Human Psychology

In this post, I shall deviate a little from my normal course of subjects and delve into area of human psychology. I highlight the importance of this is because it is necessary to take note that our biological decision making process which has served us so well in our natural daily lives would become fatal most of the time when it comes to financial markets.

I would first and foremost iterate that when it comes to theology, I remain an agnostic. In other words, when it comes to the supernatural, spiritual or other forms of metaphysical claims, I simply do not know the truth. I believe that such things are simply unknowable and one cannot reach a conclusion without the leap of blind faith.

However, allow me to start with a general observation that helps explain what follows. First of all humans are social primates. It does not matter whether or not evolution is true or not, the fact that we share about 95% of our DNA with chimpanzees is not subject to debate. Therefore, many of our body features and basic drives mirror the behavior those of our hairy cousins.

Our main differences lies in only three millimeters of convoluted gray matter, called the cerebral cortex. That is we are biological machines that operates 95% on a similar basis with only 5% differences. This 5% might be what accounts for our consciousness or self-awareness which has bestowed us with higher order thinking and sparked entire civilizations.

Thus, there are basic human psychological tendencies that we have to be aware of, for these applies to the human species in general.

The first is Pavlovian conditioning, this is quite apparent for one can observe how incentives and disincentives work in the real world. Perhaps the most important rule in management is about "Getting the incentives right". Get them wrong and you will start to witness dysfunctional behaviors that games the system.

However, there is a consequent effect that receives less attention than it warrants, known as the "incentive-caused bias". A pretty decent fellow can be driven both consciously and unconsciously by incentives, into irrational behavior that alters his own reality.

This person gets into a rationalization pattern that vindicates this behavior. The cognitive drift is present in every human being and it can cause incredulity in a perfectly normal human being. Thus the principle "What a man wishes, that also will he believe".

The mis-influence can obviously be seen on televisions, whereby tearful mothers, with heartfelt convictions, declare before national television the innocence of their obviously guilty sons. I have experienced this same psychological self-denial, that such a sane person as myself could not accept the unfortunate death of a dear friend long time ago.

That being said, there is another form of warping one's own self-reality. Coming from an accounting background, there is an old saying in the accounting world, "Whose bread I eat, his song I sing." When corporate management of established institutions ask the accountants to jump, the reply was "How high?" The natural results of incentive caused bias is well-developed in economics. Also well-known as the "Agency Problem".

Although money is the main driver amongst rewards, it is not the only reward that works. People also alter their realities and cognition to avoid pain or to gain identity, friendship, companionship, advancement in status and many other non-monetary items. It is important to recognize one's self incentive-caused bias taking place sub-consciously, for it is the cause that has led to many imprudent behaviors.

The second is a hating/disliking tendency. All humans need at least an object of hate within a group, which is also part of the "us against them" mentality. Whereby people bond together through a commonality of enemies. Consider the fact that the world's most successful religions have successfully garnered irrational hatred towards evils such as "demons or devils". It is usually way easier for a person to blame something for his shortcomings, misfortune or some feelings of guilt, than to take responsibility for them.

The triggering of such a tendency is the feeling of loss. A man ordinarily reacts irrational intensity over a small loss or threatened loss of property, love , friendship, dominated territory, opportunity, status or any other valued tangibles or intangibles. As a natural result, infighting in corporate settings over dominated territories often cause immense damage to an institution as a whole.

This also protects ideological or religious views by the feelings of dislike and hatred directed towards vocal non-believers. This happens in part, because the idea of nonbelievers if they spread will diminish the influence of views that are supported by a comfortable environment including a strong self-belief maintenance system.

This ideology-based group think rejects all conflicting inputs. When the vocal critic is a former believer, hostility is often boosted with a concept of betrayal that triggers hatred because a colleague is lost and fears that conflicting views will have extra persuasive power when they come form a former colleague. The result in history is the accusation of heresy which justified much killing of heretics, frequently over torture or burning the victims alive.

It is almost everywhere the case that extremes of ideology are maintained with great intensity and with great anitpathy to non-believers, causing extremes of cognitive dysfunction. This happens when other psychology tendencies are acting concurrently.

The third is doubt-avoidance tendency. The brain of man is programmed with a tendency to quickly remove doubt by reaching some decision. This doubt-avoidance tendency is well hard-wired into our survival instincts. After all, the one thing that is surely counter-productive for a prey animal is to take a long time in deciding what to do.

So pronounced is this tendency that it is logical to believe that at least some leaps of religious faith are greatly boosted in order to remove self-doubt. Even if one is satisfied that his own faith comes from revelation, one must still account for the inconsistent faith of others. This results in the aggressive evangelism activities to convert others.

What usually triggers doubt-avoidance tendency is some puzzlement and stress. Such as what is the meaning of life? Why do we exist? As we shall see later, this tendency usually works in tandem with social proof tendency and stress influence tendency. Many of these factors, naturally occur when facing religious issues. Thus, the natural state of most men is some form of religion. And this is what we observe.

The fourth is the congruence principle also known as the "status-quo bias". The brain of man conserves programming space by being reluctant to change which is a form of avoiding inconsistency. Anything that is inconsistent, causes a phenomenon known as cognitive dissonance. Cognitive dissonance is an uncomfortable feeling caused by holding two contradictory ideas simultaneously and trust me it is not a pleasant experience at all. The desire to avoid such unpleasant feelings to make a person feel better are what leads to confirmation bias, the denial of evidences that point out to the contradictory or other ego boosting mechanisms.

It is easy to see that a quickly reached conclusion triggered by the doubt avoidance tendency when combined with a tendency to resist any change in that conclusion will naturally cause alot of errors in cognition for the modern man. As it works out in an observable manner, we deal with many people whom we diagnose as imprisoned in poor conclusions that they will rather carry to their graves. So bad is the problem that, radically new ideas are seldom accepted by the old guard. Such events can be recognized by Galileo's persecution by the church. Instead, much progress is made by subsequent new generations who comes along and are less brain-blocked by previous generations.

One corollary of this tendency us that a person who has just made an investment or sacrifice in the course of assuming a new identity will intensify his devotion to the new identity. Afterall, it would be inconsistent behavior to make a large sacrifice for something that was no good. And thus, civilisation has invented many tough and solemn initiation ceremonies, often public in nature that instensify new commitments made. Examples that usually come to mind includes, baptism, blood oaths, pledges and even marriage solemnization.

The human mind works a lot like a human egg, there's an automatic shut-off device that bars any other sperm from getting in.

This tendency will often make humans into a subject of manipulative practitioners that gain advantage from triggering this tendency. So strong is the tendency that it can be manipulated to lead people into behaving horribly as a result. Two famous studies in psychology the Stanford prison experiment and the Milgram experiment are done to prove the existence of such a tendency in perfectly normal human beings. We do not know the horrible acts that we humans are capable of.

Though there are still many others, the last tendency that I will discuss here is the social proof tendency. Also known as the monkey-see monkey-do tendency. It has been proven that social animals possess a mirror gene expression. It is triggered in the puzzlement or stress, and particularly when both exist. Since so many others are doing it and I do not know any better, I must be right in doing it as well.

This social proof tendency interacts in a perverse way with the envy and hatred tendencies. A common expression is when people fight over a single man or woman when they are surrounded by an entire forest of better ones. Political versions becomes dead serious as the Middle East threatens nuclear war just because of some land that can easily be divided arbitrarily.

The important takeaway here is that several powerful psychologies work in tandem that causes us to do what we do. Although in several circumstances, it serves us well. In others, it can be extremely faulty especially when it comes to financial markets or religious beliefs. We may think we are above all these because we are rational humans which think for themselves. Though occasionally logic and reason can be used to determine a course of action, men and women including myself are more persuasively motivated by emotions which are also our psychological tendencies. Often, we simply use our intellects to rationalize those emotional actions after the fact.

How Stock Market Operates (Part II)

When for a long period of time a particular stock has been selling in a certain price range, say from a low of 25 to a high of 30, there is almost an irresistible tendency to attribute true value to this price range. Giving in to this urge can be very costly. This is because the genuinely worthwhile profits in stock investing come from holding the surprisingly large number of stocks that have gone up many times from its original costs. The only true test of whether a stock is "cheap" or "expensive" is not its current price in relation to some former price, but whether future cashflows realized are significantly more or less favorable than the current appraisal of that stock.

Taking from a Graham parable, the market is not a weighing machine on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather it is more like a voting machine, whereon countless individuals register their choices which are the product partly of reason and partly of emotion.

This is an important principle because despite the laws and regulations in place today, pools of manipulation of shares still exist. The methods of all these pools are fundamentally similar. The members would sell stocks back and forth amongst themselves at gradually rising or constant prices. All this activity on the stock price would attract attention of others who would then start buying shares and take a portion of the shares off these pools' hands at still higher prices. These highly skilled manipulators were quite experienced and able practitioners of this rather questionable art.

The conservative investor must be aware of the nature of the current appraisal by the financial community of any industry he is interested in. Determining whether at that moment the price of a stock is attractive, unattractive or somewhere in between depends on most part how far off these appraisals deviate from reality. However, to the extent that the general level of stock prices affects the total picture, it also depends somewhat on correctly estimating coming changes in purely financial factors, of which interest rates are by far the most important.

Allow me to close this chapter with a simple summary, prices have only one significant meaning for the investor. They provide him with an opportunity to buy wisely when prices fall sharply below its calculated intrinsic value. Throughout the investment process, he will be better off ignoring market prices and pay attention to his calculated range of future cashflows lest he gets anchored by some misleading price conditioned into his mental memory.

How the stock market operates? (Part I)

Every significant price move of any individual common stock occurs because of a changed appraisals of that stock by the financial community. It should never be forgotten that an appraisal is a subjective matter. It has nothing necessarily to do with what is going on in the real world around us. Rather, it results from what the person doing the appraising believes is going on, no matter how far from the actual facts such a judgment may be.

The key point to note is this, any individual stock does not rise or fall at any particular moment in time because of what is actually happening or will happen to that company. It rises or falls according to the current consensus of the financial community as to what is happening and will happen regardless of how far off this consensus may be from what is really occuring or will occur.

Because of a financial community appraisal that is at variance with the facts, a stock might well sell for a considerable period for much more or much less than it is intrinsically worth. Furthermore, many segments of the financial community of a habit of playing "following the leader", particularly when that leader is one of the larger New York City banks.

This sometimes means that when an unrealitic appraisal of a stock is already causing it to sell well above what a proper recognition of the facts would justify, the stock may stay at this too high level for a long period of time. Actually, from this already too high a price, it may go even higher. These wide variations between the financial community's appraisal of the stock and the true set of conditions affecting it may last for several years.

However, there will come a time when the bubble bursts. When a stock has been selling too high because of unrealistic expectations, sooner or later a growing number of stockholders grow tired of waiting. Their selling soon more than exhausts the buying power of the small number of additional buyers who still have faith in the old appraisal. The stock then comes tumbling down. Sometimes, the new appraisal is quite realistic. However, this re-examination is frequently evolved under the emotional pressure of falling prices, the negative is over-emphasized, leading to under valuation. It may take quite some time for a more favorable image to supplant the existing one.

It is important to note that in several instances what has shifted was the emphasis not the facts. Though, the facts too can change. A clearer picture develops when an investor ascribes price and intrinsic value to 2 different dimensions. The former is based on perceptions and the latter is based on reality.

For the purposes of clarity, I would define intrinsic value to be the amount that is justified by current facts. The reason I did not choose the absolute future cashflows is because there will be circumstances by which are not even reasonably foreseeable even by the extremely skilled investor.

Under such defintions, both price and instrinsic values are dynamic in nature. Though both are not the equivalent of each other, both can influence each other in several profound and important ways. The characteristics of a business intrinsic value will very much depend on the nature of the underlying business itself. Whereas for the price, much more will be due to behavioral traits of shareholders. With this picture in mind, the investor will have a clearer idea of how the stock market operates.

Thus, from here, arises an old Graham key principle.You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right. This principle effectively shows why regressing historical prices against an index does not produce any meaningful results. It is in direct conflict of the the traditional Capital Asset Pricing Model (CAPM).

This can be quite interesting philosophically, because if a huge amount of people is willing to pay $2 for a $1 bill for an extended period of time, does it make that $1 bill to be worth $2? Fuzzy logic but an important thought to hold.