Welcome, Sandbox friends.
Today’s Daily discusses:
from behavioral missteps to rational investing
Let’s dig in.
Blake
Markets in review
EQUITIES: Russell 2000 +1.95% | Nasdaq 100 +1.30% | Dow +1.12% | S&P 500 +1.07%
FIXED INCOME: Barclays Agg Bond +0.17% | High Yield +0.20% | 2yr UST 3.459% | 10yr UST 3.984%
COMMODITIES: Brent Crude -0.49% to $60.99/barrel. Gold +4.03% to $4,383.3/oz.
BITCOIN: +1.91% to $110,985
US DOLLAR INDEX: +0.17% to 98.596
CBOE TOTAL PUT/CALL RATIO: 0.93
VIX: -12.27% to 18.23
Quote of the day
“Patience is bitter, but it’s fruit is sweet.”
- Aristotle
From behavioral missteps to rational investing
Classical economics assumes individuals make rational choices, but human behavior is rarely rational in practice.
The application of psychology to economics dates back centuries, but it wasn’t until the 1970s did Daniel Kahneman (a psychologist and winner of the 2002 Nobel Prize in Economic Sciences), Richard Thaler (winner of the 2017 Nobel Prize in Economic Sciences), and others show that people make decision errors due to biases of intuition.
These behavioral biases and cognitive errors recur predictably under many circumstances, leading to suboptimal outcomes for investors.
Sewing together theory and practice is the messy middle that we investors often find ourselves.
Psychologists use a System 1/System 2 framework to explain how people think and make decisions.
System 1 employs human intuition. It’s fast, emotional, and highly instinctual. The mental processes of System 1 are rooted in survival and evolution, helping us make quick judgments and react instantly without much effort. Think of slamming on the brakes when someone runs into the street. Unfortunately, System 1 produces a variety of systematic errors, or behavioral biases that can be costly in the long run.
Fortunately, we can call upon System 2, which employs logic and reason. It’s slow, deliberate, and methodical. System 2 monitors System 1 and can override it, helping us overcome behavioral biases. But it takes more energy and focus to process System 2, so we use it sparingly. Although we like to believe System 2 is who we are, System 1 is usually running the show.
People are not intuitive statisticians. We are good at thinking causally, using association and heuristics – but not statistically, where we encounter too much going on at once.
Problems arise when we don’t acknowledge and process all of the uncertainty around us, underappreciating anomalies and the role of chance.
Our decision weights – the subjective probabilities we assign when making decisions – differ from true probabilities. We tend to ignore the statistical probabilities of events actually occurring (base rates) and overweigh the likelihood of improbable outcomes, whether those outcomes are good or bad. Instead of considering base rates, we prefer linear narratives.
Numerous documented behavioral biases and cognitive errors produce systematic errors in judgment. Many of these undermine long-term investment outcomes.
How can investors best overcome behavioral biases? How do we reconcile them with the efficient markets theory (EMT)? What are the implications for markets and your portfolio?
This week, we will address some of the most common and financially destructive biases and errors that investors make, then provide a framework to mitigate these deficiencies in efforts to provide more optimal outcomes for investors.
More to come this week.
Sources: Daniel Kahneman: Thinking, Fast and Slow, CFA Institute
That’s all for today.
Blake
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Welcome to The Sandbox Daily, a daily curation of relevant research at the intersection of markets, economics, and lifestyle. We are committed to delivering high-quality and timely content to help investors make sense of capital markets.
Blake Millard is the Director of Investments at Sandbox Financial Partners, a Registered Investment Advisor. All opinions expressed here are solely his opinion and do not express or reflect the opinion of Sandbox Financial Partners. This Substack channel is for informational purposes only and should not be construed as investment advice. The information and opinions provided within should not be taken as specific advice on the merits of any investment decision by the reader. Investors should conduct their own due diligence regarding the prospects of any security discussed herein based on such investors’ own review of publicly available information. Clients of Sandbox Financial Partners may maintain positions in the markets, indexes, corporations, and/or securities discussed within The Sandbox Daily. Any projections, market outlooks, or estimates stated here are forward looking statements and are inherently unreliable; they are based upon certain assumptions and should not be construed to be indicative of the actual events that will occur.
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