30 second reviews
Our goal is to reconnect you with useful things you might have already read and help connect those ideas to investor behaviour.
The Little Prince by Antoine de Saint-Exupéry
In this two-part edition, we have Emerging Markets Portfolio Manager Christine Tan with us to discuss two very different bestsellers: The Little Prince and Why Nations Fail. We will start this month with the former, and post our Q&A about Why Nations Fail in September.
Antoine de Saint-Exupéry’s The Little Prince was first published in 1943, in French. According to the New York Times, the 84-page novella has been translated into 250 languages and dialects, and sells approximately 2 million copies a year. It has a little prince, of course, and the very small planet he lives on. The setting is the Sahara, where a pilot (perhaps a version of the real-life pilot, Saint-Exupéry himself) has crashed his plane, and where he meets the traveling prince.
Question: This is an unusual book. When it was first released, people didn’t know what to make of it, and then its sales took off. Why do you think people find it important? Why did you choose this book for discussion?
Christine Tan: My English teacher (my all-time favourite high school teacher) gave me this book when she retired. She simply told me that it’s a book I should read from time to time over the years. And I have. Surprisingly, The Little Prince is very relevant to me as a portfolio manager, because one of its messages is to not make assumptions. Whether I’m meeting a CEO or assessing a new country, like investing in Vietnam – now that it’s becoming an emerging market as opposed to a frontier market – it’s important to approach it with a curious mind, and not let my previous assumptions bias me to quick conclusions.
The simple example in the book is that, as a child, the author draws a picture of a boa constrictor swallowing an elephant. And, in his child’s mind, that’s what his drawing represented. But, when he shows it to adults, they all tell him that it looks like a hat. That is a message I try to keep in mind. The more great companies you meet, the more you form an idea of what the key success factors are and what you should be looking for. While the knowledge gained from analyzing strong companies is valuable, it’s also important to be open and curious. By trying to prevent myself from jumping to conclusions too quickly, I will ask myself, for example, is there something different about the dairy industry in Vietnam compared to the dairy industry in Canada?
In that light, the book is using the observations of a child – the prince – to look critically at how adults behave and think. The child is outside of the day-to-day adult world, so he asks a lot of “why” questions. The prince visits six different, tiny planets and meets six different characters – adults, as he calls them. But each adult is a caricature of a different trait. There is an arrogant king who has no subjects, but he still believes he rules everything he sees. Most of the things he says are issued as orders. Another character is the businessman who is always busy counting the stars so that he can own them. These caricatures remind me to be aware of certain “adult” personality traits that, taken to the extreme, could become flaws. For example, am I really are too busy for my hobbies or to see friends, or am I behaving like the businessman, constantly counting stars that never change.
Another unique aspect of The Little Prince is that although the prince is a child, he goes through a lot of introspection – thinking about his relationship with the rose, and his home planet. So I find it’s a book that can be read at many ages. For example, I read it to my young godson and he loves the simple story of the little child prince who travels to various tiny planets. And he isn’t even aware of the life-and-death ending of the story. For me, each time I’ve re-read this simple book over the years, a different aspect impacts me….and it is a timely reminder to never stop being curious.
Thinking, Fast and Slow by Daniel Kahneman (2011)
1. Behavioural economics: Cognitive ease as a force for good
The description of cognitive ease comes early in Daniel Kahneman’s book, Thinking, Fast and Slow. It refers to the fact that we like it when our assessments are made easier. For example, a sentence printed in a clear font is easier to understand than one in an ornate font. A side effect is that, other things being equal, we are more likely to believe a sentence in a clear font.
If you were to put together a chain of connections, it might look like the following:
Clear font – easier to read – more relaxed – more receptive – more likely to believe.
Here are a few more factors associated with cognitive ease:
Simpler writing – easier to understand
Primed idea* – familiar feeling
Repeated experience – familiar feeling
Good mood – feels good
*Priming refers to the unconscious effect of the context in which something is presented. Here is an experiment described in Thinking, Fast and Slow that illustrates its surprising influence: Young adults were asked to write a paragraph using words associated with old age (e.g., “Florida, wrinkle”). After the exercise, they were asked to perform another task in a room down the hall. Compared to matched participants who hadn’t had the “old age” priming, they walked significantly slower to the next exercise. “Old” words made them act older. Interestingly, using money as a primer tends to encourage selfish behaviour.
Why cognitive ease is a key concept
Kahneman uses cognitive ease to show how System 1 – our uncontrolled, effortless, associative, unconscious judgments – can be influenced by certain techniques. Recall that Kahneman’s key observation is that System 1 has mixed results in terms of accuracy, but it is powerful. In fact, it often overshadows our more analytical System 2 work, because the latter takes significant effort. Sometimes, System 2 gets co-opted into devising complex explanations to back up our initial System 1 snap judgments. Refer to every political discussion in the last 2,000 years as evidence.
Cognitive ease as a force for good
Consider this statement, which few advisors would disagree with:
“I want my Clients to do things that increase their chances of reaching their financial goals, such as
- Being aware of their timelines;
- Saving early, consistently and enough;
- Living within their means; and
- Taking a holistic view of family finances.”
If there is a Client-success behaviour you are hoping to encourage, how might you use repetition, simplicity and clarity to get there?
2. Behavioural economics: Buying, selling and the endowment effect
The CBOE Volatility Index had two spikes above 36 in 2018, one in February and one in late December –roughly double the long-term average. Canadian investors had positive flows into money market funds, a departure from previous years.
Money market fund flows in Canada, 2018: $2.44 billion1
Average annual money market fund flows, 2015-2017: -$381 million2
We have a sense that loss aversion is important in many areas of life, especially investing. This is the tendency to overweight losses, psychologically. As documented by Nobel laureate Daniel Kahneman in his 2011 bestseller, Thinking, Fast and Slow, in experiments, subjects experienced around twice as much emotional pain from loss as they experienced joy from an equivalent gain.
Here are some questions that tie to loss aversion, which are more thought-starters than prescriptions:
- How might loss aversion affect investor behaviour during and after periods of market volatility, and what is the role of the advisor?
- Is loss aversion necessarily a negative thing?
- Are there investment strategies that seek to minimize the sting of loss aversion but leave room for potential growth? What is the role of guaranteed products? Asset class diversification? Low-volatility strategies?
- How might Clients react to a service they had previously enjoyed being removed?
Fellow Nobel laureate Richard Thaler related loss aversion to the endowment effect, where people often “demand much more to give up an object than they would be willing to pay to acquire it.3” The basic interpretation of the endowment effect is that once we own something, we have a hard time parting with it. In Thinking, Fast and Slow, Kahneman points out cases where the endowment effect isn’t universal. For example, compare these two situations:
- A professor purchased several bottles of wine for $10 that had risen in value to $100. She was unwilling to sell one of her bottles for $100, yet she would not consider buying more bottles for herself for $100.
- A shoe store owner had no problem selling his last pair of a popular line of shoes.
The difference between the two situations is that the professor owned goods that were held for use, while the shopkeeper had goods that were held for exchange. This is an important difference, and has implications in various transactional settings. Here are some thought-starters related to the endowment effect:
- The same financial holdings can be seen differently, depending on the person’s vantage point. For example, an employee participating in ABCD Company’s share purchase plan may be reluctant to sell any of their company shares, even though diversifying proceeds into other investments may improve their risk-adjusted returns. A second investor who has experience buying and selling shares also holds ABCD. They have no qualms about selling. Is it possible to reframe the first situation so the share purchase plan member thinks like a trader?
- A house owner recently purchased a condominium. Their house is up for sale but they “can’t sell” because offers are coming in below the house’s peak value of a year ago. How is the endowment effect making it difficult to sell, even though they need the money?
When interviewed, Kahneman is humble about the success rate in applying behavioural research insights to produce actual behavioural change. There have been wins, but they often come from building guardrails around predictable errors rather than eliminating them through logic or willpower. Advisors who go back to Kahneman’s bestseller today will be in a better position to understand Clients’ varied, human responses to financial situations.
1 Strategic Insights, Investor Economics, January 2019, p. 19.
3 Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias by Daniel Kahneman, Jack L. Knetsch, Richard H. Thaler The Journal of Economic Perspectives, 5(1), pp. 193-206, Winter 1991.
3. Behavioural economics: Interesting, but what do you do with it?
Behavioural economics has inspired several good books over the past two decades, and people keep buying them. Thinking, Fast and Slow, Blink, Predictably Irrational, Nudge, The Undoing Project, The Power of Habit, Freakonomics and Outliers are all bestsellers. So, the secret is out: research shows that we often stray from the model of homo economicus, which assumes we make rational assessments to maximize utility. The question is, what are we doing with that knowledge?
System 1 and System 2
The old saying, “You can’t judge a book by its cover,” needs a postscript: “But you will anyway.”
Psychologist and Nobel laureate Daniel Kahneman, author of Thinking, Fast and Slow, spent five decades studying the way we interpret events and make decisions. His conclusion: people can be trained to make more thoughtful decisions but, ultimately, we are biased to making quick, intuitive judgments. Our more reflective processes, in many cases, align to support these judgments.
Through measurements of brain activity, researchers have evidence of fundamentally different processes at work, which Kahneman calls System 1 and System 2. System 1 is uncontrolled, effortless, associative, unconscious and skilled. It comes into play when we respond automatically to a photo of an angry person’s face. Similarly, tasks that have been practiced over and over can become a System 1 response. System 2, by contrast, is controlled, effortful, deductive and slow. It goes to work when people are asked, “What is 17 times 14?”
System 1 responses are powerful. From an evolutionary perspective, this makes sense. Snap judgments help us keep out of harm’s way and they conserve energy. Unfortunately, System 1 responses are also error-prone. This combination, of making errors but being powerful, means we have cognitive biases.
One of the most common patterns is that we substitute an easy question for a hard one. When asked what we think of a politician, we substitute the question “Does he look like a leader?” System 1 comes up with a quick answer: “He’s too young/old!” System 2 would entail time-consuming analysis to provide a more accurate answer: “What are his policies? How do they compare to the other candidate’s?” Since System 2 consumes energy, System 1 substitution takes place, and then System 2’s supporting points are brought in after the fact.
Practical tidbit: Have you ever walked out of a client meeting and thought, “Wow, we didn’t even get to (name the important issue)!” The “halo effect” in meetings is one example of System 1 taking over: issues that are introduced first and most forcefully tend to dominate the entire proceedings. One way to lessen this effect is to have meeting participants write down their ideas before anyone speaks.
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