Kahnemann’s Prospect Theory: a summary in one graphic

Human behaviour isn’t that hard to understand if you do the work. And my favourite theory of it involves Cognitive Biases: the core emotionally-led behaviours that drive the decisions we actually make, rather than the decisions that might be more rational.

Cognitive Biases are rooted in Kahneman and Tversky’s Prospect Theory, which was crucial to my MBA thesis some years back. (Nice of him to summarise his life’s work AFTER I’d ploughed through the academic literature.) Basically, it’s an add-on to Expected Utility Theory (where we take risks based on the outcome we expect) that draws in Cognitive Biases (the emotional factors that govern what we actually do.)

While the concepts aren’t hard, there are around a hundred Cognitive Biases recognised in human psychology, making it hard to summarise with any rigour. But there’s a great diagram in Thinking, Fast and Slow that brings its three key points together.

prospect-theory

First, note the y-axis, “Psychological value”. That takes account of the human factor Expected Utility doesn’t: £500 has different perceived value to a pauper and a millionaire, so setting this axis for your audience – the  “base rate” on which they make decisions – is key.

Second, note it’s S-shaped. If you’re winning, it takes a lot more wins to get the same flush of excitement you did on your first win. (Diminishing returns are what keep sensible adults at slot machines for hours at a time.) The perceived utility depends on how much utility you’ve got already.

Third, note it’s not symmetrical. This illustrates the biggest Cognitive Bias of all: Loss Aversion. (We tend to resist losing a lot more than we accept winning; it’s why investors ride their losing stocks down, while selling their winners while they’re still rising.) Loss Aversion is at the core of much human behaviour.

And that’s it. In tune with my theory that you only need one good book to understand 90% of any field, that’s all any marketer needs to know about Cognitive Biases and how useful they can be in understanding customers. If you’d like some of these principles applied to your own marketing, contact me.

Adventures in spread betting, episode 2: Facebook

Sometimes the winning move is not to play.

Two bets were possible as Facebook hit the markets: the normal one when it started trading, and a pre-market punt on how many billions over $100bn the valuation would go on its first day. The latter attracted plenty of bets and at $137bn two-thirds of betters were long – hardly unanimous. I stayed out for two reasons. First, at a minimum bet of £10/pt and a stop no narrower than 100pts, my exposure was £1000 straight off the bat – well outside my risk taste at this stage. But second was simply instinct. While I’m familiar with technology valuations and Facebook’s finances, something didn’t feel right about the $38-per-share IPO, so I stayed on the sidelines.

This was the right decision: at the close, Facebook’s valuation was barely in twelve digits. (I.e a lot of people got burned.)

In the secondary market itself, the stock’s now trading around $33, way below its offer price. (It also seems Morgan Stanley has stepped in several times to prop it up.) If this surprises you – the hotttest technology IPO in years from a company that picks up around a third of all web pageviews in the Western world – here’s why.

(Learn the basics of spread betting by checking out this free trading guide. I still use it for reference even though I’ve probably read every page by now.)

Facebook and Google have roughly equal visitors and pageviews, but Google monetises each user around ten times better ($40bn revenues vs $3.8bn) at higher margins. The social network may be a great comms infastructure, but not perhaps a great investment. The site’s not going away – I believe (as a big user myself) it’ll continue to be the default social network for a billion people – but it’ll prove hard to monetise at a level that answers a high NASDAQ tick.

Facebook is a killer app… but a killer app the way email is a killer app. Not the way Office is a killer app.

And here’s the kicker. If I’d followed my instincts, I’d be £4480 richer. (Shorted when it started falling from $40 or so, sold when it hit $35ish.) Risking around £3k, sure, but my instincts tend to be right on such things. And that’s why I didn’t do it. Spread betting, for me, is not gambling; I treat it as I would any other investment. I don’t risk my pot on hunches.

If you don’t know why you’re making the bet, don’t make it. I may have “lost” £4k+, but I’m gaining the discipline I need to be among the third of spread betters who make money at it.

Adventures in Spread Betting: episode 1

The interesting thing about financial spread betting is just how unlike betting it is. It's amazing how few "City traders" actually work in the City.

Betting on spreads – where you’re given bid/ask prices by your spread betting provider, and you wager a sum per point on how far and in what direction the price will move outside this range – is classed as gambling in the UK. But since you can back your decisions with all the normal tools of the financial business – technical analysis, corporate fundamentals, information – spread betting isn’t really about gambling, any more than poker’s about gambling if you know where all the aces are.

However, it’s not really about investing either. (You’re not buying a share; you’re contracting with a bookie about where its price will go.) Spread betting is really about trading. Buying cheap and selling high, like every form of mercantile exchange for 30,000 years. Like a bank extending you credit, you can trade on the margin: with most bets your provider will only ask you to front 5% of your total exposure. And you can use leverage to magnify your wins (betting £10 a point, a penny’s rise in share price gives you a thousand times that in profit) meaning the profit opportunities are large. Of course, the downside is just as big – which most people find out very, very quickly.

(One resource I use a lot is this site: http://www.financial-spread-betting.com/. It’s got a huge array of articles on pretty much every aspect of spread bet investing, including stuff about other exotica like CFDs.)

I’ve been FSBing a day or three a month for the last six months, and just starting to get into it seriously. It’s something I thought I’d enjoy; I never expected it to get vocational. But when I looked back on trades the Why of it became obvious. I don’t have a gambling mentality; in twenty trips to Las Vegas I’ve sat down at a blackjack table precisely once. But I do have an affinity with charts and patterns – the trends and trajectories of technical analysis. In spread betting, that’s what you’re really betting on – herd behaviour, not the fall of a dice or the turn of a card.

I wrote a thesis on behavioural finance once; the way human biases affect markets is a subject I know a lot about. In addition, the complexities of financial derivatives that keep most people out of the game – the calculations around stops and limits, the patterns of market timing, when to go on margin and how far to pull the leverage – are, at the scale I’m doing it, simple enough to fit on a spreadsheet.

Now I’m starting to trade seriously I’ve decided to blog my wins, losses and learnings – keeping it open keeps me honest. As with all writing, the critical thinking it forces will help me develop a trading strategy – patterns that work, patterns that don’t, places where my own cognitive biases get in the way. In two years or so I hope to be trading for a consistent monthly profit; note what matters here is consistency rather than number of zeroes. Here goes nothing…