Fourth is mental compartments. So, Hurt Shefrin and Richard Thaler said that people- these are economists now talking about investors, that people don't look at the whole portfolio the way the capital asset pricing model assumed. The theory says that you shouldn't care about what your whole portfolio does, what's it's expected return and what's at variance. But that's not the way people think. In fact, Shefrin and Statman said that people have two portfolios often, or maybe even more than two- men talk about- but let's just talk about two. You have a safe part of your portfolio that you will not risk and you have a risky part that you can have fun with. In fact, some people even said I talked to my spouse and we agreed that I can have fun investing for 20 percent of my- of our portfolio. Again, see that's totally at variance with. And then at cocktail parties he or she will boast about how the fun portfolio did, rather than talk about the- They don't talk about the overall thing, that's boring. So option salesmen trying to get you to buy a put on a single stock and they will advertise it to you in such a way that does not make any reference to the impact this will have on your whole portfolio, which is probably minuscule. They don't think that way. Fifth is attention anomalies, and that is that we tend not to pay atten- But first of all, psychologists have long understood that you can't pay attention to everything. You have to decide, "Am I going to pay attention to the stock market? Should I watch it every day or is it a waste of my time? Should I be watching other things?" So, the problem is that too many people watch the stock market every day and if the market moves a lot, then they will even pay more attention to it even though a day to day move is irrelevant, generally. There's a social basis for attention and that is that you tend to pay attention to the same things that other people pay attention. Now this social basis for attention may have evolved for a good reason. So for example in a primitive caveman society, if somebody else is looking." What's that over there?" You'll look too. So will everybody. Maybe it's maybe it's a wolf coming to attack or who knows what it is. So we have that tendency to pay attention to everyone else at the same time. But what that means is, there's going to be mispricings in markets. If everyone is paying attention to some stock, it creates the probability that it will be overpriced. Now, in finance we tend to talk about the no arbitrage assumption, that is, that there is no way to make money without risk- no 10 dollar bills lying around on the sidewalk. That works counter to a- This is a theory that is not so vulnerable to attention anomalies. Have you ever found a $10 bill lying on the sidewalk? Probably not. Right? Maybe you have once in your life. Doesn't happen very often. That's because somebody will pick it up before you got to it. We do have an ability to pay attention to independently of others. So $10 bills get picked up. That means there's no sure money machine. But when it comes to more ambiguous investing, then we become vulnerable to the attention anomaly. So, some stocks get overpriced and others are just forgotten, they're underpriced because people aren't thinking about them. Anchoring refers to a tendency in ambiguous situations to allow one's decisions to be affected by some anchor. So, the famous experiment that Kahneman and Tversky did involved a device called the Wheel of Fortune, which you might see on quiz shows. So what they did is they had a- they had a wheel with the numbers that were maybe 1 to 100 on the wheel, and the guy would spin the wheel and it would stop randomly on some number between 1 and a 100. So this is their experiment. They ask them questions that had numerical answers between 1 and a 100. So one of the questions was, "what percent of African nations belong to the United Nations?" Okay? Most people haven't thought about that. Then they spin the wheel but they said, before you answer I want-I am just going to spin this wheel, ignore it. But they spin the wheel and it comes up with a number between 1 and a 100 and then Okay, now I want to hear the answer to your question. People tended to give a number close to the one that just came up on the wheel. Amazing. So then after the experiment, they pointed it out after the experiment was over they said, "did you know that you tended to pick a number close to the wheel?" And they would say, "no I didn't, I wouldn't pay attention to that." It was subconscious. They were influenced by it, that's anchoring. So it it's the same way I think with stock prices, that stock prices are anchored to past values. Nobody knows what this company is worth but it was worth something yesterday. And so, our opinions tend to be influenced by anchoring just as they were in the Kanneman and Tversky experiment. So, companies know that stock prices are anchored to past values. They also like to do splits with a- if a stock reaches $60 a share, they'll split it so that it becomes $30 a share just because that seems to be a good solid anchor. I formed a company with my student here at Yale, Alan Weiss- Case-Shiller Weiss incorporated in 1991. And shortly after in the late 1990s, we were trying to raise money for our company and we went to an investment bank that was- heard us out. And he said, "Well, maybe we can come up with money for your business but, could you consider changing the name of your company? I don't want it to be CSW inc. We want to be CSW.com. Now, if you know this is the dotcom bubble days in the late 1990s. So we had a meeting at our company. Should we change the name? We had a website in the late 90s, so we could call ourselves dotcom. We were selling on the web. But we didn't do it. That was fake. That was trying to anchor us to the dot.com stocks. But you know there was a horrible dot.com bubble at the at the end of the 90. People would pay anything for a dot.com company. So it just didn't make a lot of sense. Seven is the Representativeness Heuristic. People judge things by familiarity to familiar types. So, there was a famous example illustrating the representativeness in heuristic, this is Kanneman and Tversky again. They described people in terms of their characteristic and then asked you to guess their occupation. For one of the persons for example, they describe a woman and said that she is sensitive, artistic. Okay. And then, you're asked the, what would you just guess her occupation is? And the choices involved bank teller or sculptress. Well, people tended to take sculptress rather than bank tellers. Now Kanneman and Tversky said, "That's totally wrong, because there are so many more bank tellers than there are sculptresses." It's not not a rational choice. But they looked to see the best fit rather than what is statistically probable. So for example, 1929 stock market crash is still widely remembered. I don't know how well it is remembered for your generation but you've heard of it. Right? So you tend to look to see is it 1929 again? And if it fits 1929, you exaggerate the probability that we're fist facing 1929 again. The disjunction effect is the inability to make decisions in advance in anticipation of future information. So for example, Shafir and Tversky actually did experiments with Samuelson's lunch colleague bet. But then they did a variation of the experiment, they asked people to decide in advance whether they'll take the second bet. And then most would not take the second bet before they knew the outcome of the first bet. What I'm saying is people couldn't understand how they will feel later. They don't anticipate their emotions later. So, they can't work through a decision tree correctly. So, with these biases people have, do you think there's any way to try to mitigate them? Or do you think it's better to try to accommodate them when we think about planning for our financial futures? Well, one thing that we can do is financial education. And that is important. Many people- there have been studies of the level of knowledge among the general population of financial basics and the general conclusion is, it is extremely low. For example, it's pointed out that people don't understand compound interest. But it goes even beyond that, they don't even understand- a lot of people, maybe a minority. A lot of people if you say, "If the interest rate is 2 percent and there's no compounding, how much do you have after five years?" They can't answer that. They'll say 2 percent. So, I mean- I don't mean to be disparaging of these people, but there is a definite need for financial education. We also have to try to get a standard for presentation of facts about investments to people that are done in a way that's not exploitive or manipulated. And we already have a lot of- they go back a long time, rules about how advertising can work and for financial products. It's a difficult situation. But hey, we have a lot of young professionals who can work as regulators. And it's not just government regulation, it's also self-regulation within the industry. Things like better business bureaus and chambers of Commerce that impose a higher standard on business.
