Archive for the ‘Thinking Tools’ Category

Epistemic arrogance, running through traffic lights & Black Swans

Thursday, November 25th, 2010

Today, we received an email from one of our readers. After reading Failure to understand Black Swan leads to fallacious thinking, this is what he thought:

I liked your use of the term “Epistemic arrogance”. Recently I was driving and almost ran straight through a red light at a pedestrian crossing and I was trying to think how I could have been so reckless. I mean I am a great driver (?) and I had been down that road numerous times, yet I still almost managed to run down an almost-unfortunate couple. Sure the red light is in a seemingly random position, and the green light at the intersection 50m down the road can cause very slight confusion, but a red light is a red light.

Its then I theorised the issue. If it was my first time driving, or my first time driving down this road, there would be no way that I would have missed this red light. I would watch out for all hazards because I know that I don’t know. An arrogant driver on the other hand, as I was, thinking they know the lay of the land, can get into strife when the unexpected (in their mind) pops up.

Its this “epistemic arrogance” which leads the learned to cause crashes and accidents… I’m sure there are many top minds in the world who fail to look beyond their view… Learning from one’s mistakes is a great way to improve your management of risk!

This is a very great point. And by the way, it is Nassim Nicholas Taleb that came up with the term “”epistemic arrogance.”

We also have an example that is relevant to investing. Marc Faber once mentioned that the financial valuation of asset prices severely underestimate the possibility of geo-political Black Swans. The recent North Korean artillery pot-shots at their southern neighbour is a case in point. The US and South Koreans are planning to hold military exercises this coming Sunday in response to North Korea’s provocation. The North Korean had already warned repeatedly that they will be provoked with such actions, especially when they are happening so closely to the border. With a juvenile rookie dictator-in-waiting probably calling the shots in Pyongyang, we wonder at the wisdom of the American and South Koreans.

The Korean peninsular is just one example of geo-political Black Swans. We can also include Afghanistan, Lebanon, Iran, Pakistan as well.

Another biased media report: home loans on the rise?

Tuesday, July 13th, 2010

In our report, How To Foolproof Yourself Against Salesmen & Media Bias, we wrote about how the media uses headlines to slip in their bias.

Well, here is a great example from this article in the Sydney Morning Herald (SMH)- Home loans on the rise:

The number of home loans issued to borrowers have marked their first rise in eight months are buyers looked beyond higher interest rates to wade back into the market. In a sign of caution, though, the size of a typical loan shrank.

In an another article from the SMH- Home loans up for first time in eight months:

A WEAK spot in the property market is showing tentative signs of recovery, after a surprise bounce in new lending to home buyers.

The headlines from the Daily Telegraph isn?t much better.

Despite the positive spin in these headlines, there?s a little detail that caught our eye. What is it?

These paragraphs were tucked in Home loans on the rise:

The monthly rise also masked some mixed trends including a surge of refinancing sparked by lower 3-year fixed rate loans, said Westpac senior economist Andrew Hanlan.

Excluding refinancing, the May figure is up only 0.8 per cent, following a 0.1 per cent fall in April, according analysis by Westpac.

Borrowing for owner occupied housing also edged down 0.3 per cent to $13.7 billion, seasonally adjusted.

In other words, most of the ‘rise’ in home loans are due to refinancing. Refinancing basically means ‘closing out’ the existing loan and taking out a new loan. The headline number included the refinanced new loan but does not subtract the old loan that was ‘closed out.’

Arguably, when refinancing increases, it is a sign of financial stress as borrowers tend to refinance themselves out of problems first before trying other options. Although this may or may not be the case for the majority of refinancing, at the very least, the reality is not as positive as what the headline implies.

We shall see.

Should precise percentage of odds (of whether something will happen) be treated as nonsense?

Tuesday, June 29th, 2010

Recently, we saw an article that reported,

There is a 10 percent to 20 percent chance of BP being taken over,? said Gudmund Halle Isfeldt, an Oslo-based analyst at DnB NOR ASA, in an e-mailed note this week.

Whenever we read about analysts stating precise odds about whether certain event will happen (e.g. takeover, interest rates movement), we get very suspicious. How do they come up with such precise percentage? More importantly, are these kinds of precise numbers valid in the first place? If not, why?

To answer this question, let?s go back to the very basics.

Consider the odds of a dice showing up a ?1? on a throw. Obviously, the odds are 1/6. What if you do not know that the dice has 6 sides and instead, incorrectly think that there are only 5 sides on it? In that case, your computation of the odds (1/5) will be wrong. What if, you correctly understand that the dice has 6 sides but instead, do not know that the dice is loaded? In this case, your computation of the odds (1/6) is wrong because the dice is biased.

In both cases, there is a gap between how much you think you know and how much you actually know. The wider the gap, the more wrong your computation of the odds will be. As we quoted Nassim Nicholas Taleb in Failure to understand Black Swan leads to fallacious thinking,

Epistemic arrogance bears a double effect: we overestimate what we know, and underestimate uncertainty, by compressing the range of possible uncertain states (i.e. by reduce the space of the unknown).


I remind the reader that I am not testing how much people know, but assessing the difference between what people actually know and how much they think they know.

Whenever an analyst give such precise percentage for the odds of whether something will happen, he is implying that the gap between how much he actually know and how much he thinks he knows is very small. Perhaps it is true that he is really that knowledgeable. But it is very common for humans to underestimate the size of that gap when it comes to assessing themselves.

In the case of assessing the odds of a corporate takeover that has implications on national interests, perhaps something is happening secretly within the inner recesses of corporate and political machinery? Chances are, if the analyst is privy to the secret happenings, he will have to drastically change his assessment of the odds. If not, his assessment is like assessing the odds of a dice while not knowing it is loaded. When analysts show their confidence by giving such precise percentages, we can?t help but wonder whether he is falling into Ludic Fallacy (see How To Foolproof Yourself Against Salesmen & Media Bias).

For investors, they are at a disadvantage. You see, when assessing the odds of a dice throw, you can easily verify whether your assessment is correct or not (e.g. whether the dice is loaded) by repeating the throw many times and then use statistical analysis to check the results. But what about assessing whether BP will be taken over? Unfortunately, this event, if it happens, will only happen once. That means there?s no way you can verify the analyst?s number. For example, if the analyst said that there?s a 91.32 percent change that BP would be taken over and if that event did not happen, there?s no way you could prove that the analyst got the number very wrong. He could argue that it is due to sheer bad luck that it did not happen.

Thus, whenever analysts give such precise percentage of odds, ponder how big the gap is.

Hoodwinked by Craig James’s “CommSec National Performance Gauge”

Thursday, March 25th, 2010

Just this week, CommSec’s Chief Economist, Craig James released a CommSec National Performance Gauge that purportedly declared that Australia have never had it so good (as at end of 2009). According to this news media article, Craig James was quoted as saying,

The CommSec National Performance Gauge attempts to fill the void by focusing on issues that matter to ordinary Aussies. That is, financial decisions like buying a car or house, filling up the car with petrol, the state of the job market, wages and confidence levels.

That gauge takes seven measures, of which four of them involves spending capacity. Among the four, one of them is on car affordability. As that article reported,

The gauge shows that car affordability is the strongest in 35 years, taking a person on the average wage just under 30 weeks to buy a new Ford Falcon, down from 36 weeks five years ago.

The idea is that as the number of weeks an average worker earns to buy a car decreases, the ‘better’ and ‘more’ well-off’ this measure indicates. A car is probably chosen because it is representative of the material well-being of Australians. According to our friends at FN Arena (please note that the original article has an overall air of sarcasm against Craig James’ gauge),

But in the wider cohort, income per capita is up 6% over five years and retail spending up 7%. Today it takes 30 weeks of average wages to buy a new Falcon, down from 36 weeks five years ago and the most affordable level in 35 years. It takes 1.58 weeks of average wages to make one average mortgage payment, which despite ?unaffordability? cries is the same level of five years ago. And despite rising oil prices, drivers can afford 7% more petrol from the average wage than five years ago.

That sounds correct right?

Unfortunately, if you’re not careful, you can fall for a mental pitfall here. Even Craig James was reported to qualify his exuberance by saying, “that is probably a big call and one that would attract a lot of discussion.”

So, what is the mental pitfall trap hidden within this performance gauge that can lead you astray?

Remember there’s a mental pitfall called Lazy Induction in our report? There, we wrote,

The trouble starts when the sample that we used for our observations is drawn from our own personal bias. Then, from the observations of the biased sample, we make generalisations based on our flawed observations.

In Craig James’ CommSec National Performance Gauge, what is the basis for including or excluding specific consumer goods for use in the measure? For example, why is the price of Falcon (relative to income) used as a measure and not, say, your insurance premium (which is going up)? Or food & groceries (which are going up and arguably more important than a Falcon)? Or house prices (which are going up relative to income in Australia)? Or how about notebook computers, which are steadily falling in prices over the years (which will certainly boost the affordability measure). Or your electricity/gas/water bills (which are going up)? In other words, improvements in these seven measures of the gauge cannot be generalised into improvements in the standard of living of Australians in general. Some of the included measures are important only to some Australians. Some of measures that are not included in the gauge are important to some Australians. Therefore, depending on which measures to include in the gauge, bias can be introduced.

The issue with Craig James’ CommSec National Performance Gauge is the same with the construction of the consumer price inflation index. As we quoted Ludwig von Mises in How much can we trust the price indices (e.g. CPI)?,

People began to devise methods for working up complexes of commodity units to be contrasted to the monetary unit. Eagerness to find indexes for the measurement of purchasing power silenced all scruples. Both the doubtfulness and the incomparability of the price records employed and the arbitrary character of the procedures used for the computation of averages were disregarded.

A judicious housewife knows much more about price changes as far as they affect her own household than the statistical averages can tell. She has little use for computations disregarding changes both in quality and in the amount of goods which she is able or permitted to buy at the prices entering into the computation. If she ?measures? the changes for her personal appreciation by taking the prices of only two or three commodities as a yardstick, she is no less ?scientific? and no more arbitrary than the sophisticated mathematicians in choosing their methods for the manipulation of the data of the market.

In the same way, Craig James’ gauge is as ‘unscientific’ as a housewife’s gut feel. That’s why Craig James conceded that his own findings was a “big call.”

How To Foolproof Yourself Against Salesmen & Media Bias

Sunday, March 21st, 2010

Over the weekend, we have released a new instant download, PDF report, “How To Foolproof Yourself Against Salesmen & Media Bias” at only US$4.95. In addition, we had set up a Facebook Group related to this report for those who want to discuss more on the topic.

Basically, this report is an expansion and rehash of the mental pitfall series of articles (some of which are still available in this web site) and written from a different perspective. This report is divided into two parts. The first part is the most important part- it expands from the common mental pitfalls ideas on this web site:

  1. Accuracy-Precision Confusion
  2. Anchoring
  3. Bigness Bias
  4. Confirmation Bias
  5. Correlation-Causality Fallacy
  6. Endowment Effect
  7. Herd Behaviour
  8. Lazy Induction
  9. Ludic Fallacy
  10. Mental Accounting
  11. Money Illusion
  12. Narrative Fallacy
  13. Overconfidence
  14. Recency Bias
  15. Status Quo & Loss/Regret Aversion Bias
  16. Sunk Cost Fallacy
  17. Survivorship Bias
  18. Turkey Thinking
  19. Wishful Thinking

The second part is on some of the common tricks employed by biased media:

  1. Context Twisting
  2. Headline Judgement
  3. Images
  4. Names, Titles, Word Choice & Tone
  5. Selection & Omission
  6. Source Bias
  7. Story Placement

This report is in the PDF format and the total number of pages is 50 pages. It is specially designed to look well as a slide presentation, which means the larger fonts will be easier on your eyes. That makes it an ideal e-book. You can also print this PDF report but we would urge you not to do so for the sake of the trees.

For those who had already donated to this web site, this report will be given to you free of charge. You will receive an email from us (sent via e-Junkie) with the download link.

Click here to get this report now!

Thinking tool: going beyond causes & effects with systems thinking

Wednesday, March 3rd, 2010

Recently, we were reading a property investment newsletter. As expected, it listed reasons why despite house price inflation over the decades, housing is still ‘affordable.’ One of the reasons is this: Decades ago, families lived on single income. Today, families are living on double income, which means their purchasing power had increased over the decades. Hence, with increased purchasing power, house price increases. Basically, the increase in the number of dual-income households is (one of) the cause and house price inflation is the effect.

At first glance, this cause and effect seems logical isn’t it? Is this argument the truth? We don’t know, but we know that if one buy into that argument, then that’s another justification for house price inflation, which depending in one’s bias, is good enough.

What if we reverse the cause and effects? That is, house price inflation is the cause and the increase in the number of dual-income households is the effect? Another way of saying that is that as houses become more and more unaffordable, more and more families are forced to depend on dual income to service the mortgage debt. Certainly, this is the situation of young families nowadays.

Now, the point of this article is not to argue which is the cause and which is the effect. Both of them are unprovable interpretations. Since they are unprovable, each of them panders to our beliefs and bias. The main point of this article is this: always be alert to reverse the and cause and effects and see if the logic still holds. If so, you may be on to something more subtle and complex.

In this example, the property investment newsletter’s interpretation is probably an oversimplified narrative. Human nature is such that everyone has an unbreakable habit of simplifying and reducing the complexities in life into easy to understand story. As we wrote before in Mental pitfall: Narrative Fallacy,

Narrative Fallacy is a natural human weakness because by default, our minds seek to form theories, jump into conclusion, seek judgements and explain what we see. It takes a conscious act will to do otherwise.

The reality could be more complex than just a simple cause and effect. It is possible that over the years, rising house price (among other factors) led to the effect of more dual income families (among other effects), which in turn led to even more rising house price, which in turn lead to more dual income families and so on and so forth. In other words, the cause leads to effect, which feed-back into causes, which in turn feed into more effects i.e. a positive feedback loop.

If you can think along this line, congratulations! You’re now utilising systems thinking. Systems thinking is a very important skill that can gives you the edge not only in investing, but also in other aspects of life. We will be covering more of systems thinking in the days to come. Meanwhile, if you are interested to learn more on your own, we recommend this introductory book: The Art of Systems Thinking. This is a fascinating subject and we can only bring it to life through practical examples in the field of investing and economics.

Lastly, our friend, Professor Steve Keen utilises systems thinking in his modelling, which is something that neo-classical economists are lacking.

Mental pitfall to avoid: mental accounting

Tuesday, February 23rd, 2010

Following feedback from our readers, we learnt that many are interested in learning more about the mental pitfalls that afflict every human being. To be a good investor, one has to overcome or at least be aware of his/her vulnerability to mental pitfalls in order to make rational investment decisions. If you can do that, it will, by definition, make you a contrarian investor.

Today, we will look into mental accounting. In mental accounting, individuals tend to divide up their current and future assets into separate accounts and then assign different subjective values to these accounts.

Let’s look at the following scenarios:

  1. You divide your total wealth into two accounts: Retirement Account and Speculation Account. The former is meant to be ‘safe’ place to store your wealth for future retirement while the latter is for you to gamble in the financial markets. Say, you gamble $10,000 and lost the entire lot. Which outcome will make you feel better: (1) you lost $10,000 on the Retirement Account or (2) you lost $10,000 in the Speculation Account?
  2. Say you invest in stock A and B. The price of stock A decreased by 10% whereas the price of stock B increased by 10%. Let’s say you have to raise cash in a hurry. Everything else being equal, which stock will you liquidate in order to raise cash?

In the first scenario, chances are, a person using mental accounting will feel more pain in outcome (1). In the second scenario, one is more likely to sell the winning stock. But if one looks at them rationally, there’s no different between either outcomes in both of the scenarios.

The root characteristic of mental accounting is that it violates the principle that money is fungible. Recall that in Properties of good money, we wrote that

Any commodity that functions as money ought to be fungible. That is, you can trade or substitute it for equal amounts of like commodity.

To put it simply, a dollar is a dollar, no matter where it pick it up from. A dollar you deposit in the bank is not exactly the same physical dollar when you withdraw it three days later. But for all intention and purposes, both of them can be substituted for each other.

Diamonds, on the other hand are not fungible. Each is unique from the other and hence, cannot be substituted for another. Your pet dog is not fungible too. If it died over the weekend, you cannot simply pick a similar one from the pet shop and substitute it for your dead pet.

In the same way, a dollar in the Retirement Account is fungible from a dollar in the Speculative Account. But the fact that one is more likely to feel more pain from a loss in the Retirement Account then an identical loss in the Speculative Account shows that both dollars are no longer fungible in one’s minds.

Arguably, mental accounting helps make Kevin Rudd’s free $900 stimulus cheques more effective (in ‘stimulating’ the economy) then it would have been. Tax-payers who received $900 tend to put the that in the “Free Lunch” mental account. Money in the “Free Lunch” account is more likely to get splurged on consumer items that make one feel good. What if the government made that $900 be automatically credited into tax-payers’ debt account (e.g. mortgage debt, credit card debt)? In that case, most will be reluctant to spend $900. In both cases, the government spends $900 and each tax-payer’s network increased by $900. But the latter will result in most people choosing to close up their wallets. The rational choice in the former case would be to repay debts.

In another real-life example, one of our Chinese friends made an investment in physical gold and managed fund in 2007. As we all know, both the Chinese stock market and gold fell in the second half of 2008. By early 2009, he had made some paper profits in gold while the managed fund was still in the red. Due to some personal circumstances, he had to raise funds. So, he sold his gold for a tiny profit. Today, gold is at a much higher price than when he sold it and his managed funds is still in the red. The reason why he sold his gold was not because he believed that managed funds had a better prospect. Instead, he the reason was because he did not want to realise the losses in his managed fund.

Answer to reader quiz: likelihood of takeover

Tuesday, August 18th, 2009

In our previous article, we gave our readers a short quiz to assess the likelihood of a takeover. The purpose of this quiz was not to be a lesson on takeover analysis- the takeover discussion was a red herring to distract you from the core of the issue. As Pete, one of our readers said,

Whilst looking at these takeover targets from a “what has happened in the past” perspective seems intelligent, takeovers rely on much more than is mentioned in those points.

Instead, the purpose of this quiz is to show you a very common mental pitfall that will deceive the minds of many unsuspecting investors.

Now, let’s take a look at this paragraph in the quoted Eureka Report article:

Of the six [takeover likelihood criteria], I find that the presence of strategic shareholdings is the strongest predictor of corporate activity; in fact, since 2000 about 60% of listed Australian companies receiving takeover bids had such strategic shareholders already on their register, even though only about 20% of total companies in the ASX 300 index fulfil this condition.

Upon reading that paragraph, it is easy to conclude that if a company fulfils all the six criteria, then its likelihood of takeover (based on statistical probability and assuming that all takeover bids are successful) is at least 60%.

Unfortunately, even if you believe that statistical probability is an accurate gauge of takeover probability (those who believe in that must read Failure to understand Black Swan leads to fallacious thinking), that number is wrong. The reason why 60% is the wrong number is because it is skewed by survivorship bias.

As we quoted an article in Mental pitfall: Survivorship Bias, the

… tendency for failed companies to be excluded from performance studies because they no longer exist. It often causes the results of studies to skew higher because only companies which were successful enough to survive until the end of the period are included.

That 60% is based on companies who were taken over. It does not include companies who fulfil those criteria and were not taken over. If we take the entire sample of all companies that fulfil those criteria, the proportion of those who was taken over could well be far below 60%.

Today’s lesson on survivorship bias is very instructive on how statistics can be misused to lie and deceive.

Reader quiz: likelihood of takeover

Monday, August 17th, 2009

Today, we will give our readers a simple quiz.

Last month, Eureka Report released an article titled “Top Ten Takeover Target.” The article goes like this:

PORTFOLIO POINT: What are the most likely takeover targets for the year ahead? Here?s my list.

Will BHP come back for Rio? Will Kerry Stokes go the whole way and make an audacious bid for the
Packer family’s Consolidated Media.

It’s never easy picking takeover targets in advance, but neither it is impossible. Over the years I have devised certain criteria that I hope you’ll find useful. There are some obvious factors, such as a wave of pending consolidation; and others that might not be too obvious to the untrained eye, such as ?lazy? balance sheets.

The six main criteria I use to select takeover targets are:

  • The presence of a strategic shareholding on its register.
  • Industry consolidation taking place.
  • Substantial changes to the legislative or regulatory environment.
  • The occurrence of a previous (and unsuccessful) bid for the company in question.
  • Monopolistic and/or duopolistic industry structures.
  • Underutilised balance sheets and strong cash flows.

Of the six, I find that the presence of strategic shareholdings is the strongest predictor of corporate activity; in fact, since 2000 about 60% of listed Australian companies receiving takeover bids had such strategic shareholders already on their register, even though only about 20% of total companies in the ASX 300 index fulfil this condition.

So putting these criteria together and overlaying them on Australian stockmarket, what do you get?

Here then are my top 10 takeover targets (in no particular order) for the year ahead:

Let’s say you searched high and low for a company in the stock market. Finally, you found company XYZ that fulfils each one of the six criteria.

Our question to you is: how likely (expressed as a percentage) is company XYZ going to be taken over?

Another turkey from ABN Amro Morgans regarding China

Sunday, February 1st, 2009

Last Thursday, we saw this comment from Michael Knox, the chief economist of ABN Amro Morgans in the AFR,

It is probable that this slowdown in China is going to be relatively short-lived. China went through a period of very rapid credit growth in 2006 and early 2007.

The central bank reacted by pushing up the reserve deposit ratio to the highest in a generation. The result of that was that growth in bank lending fell in the first half of 2008. The slowing in the economy this produced can now be seen in gross domestic product and confidence in data.

The slowdown seems primarily to be the result of domestic central bank action. In the second half of 2008, the Chinese central bank dramatically eased monetary policy. It rapidly cut the reserve deposit ratio. The result of that has been an equally rapid expansion of loan growth. For the year to December, yuan and foreign currency loans were yp by 17.95 per cent for the year. Yuan loans were up by 18.76 per cent.

The money supply also grew rapidly.

The lag between Chinese loan growth and the economy is no more than two to three quarters.

This means that the re-acceleration of loan growth should lead to an equally strong acceleration in the Chinese economy in the second half of 2009. At last there is good news from China in the form of the re-acceleration in bank lending.

Let us write our version of why the Chinese economy ‘should’ accelerate in the second half of 2009:

It is probable that this slowdown in China is going to be relatively short-lived.

Adelaide’s temperature went down to one of the lowest in the first half of 2008. The result of that was that growth in Chinese economy fell in the second half of 2008. The slowing in the economy this produced can now be seen in gross domestic product and confidence in data.

The Chinese economic slowdown seems primarily to be the result of Adelaide’s temperature. In the second half of 2008, Adelaide’s temperature increased progressively to one of the highest in a generation at the end of January 2009.

The money supply also grew rapidly.

The lag between Adelaide’s temperature change and the Chinese economy is no more than two to three quarters.

This means that the re-acceleration of Adelaide’s temperature should lead to an equally strong acceleration in the Chinese economy in the second half of 2009. At last there is good news from China in the form of the re-acceleration in Adelaide’s temperature.

The background understanding of this sacarstic humour can be found at Does correlation implies causality?.