BijaAdvisors

Better Decisions, Better Results

Seeds of Thought
Cognitive Science Meets Investment Management
Issue 15-19
June 2, 2015

In This Edition

Cognitive science explains how a political party with far fewer supporters is able to compete and
how three key issues are likely to put another Democrat in the White House next year, but only if
theyre paying attention.

How asking the wrong questions leads to underperformance, and what you can do to improve.

The Mother Lode of Political Intel

Nobel prize winners, Daniel Kahneman and
Amos Tversky, improved upon one of the
fundamental tenets of economics when they
pointed out a simple, but powerful fact. It turns
out we dislike losses more than we enjoy gains,
and not just by a little bit. For most people, losses
are twice as powerful as gains. Its thought to be
an evolutionary response mechanism, helping to
keep us safe from predators. However, it doesnt
only apply when we feel physically threatened.
Your brain responds with greater urgency and
intensity to negative words like war and
crime than it does to peace and love. The
result is a cognitive bias known as loss aversion,
which simply means we will work harder to
avoid losses than we will to achieve gains.
We see this bias play out in so many aspects of
our daily lives. Customer reviews tend to be
skewed toward the negative, so too are news
reports and even idle conversations. We have a
natural predilection for the darker side of life.
Nowhere is that partisanship more evident than in
politics.

Thats right, it isnt that politicians are inherently

evil, its actually you, their target audience, that
dictates how nasty campaigns get. The more
hotly contested the position, the uglier the ads are
likely to become, and it all goes back to loss
aversion.
In order for a politician to win, they must
motivate their supporters to show up at the voting
booth come election day. Its really that simple.
Regardless of how many people support a
politicians policies, if proponents dont cast a
vote, the candidate simply cannot win. This is
where loss aversion really comes into play.
According to a combination of Gallup and Pew
research, Democrats have maintained a healthy
advantage over Republicans in the sheer number
of voters who identified with their party, and for

While we may complain about negative

campaign ads, the truth is, politicians run them
because they are effective. Like it or not, and
even if you arent aware of it, you respond more
vehemently to negative than positive messages.
!
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the most part, its been that way going back to

1939. At times, the margin was so large its hard
to imagine a Republican presidential candidate
could possibly have been considered a serious
contender and yet even during those moments,
they win as often as the Democratic nominees.
Loss aversion may help us understand how thats
not only possible, but very likely. It all comes
down to the composition of each partys
supporters.
Statistics furnished by the Census Bureau provide
a very clear picture of party affiliations. None of
which is likely to surprise anyone. The
demographic groups with an overwhelming
tendency to lean Republican are those who are
older, wealthier, religious and white. Democratic
leaners, on the other hand, tend to be young,
poor, and minority. These may sound like tired
old stereotypes, and they are, but it doesnt

Issue No. 15-19

require a PhD in statistical analysis to see there is

serious substance to these cliches.
Take another look at the groups and youll see
they can be broken into two simple categories,
those who have something to lose, and those who
dont. Considering the findings of Messrs.
Kahneman and Tversky, it is indeed significant,
and goes a long way to explain how it is that a
party with far fewer supporters is able to
compete, and win so often. The answer, of
course, is loss aversion.
Naturally, each group has something at stake and
a reason to vote, but as cognitive science teaches
us, the motivation derived from protecting
against loss is far more powerful than that which
is driven by the anticipation of gain. Again,
politicians are well aware of this fact, which is
why ads are rarely about what can be gained as a
result of policies being proposed by a candidate,
and instead, tend to emphasize what will be lost
if their opponent is given the opportunity to take
it away. The more you have to lose, whether its
wealth, income, religious freedom and/or
privilege, the more fervent you will be in your
opposition to the other side, and the more likely
you are to pull that lever come election day.
While those who tend to support the Democratic
party may have less to protect, there are two
things many Democrats do have and do not want
to lose, which is why its candidates can be
counted on to bring them to the attention of
voters at every election. They are social security /
medicare and abortion rights. However, for the
first time in a very long time, it would appear the
odds are tipping heavily, and perhaps
strategically in favor of the Democrats, at least as
it relates to the 2016 Presidential race. This is
where the other aspects of Kahneman and
Tverskys work come into play.
Loss aversion was actually just one of several
key concepts introduced with their seminal work
known as, Prospect Theory. One of the other very
relevant, and truly groundbreaking aspects is

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known as the reference point. What these Nobel

Laureates showed is that gains and losses are
perceived in relation to a reference point, but
heres the truly interesting thing about it. The
reference point isnt necessarily the status quo. In
other words, you dont have to be in possession
of something in order to consider not having it as
a loss. It is enough to simply anticipate it, or feel
entitled to it. This is significant, especially as it
relates to perhaps the most important, and to date
the most elusive demographic group for
Democrats, young voters.
Millennials now outnumber every other age
group and that should be a huge positive for the
Democratic Party. However, because young
people don't have much, and therefore don't have
much to lose, they are traditionally
underrepresented in the voting booth, often by a
large margin. In 2016, if the Democrats do a little
research into Prospect Theory, they may find the
mother lode of political intel.
Young adults are at that point in their lives when
they are struggling to find their own identity. As a
result, they seek to be seen as independent of the
generations that came before, and don't like to be
told how to think or how to act. Three key social
issues which appeal to this particular
psychological state have risen to the fore in both
American and global politics, and as a result are
likely to play a key role in the mobilization of
this, the most sought after and elusive
demographic. All three issues appeal directly to
this desire for independence, but just as
importantly, the groundswell of support and
actual legislative implementation in many states,
and in a number of developed countries around
the world has turned them from potential gains, if
adopted nationally, to potential losses, if they are
not.
Marriage equality, the legalization of marijuana
for recreational use and free tuition for college
are those issues, and if the Democrats are smart,
they will not only put them front and center on

Issue No. 15-19

the agenda, they will speak of each of them as

though they are foregone conclusions. Then, by
the time the primaries are out of the way and the
showdown between red and blue begins, they can
begin the process of portraying their opposition
as the ones who want to take these things away
from the Millenials.

Yeah, but WHY?

If you're a CIO, asset allocator, or hedge fund
investor, I'd like to share a secret with you. Its
very likely you aren't selecting your portfolio
managers based on their qualifications. You are
selecting them based on your own. Therefore,
blaming them for the poor performance of your
portfolio makes as much sense as a PM blaming
his trades for his. Here's why.
It all starts with the questions you ask in the
introductory meetings, as part of your due
diligence and in those weekly, monthly and/or
quarterly investor meetings, once you've made
the decision to allocate. Simply stated, youre
asking the wrong questions, and it may go a long
way to explain underperformance. Where they
think the Euro is headed, whether they see the
stock market as overvalued or what their opinion
of emerging markets happens to be at a given
moment provides little more than rhetorical
banter. The reasons are plentiful, but I'll share
just a few.
First, at the moment you are asking, it is
impossible for you to gauge whether or not their
view is correct. All you can gain is cognitive
bias. If their view agrees with yours, you will
weigh their skill higher than those who disagree.
As a result, you aren't rating their valuation
ability so much as you are rating your own. With
that being the case, the real question that must
precede any meetings is, how good are you at
predicting the future of EUR, the S&P or
emerging markets? If you say its good, what
evidence do you have to support your belief? For
most, including the PMs themselves, the answer
is, none.

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A few years ago I was coaching a very

experienced PM. His initial trade write-up noted
only the impact of inventories as being
significant from a fundamental perspective. What
weighed most heavily in the decision to put on
the trade was how much could be made if the
underlying price broke out of its well-established
range. In other words, it was a lottery ticket
masquerading as something with more substance.
What follows is the email traffic that resulted,
particularly as it relates to the thesis Ive laid out
above. (Note how quickly the rationale changed
when it no longer supported the belief. Italics
added by me for emphasis.)
PM: This is a tactical technical trade for
me that is not driven by inventories. The
driver is the inability to press higher in
light of the moves in the USD and S&P.
Todays failure to bounce on the FOMC is
my timing/news catalyst. Its the kind of
trade that should work more than half of
the time and should happen soon. So if it
doesnt, I have a price stop and a time
stop. If the trade doesnt work out,
hopefully my time stop takes me out
before I lose the $2.15.
ME: "Its the kind of trade that should
work more than half of the time and
should happen soon." Do you track
statistics like this? How do you know its
slightly better than 50/50 and not slightly
worse? What precisely do you mean by
"the kind of trade?
PM: I don't have stats but am hoping that
this is what we will be tracking with your
system. I say 50/50 but think its higher. In
time, we'll track it and see.
We did. It was in fact much lower, but even the
data couldn't undermine his deeply entrenched
beliefs. These are the kinds of simple questions
investors and CIOs should be asking, but they
dont, and so the red flags that should be flying
high remain in their canisters. To be honest, PMs

Issue No. 15-19

should be asking themselves these questions first,

but more often than not, they don't either.
One of my favorite narrative fallacies is that short
term trading helps to smooth out the more
volatile interim performance of longer term
positions. In the case of one fund I was advising,
that is what theyd sold to investors, even though
it wasnt aligned with reality. After a full year
tracking not just the firms returns and individual
PM returns, but digging deeper into its
components, here is what I reported.
The day trading strategy is supposed to
smooth p&l by providing a large number
of small positive days vs small number of
small negative days, but what weve
witnessed is roughly equal up and down
days in roughly equal amounts (so its a
non-event excluding brokerage fees) for
the performance of one of the short-term
PMs. Meanwhile the other has had a
positive ratio in positive/negative days,
but the negatives have been 2x the
positives. On a monthly basis, PM1 has
significantly more negative months at
roughly 1 to 1 in gains vs losses (ie 1 step
up 2 steps back). PM2 is roughly 50/50 in
monthly returns and number of months
(so its a non-event excluding brokerage
fees). Bottom line, since inception, day
trading is a negatively skewed risk /
reward mandate, on a daily and monthly
basis. On the other hand, medium term
trading has generated positively skewed
frequency and magnitude of returns.
Precisely the profile your investors desire.
The same goes for how they manage risk. If they
use the same techniques as everyone else,
including Peloton and LTCM, should you really
be ticking the box? If they use speed bumps, ask
them why. When they tell you it is to help a PM
or the fund regain objectivity, to see things
clearly again, follow up with two others. If you
know you will be losing objectivity, why don't

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you do something to combat it ahead of time?

And while youre at it, try these additional
queries. How long before you turn the risk back
on? Why that long? What evidence do you have
to support your belief that speed bumps add
value? Do they protect against systemic risk?
The truth of the matter is this. From what I have
witnessed over 14 years as a partner at four
hedge funds, while nearly every PM and CIO
knows how to answer the questions that are

Issue No. 15-19

asked, true investment process is extremely rare

and evidence based introspection is nearly nonexistent. If you truly want to find better
managers, try this one simple question as it
relates to investment process, and repeat it ad
nauseam. Yeah, but WHY? Youll be amazed
by the results.
P.S. For you PMs, how do you track the
performance of your decisions? Are you asking
yourself the right questions? How do you know?

About the Author

For nearly three decades, Stephen Duneier has applied cognitive science to investment management, and
life itself. The result has been top tier returns with near zero correlation to any major index, the
development of a billion dollar hedge fund, a burgeoning career as an artist and a rapidly shrinking
bucket list.
Mr. Duneier teaches Decision Analysis in the College of Engineering at the University of California
Santa Barbara. Through Bija Advisors' publications and consulting practice, he helps portfolio managers
and business leaders improve performance by applying proven decision-making skills to their own
processes.
As a speaker, Stephen has delivered informative and inspirational talks on global macro economic
themes, how cognitive science can improve performance, and the keys to living a more deliberate life, to
audiences around the world for more than 20 years. Each is delivered via highly entertaining stories that
inevitably lead to further conversation, and ultimately, better results.
Stephen Duneier was formerly Global Head of Currency Option Trading at Bank of America and
Managing Director of Emerging Markets at AIG International. His artwork is represented by the world
renowned gallery, Sullivan Goss. He received his master's degree in finance and economics from New
York University's Stern School of Business.

Bija Advisors LLC

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In publishing research, Bija Advisors LLC is not soliciting any action based upon it. Bija Advisors LLCs publications contain material based upon publicly
available information, obtained from sources that we consider reliable. However, Bija Advisors LLC does not represent that it is accurate and it should not be
relied on as such. Opinions expressed are current opinions as of the date appearing on Bija Advisors LLCs publications only. All forecasts and statements
about the future, even if presented as fact, should be treated as judgments, and neither Bija Advisors LLC nor its partners can be held responsible for any
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securities and other positions, in equity, bond, currency and commodities markets, from which they will benefit if the forecasts and judgments about the
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Copyright 2015 by Bija Advisors LLC.; BijaAdvisorsLLC.com
Reproduction or retransmission in any form, without written permission, is a violation of Federal Statute
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