This is Your Brain on Stocks:

Behavioral Economics,
Neurofinance, Risk Aversion:

Why You Are Not Wired to Make
Intelligent Financial Decisions


Presentation by
Barry Ritholtz
FPA NorCal Conference
May 27, 2014
Todays Discussion:
1. Review Investor Behavior, noting most common investing
errors;
2. Explore how and why these occur;

3. Learn how you can help prevent your clients from making
these exact same investing errors + hurting themselves
This is Your Brain.
This is Your Brain on Drugs
1987 PSA

This
is
your
brain

Your brain weighs 3 pounds, and is 100,000 years old. It is a dynamic, opportunistic, self-organizing system
of systems. MRIs have revealed to Neurologists what our brains looks like when making decisions. We can
observe it 1) in real time; 2) under actual conditions, and 3) in reaction to financial risk/reward stimuli.

Once we begin trading stocks, however, our brains begin to undergo subtle physical change that we can
actually see in the MRIs of Traders . . .
This
is
your
brain
on
stocks

1. Herding, Groupthink
2. Optimism Bias
3. Confirmation Bias
4. Expert Opinions
5. Recency Effect
6. Endowment Effect
7. Hindsight Bias

Behavioral Economics Neuro-Finance
How Your Brain Interferes with Your Investing
Risk Aversion
1. Anticipation vs. Rewards
2. Selective Perception/Retention
3. Words vs Images
4. Pattern Recognition
5. Data vs Narrative
6. Cognitive Dissonance
7. Species of Dopamine Addicts

1. Humans dont understand risk
2. What we fear
3. Black Swans
4. What will kill you
5. Clients biggest financial Fears
5. What hurts their portfolios
A brief intro to
Behavioral
Economics
Source: Kal, Economist
Herding







Mutual of Omaha

Lone Gazelle

Sources: Ritholtz.com, NYT, McKinsey, Marketwatch
1. Only 5% of Wall Street
Recommendations Are SELLS
-NYT, May 15, 2008

2. Why Analysts Keep Telling Investors
to Buy
-NYT, February 8, 2009

3. Equity Analysts Too Bullish and
Bearish at the Exact Wrong Times
-McKinsey, June 2nd, 2010

4. None of the S&P 1500 have a Wall St.
Consensus Sell on them
-Robert Powell, Editor, Retirement Weekly, August
2011
It is better for one's reputation to fail
conventionally than to succeed
unconventionally.
-John Maynard Kyenes
Groupthink
Sources: IMDB, Wines & Vines
The Sideways Effect
In 2004, Merlot was the best
selling wine in America = 15%
of all sales.

Pinot Noir was < 3%

Paul Giamatti (Miles): I am
NOT drinking any f&%king
Merlot!

Merlot sales plummeted 35%
and Pinot Noir sales rose more
than a 100%.

This became known as the
Sideways Effect.

Source: McKinsey & Co.
Analysts have been persistently overoptimistic for the
past 25 years, with [earnings] estimates ranging from 10 to
12 percent a year, compared with actual earnings growth of
6 percent On average, analysts forecasts have been
almost 100 percent too high

-McKinsey study
Analysts: Over-Optimistic GroupThink
Here, Kitty, Kitty, Kitty


Optimism Bias

The Math of Active Management is Daunting:

1. Only 20% of active managers (1 in 5) can outperform their benchmarks in
any given year;
2. Within that quintile, < half (1 in 10) outperform in 2 out of the next 3 years;
3. Only 3% stayed in the top 20% over 5 years (1 in 33)
4. Add in costs and fees, less than 1% (1 in 100)
manage to outperform (net).
5. What are the odds of picking that that
1-in-100 manager?
Passive vs Active Management
Source: Morningstar, Vanguard
You are an above average driver

Your kids are better than their kids

You saw the crisis coming

You can pick stocks

You can time markets

Lake Wobegone Effect
Dunning Kruger Effect: DK is a cognitive bias in which unskilled people make poor
decisions and reach erroneous conclusions, but their incompetence denies them the
metacognitive ability to recognize these mistakes.

Metacognition: The less competent you are at a task, the more likely you are to over-
estimate your ability to accomplish it well. Competence in a given field actually weakens
self-confidence.

This has devastating consequences in the investment world.

Dunning Kruger Effect

Glaser & Weber, University of Mannheim surveyed
investors, asking them recent performance. Most
considered themselves above average. On average,
investors overestimated annual returns by 11.6% per
year. In fact, the lower the actual returns the worse they
were at judging their returns.

The correlation between self ratings and actual
performance is not distinguishable from zero.
Source: Zweig, Your Money & Your Brain; Grants Interest Rate Observer,
Expert forecasters do no better than the average member
of the public; Statistically, expert predictions are the =
random guesses. (Philip Tetlock)

Experts acknowledge future is inherently unknowable are
perceived as being uncertain and therefore less
trustworthy. (Isaiah Berlin: Hedgehog vs Fox)

The more self-confident an expert appears, the worse
their track record is likely to be. And, the more likely he is
to be believed by TV viewers;

Most famous = least accurate.
Least accurate = most confident

Forecasters who get a single big outlier correct are more
likely to underperform the rest of the time;

The Articulate incompetents The Tao Jones (1984) by
Bennett Goodspeed

Expert Forecasting versus Ambiguous Uncertainty
1. We tend to read that which we
agree with; We avoid that which
disagrees with our preconceived
biases, notions or ideologies;

2. Our biases change the way we
perceive objects literally, the way
we see the world.

3. The same biases affect our
memories we retain less of what
we disagree with . . .

4. Expectations Affect Perception

Selective Perception & Retention
Confirmation Bias
Source: WSJ
WSJ: 2007 WSJ: 2010
Beware the Recency Effect
Source: Fortune, Time
Time, June 2005
Fortune, June 2005
What Just Happened vs. What is Going to Happen
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1= very sLrong predlcLablllLy
0= very weak predlcLablllLy


Var|ance of 10-year rea| stock returns exp|a|ned by var|ous metr|cs, s|nce 1928
What Makes the Market Tick?
Source: Ritholtz.com BigCharts.com

These are poorly designed tax cuts - Stay Out of Markets!
2003: Politics and Asset Management Dont Mix
Source: Ritholtz.com, BigCharts.com
2003 Tax Cuts > $1 Trillion

How did that political trade up over 90% over 4 years
work out for you . . . ?
2003: Politics and Asset Management Dont Mix
Source: Ritholtz.com, BigCharts.com
Obama is a Socialist! Stay Out of Markets!
2009: Political Investing
Source: Ritholtz.com, BigCharts.com
FASB 157, ZIRP, QE +VERY Oversold Markets

The political trader missed the best rally in a generation
Up 140% over 50 months



2009: Politics and Asset Management Dont Mix
Source: DALBAR
Investor Performance (10 Years)
Source: Ritholtz.com
Sentiment Cycle
Clinton State of the Union, 2000
We begln Lhe new cenLury wlLh over 20 mllllon new [obs, Lhe fasLesL economlc
growLh ln more Lhan 30 years, Lhe lowesL unemploymenL raLes ln 30 years, Lhe lowesL
poverLy raLes ln 20 years, Lhe lowesL Afrlcan-Amerlcan and Plspanlc unemploymenL
raLes on record, Lhe rsL back-Lo-back budgeL surpluses ln 42 years. And nexL monLh,
Amerlca wlll achleve Lhe longesL perlod of economlc growLh ln our enure hlsLory.

We have bullL a new economy. And our economlc revoluuon has been maLched by a
revlval of Lhe Amerlcan splrlL: crlme down by 20, Lo lLs lowesL level ln 23 years, Leen
blrLhs down seven years ln a row, adopuons up by 30, welfare rolls cuL ln half Lo
Lhelr lowesL levels ln 30 years.

My fellow Amerlcans, Lhe sLaLe of our unlon ls Lhe sLrongesL lL has ever been."
"#$$% &'()* +&),(-. /$00&1.(2 &%2 -3( (/$%$+4 .56()(2 7-. 8$).- 2(/&2( 7% 9: 4(&).;
Source: Morgan Housel, Motley Fool
Obama State of the Union, 2010
One in 10 Americans still cannot find work. Many businesses have shuttered. Home
values have declined. Small towns and rural communities have been hit especially hard.

And for those who'd already known poverty, life has become that much harder. This
recession has also compounded the burdens that America's families have been dealing
with for decades -- the burden of working harder and longer for less; of being unable to
save enough to retire or help kids with college.

[Soon after, stocks surged.]
Source: Morgan Housel, Motley Fool
What does this mean for investors?
We have an Optimism bias (helps our survival).
Our brains are better at processing good news about the future than bad.
Anticipation of financial reward > than actual benefits (Buy Rumor, Sell News)
Gamblers, Alcoholics, Sex Addicts, Junkies, OA, Hyper-Traders = Dopamine High.
A Species of Dopamine Addicts
A brief intro to
Neuro
Finance
If u cn rd ths
This animation . . .
. . . is not an animation
When it absolutely positively
has to deceive your eyes overnight
Source: Federal Express
No, this was not photoshopped
Source: 11even.net
We prefer stories to data

Pre-writing, story-telling is how
Humans evolved to share information

We are vulnerable to anecdotes that
mislead or present false conclusions
unsupported by data

Monkeys Love a Narrative
A brief introduction to
Misunderstanding Risk
We Are All Going to Die. Heres How.
Shark: A perfectly evolved killing machine, immortalized in Spielbergs 1975 film, Jaws.

10 People a year are killed by sharks
worldwide

There are other large predators that
each year manage to whittle down a
few off of that 7 billion number:

Humans live on land

Lions? (100)
Elephants (100)
Hippos (500)
Crocodiles (1,000)
Snakes (50,000).

Dogs (25,000) almost all due to rabies.

Source: Gates Foundation, CDC
The Deadliest Animal in the World
Mosquitoes are the deadliest creature
on earth; Man only comes in second
Your Risk of Terrorism
2010: 25 U.S. noncombatant
fatalities from terrorism worldwide

2011: Terror related deaths = 8

People who die after being struck
by lightning: 29.

Americans abroad most likely to be
killed in car accidents than any
other reason

Study found 500 additional people
die in cars accidents each year after
9/11 due to fear of terrorism. Since
then, double the number of
casualties
Source: CDC, Mueller & Stewart, Terror, Security, and Money.
Your Actual Risk
You are
35,079 times more likely to die of heart disease
33,842 times more likely to die of cancer
than a terror attack.
Source: CDC
What are your clients afraid of?
Market Crashes

HyperInflation

Collapse of the
Dollar

Looking foolish

1987 Crash in Imminent!

Marc Faber: 2014 crash will be worse than 1987s
CNBC, April 10, 2014

Marc Faber Says Stocks Have Likely Peaked for 2009 Bloomberg, 9/25/2009

Faber on Hyperinflation: Not A Matter Of If But When Business Insider, 9/23/2010

'The Bear Market Is Starting' Marc Faber CNBC, August 3, 2011

Faber: The Dollar's Value In The Future Will Be Zero Business Insider, 4/18/ 2011

Marc Faber: We Could Experience A 1987-Style Crash This Year Business Insider,
5/10/2012

Marc Faber: Look out! A 1987-style crash is coming. CNBC, August 8, 2013

2014 crash will be worse than 1987's: Marc Faber CNBC, April 10, 2014


My prediction? In 2015, Faber will predict crash . . .


1987 Crash in Imminent!

What Really Hurts Portfolios . . .
People fear Black Swans Terrorist attacks,
Sharks, Disasters when its the mundane things
like heart disease, cancer and diabetes that get you
in the end.

Investors fear Black Swans Market Crashes,
Hyper-Inflation, Collapse of the Dollar when its
the mundane things such as fees, expenses, taxes,
performance chasing and emotions that lead to poor
investment performance.

Investor Performance (20 Years)
Now I understand these
cognitive issues, what can I
do about them?
Avoid making all the usual errors
investors make!
We have met the
enemy, and he is us.

-Walt Kelly, Pogo, 1971
Barry L. Ritholtz
Chief Investment Officer,
Ritholtz Wealth Management
90 Park Avenue, 18
th
floor
New York, NY 10016
212-455-9122
Info@RitholtzWealth.com

for more information, please contact
My favorite books on these subjects can be found at
http://www.ritholtz.com/blog/behavioral-books