitful work toward bridging this gap, with Richard Thaler, Daniel Kahneman, and Amos Tversky being three prominent examples. This effort gave birth to the field of behavioural economics, which offers fascinating explanations for the not-quite-rational “animal spirits” that we see on display each and every day on the financial markets.

What Jason and I have found over the years is that the finds of behavioural economics are particularly useful when it comes to understanding why certain investing strategies continue to work year after year, whereas others rise and fall like fads. On the whole, studying behavioural economics has reinforced our confidence in the robustness and sustainability of value investing as an investment strategy, and has helped us forge ideas about how best to apply that strategy.

In The Intelligent Investor, Benjamin Graham uses the famous character of Mr. Market to describe the irrationality of the stock market and impart an intuitive understanding for how we can leverage Mr. Market’s mood swings to our advantage.

But Graham’s perspective was one of an investor, rather than a psychologist. He understood the “hows” of value investing, but not the “whys”. In 1955, Graham was questioned by the Senate Banking Committee as to why stock prices tend to move toward their intrinsic values over time. He replied that “that is one of the mysteries of our business, and it is a mystery to me as it is to everybody else.”

Unraveling this mystery takes time. Sir Isaac Newton first described the law of universal gravitation in the Principia in 1713, but it took another couple hundred years for Albert Einstein to explain why gravity works the way it does. Similarly, it took about half a century since the publication of Security Analysis for behavioural economics to explain why value investing works the way it does.

We firmly believe that investors benefit not just from knowing what works in investing, but also why. Having that second level of understanding is very helpful, because when times get tough, it can be very tempting to deviate from even a winning strategy. Having a deep understanding of why the strategy works makes it easier to weather the storm.

That’s why we are excited to bring you more content focused on the insights from behavioural economics that are particularly relevant for investing. Stay tuned!

 

Footnotes

[1]: Technically, Jamie’s overall wealth had increased by $400 (2 tickets), but the impact of this should be trivial in changing Jamie’s valuation for the ticket if he is rational. To illustrate this, let’s say that instead of meeting Sally, Jamie’s stock portfolio distributed a $400 dividend to his bank account that afternoon. Jamie will be far less likely to purchase the tickets himself than he is to attend the show when given “free tickets”, despite the two scenarios costing him exactly the same.

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