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A Few Notes on Investing and the Irrational Mind

April 6, 2011 • Posted in Animal Spirits

In his 2011 book Investing and the Irrational Mind: Rethink Risk, Outwit Optimism, and Seize Opportunities Others Miss, author Robert Koppel posits that investing has “less to do with the science of computation and more to do the art of managing one’s outlook, emotions, and consciousness.” He seeks to explain “how to overcome debilitating emotions, irrational biases, and investment fallacies and arrive at an understanding of overall market risk through an approach that identifies, assesses, and controls losses. …how we can master our irrational minds to gain the skills necessary to control our financial decisions.” Some notable points from the book are:

From Chapter 2, “The Inner Game” (Page 29): “Success requires focused concentration that permits unbiased perception of the market, fortified by a system of personal beliefs that allows the investor to simulate the feeling of being in control.”

From Chapter 3, “Hardwired and Irrational” (Pages 44, 46): “The answer from neuroeconomics is that the best investment results come from understanding the irrational nature of our brains in order to strike a balance between emotion and reason. …It is precisely because our brain is hardwired to respond in ways that it judges to be in our best interest that it causes us to be impulsive, inconsistent, disorganized, and irrational in situations involving risk. That is also why, although you may be able to recite all the correct market axioms, it will always be difficult to put them into practice.”

From Chapter 4, “A User’s Guide to the Brain” (Page 57): “…success depends on a strong subjective awareness of yourself as well as an objective understanding of the market (which is made up of others), armed with strategy and risk control without fear or wishful thinking.”

From Chapter 5, “The Market: It’s a Jungle Out There” (Pages 67, 78): “…our brains view the market as an issue of life-or-death survival rather than one of arithmetic problem solving. …it will serve us well to remember how easily investors are seduced and injured by the call of the wild.”

From Chapter 7, “Defining the Big Picture” (Pages 112, 113): “…the best way to overcome…psychological challenges is to obtain what professional traders call an ‘edge.’ an edge is the investor’s leg up on the competition, a particular point of focus that provides a subjective advantage and point of entry into the market. …your edge derives not only from your investment style and game plan, but, most important, from your psychology.”

From Chapter 8, “Cognitive Biases” (Pages 121, 134): “It is only through awareness and an intellectual and emotional commitment to change that we can begin to overcome the potential pernicious effects of our individual biases. …No matter how much we know about markets, there is always more to learn about ourselves.”

From Chapter 10, “Illusions” (Page 169): “Awareness alone will not allow you to overcome…cognitive distortion. …commitment to improve and repeated trial and error are the ultimate recipe for overcoming illusions’ undesirable effects.”

From Chapter 11, “Taking a Loss” (Pages 173, 185): “…knowing how to take a loss is the hardest and most important lesson that an investor has to learn. …this means beginning to see them as an intrinsic, inevitable part of investing and not as disruptive or failed events.”

From Chapter 12, “Risky Business” (Page 202): “There are many successful approaches and techniques for managing risk. The real difficulty is finding one that works for you. It could be systematic or discretionary, but it needs to suit you in order to protect you from yourself, that is, from your natural biases and your predispositions to act in a self-sabotaging way.”

From Chapter 13, “The Power of Intuition” (Pages 214, 220): “As investors, it is critical for us to appreciate the critical role that intuition plays in making better decisions. The essential point is that intuitions should not be blindly followed by novices, but rather should be understood as vital to our decision making in a way that cannot be replaced by analysis or procedure. …I would argue for using analysis to support intuition, as opposed to the other way around.”

From Chapter 15, “The Psychological Challenge” (Pages 253, 254): “…as validated by behavioral economics and neuroscience, investing is recognized as having less to do with the science of computation and more to do with the art of managing one’s outlook, emotions, and consciousness.”

In summary, while focused on professional investing, Investing and the Irrational Mind is a reasonably comprehensive and well-cited treatment of individual survival in the jungles of any occupation or mission. Its advice is not formulaic, and thus difficult to test.

Reservations about the book include:

  • The ultimate retreat into art from science is deflating for readers seeking rules for systematic improvement.
  • While frequently citing formal research, the book bases some notable points on interviews with well-known (successful) traders, who are each subject to personal confirmation bias. This bias vitiates discrimination between critical success factors and coincidences. A more controlled approach would compare and contrast successful and unsuccessful traders.
  • A nagging intuition suggests that the assertion of “debilitating emotions, irrational biases, and investment fallacies” derives from a definition of rationality that assumes idealized distributions of outcomes applied to constrained samples. In other words, our brains may be well-tuned to the empirical long-run distribution of jungle outcomes but not to modeled distributions constructed from little sections of jungle over short periods. In even other words, researchers bounded by available data may not outshine natural selection in defining rationality.
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