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Talking Finance

When bulls and bums collide

This article originally published in The Northern Daily Leader on 3 September 2011.

Committing life-threatening acts with little protection besides a red scarf and the false invulnerability of a dozen full-strength beers under the belt sounds pretty silly. Yet this is exactly what many young Australians do each year at Pamplona – the scene of an annual experiment to determine what happens when the sharp end of a bull’s horn meets a soft bum. Of course we all know the answer to that one and each year the TV news shows us in graphic detail as the bulls stampede over the hapless runners.

In typical laconic Spanish style, the Pamplona city council’s official website contains this nugget of encouragement for aspiring runners –“Number of injured a year: Between 200 and 300. Only 3% seriously.” There you go, on average only 9 people per year are seriously injured, nothing to worry about. The probability of hosting such an event in Australia? Zero. Clearly the nanny-state, a condition familiar to most Australians, has yet to arrive in Pamplona.

Surprisingly (or unsurprisingly, to regular readers of this column), there are some parallels with the stock market and the chaos in Pamplona. Much like the unfortunate runners at Pamplona who are trampled underfoot by a herd of bulls, investors in the stock market can suffer the same fate. When faced with uncertainty, investors fall prey to herding behaviour, where they simply start copying what everyone else is doing, in the hope that everybody else knows what they’re doing. Reasoning and rational analysis get discarded in a hurry as investors join the rush towards gold, cash, property or tulips – it actually doesn’t matter what it is, if everybody else is doing it, then so am I! Researchers describe these manias as self-organised, in that they are brought about by a combination of uncertainty and mimicry.

So how do you stop yourself from becoming one of the herd, or even worse, being trampled by the herd? The majority of our investment mistakes result from our cognitive and emotional biases, where our emotions get in the way of rationality, so a simple solution is to let someone else make the decisions for you. It’s easier to make rational decisions about someone else’s investments than your own – there’s no emotional attachment to complicate the process. Of course should you find yourself at Pamplona next July, there’s no point being rational when confronted by a real bull – just run like hell.

Don’t just do something, sit there!

This article originally published in The Northern Daily Leader on 20 August 2011.

Nearly thirty years ago, as a knobbly-kneed schoolboy, winter meant more to me than just cold weather and frosty mornings, it was also the start of soccer season.
Before ‘grown-up’ sports like cricket and rugby captured my attention, life revolved around soccer, evidenced by my Liverpool doona, Liverpool pyjamas and Liverpool slippers. On the other hand, Dad was a Spurs supporter, so we always had plenty to talk about.

Like many soccer players, my greatest dread arose whenever I was asked to take a penalty kick – all that attention and pressure, and all at the tender age of 9 years old! Of course I never considered the feelings of the goalkeeper, who faced his or her own dilemma – dive left, dive right or just do nothing and stay in the middle? Unsurprisingly, these are the sort of questions that scientists love to answer, and a 2007 study by a group of Israeli researchers found that when facing a penalty kick, goalkeepers have an ‘action bias’ – which means that they tend to dive left or right more frequently than was useful. The study showed that goalkeepers went left or the right 94% of the time – meaning they stay in the middle for only 6% of the kicks they faced. However, the penalty shot went straight at the middle of the goal 29% of the time, so it turns out that goalkeepers could increase their chances of saving the penalty kick simply by doing nothing. The explanation for the goalkeeper’s actions is that they are motivated by the fear of regret rather than the fear of failure- to have dived and failed to stop the goal feels better than standing still and watching the ball go past you into the back of the net.

Recent stock market volatility presents investors with the same dilemma – should you sell out or hang in there? The action bias exhibited by the goalkeepers is just as strong in investors, where we feel the urge to do something…anything! Don’t let this happen to you – if you have an investment plan, then stick to it. A plan becomes even more important when markets get rocky, it’s definitely not the time to throw it out the window. And if you don’t have a plan (or a Liverpool doona), then do yourself a favour and get both. You won’t regret it.

Take That

This article originally published in The Northern Daily Leader on 6 August 2011.

They say there is a little bit of prison-camp guard in most of us. Not a pleasant thought, but that’s what Yale University psychologist Stanley Milgram discovered in a series of controversial experiments in the 1960’s. In the experiments, unwitting university students were instructed to give apparently painful electric shocks to another person (in reality an actor, privy to the full experiment) each time that person gave the wrong answer to a simple memory test. At each incorrect answer the voltage of the shock increased, to a point where it would apply a fatal shock of 450 volts. The students could hear the person scream when they were zapped, but could not see them – in fact the cries of pain were actually a series of tape recordings, as there was no actual shock applied – it was all an elaborate ruse to determine how far the students would go in applying ever more painful ‘shocks’ to the hapless person in the adjacent room. Somewhat worryingly, Milgram found that 65% of the students who participated in the experiment were willing to administer the final and fatal 450 volt shock, despite the obvious discomfort (to put it mildly) of the actor in the room next door.

You’re probably asking yourself what all this has to do with finance – well fortunately psychologists do more than simply terrorise students into thinking they’ve shocked someone to death; they also explore people’s behaviour when dealing with money and investments. And they have unearthed some surprising findings – for example, did you know that most people ‘feel’ a loss twice as keenly as they appreciate a gain of the same magnitude? So losing $5 makes you twice as upset as the happiness you gain from making $5, which seems fairly irrational! Psychologists also found that most of us suffer from ‘confirmation bias’, which means that we tend to favour information that confirms our views, regardless of whether the information is true or not. Another discovery is the ‘house-money’ effect, which found that people tend to gamble more recklessly with money from a windfall (such as a profitable investment or a winning scratchie). It’s no surprise why casinos are happy to give you free chips when you join their loyalty club. It turns out that investing behaviour is driven by our cognitive and emotional wiring, a lesson learned thanks to psychologists like Milgram and his tyrannical students!

Hello Brian!

This article originally published in The Northern Daily Leader on 23 July 2011.

The ‘Do Not Call Register’ is a great idea – apparently signing up to the register means you won’t be troubled by pesky telemarketers, who have a knack for knowing when you have just sat down for dinner. Last week, while my wife and I were preoccupied with convincing our six month old son Jack, that liquidised pumpkin is a tasty food source, we were interrupted by a telephone call from ‘Brian’. In hindsight we should have just ignored the call, but we had been expecting a call from a family member.

Brian seemed to have skilfully evaded the restrictions of the ‘Do Not Call Register’, as it quickly became clear that Brian was neither friend nor family. However he did have some alarming news – apparently his company (which he failed to name) had detected, over the internet, that our home computer was corrupted or infected by viruses. Much of the conversation was actually inferred, as there were some language difficulties, but the gist of the call was that we needed to switch on our computer immediately and Brian would help us resolve our problems. Naturally, feeding Jack was more pressing, so we declined Brian’s advice, though I did get his number to call him back later.

Once dinner was finished, I entered Brian’s telephone number in Google, and was rewarded with a lot of information and many complaints about Brian’s employer. Apparently Brian was planning to show us the error log on our computer, which always contains a large number of innocuous warnings which have no impact on the ability of your computer to work correctly. Brian would then convince us that the only way to ‘fix’ these problems was to install (and pay for) some software provided by his company.

Essentially Brian wanted to sell us a product we didn’t need, by identifying a problem we didn’t have (and it wasn’t even illegal). Unfortunately there are also (still) many ‘Brian’s’ in the financial services industry – despite a lengthy ongoing process to clean up the industry, some financial advisers identify problems you don’t have and then try to sell you products you don’t need. Your response should be the same as mine – do some research, talk to friends or family and don’t feel compelled to do anything that makes you uncomfortable. And could somebody fix the ‘Do Not Call Register’!

Bubble in Paris

This article originally published in The Northern Daily Leader on 9 July 2011.

Life as a Parisian hunchback in the 18th century must have been a challenge. More likely than not the object of public disdain and ridicule, as suffered by Quasimodo, the titular protagonist in Victor Hugo’s The Hunchback of Notre Dame, it’s fair to say that there were probably few situations where being a hunchback was an advantage. However, one of the greatest financial bubbles in history provided an opportunity for one enterprising 18th century hunchback.

In 1719, an inventive Scotsman, John Law, established the Mississippi Company, which was granted exclusive trading rights to the East Indies, China and South Seas by King Louis XV (Law had fled to Paris to escape the wrath of the authorities following a fatal duel over the attractions of a young woman). Through a combination of clever marketing and royal patronage, Law was able to convince his fellow Parisians that an investment in the company was simply too good an opportunity to miss, with a promised initial income return of 120%! So enthusiastically did the citizens of Paris respond, that the street outside Law’s house became thronged with budding investors, desperate to purchase shares in the company. Day and night people gathered in the Rue de Quincampoix, frantically trading back and forth shares in the Mississippi Company, speculating that the stock price would continue to rise inexorably higher. The eagerness and desperation of the speculators provided the perfect opportunity for our enterprising hunchback, who, according to legend, earned a sizable fortune for himself by renting out his hump as a writing-desk to the would-be investors.

As it turned out, providing writing-desk services to the eager investors was probably more profitable than investing in the shares of the Mississippi Company. The promised riches failed to materialise and the company and the private bank Law had established to finance it collapsed in flurry of worthless pieces of paper. The lesson learned by those over-enthusiastic Parisians is as relevant today as it was back in 1719 – if it’s too good to be true, it usually is. Too often we see ordinary Australians being duped by the modern-day equivalent of John Law and his exciting yet ultimately worthless investment opportunity. So whenever a ‘John Law’ comes your way, be a sceptic first and a believer second. The Mississippi Company wasn’t the first speculative bubble to collapse, and it certainly won’t be the last.