HARDBOUND

Putting theory to practice

Santa Clara University's Meir Statman breaks down the tenets of behavioural finance to help you make smarter decisions

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Published 3 years ago on Sep 23, 2017 Read

A commercial for running shoes illustrates framing shortcuts and errors. Two barefoot men are bantering as they walk in an African savanna. Suddenly, they spot a growling lion. “Do you think you’re faster than a lion,” asks one as he watches the other put on his running shoes. “No,” says the man, “but I’m faster than you.” And with that he runs away. Next we see the lion closing in on the barefoot man, who lags behind.

The man in running shoes possesses human – behaviour and “race facts” knowledge. He uses a good framing shortcut, whereas the barefoot man commits a framing error. The man in running shoes frames the race correctly as between him and the barefoot man, whereas the barefoot man frames the race in error as between each of them and the lion.

Think of trading stocks, bonds, and other investments as a trading race. Traders who commit framing errors frame the trading race as between them and the market, as the barefoot man frames his race as against the lion. Where is the economy going, ask “barefoot traders,” and what are the prospects of this company?

Traders possessing human- behavior and financial- facts knowledge frame trading correctly as against traders on the other side of the trades — the likely buyers of what they sell and likely sellers of what they buy. This is the frame of “traders in running shoes” who ask, do my computers help me outrun other traders as my running shoes help me outrun barefoot men, or are the computers of high- frequency traders on the other side of my trades much faster than mine? Do I know more about the prospects of this company than company insiders who might be on the other side of my trade, wearing “running shoes” of exclusively or narrowly available information, whereas I wear “heavy boots” of widely available information? Traders committing framing errors fail to understand that trading is a race against other traders. It is no wonder that such traders predominate among losers.

This is an extract from Meir Statman's Finance For Normal People published by Oxford University Press