Standard Deviations with Dr. Daniel Crosby

In this episode we look answer:

How do financial bubbles form?

How likely is a bubble to burst?

How can I know a bubble when I see one?

What seldom-uttered phrase can make you wealthier and more likeable?

Why did a bank robber use lemonade to commit crimes?

Why don't dumb people know how dumb they are?

Your brain is a miracle unrivaled by even the most sophisticated technology, but it is a miracle equipped for a different time and place. After millennia of fighting famine, war and pestilence, we now live in a society of greater and greater ease that is increasingly left to fight psychological battles. Obesity will kill more people this year than hunger. Suicide claims more lives annually than war, terrorism and violent crime combined. Your brain is still fighting a war won eons ago and you must steel it for a new battle that rewards patience and consistency over speed and strength.

Let me ask you a question, “Do you like laugh tracks?” Didn’t think so.

If laugh tracks are so universally disliked, why do Hollywood executives continue to include them? These executives understand something that we may not; however irksome canned laughter may be, it provides valuable social cues to viewers. Research has repeatedly shown that laugh tracks cause viewers to laugh longer and harder and to rate the viewing experience as more enjoyable. In fact, laugh tracks have been shown to be most effective at improving the appraisals of jokes that are especially bad! We are programmed to do what others are doing, even when those others only exist on tape.

How many decisions would you guess that you make in a given day? Take a second, mentally walk through your day and hazard a guess. Most people I ask this question land somewhere around 100, which is way off – try 35,000.

That’s right, you make 35,000 decisions per day.

Canonical models of decision-making deal with two types of decisions – certain (i.e., with a known set of alternatives with certain outcomes) and uncertain (just the opposite). In theory, decisions made under conditions of certainty involve ranking the known alternatives and choosing the most preferred option, simple enough.

Uncertain decisions operate from a similar theory, with the only kink being that subjective probabilities are assigned to the different outcome likelihoods. Thus, decision makers weigh the desirability of a given option by the chance that it will or won’t occur. These are nice ideas and make a certain amount of sense until you consider the sheer volume of decisions we make each day.

When you consider that you make 12,775,000 decisions each year, thinking that each determination is made by weighing its probabilistic utility starts to strain credulity. If making that many decisions sounds exhausting, the research supports that it is, which leads us to disproportionately stick with the familiar.

If bees organize by innate mandate and chimps through tight-knit social interactions, the miracle of human ascendance in the animal kingdom owes to a penchant for behaving in accordance with social narratives. To put it bluntly, we act as if the stories we make up are real.

As Harari writes in the magisterial Sapiens, “As far as we know, only Sapiens can talk about entire kinds of entities that they have never seen, touched or smelled.” A monkey can say, “There is a caribou by the river” but could never communicate that, “The caribou by the river is the spiritual guardian of our city.”

This ability to communicate about the unreal allows us to create all manner of social structures that help bring about predictable human behavior and that reliably breed trust. The State of Alabama, the Catholic church, the Constitution of the United States of America, the inalienable civil rights of man: none of these things are “real” in the strictest sense, but our shared belief in them and behaving as though they are real brings about orderly civilizations steeped in mutual trust. This ability to form and buy in to collective fictions is why, “…Sapiens rule the world, whereas ants eat our leftovers and chimps are locked up in zoos.”

If our dominance as a species is a function of our shared trust in fictions, there is one fiction in particular that reigns supreme: money. Harari pulls no punches, “Money is accordingly a system of mutual trust, and not just any system of mutual trust: money is the most universal and most efficient system of mutual trust ever devised.”

We’re all familiar with the term “keeping up with the Joneses” but it’s doubtful that we understand just how deeply ingrained this is in our concept of success and how the neurological processes we’ve touched on here contribute. Each year, a Gallup poll asks Americans to determine “What is the smallest amount of money a family of four needs to get along in this community?” Gallup finds that the answers to this question moves up in line with average incomes of the respondents. “Enough”, it seems, is a moving target that our flawed neurology won’t quite let us scratch. The amount of money we need to survive is just a little bit more than we have right now.

Our brains push us toward comparative notions of financial wellbeing that only provide transitory joy, but understanding our limitations is a first step toward making a different choice. Indeed, the Western tendency toward outward displays of wealth and comparative measurement is not endemic to all developed countries. Switzerland is just one example of a very wealthy country with a diametrically opposed philosophy relative to showy wealth. As opposed to the American mantra of, “If you’ve got it, flaunt it” the Swiss take an “If you’ve got it, hide it” approach so as not to provoke envy in others. The Swiss approach demonstrates that our views are an outcropping of a specific way of viewing wealth rather than something deterministic about human nature. We are not our worst impulses and it is up to us to determine to support each other on the way to balance and true happiness rather than prodding each other toward jealousy and excess.

“Daniel Kahneman helmed a Princeton study set out to answer the age-old question, “Can money buy happiness?” Their answer? Sort of. Researchers found that making little money did not cause sadness in and of itself but it did tend to heighten and exacerbate existing worries. For instance, among people who were divorced, 51% of those who made less than $1,000/month reported having felt sad or stressed the previous day, whereas that number fell to 24% among those earning more than $3,000/month. Having more money seems to provide those undergoing adversity with greater security and resources for dealing with their troubles. However, the researchers found that this effect (mitigating the impact of difficulty) disappears altogether at $75,000.

For those making more than $75,000 individual differences have much more to do with happiness than does money. While the study does not make any specific inferences as to why $75,000 is the magic number, I’d like to take a stab at it. For most families making $75,000/year, they have enough to live in a safe home, attend quality schools and have appropriate leisure time. Once these basic needs are met, quality of life has less to do with buying happiness and more to do with individual attitudes. After all, someone who makes $750,000 can buy a faster car than someone who makes $75,000, but their ability to get from point A to point B is not substantially improved. It would seem that once we have our basic financial needs met, the rest is up to us.”

How to Avoid Financial Scams

Stephen Greenspan is a psychologist and author of the Annals of Gullibility: Why We Get Duped and How to Avoid It. Greenspan’s book outlines notable instances of gullibility including the Trojan Horse, the failure to locate weapons of mass destruction in Iraq and the bad science surrounding cold fusion. Most of the book focuses on anecdotes, but the final chapter sets forth the anatomy of being fooled and attributes it to some combination of the following factors:

• Social pressures – Fraud is often committed within “affinity groups” such as people who hail from a similar religious background.

• Cognition – At some level, being duped represents a lack of knowledge or clarity of thought (but not necessarily a lack of intelligence).

• Personality – A propensity toward belief and difficulty saying “no” may lead people to be taken advantage of.

• Emotion – The prospect of some emotional payday (e.g., the thrill of making easy money) often catalyzes questionable decision-making.

In a candid assessment of his own gullibility, Greenspan wrote in the Wall Street Journal:

“In my own case, the decision to invest in the Rye fund reflected both my profound ignorance of finance, and my somewhat lazy unwillingness to remedy that ignorance. To get around my lack of financial knowledge and my lazy cognitive style around finance, I had come up with the heuristic (or mental shorthand) of identifying more financially knowledgeable advisers and trusting in their judgment and recommendations.

This heuristic had worked for me in the past and I had no reason to doubt that it would work for me in this case.

Greenspan has excellent insight into his own decision-making and motivation. He admits that he was relying on a shortcut (“Let other people think about it”) that had worked in the past, without considering why it might not work this time around. Likewise, the professionals in the story had no interest in critically examining a system that was making them look like geniuses! As Francis Bacon said beautifully, “The human understanding when it once adopted an opinion draws all things else to support and agree with it. And though there be a great number and weight of instances to be found on the other side, yet these it either neglects and despises or else by some distinction sets aside and rejects; in order that by this great and pernicious predetermination the authority of its former conclusions may remain inviolate.”

Just as Irvin Yalom found it difficult to entreat young lovers to think critically about the potential flaws in their relationship, it is nearly impossible to get someone who is making money to ask, “Why might I be wrong?”

There are three things that intelligent investors must understand if they are to truly inoculate themselves against the fear peddled by the profiteers of peril: corrections and bear markets are a common part of any investment lifetime, they represent a long-term buying opportunity and a systematic process is required to take advantage of them.

A “correction” is defined as a 10% drop in stock prices, whereas a “bear market” is defined as a 20% drop. Both definitions are entirely arbitrary, but inasmuch as they are widely watched and impact the behaviour of other investors, they are worth considering.

From 1900 to 2013, the US stock market experienced 123 corrections – an average of one per year! The more dramatic losses that are the hallmark of a bear market occur slightly less frequently, averaging one every 3.5 years. Although the media talks about 10% to 20% market losses as though they are the end of the world, they arrive as regularly as spring flowers and have not negated the tendency of markets to dramatically compound wealth over long periods of time.

It is incredible to consider that over that 100 plus years, one could expect both double digit annualized returns with attendant double digit percentage losses. This being the case, please repeat after me: “Bear markets are a natural part of the economic cycle and I should expect 15 to 20 in my lifetime.”

We rely on the crowd to do everything from run our governments to help us select a place to eat, but does the wisdom of the crowd apply to the stock market? By examining the anatomy of a good decision set forth by Richard Thaler we arrive at the conclusion that crowds are wise in some respects but can lead us astray in others.