Stocks & Happiness – Will We Never Learn?

    Authored by Nicholas Colas via DataTrekResearch.com,

    Every few months for the last +5 years I have watched Daniel Kahneman’s TED Talk titled “The Riddle of Experience Versus Memory.” Kahneman, you may recall, won the 2002 Nobel Prize in Economics despite having no degrees in the subject. That freedom from traditional dogma gave him and partner Amos Tversky an open field to develop Prospect Theory – the notion that humans make decisions based on potential losses and gains rather than rational expectations of final outcomes.

    A quick example. Would you rather:

    • Receive $ 100, no strings attached…

    • Or flip a coin where heads means you get $ 0 but tails nets you $ 250

    The expected value of the game is $ 125, and therefore greater than the $ 100 sure thing; classical economics says everyone should always take the coin toss. But in real life, many people choose the sure $ 100 because they anticipate the sense of regret they will feel if they lose the coin toss (“I just walked away from free money…”). Prospect Theory explained in a rigorous way – and for the first time – why humans don’t maximize utility at every turn.

    Kahneman’s TED talk is about a seemingly easy topic in comparison to Nobel Prize winning work: “Happiness”. What makes us happy? What should we do to be happier?

    As with Prospect Theory, Kahneman’s perspective is that human mental processing makes these questions more complex than we realize. His work concludes that we have two “selves” and the dichotomy between them is large:

    • The experiencing self. Right now your experiencing self is reading this note. After you are done, that same “in the moment” self will likely open another email and read that. Then it might talk to a friend or colleague or watch TV.

    • The remembering self. This part of your personality sits in the background of your daily existence, creating and refining stories that help you make sense of your life. Unlike your experiencing self, it deeply anchors your perceptions on change, emotion, and (most importantly) on how a given story ends.

    In the narrow confines of the “What makes us happy?” question, these two selves are very different.

    • Your experiencing self wants to be out with family and friends having a good time, however you choose to define that. If a survey taker happened to ask you “Are you happy in this moment?” you would reply with a hearty “Yes.” It would be true; the research shows such environments create “Peak happiness” for the experiencing self.

    • Your remembering self is very different. The analog survey question here is “Are you happy with your life?” That requires you to assess different questions, like “Am I achieving my life goals?” and “am I financially secure?”

    • Kahneman’s work shows just a 50% correlation between respondents who say they are happy “In the moment” and those who are happy “with their lives”. The two concepts are both important but are clearly not the same. We make a grave error when we try to conflate them.

    As investors, we all try to use our “remembering selves” and limit the impact of the “experiencing self”. The latter would sell everything after a few rough days. The former is supposed to be the rational, goal driven self that keeps us to our strategy and vision.

    That would work well if the “remembering self” were a robust and consistent partner, but it isn’t. Here are three major problems with it:

    #1. It is highly selective, and arbitrarily so. I remember exactly where I was during the March 2009 lows, and the Monday morning of the August 2015 flash crash. By contrast, I literally do not remember any individual trading day last year. Why? No volatility means no standout memories. And therefore nothing upon which the remembering self to build a story. I know the S&P 500 was +20% on the year, but only because I have run the numbers.

    #2. It is heavily dependent on how stories end. Like most investors and traders who have been in the game for a while, I have a “Do Not Trade” list. These are securities where I have tried to make money over the years and lost every time. Enough bad endings and the “remembering self” convinces you to alter your behavior. Go back to the Great Depression, and a whole swath of Americans swore they would never invest in the stock market again after being wiped out in 1929. Fast-forward to millennials today, and you see some of the same caution.

    #3. It sways decision making towards “Anticipated memories”. At one point in the TED talk, Kahneman poses a question: when planning a vacation, would you take the same trip if I told you that once completed I would wipe all memory of it from your brain?” If the answer is “No”, then you are taking the wrong vacation. Your “remembering self” is trying to hijack your “experiencing self” in that case.

    Take the recent market volatility as a case study in these points. Despite a different environment from 2008/2009, it was all too easy to anticipate a memory of another market decline like that one (Point #3). Last year’s low volatility environment made the early February swoon seem like a bolt out of a clear blue sky (Point #1). And there was certainly enough market commentary likening the action in volatility ETFs to past derivative-based market meltdowns that the “ending” seemed clear (Point #2).

    In the end, we find the best two ways to short-circuit these mental challenges are:

    • Don’t let the highly selective “remembering self” dismiss or delete important “market memories”. Jessica’s note below about historical market volatility is a good example of how to avoid that pitfall.

    • Banish the notion that “It’s never different this time” from your thought process – it is too powerful a call to elicit “anticipated memories”. That’s not a free pass to ignore the lessons of history (see the prior point), of course. But recognize that the “remembering self” is essentially lazy and forgets large chunks of time. Unplug it as much as possible, and follow your process.

    And, of course, don’t forget to let your “experiencing self” out as frequently as you can in your personal life.

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