Saturday, January 17, 2015

Happiness and systematic trading



Happiness and systematic trading. You may think I actually mean happiness is systematic trading, but that is not always the right answer. What I refer to is the idea that concepts of happiness actually effect how we build models and how we evaluate managers. Economists have often used concepts of utility to refer to our happiness, but recently there has been a greater push to explain what makes us happy gives us feelings of happiness and how our decisions effect our level of  happiness.

Researchers have found that one of the key characteristics of happiness is that intensity is more important than duration. An intense pleasure experience will have a more lasting impact than a long period of bliss. Similarly, an intensely negative experience will have a greater impact on our overall well-being than low level negative feelings. Additionally, our happiness about an event changes through time. Our feelings about a financial crisis during the event will be different than how we feel years later. Also our expectation of happiness is higher before an event than after it occurs.

So how can we make the right decision for structuring a portfolio if our feeling of happiness about the portfolio changes? For starters, we need to understand the dynamics of happiness and how it may effect our portfolio construction. We cannot be fooled by our changing feelings of happiness.

As described by Daniel Kahneman, the heart of the happiness issue is that it seems we have two selves, the experience and memory self. The difference between these two affects how we think about happiness. There is the actual experience we feel and then there is the memory of those feelings. These do not always match. How we feel about an event, either good or bad will be different through time. Our immediate experience does not always match our memory which will fad through time. Our memory will record vivid events more than long-term feelings. We should not overreact to what think we will feel or what we feel at the time of the event.

Building models can eliminate the Kahneman problem of two selves or at least place them in check. The pleasure or pain we receive from investment success or failure will be static to a model. The experience and memory in a model will be the same. It breaks the problem of two selves by avoiding issues of experience and memory. The fact that there was a financial crisis in the past may not matter.

Because our experienced utility and affected forecasting (predicted utility) do not match, the expected happiness of a good return will not match what we actually feel. We wish for good returns but the level of happiness that we get for those returns will usually be more muted. Again, a model can eliminate these differences.

Now, models can have a difference in experience and memory if we throw out information. If we drop data of a bad experienced return, we are in essence dropping it from our model memory. If we weight data equally, any strong experience will have less impact on our model memory. Longer averages will smooth out feeling of happiness surrounding any one event. In that sense, the "feelings" of model will be affected over time.

While you may think that happiness will just come from steady returns, our reaction to events will have a strong impact on our future behavior. Those unpleasant investments as well as those that gave us pleasure will shape portfolio construction. Feelings should not be dismissed, but should be controlled. 

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