The Psychology Of Human Misjudgment VII

Overconfidence
and Overoptimism
 Myron Scholes Robert merton

Members of LTCM's board of directors included Myron S. Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economic Sciences for a "new method to
determine the value of derivatives".

2 Nobel laureates who blew up

Why do smart people do dumb things?
 Beginning of 1998:

Equity: $4.72 billion

Debt: $124.5 billion

total assets: $129 billion

debt to equity: more than 25 to 1

The company used complex mathematical models to take advantage of fixed income arbitrage deals (termed convergence trades) with government bonds. Differences in the government
bonds' present value are minimal, so any difference in price should be eliminated by arbitrage. Price differences between a 30 year treasury bond and a 29 and three quarter year old
treasury bond should be minimal—both will see a fixed payment roughly 30 years in the future. However, small discrepancies arose between the two bonds because of a difference in
liquidity. By a series of financial transactions, essentially amounting to buying the cheaper 'off-the-run' bond (the 29 and three quarter year old bond) and shorting the more expensive, but
more liquid, 'on-the-run' bond (the 30 year bond just issued by the Treasury), it would be possible to make a profit as the difference in the value of the bonds narrowed when a new bond
was issued.

Low spread.
Leverage required to make money.
The value of $1000 invested in the hedge fund Long-Term Capital Management, of $1,000 invested in the Dow Jones Industrial Average, and of $1,000 invested monthly in U.S.
Treasuries at constant maturity.

http://en.wikipedia.org/wiki/Long-Term_Capital_Management
https://youtu.be/KkCZszQzkMo
Would you like to jump out of this plane
with this parachute which opens 99% of
the time?

Modern Risk Management Practices

Advocate that you should jump
The Market Can Stay
Irrational Longer Than
You Can Stay Solvent -
Keynes
 Victor Niederhoffer

http://en.wikipedia.org/wiki/Victor_Niederhoffer
 The Mouse with one hole is quickly cornered

"The mouse with one hole is quickly cornered." That is key. There are certain decisions you make in life that are irreversible, that lead you into a path you can't get out of, and unless you
have more than one escape clause, the adversary can gang up on you and destroy you. What else? I didn't have a proper foundation. I was not sufficiently private in my activities. I was
playing poker with men named Doc. I must've made a hundred errors on that one, but those are five or six that come to mind. - Niederhoffer
Source:THE FOURTH QUADRANT: A MAP OF THE LIMITS
OF STATISTICS By Nassim Nicholas Taleb
Why Iam skeptical of the bank business model
 Wait Until You
Shake Your
Headtext

It’s easy to lend money and fool yourself into believing that you’ll make a good rate of return. It reminds me of a story about two men in a sword fight. One of them takes a big swipe on
the other one’s neck whereupon the other one says “You missed me.”

The swiper says, “Wait until you shake your head.”

Source: Story as told by Charlie Munger.

The Opera House was formally completed in 1973, having cost $102 million. The original cost estimate in 1957 was $7 million. The original completion date set by the government was
26 January 1963. Thus, the project was completed ten years late and over-budget by more than fourteen times.

http://en.wikipedia.org/wiki/Sydney_Opera_House

Be wary of grandiose projections made by managements

The Company was formed on 13 August 1986 with the objective of financing, building and operating a tunnel between England and France. The Company let a contract for the
construction of the tunnel to TransManche Link. The tunnel cost around £9.5bn to build, about double its original estimate of £4.7bn. The tunnel, which was financed partly from
investment by shareholders and partly from £8bn of debt, was officially opened on 6 May 1994. In its first year of operation the Company lost £925m because of disappointing revenues
from passengers and freight together with heavy interest charges on its £8bn of debt.
The noida toll bridge
Interest expense is twice of Revenue.
Normal Human
Tendency
90% Of Drivers Think
That They Are Better Than
Average Drivers
Give high and low estimates for the average weight of an empty Boeing 747 aircraft. Choose numbers far enough apart to be 90 percent certain that the true answer lies somewhere in
between. Ans: 177 tons

If you are 90% sure, then you should be comfortable betting $9 against prospect of willing just $1 that the real is within your chosen range.
Give high and low estimates for the diameter of the earth’s moon in kms. Again, choose numbers far enough apart to be 90 percent certain that the true answer lies somewhere in between.
Ans: 3,476 kms

If you are 90% sure, then you should be comfortable betting $9 against prospect of willing just $1 that the real is within your chosen range.

Because most people who attempt to answer these questions don’t recognize how little they really know about the subjects or how difficult it is to bracket high and low estimates so that
there’s a sufficiently strong chance that the real answer will fall somewhere in between. As a result, most people fail to spread their estimates far enough apart to account for their ignorance.
Terrance Odean and Brad M. Barber of the University of California analyzed the trading records of more than 60,000 investors at a large brokerage firm. They found that individuals
who trade stocks most frequently post exceptionally poor investment results.

http://faculty.haas.berkeley.edu/odean/papers%20current%20versions/individual_investor_performance_final.pdf
Excel can make you go nuts.

The definition of value is very precise. There is no ambiguity about it. All one has to do is to take the future cash flows and then bring them back to the
present value using discount factor which is the opportunity cost of capital derived from a very precise model called the Capital Asset Pricing Model. You
punch in the numbers in that model and out comes the cost of capital and then you punch that number in another excel model containing future cash
flows and the precise formulas in that excel model will tell you instantly what that business is worth.

The sheer number of assumptions in a valuation model are mind boggling

Just look at the number of variables and the number of scenarios.

I have many problems with Excel.

 #1:
SPINNING STORIES

I don’t know who said this but I found it really apt: “The most popular software for writing fiction is not Microsoft Word. It’s Microsoft Excel….”

THE COMBINATION OF PRECISE

FORMULAS WITH HIGHLY
IMPRECISE ASSUMPTIONS
CAN BE USED TO ESTABLISH,
OR RATHER TO JUSTIFY,
PRACTICALLY ANY VALUE ONE
WISHES, HOWEVER HIGH, FOR
A REALLY OUTSTANDING
ISSUE. – BEN GRAHAM IN THE
INTELLIGENT INVESTOR
THE FIRST PRINCIPLE
IS THAT YOU MUST NOT
FOOL YOURSELF AND
YOU ARE THE EASIEST
PERSON TO FOOL.
— RICHARD FEYNMAN
Man is not a rational animal. Man is a rationalizing animal.
ANY BUSINESS CRAVING OF
THE LEADER, HOWEVER
FOOLISH, WILL BE QUICKLY
SUPPORTED BY DETAILED
RATE-OF-RETURN AND
STRATEGIC STUDIES
PREPARED BY HIS TROOPS.
 WHILE DEALS OFTEN FAIL
IN PRACTICE, THEY NEVER
FAIL IN PROJECTIONS - IF
THE CEO IS VISIBLY
PANTING OVER A
PROSPECTIVE ACQUISITION,
SUBORDINATES AND
CONSULTANTS WILL
SUPPLY THE REQUISITE
PROJECTIONS TO
RATIONALIZE ANY PRICE.

Someone please tell this to Ratan Tata, Kumarmanglam Birla and Sunil Mittal
 #2:
BLIND EXTRAPOLATION
 IT’S STUPID THE WAY
PEOPLE EXTRAPOLATE
THE PAST- AND NOT
SLIGHTLY STUPID,
BUT MASSIVELY
STUPID.

Especially in cyclicals and especially for insiders.

We end up putting arrows at the end of trend-lines…

 #3:
SCENARIO ANALYSIS

especially when possible ranges of outcome are very wide

Oil Price Chart

The statistician who drowned in water which was, on average, only 4 feet deep. He forgot that the RANGE of depth was between 3 feet and 10 feet!
 “THE WORST CASE
SCENARIO IS OFTEN
MORE
CONSEQUENTIAL
THAN THE FORECAST
ITSELF.”
— NASSIM TALEB

We will talk more about this important idea in a while but you have to be very skeptical of scenarios analysis and reducing the value to a single number called expected
value when ranges of possible outcome are very wide…

 “I DON’T THINK YOU

CAN STICK NUMBERS
ON A HIGHLY
SPECULATIVE
BUSINESS WHERE THE
WHOLE INDUSTRY IS
GOING TO CHANGE IN 5
YEARS AND HAVE IT
MEAN ANYTHING.

I don’t think you can stick numbers on a highly speculative business where the whole industry is going to change in 5 years and have it mean anything.
 IF I TAUGHT A
COURSE IN
INVESTMENTS, MY
FINAL EXAM WOULD
BE TO VALUE THIS
INTERNET STOCK.

“And if they came up with an answer, they'd flunk. And if they came up with a blank sheet of paper, I'd probably give them a B. “And if they said how the hell could you
ask something so dumb? I’d give them an A.”

All this hunger for quantification is an example of physics envy which Charlie has spoken about.
There is an element of randomness in success and we don’t notice it.
This is Joshua Bell.

http://en.wikipedia.org/wiki/Joshua_Bell

He is playing Vivaldi Four Seasons.

http://www.youtube.com/watch?v=iNcYT7jpH9E

People pay hundreds of dollars to watch him play.

One day Joshua Bell played the violin at a subway station in Washington D.C - incognito - on behalf of The Washington Post.

See this: http://www.youtube.com/watch?v=hnOPu0_YWhw

Read this: http://www.washingtonpost.com/wp-dyn/content/article/2007/04/04/AR2007040401721.html

Now this is not a controlled experiment. One can claim that the commuters were busy, had other stuff on their minds etc etc.
This is one of best controlled experiments in social science I have read about..

http://www.nytimes.com/2007/04/15/magazine/15wwlnidealab.t.html

Web-based experiment. More than 14,000 participants registered at Music Lab (www.musiclab.columbia.edu), and were asked to listen to, rate and, if they chose, download songs by
bands they had never heard of. Some of the participants saw only the names of the songs and bands, while others also saw how many times the songs had been downloaded by previous
participants. This second group — “social influence” condition — was further split into eight parallel “worlds” such that participants could see the prior downloads of people only in their
own world. All the artists in all the worlds started out identically, with zero downloads — but because the different worlds were kept separate, they subsequently evolved independently of
one another.

You should see the parallels with Darwin’s Theory of Evolution as you read about this story.
In all the social-influence worlds, the most popular songs were much more popular (and the least popular songs were less popular) than in the independent condition.

At the same time, however, the particular songs that became hits were different in different worlds, just as cumulative-advantage theory would predict. Introducing social influence into
human decision making, in other words, didn’t just make the hits bigger; it also made them more unpredictable.

When people tend to like what other people like, differences in popularity are subject to what is called “cumulative advantage,” or the “rich get richer” effect. This means that if one object
happens to be slightly more popular than another at just the right point, it will tend to become more popular stil.

As a result, even tiny, random fluctuations can blow up, generating potentially enormous long-run differences among even indistinguishable competitors...

Thus, if history were to be somehow rerun many times, seemingly identical universes with the same set of competitors and the same overall market tastes would quickly generate different
winners: Madonna would have been popular in this world, but in some other version of history, she would be a nobody, and someone we have never heard of would be in her place.
Overconfidence leads to arrogance
The Benefits of Overoptimism
 The Main Benefit Of
Optimism Is
Resilience In The Face
Of Setbacks.

Optimistic bias a role—sometimes the dominant role—whenever individuals or institutions voluntarily take on significant risks. More often than not, risk takers underestimate the odds they
face, and don’t invest sufficient effort to find out what the odds are. Because they misread the risks, optimistic entrepreneurs often believe they are prudent, even when they are not. Their
confidence in their future success sustains a positive mood that helps them obtain resources from others, raise the morale of their employees, and enhance their prospects of prevailing.
When action is needed, optimism, even of the mildly delusional variety, may be a good thing. - Kahneman
Some People Just
Don’t Give Up
http://www.youtube.com/watch?v=45mMioJ5szc
If Something Is
Important Enough,
Even If The Odds Are
Against You, You
Should Still Do It.
Failure Is An Option
Here. If Things Are
Not Failing, You Are
Not Innovating
Enough
The First Step Is To
Establish That Something
Is Possible; Then
Probability Will Occur.
Persistence Is Very
Important. You
Should Not Give Up
Unless You Are
Forced To Give Up.
Being An Entrepreneur Is
Like Eating Glass And
Staring Into The Abyss Of
Death
Never Underestimate A
Man Who Overestimates
Himself
Bias from
Overinfluence of
Authority
The Milgram experiment is the most cited experiment in social psychology.

http://www.youtube.com/watch?v=BcvSNg0HZwk

http://www.youtube.com/watch?v=IzTuz0mNlwU

http://www.youtube.com/watch?v=CmFCoo-cU3Y

Psychology textbooks include this experiment in the chapter that deals with conformity or authority. However, something as big as this (a lollapalooza outcome) simply cannot be explained
by ONE model. There are other models in force here.
 The Hospital Experiment

From Cialdini’s Influence:

Group of researchers, composed of doctors and nurses with connections to three hospitals.

To twenty-two separate nurses’ stations on various surgical, medical, pediatric, and psychiatric wards, one of the researchers made an identical phone call in which he identified himself as
a hospital physician and directed the answering nurse to give twenty milligrams of a drug (Astrogen) to a specific ward patient.

(1) The prescription was transmitted by phone, in direct violation of hospital policy. (2) The medication itself was unauthorized; Astrogen had not been cleared for use nor placed on the
ward stock list. (3) The prescribed dosage was obviously and dangerously excessive. The medication containers clearly stated that the “maximum daily dose” was only ten milligrams, half
of what had been ordered. (4) The directive was given by a man the nurse had never met, seen, or even talked with before on the phone.
Yet, in 95 percent of the instances, the nurses went straightaway to the ward medicine cabinet, where they secured the ordered dosage of Astrogen and started for the patient’s room to
administer it. It was at this point that they were stopped by a secret observer, who revealed the nature of the experiment...
Flight Simulator Experiment cited by Charlie Munger:

“You get a pilot and a co-pilot. The pilot is the authority figure. They don’t do this in airplanes, but they’ve done it in simulators. They have the pilot do something where the co-pilot,
who's been trained in simulators a long time - he knows he’s not to allow the plane to crash - they have the pilot to do something where an idiot co-pilot would know the plane was going to
crash, but the pilot’s doing it, and the co-pilot is sitting there, and the pilot is the authority figure. 25% of the time the plane crashes…”
http://www.youtube.com/watch?v=v4jt3686C6U
http://www.youtube.com/watch?v=gCMzjJjuxQI
 Mr. Market As A
Symbol Of Authority

Mr. Buffett has correctly called stock market as a “semi-psychotic creature given to extremes of elation and despair.”

However, the vast majority of people, and academic finance in particular, treat market prices as correct and give it the respect reserved for authority figures….

Buffett writes the following about Ben Graham’s “Mr. Market” metaphor in his book, “The Intelligent Investor”:

“Ben Graham explained why in Chapter 8 of The Intelligent Investor. There he introduced “Mr. Market,” an obliging fellow who shows up every day to either buy from you or sell to you,
whichever you wish. The more manic-depressive this chap is, the greater the opportunities available to the investor. That's true because a wildly fluctuating market means that irrationally
low prices will periodically be attached to solid businesses. It is impossible to see how the availability of such prices can be thought of as increasing the hazards for an investor who is totally
free to either ignore the market or exploit its folly.”

By giving too much importance to Mr. Market, most investors make a fundamental mistake of converting their basic strength into a weakness

Important Principle: Don’t use stock prices to determine value… (this happens all the time e.g. when people use MTM accounting, or when analysts used peer valuation etc).
There Are A Lot Of
“Experts” In Social
Science Who Make
Predicttions
We Make No Attempt To
Predict How Security Markets
Will Behave; Successfully
Forecasting Short Term
Stock Price Movements Is
Something We Think Neither
We Nor Anyone Else Can Do.
We Believe That Short-Term
Forecasts Of Stock Or Bond
Prices Are Useless. The Forecasts
May Tell You A Great Deal About
The Forecaster; They Tell You
Nothing About The Future.)
Short-Term Market
Forecasts Are Poison And
Should Be Kept Locked Up In
A Safe Place, Away From
Children And Also From
Grown-Ups Who Behave In
The Market Like Children.
“There Are 60,000 Economists In The U.S.,
Many Of Them Employed Full-Time
Trying To Forecast Recessions And
Interest Rates, And If They Could Do It
Successfully Twice In A Row, They'd All
Be Millionaires By Now...As Far As I
Know, Most Of Them Are Still Gainfully
Employed, Which Ought To Tell Us
Something.” - Peter Lynch, One Up On
Wall Street
We Have Two Classes Of
Forecasters: Those Who
Don't Know – And
Those Who Don't Know
They Don't Know –
Galbraith.
 We Will Continue To
Ignore Political And
Economic Forecasts, Which
Are An Expensive
Distraction For Many
Investors And
Businessmen.

Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet
Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%.

But, surprise - none of these blockbuster events made the slightest dent in Ben Graham's investment principles. Nor did they render unsound the negotiated purchases of fine businesses at
sensible prices. Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when
apprehensions about some macro event were at a peak. Fear is the
foe of the faddist, but the friend of the fundamentalist.

Social Proof + Authority (predictions by experts),

Tetlock is the fella who demonstrated the lunacy of the idea of most “experts” in social science...

People who make prediction their business— people who appear as experts on television, get quoted in newspaper articles, advise governments and businesses, and participate in punditry
roundtables—are no better than the rest of us. When they’re wrong, they’re rarely held accountable, and they rarely admit it, either. They insist that they were just off on timing, or
blindsided by an improbable event, or almost right, or wrong for the right reasons.

Required Reading:

http://www.newyorker.com/archive/2005/12/05/051205crbo_books1
 “The Fox Knows Many
Things, But The Hedgehog
Knows One Big Thing.” -
Isaiah Berlin

Tetlock borrows a marvelous metaphor from Isaiah Berlin.

A Hedgehog knows how to curl itself into a ball to escape its enemies. That’s all he knows. A fox on the other hand has many more models in his head...
Berlin divides writers and thinkers into two categories: hedgehogs, who view the world through the lens of a single defining idea...
...and foxes who draw on a wide variety of experiences and for whom the world cannot be boiled down to a single idea.
 Follow Single Doctrine Avoid Ideology

One Big Idea Lots of Ideas (multi-disciplinary)

Flexible Mind (Know how to deal

Cling on to their One Big Idea
with surprise)

Confirmation Bias No Confirmation Bias

Overconfident Doubtful

Articulate Not very Articulate

Poor predictive ability, but

Better Predictors
occasionally bang on target

http://en.wikipedia.org/wiki/The_Hedgehog_and_the_Fox

http://www.longnow.org/seminars/02007/jan/26/why-foxes-are-better-forecasters-than-hedgehogs/
A hedgehog: http://www.youtube.com/watch?v=gUkbdjetlY8
A Fox: http://www.youtube.com/watch?v=IaO69CF5mbY
 How To Spot A
Hedgehog Or A Fox

“Count how often they press the brakes on trains of thought. Foxes often qualify their arguments with “however” and “perhaps,” while hedgehogs build up momentum with “moreover”
and “all the more so.” Foxes are not as entertaining as hedgehogs. But enduring a little tedium is worth it if you want realistic odds on possible futures.”

“Listen to yourself talk to yourself. If you're being swept away with enthusiasm for some particular course of action, take a deep breath and ask: Can I see anything wrong with this? And if
you can't, start worrying; you are about to go over a cliff.”
 Tip #1: Stare At Who
You Want To Become

https://www.amazon.com/Little-Book-Talent-Improving-Skills/dp/034553025X/

TIP #1 STARE AT WHO YOU WANT TO BECOME If you were to visit a dozen talent hotbeds tomorrow, you would be struck by how much time the learners spend observing top
performers. When I say “observing,” I’m not talking about passively watching. I’m talking about staring—the kind of raw, unblinking, intensely absorbed gazes you see in hungry cats or
newborn babies. We each live with a “windshield” of people in front of us; one of the keys to igniting your motivation is to fill your windshield with vivid images of your future self, and to
stare at them every day.
 Tip #1: Stare At Who
You Want To Become

https://www.amazon.com/Little-Book-Talent-Improving-Skills/dp/034553025X/

The key to effective engraving is to create an intense connection: to watch and listen so closely that you can imagine the feeling of performing the skill. For physical skills, project yourself
inside the performer’s body. Become aware of the movement, the rhythm; try to feel the interior shape of the moves. For mental skills, simulate the skill by re-creating the expert’s decision
patterns. Chess players achieve this by replaying classic games, move by move; public speakers do it by regiving great speeches complete with original inflections; musicians cover their
favorite songs; some writers I know achieve this effect by retyping passages verbatim from great works. (It sounds kind of Zen, but it
works.)Read more at location 185   • Delete this highlight
https://youtu.be/pzXL-KM2UqU
“Cherish Some Man Of High
Character, And Keep Him Ever
Before Your Eyes, Living As If He
Were Watching You, And
Ordering All Your Actions As If
He Beheld Them.” — Seneca
Thank You