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Why do people knowingly follow bad investment strategies?

I won’t ask (in this post) about why people hold foolish beliefs about investment strategies. I’ll focus on people who intend to follow a decent strategy, and fail. I’ll illustrate this with a stereotype from a behavioral economist (Procrastination in Preparing for Retirement):[1]

For instance, one of the authors has kept an average of over $20,000 in his checking account over the last 10 years, despite earning an average of less than 1% interest on this account and having easy access to very liquid alternative investments earning much more.

A more mundane example is a person who holds most of their wealth in stock of a single company, for reasons of historical accident (they acquired it via employee stock options or inheritance), but admits to preferring a more diversified portfolio.

An example from my life is that, until this year, I often borrowed money from Schwab to buy stock, when I could have borrowed at lower rates in my Interactive Brokers account to do the same thing. (Partly due to habits that I developed while carelessly unaware of the difference in rates; partly due to a number of trivial inconveniences).

Behavioral economists are somewhat correct to attribute such mistakes to questionable time discounting. But I see more patterns than such a model can explain (e.g. people procrastinate more over some decisions (whether to make a “boring” trade) than others (whether to read news about investments)).[2]

Instead, I use CFAR-style models that focus on conflicting motives of different agents within our minds.

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Book review: Are We Smart Enough to Know How Smart Animals Are?, by Frans de Waal.

This book is primarily about discrediting false claims of human uniqueness, and showing how easy it is to screw up evaluations of a species’ cognitive abilities. It is best summarized by the cognitive ripple rule:

Every cognitive capacity that we discover is going to be older and more widespread than initially thought.

De Waal provides many anecdotes of carefully designed experiments detecting abilities that previously appeared to be absent. E.g. asian elephants failed mirror tests with small, distant mirrors. When experimenters dared to put large mirrors close enough for the elephants to touch, some of them passed the test.

Likewise, initial observations of behaviorist humans suggested they were rigidly fixated on explaining all behavior via operant conditioning. Yet one experimenter managed to trick a behaviorist into demonstrating more creativity, by harnessing the one motive that behaviorists prefer over their habit of advocating operant conditioning: their desire to accuse people of recklessly inferring complex cognition.

De Waal seems moderately biased toward overstating cognitive abilities of most species (with humans being one clear exception to that pattern).

At one point he gave me the impression that he was claiming elephants could predict where a thunderstorm would hit days in advance. I checked the reference, and what the elephants actually did was predict the arrival of the wet season, and respond with changes such as longer steps (but probably not with indications that they knew where thunderstorms would hit). After rereading de Waal’s wording, I decided it was ambiguous. But his claim that elephants “hear thunder and rainfall hundreds of miles away” exaggerates the original paper’s “detected … at distances greater than 100 km … perhaps as much as 300 km”.

But in the context of language, de Waal switches to downplaying reports of impressive abilities. I wonder how much of that is due to his desire to downplay claims that human minds are better, and how much of that is because his research isn’t well suited to studying language.

I agree with the book’s general claims. The book provides evidence that human brains embody only small, somewhat specialized improvements on the cognitive abilities of other species. But I found the book less convincing on that subject than some other books I’ve read recently. I suspect that’s mainly due to de Waal’s focus on anecdotes that emphasize what’s special about each species or individual. Whereas The Human Advantage rigorously quantifies important ways in which human brains are just a bigger primate brain (but primate brains are special!). Or The Secret of our Success (which doesn’t use particularly rigorous methods) provides a better perspective, by describing a model in which ape minds evolve to human minds via ordinary, gradual adaptations to mildly new environments.

In sum, this book is good at explaining the problems associated with research into animal cognition. It is merely ok at providing insights about how smart various species are.

Book review: The Secret of Our Success: How Culture Is Driving Human Evolution, Domesticating Our Species, and Making Us Smarter, by Joseph Henrich.

This book provides a clear explanation of how an ability to learn cultural knowledge made humans evolve into something unique over the past few million years. It’s by far the best book I’ve read on human evolution.

Before reading this book, I thought human uniqueness depended on something somewhat arbitrary and mysterious which made sexual selection important for human evolution, and wondered whether human language abilities depended on some lucky mutation. Now I believe that the causes of human uniqueness were firmly in place 2-3 million years ago, and the remaining arbitrary events seem much farther back on the causal pathway (e.g. what was unique about apes? why did our ancestors descend from trees 4.4 million years ago? why did the climate become less stable 3 million years ago?)

Human language now seems like a natural byproduct of previous changes, and probably started sooner (and developed more gradually) than many researchers think.

I used to doubt that anyone could find good evidence of cultures that existed millions of years ago. But Henrich provides clear explanations of how features such as right-handedness and endurance running demonstrate important milestones in human abilities to generate culture.

Henrich’s most surprising claim is that there’s an important sense in which individual humans are no smarter than other apes. Our intellectual advantage over apes is mostly due to a somewhat special-purpose ability to combine our individual brains into a collective intelligence. His evidence on this point is weak, but it’s plausible enough to be interesting.

Henrich occasionally exaggerates a bit. The only place where that bothered me was where he claimed that heart attack patients who carefully adhered to taking placebos were half as likely to die as patients who failed to reliably take placebos. The author wants to believe that demonstrates the power of placebos. I say the patient failure to take placebos was just a symptom of an underlying health problem (dementia?).

I’m a bit surprised at how little Robin Hanson says about the Henrich’s main points. Henrich suggests that there’s cultural pressure to respect high-status people, for reasons that are somewhat at odds with Robin’s ally/coalition based reasons. Henrich argues that knowledge coming from high-status people, at least in hunter-gatherer societies, tended to be safer than knowledge from more directly measurable evidence. The cultural knowledge that accumulates over many generations aggregates information that could not be empirically acquired in a short time.

So Henrich implies it’s reasonable for people to be confused about whether evidence based medicine embodies more wisdom than eminence based medicine. Traditional culture has become less valuable recently due to the rapid changes in our environment (particularly the technology component of our environment), but cultures that abandoned traditions too readily were often hurt by consequences which take decades to observe.

I got more out of this book than a short review can describe (such as “How Altruism is like a Chili Pepper”). Here’s a good closing quote:

we are smart, but not because we stand on the shoulders of giants or are giants ourselves. We stand on the shoulders of a very large pyramid of hobbits.

Book review: Bonds That Make Us Free: Healing Our Relationships, Coming to Ourselves, by C. Terry Warner.

This book consists mostly of well-written anecdotes demonstrating how to recognize common kinds of self-deception and motivated cognition that cause friction in interpersonal interactions. He focuses on ordinary motives that lead to blaming others for disputes in order to avoid blaming ourselves.

He shows that a willingness to accept responsibility for negative feelings about personal relationships usually makes everyone happier, by switching from zero-sum or negative-sum competitions to cooperative relationships.

He describes many examples where my gut reaction is that person B has done something that justifies person A’s decision to get upset, and then explaining that person A should act nicer. He does this without the “don’t be judgmental” attitude that often accompanies advice to be more understanding.

Most of the book focuses on the desire to blame others when something goes wrong, but he also notes that blaming nature (or oneself) can produce similar problems and have similar solutions. That insight describes me better than the typical anecdotes do, and has been a bit of help at enabling me to stop wasting effort fighting reality.

I expect that there are a moderate number of abusive relationships where the book’s advice would be counterproductive, but that most people (even many who have apparently abusive spouses or bosses) will be better off following the book’s advice.

Book review: Leadership and Self-Deception: Getting out of the Box, by the Arbinger Institute.

In spite of being marketed as mainly for corporate executives, this book’s advice is important for most interactions between people. Executives have more to gain from it, but I suspect they’re somewhat less willing to believe it.

I had already learned a lot about self-deception before reading this, but this book clarifies how to recognize and correct common instances in which I’m tempted to deceive myself. More importantly, it provides a way to explain self-deception to a number of people. I had previously despaired of explaining my understanding of self-deception to people who hadn’t already sought out the ideas I’d found. Now I can point people to this book. But I still can’t summarize it in a way that would change many people’s minds.

It’s written mostly as a novel, which makes it very readable without sacrificing much substance.

Some of the books descriptions don’t sound completely right to me. They describe people as acting “inside the box” or “outside the box” with respect to another person (not the same as the standard meaning of “thinking outside the box”) as if people normally did one or the other, we I think I often act somewhere in between those two modes. Also, the term “self-betrayal”, which I’d describe as acting selfishly and rationalizing the act as selfless, should not be portrayed as if the selfishness automatically causes self-deception. If people felt a little freer to admit that they act selfishly, they’d be less tempted to deceive themselves about their motives.

The book seems a bit too rosy about the benefits of following it’s advice. For instance, the book leaves the reader to imagine that Semmelweis benefited from admitting that he had been killing patients. Other accounts of Semmelweis suggest that he suffered, and the doctors who remained in denial prospered. Maybe he would have done much better if he had understood this book and been able to adopt its style. But it’s important to remember that self-deception isn’t an accident. It happens because it has sometimes worked.

Book review: Drive: The Surprising Truth About What Motivates Us, by Daniel H. Pink.

This book explores some of the complexities of what motivates humans. It attacks a stereotype that says only financial rewards matter, and exaggerates the extent to which people adopt that fallacy. His style is similar to Malcolm Gladwell’s, but with more substance than Gladwell.

The book’s advice is likely to cause some improvement in how businesses are run and in how people choose careers. But I wonder how many bosses will ignore it because their desire to exert control over people outweighs their desire to create successful companies.

I’m not satisfied with the way he and others classify motivations as intrinsic and extrinsic. While feelings of flow may be almost entirely internally generated, other motivations that he classifies as intrinsic seem to involve an important component of feeling that others are rewarding you with higher status/reputation.

Shirking may have been a been an important problem a century ago for which financial rewards were appropriate solutions, but the nature of work has changed so that it’s much less common for workers to want to put less effort into a job. The author implies that this means standard financial rewards have become fairly unimportant factors in determining productivity. I think he underestimates the importance they play in determining how goals are prioritized.

He believes the changes in work that reduced the importance of financial incentives was the replacement of rule-following routine work with work that requires creativity. I suggest that another factor was that in 1900, work often required muscle-power that consumed almost as much energy as a worker could afford to feed himself.

He states his claims vaguely enough that they could be interpreted as implying that broad categories of financial incentives (including stock options and equity) work poorly. I checked one of the references that sounded like it might address that (“When performance-related pay backfires”), and found it only dealt with payments for completing specific tasks.

His complaints about excessive focus on quarterly earnings probably have some value, but it’s important to remember that it’s easy to err in the other direction as well (the dot-com bubble seemed to coincide with an unusual amount of effort at focusing on earnings 5 to 10 years away).

I’m disappointed that he advises not to encourage workers to compete against each other without offering evidence about its effects.

One interesting story is the bonus system at Kimley-Horn and Associates, where any employee can award another employee $50 for doing something exceptional. I’d be interested in more tests of this – is there something special about Kimley-Horn that prevents abuse, or would it work in most companies?

Book review: Hierarchy in the Forest: The Evolution of Egalitarian Behavior, by Christopher Boehm.

This book makes a good argument that a major change from strongly hierarchical societies to fairly egalitarian societies happened to the human race sometime after it diverged from Chimpanzees and Bonobos. Not due to any changes in attitudes toward status, but because language enabled low-status individuals to cooperate more effectively to restrain high-status individuals, and because of he equalizing effects of weapons. Hunter-gatherer societies seem rather consistently egalitarian, and the partial reversion to hierarchy in modern times may be due to the ability to accumulate wealth or the larger size of our societies.

He provides a plausible hypothesis that this change enabled group selection to become more powerful than in a typical species, but that doesn’t imply that group selection became as important as within-group selection, and he doesn’t have a good way of figuring out how important the effect was.

He demonstrates that humans became more altruistic, using a narrow biological definition of altruism, but it’s important to note that this only means agreeing to follow altruistic rules. He isn’t able to say much about how well people follow those rules when nobody notices what they’re doing.

Much of the middle of the book recounting anthropological evidence can be skipped without much loss – the most important parts are chapters 8 and 9.

Book review: Happiness from the Inside Out: The Art and Science of Fulfillment by Robert Mack.

This easy to read book describes many of the approaches I’ve used to make myself happier. That makes me somewhat tempted to believe the rest of his advice, but he seems to exaggerate enough that I have some doubts.

Being less concerned about what others think of me is an important part of his advice. But it seems implausible that I can be completely unharmed by other peoples opinions of me. He seems to believe that it’s possible to have a romantic relationship without risking being disappointed by one’s partner. I can somewhat reduce my emotional reaction to a partner not acting as I expected, but complete detachment would seem to make it hard for me to sympathize with a partner when appropriate.

There’s plenty of peer pressure for people to claim to be less susceptible to peer pressure than they actually are, so many people will be unaware of how to reduce those influences. This book’s focus on optimism is likely to distract people from such unflattering insights. You should look elsewhere for awareness of your desires for status, and choose wisely which status hierarchies you want to care about.

His paints a misleadingly gloomy picture of long-term happiness trends in the U.S., by selective evidence such as rising teen suicide rates, but not the fact that overall suicide rates are lower than a few decades ago.

His discussion of the genetic influence on happiness is unnecessarily discouraging. He mentions height as a stereotypical trait influenced by genes. I suggest thinking about hair color – it’s probably more influenced by genes than happiness, yet people who decide their hair should be purple often succeed quickly.

His claim that “Happiness is a particularly personal journey and no amount of data or research can tell you what will bring you happiness” is somewhat misleading – see the book Stumbling on Happiness for a very different perspective.

Impro

Book review: Impro: Improvisation and the Theatre, by Keith Johnstone.

This book describes aspects of the human mind and social interactions which actors often need to analyze more explicitly than others, because actors need to be aware of the differences between various roles/personalities that they play, whereas unconscious understanding is adequate for people who only interact as a single personality.

The best chapter is about status, and emphasizes the important role that status games play in most social situations and how hard it is to be aware of one’s status-related behavior.

One disturbing claim he makes is that “acquaintances become friends when they agree to play status games together”. I’m very tempted to deny that I do that (as he predicts most people will deny acting). But I know there’s more happening in social interactions than I’m aware of, so I’m hesitant to dismiss his claim.

The chapter on spontaneity has apparently important insights about the role self-censorship plays in spontaneity and creativity. But I find it hard enough to change my behavior in response to those insights that I can’t be confident he’s correct.

He has the insight that “personality” functions as a public-relations department for the mind. Personality doesn’t seem like quite the right word here, but this is remarkably similar to an idea that Geoffrey Miller later developed from evolutionary theory in his excellent book The Mating Mind.

The chapter on masks and trance is strange and hard to evaluate.

Book review: Finding Alpha: The Search for Alpha When Risk and Return Break Down by Eric Falkenstein.

This book presents mostly convincing arguments that refute the basic principle of CAPM that riskier investments are rewarded with higher returns, and the relation between risk and returns is better explained by modeling investors as wanting high returns relative to other investors rather than high absolute returns. But the quality of the arguments is quite variable. Much of the book assumes a good understanding of finance theory. If you don’t understand the importance of a Sharpe ratio, you’re not in his target audience.

I was not convinced by his most heavily emphasized empirical claim, that returns on equities are unrelated to beta because controlling for size eliminates the apparent relation. There’s enough connection between size and risk that this raises many questions he doesn’t answer (e.g. JB Berk, A critique of size-related anomalies). But later on he devotes a chapter to a wide variety of evidence that overcomes these concerns, and somewhat supports his claim that for riskier investments, the correlation between risk and return is negative (for the safest investments, it’s positive). And the authoritative Fama and French paper has more convincing evidence about beta – even without controlling for size, the correlation between beta and returns vanished during the 1963 to 1990 period.

He claims that the equity risk premium is effectively zero for a typical investor. His attempt to add up the different adjustments is confusing. He concludes with a table showing size adjustments to that standard estimate that add up to a mind-boggling 15 percent, which would result in a “premium” of -9 percent or so. But adding them is clearly wrong – the tax adjustment assumes the absence of some of the other adjustments. Still, the arguments he assembles from other researchers imply a good chance that the sign of the equity risk premium varies with the time period over which it’s measured.

He suggests some strategies to invest more wisely as a result of the ideas he presents, which he aptly summarizes as “selling hope relative to the market” (i.e. treating volatile stocks as overpriced due to a hope premium). But claiming this produces “superior returns, with less risk however measured” is too strong. Financial risk is not the only relevant measure of risk. Following his advice has social risks that he hints at elsewhere. Being invested in boring stocks in a bubble impairs your ability to engage in some interesting conversations, and you won’t make up for that by mentioning how you outperform the market in times when other want to avoid remembering their investments. Is it possible to minimize both kinds of risks by investing token amounts in ways that trendy folks are talking about, and investing most of your money to maximize your Sharpe ratio? Or does that require too much cognitive dissonance?

The book encourages pessimism, especially about the effects of people wanting relative wealth, and makes disturbing claims such as “Envy is necessary for compassion”.

He provides a number of other good ideas about investing, such as the possibility that the internet bubble adds a big anomaly to many data sets used for backtesting.