Cognitive Dissonance

INVESTOR PSYCHOLOGY




Improve your investing by improving your way of thinking.





"Cognitive dissonance" is the name for anxiety caused by disconcerting thought processes. That is, when people are faced with facts that make them uncomfortable, they tend to ignore these facts, literally to the point of self-denial.

Cognitive dissonance is the reason why a mother won’t accept that her son is dead, even when the police are standing in the doorway telling her. Cognitive dissonance is the reason why a husband with an unfaithful wife will always be the last to know. It is why those in debt do not open their mail. It is why Al Capone thought he was a good person because he donated to charity. And, it is why Americans who wished to buy a home in 2006 (or already had one) insisted that there was no housing bubble, despite all evidence to the contrary.

It is a natural thing for people to seek confirmation of their existing beliefs. Finding facts to prove you are right is both satisfying and comfortable. This is why conservative Republicans watch Fox News, anti-globalization protesters read Noam Chomsky, and why environmental activists seldom read the Oil and Gas Journal. But in order to be a truly effective thinker, one must embrace cognitive dissonance by intentionally seeking disconfirming evidence. For many great thinkers, including investors Charlie Munger and George Soros, the best technique for embracing cognitive dissonance is a simple one known as “Inversion.”

Inversion states that in order to prove that something is true, you should try to prove it false; that is, for any strong belief that you have, regularly search for evidence you might be wrong. If you wish to buy a stock, for example, you would include a search for reasons not to buy it. You would read not just the glowing press releases about the company, but also seek out all negative facts about the company, and judge these facts without emotion. Only after finding no significant reasons not to buy the stock would you actually buy it.

Cognitive dissonance is not easy to overcome. You will be fighting natural human emotion every step of the way. Despite a lifetime of working on it, I have fallen prey at least twice, and will no doubt do so again. But by making a habit of questioning your own judgements and attempting to prove your own beliefs false, you will become a stronger and more reliable investor (and possibly a better person). Soon, you will find that your mental discomfort becomes a source of pride and pleasure, not to mention lucrative.
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“Faced with the choice between changing one’s mind and proving there is no need to do so, almost everyone gets busy on the proof.”
John Kenneth Galbraith

The Financial Reform Bill

THE GOOD, THE BAD, AND THE....WELL, YOU KNOW


Both Democrats and Republicans who voted for the bill say that it is not about "revenge" against Wall Street, but merely about prudent regulation and control. Are they right?

In this article, we review the details of the bill that changes everything.


The Good

No Compensation for Lies – Requires public companies to set policies to take back executive compensation based on inaccurate financial statements (if you have been cooking the books, you have to give back the money).

SEC Registration - Hedge Funds that manage over $100 million will now be required to register with the SEC and disclose financial data. This should lesson the amount of false disclosures and scams, common for hedge funds.

Skin in the Game – Requires companies that create securitized investment products (ex. buying crappy mortgages and selling them to others) to keep at least 5% of them on the books. If the product is awful, the company selling them will suffer too, even if just a little.

Consumer Protections – Various excellent amendments for consumers. For example, not allowing credit card companies to increase - without warning - interest rates on those who already carry balances.

Consumer Financial Protection Bureau – A board that watches for consumer scams and abusive financial practices, with the ability to autonomously write new rules and regulations.

UpFront Fund – Large institutions will pay into a fund, similar to deposit insurance, that will pay for the liquidation of a company should it fail (taxpayers will no longer pay). Until now, a financial firm could take out the equivalent of life insurance on a fellow firm, and then short-sell it to death. Now, the firm doing the killing will have to pay for it. Creating the fund will damage profits in the short term, but should enhance stability in the long term.

OTC Derivatives Clearing Houses – Former OTC derivatives will now be cleared on an exchange, similar to futures. That means fewer shady, under-the-table, interconnected deals. It also means fewer cases of institutions falling like dominoes.

Vote on Executive Pay – Gives shareholders a non-binding vote on executive pay, beyond the voting rights that shareholders currently have.


The Bad

SEC Review – Requires companies to provide a chart comparing their executive's compensation to stock performance over a 5-year period. This is a little unfair, since a company that is well run can still have mediocre stock performance. Having said that, I couldn't think of anything better myself.

Federal Reserve Oversight – The Federal Reserve will now oversee companies with assets of over $50 billion. Although the idea sounds good in theory, I’m leery of anything that causes the independent Fed to cozy up to large firms any more than they already do.

Tough to Get Too Big – Larger institutions (whose failure would create more of a threat to the overall system) will have stricter requirements for leverage, capital, and liquidity. This provision somewhat penalizes companies for getting large, which is something I don’t like. Many argue that it is a necessary evil.


The Ugly

Financial Stability Oversight Council – “Make Risks Transparent” mandate. The idea is that the council will identify systematic risks to the system before they occur. Yeah, right. If it were that easy, every financial crisis in history would have been avoided. The true crises are the ones you don’t see coming.

Office of Credit Ratings at the SEC – This office (more bureaucracy) is supposed to regulate the credit ratings agencies, and address poor performance. Good luck with that. No two analysts can look at a company and come to the same conclusion. Interestingly, the council actually has the authority to de-register a ratings agency for continued inaccuracy. Maybe in a few years all of today's ratings agencies will be gone.
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In all, I welcome the Financial Reform Bill. It is what consumers were demanding, much of it makes sense, and it could be a lot worse. Will it prevent another financial collapse? Of course not. But it should make a next one a little less disastrous.

For further information, see:
http://banking.senate.gov/public/_files/FinancialReformSummary231510FINAL.pdf

Thank you Sir, May I have Another?

It’s a terrible thing, to see a nice low limit order come tantalizingly close to being filled, only to see the stock market climb back up and away from your bid.

Financial news has been on a negativity-rampage for almost two weeks now (with a 2-day hiatus in the middle), and the markets have taken a good spanking.

Yesterday and today, news agencies pulled out all the stops, including interviews with Nouriel “Dr. Doom” Roubini, analyst Merideth Whitney (who called the market outlook “bleak,”) and even recycling frightening stories about housing from last year. Yet, the market retraced its decline today, with some financial stocks actually gaining.

Despite a stream of almost ridiculously negative headlines and advice (ex. “sell everything”), stock prices remain annoyingly unresponsive. The market is becoming desensitized. Stock news remains gloomy with stock prices to match, but another shock to the system is required.

With any luck, the U.S. financial reform bill will pass, creating enough anxiety for one more downward dive, and allowing the first tier of my low-ball orders to fill. In financial markets, one can only hope for the best of the worst.
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“You realize, you’re not in the analysis business, you are in the entertainment business.”
Fred Kittler of J.P. Morgan to analyst Andy Kessler, Wall Street Meat