A Finance Education, Through A Mondrian Prism

My advanced undergraduate investments class is working through the mathematics of Markowitz efficient frontiers and Sharpe’s intuition about systematic vs. unsystematic risk in development of the capital asset pricing model. After class, a student stopped to ask me about why the math I’m putting upon him matters. To me, “why does this matter?” is an excellent question–particularly at this stage of an education: nearing graduation, thinking about how the details fit into the bigger picture is a skill that often goes undeveloped.

My student understands the mathematics intuitively–he can visualize what’s going on, but doesn’t really see the need to spend his time learning about the math, particularly if lots of the classroom, textbook models don’t work especially well under the harsher conditions of real-world finance. Why learn about how to calculate beta if the arbitrage pricing theory or a Fama-French 3-Factor model works better?

Later in the day, I relayed that conversation to a friend who suggested I could relay the story of Piet Mondrian’s development as an artist as an analogue to this problem: why learn the basics if I have a general understanding and intuition for the craft.

Mondrian’s work is most well-known to us lay people as white backgrounds with horizontal and vertical black lines, interspersed with patches of pure color: blues, reds, yellows. He’s one of the creators of the minimalist school of abstract art, but what is frequently unconsidered is how those well-known compositions weren’t created by a young student experimenting. Instead, Mondrian is a story about an artist who learns the fundamentals of his craft before branching out into his own direction.

Near the turn of the 20th century, young Dutch painter, Piet Mondrian (b. 1872), learned the basics of translating what he saw in the world around him onto canvas. In his 20s and early 30s, his works are pretty classical–he’s painting landscapes. He clearly has a gift for illustrating what he’s seeing:

Mill 1905

Mill (1905)

If you asked me what I thought the Dutch countryside looked like at the turn of the 20th century, this is my mental image; a little windmill near some water. It’s pretty solid work; if there’s a theory to art, then this young Mondrian has clear intuition about how to capture what he’s seeing.

At 32, Mondrian is painting in the wake of the Impressionists (Renoir, Monet, Pissarro) of the late 19th century, who have become skilled at capturing what we’re seeing “not exactly,” but with enough detail that you can totally understand what’s being captured. Here, Mondrian is learning the basics–it’s a landscape, it’s fairly concrete in message, and we’re experimenting with using just enough detail to capture the scene. But he’s a few years behind–the Impressionists were at the forefront of art in the late 19th century and he’s working on this just after the turn of the century.

Woods Near Oele 1908

Woods Near Oele (1908)

Move forward a few years. Mondrian has more experience, is more comfortable with image delivery. His mastery of the basics and the ideas of the guys he’s following is clear. He’s built on his intuition about to convey something to his audience and is now pushing forward to new areas. By 1911, he’s experimenting with new styles, having caught up with the direction of the art world–this is roughly the point at which Picasso is developing cubist art–and Mondrian is creating along similar lines. This cubist art pushes the bounds of how we interpret art and the images we see.

Gray Tree 1911

Gray Tree (1911)

It’s clearly a tree. I’m certainly no art expert, but to me it’s capturing a tree, barren of leaves, stark against the dismal winter sky. But look at how little detail there is and yet the art totally convinces us to imagine the details of that knotty tree, curled in on itself, waiting out the winter’s harshness. 

Here’s where the story gets interesting. Here’s a painter that is now working alongside the leading artists of his time, pushing the envelope of how we think about what we see. He’s totally capable of producing the old works (see the landscapes in his 20s and 30s), he’s put in lots of work in post-impressionism, and cubism (see his works in his late 30s). And then he moves off into his own direction. He’s got enough of the background, enough skill with the fundamentals that he can explore and create totally new areas. He’s beginning to experiment with new ideas in his 40s:

Composition in Oval 1914

Composition in Oval with Color Planes 1 (1914)

This is the direction he goes. Ultimately, his experiments in abstraction evolve into very stark work, with the black lines interspersed with patches of pure color. By the time he’s in his fifties, he’s beginning to produce the works that he’ll become famous for: 

Composition with Blue, Yellow, Black, and Red 1922 

Composition with Blue, Yellow, Black, and Red (1922)

It’s this style that will help create an entire school of art, minimalism.

Composition No. 10 1942 

Composition No. 10 (1939-1942)

This style of art shows up in all kinds of forms. The cover of Vogue magazine in 1965 featured a girl in a Yves St. Laurent’s dress styled along these later Mondrian patterns.

Here’s the basic take-away: Piet Mondrian’s vision and experimentation helped push art into completely new territory. But it’s hard to push the boundaries if you don’t have sufficient training and mastery of the the fundamentals of the practice. When you think about Mondrian’s work, the important images that we immediately associate with his name, we’re thinking about a somewhat finished product. We don’t tend to think about where he was developmentally before his better known works of the 1920s, 30s, and 40s, when he’s in his fifties or seventies. But he started with the basics–painting landscapes in the backyard, advancing to capture some of the impressionist style, catching up with the cubists, before branching out and doing his own thing.

Ultimately, what I try to convey in class is just the first step in that long route. It’s the painting of landscapes. We’re trying to establish how we convey information–prices are information, after all. We’re illustrating the very basics of what we know and how we know it. And you’d want to master those basics and experiment off of them to see what works and what doesn’t work. To get to mastery “probably” requires some facility with mathematics, because you can experiment with ideas in a rigorous way. Of course, there are plenty of stories of guys who’ve done well in markets without any training in mathematics (and probably plenty more guys who’ve gotten crushed, but whose stories remain largely unheard). That suggests that it’s incredibly hard to do very well at the game if you don’t truly understand the mathematics at a fundamental level.

You can do alright in markets if you follow the basic instruction, just as Mondrian’s early work is pretty solid. But I’d guess that the real money is in developing the new schools of thought–understanding at a core level what is driving the bus and figuring out exactly when you want to get off and starting out on your own.

Behavioral Biases Affect All of Our Decisions

I’ve written a couple of articles for the local paper over the last couple years (the finance department takes turns writing a weekly column) and this week, it’s my turn again. Usually, my articles focus on the behavioral side of finance, though with the election upon us, it seems a good opportunity to illustrate that behavioral biases affect all kinds of decisions. The article is set to run this Sunday, November 4.

I’ve used this space before discussing how behavioral biases lead to making suboptimal investment choices. By increasing awareness of these issues, I hope we make better financial decisions. Our biases affect other decisions, too; with an election coming up in just a couple days, this is a good opportunity to pause and reflect on how we process information and improve our decision making. Evaluating evidence and setting opinions on a particular topic is mentally taxing, but it’s worth taking the time to do it right.

We like to hear that our opinions are right, while reducing the effort required evaluating new information. When we buy a share of stock, we love seeing confirmation that our decision was smart (analysts say the stock remains undervalued…YES!), while dismissing or rationalizing evidence that our play was poor (this analyst knows nothing…it’ll bounce back). This confirmation bias shows up in politics, too.

We search for information that reinforces what we already believe, while reducing exposure to sources that cause us to rethink our positions. Worse, we actively dismiss contrary evidence, too. Conservatives are more likely to watch Fox News than MSNBC (and vice versa for liberals), because we like hearing evidence that confirms our existing beliefs. It requires less mental effort hearing what already agrees with us than reevaluating our positions in the face of new evidence. Ultimately, we’re likely gathering information in a biased way, leading us towards greater polarization.

If you’ve ever tried convincing family that their beliefs are wrong, you’ve probably seen them settle into a more entrenched, less convincible position–the backfire effect in action. This bias causes people to reject evidence that contradicts an individual’s beliefs and pushes them further towards their own initial positions. That is, not only is it very difficult to sway someone, it’s hard not to push them farther away from your position!

This is particularly frustrating when a belief hinges on a falsehood. Research finds that people are more likely to trust a statement, even a false one, if they’ve heard it before—a familiar claim, regardless of validity, is more trustworthy than an unfamiliar statement. Even if it’s factually wrong, if it’s repeated often enough, people tend to think it’s right. You don’t have to know whether something is valid—instead, just hearing something often makes us more likely to believe it.

It’s hard to expose a well-cited falsehood and change minds. And because we seek out confirming evidence of our pre-existing beliefs, we avoid and dismiss contrary evidence. Even when presented with valid, contrary evidence, we frequently become even more entrenched in our existing beliefs! Our minds play lots of tricks on us, limiting our ability to process information efficiently and accurately.

This weekend, spend an extra moment revisiting your positions. Find contrary evidence and consider the validity of new information. With family gatherings, beware the backfire effect—remember it’s tough to convince someone unless they’re ready to be swayed and you’d probably prefer not to push them even farther away.

Overconfident Investing Is Bad For Your Financial Future

Fifteen months ago, I was asked to write a short article for the local newspaper. At the time I wrote it, I thought it was for the school newspaper. After it was published, I found out that I’d written it for the local newspaper, so I suppose it had a slightly broader audience. Apparently, the department takes turns writing articles for the paper. It’s my turn and below is what I drafted on the spur of the moment this evening (as I’d forgotten that the due date was noon today).

There’s a field of economic research—behavioral economics—where psychology plays a major role in developing ideas about how and why people behave the way they do. We’re learning some fascinating insights into how people act in ways that upend our beliefs of human rationality. I’ll show you a couple of examples of how our behavioral tendencies cause us to act irrationally, even in the realm of finance, and offer up a couple of suggestions for how to overcome our inherent rational shortcomings.

A common example of a behavioral bias is people’s tendency for overconfidence. I’m sure you know someone who has unrealistically positive views of their own skills, knowledge and abilities. That might even describe you. For example, how would you answer the following questions:

“Are you a good driver? Compared to other drivers you see on the road, are you above average, average, or below average?”

One study noted that 82% of sampled college students rated themselves above average! Obviously, many are wrong because they are overconfident in their skills. While being overconfident behind the wheel might not significantly impact your daily life, similar overconfidence issues can affect many things, including your financial future.

Moreover, this is not only a characteristic of the young. It’s commonly understood that most new businesses fail; yet when surveyed about their chances, many new business owners thought they had a 70% chance of success, and only 39% thought any business like theirs would be as likely to succeed!

Perhaps unsurprisingly, this overconfidence stretches even into the stock market. People who are overconfident tend to trade more actively in their investment accounts. Men tend to feel more overconfident in their ability to make investment decisions than women, resulting in more frequent trading and higher turnover for male investors than female. An examination of trading patterns of 39,000 household brokerage accounts noted that men (and single men particularly) were much more likely to trade and had 50% more turnover in their investment holdings than women, resulting in much higher expenses and significantly lower net returns.

Furthermore, overconfident investors believe they are better evaluators of new information and trade more aggressively. Except that they’re not usually as good as they think…the research on these more active traders indicates that they often pick the underperforming stocks. To quote a recent book on it, “Overconfidence-based trading is hazardous when it comes to accumulating wealth.”

If there’s a takeaway from the behavioral finance research I teach, it’s that we’re not as good at stock picking as we want to believe. It’s probably worth remembering that before pulling the trigger on the next stock tip you hear. Instead, we should usually invest in broad market index funds and do so for the long haul. That’s one way to avoid making overconfident trading decisions. Finally, it’s worth remembering that while behavioral biases are present in a vast range of our daily decisions, knowing how they impact our actions can help us overcome them.

Money ≠ Happiness

How happy would you be working for $75,000 a year?  I imagine that as you embark on a career in a few months or years, you’d be delighted to earn that kind of money doing something you liked.  I also imagine that as you look into the future, you have hopes and dreams of earning a six-figure salary, too.  How happy do you think you’d be if you earned $150,000?  Twice as happy as you were earning $75k?  A new, fascinating area of research explores how happy people are on different subjects, including personal finance, and the results might surprise you.

A lot of happiness research confirms what we already know – earning enough income to satisfy basic necessities – a nice home, worry-free transportation, comfortable retirement savings, and good schooling for your children – is very important to personal happiness.  So is having enough extra money for a vacation or two each year, some nice stuff, and a little extra for flexibility and emergencies.  How happy do you think you’d be if you had all that?  Unsurprisingly, surveys conducted asking people about their levels of happiness show that people who earn about $75k a year are pretty happy, as they have enough income to satisfy all of their basic needs, with a little extra left over for fun.

You might be thinking, “That’s great, but I’d be twice as happy if I earn $150,000.”  Too often, we think that the best jobs are the ones that pay the most.  Survey results don’t agree with you.[1]  People who earn $200k are not happier than people who earn $75k.  That’s a little strange, but we might be able to identify some reasons for this.  Higher paying jobs are often a lot more stressful, which reduces your happiness level.  Maybe you live in a more demanding social network and feel pressure to keep up with peers.  What would you do with the extra money?  Probably one of three things – you could go on more vacations, buy nicer stuff, or put it in savings and retire sooner.

There aren’t a lot of that have the flexibility for more than a couple vacations a year, and while a brand new Mercedes might be a lot nicer than a Honda, would you really get twice as much enjoyment out of a car that’s twice as expensive?  Would you really get a lot more enjoyment out of a top of the line 70” plasma television over a reasonably nice 50” one?  What about retiring early?  If you’ve taken a job that you love, you’re not likely to want early retirement – you like your work.  However, if you hate your job, retiring early doesn’t make up for all those years you dreaded it.

There’s a famous story about an investment banker on vacation in Mexico, enjoying the tranquility of fishing from the pier of a quiet village.  He talks to a local fisherman, who loves the peacefulness of his job and the free time he has to spend with his family, every day of his life.  The banker sees an opportunity to help the fisherman expand his business, build a multi-national fishing empire, become fabulously wealthy, which would enable the fisherman to move from his small house to a huge mansion and a big office to manage his growing empire.  The fisherman asks if it would be very stressful.  The investment banker replies that it would be stressful, but with the high income he could save and retire early, spending his retirement fishing peacefully from the pier of a quiet village and spending lots of time with his family.

These columns offer a lot of advice – don’t borrow too much, save money, spend wisely, etc. – but you should also consider the big picture: there’s much more to life than making money.  As you embark on a new career in the near future, look for work that interest you, is meaningful, and can make you comfortably wealthy – enough to satisfy your basic needs with a little extra for some nice stuff and a little fun.  Maximize your happiness.  All the research suggests that really wealthy people aren’t much happier, so look for jobs that put you on a career track that makes you happy, not necessarily the ones that pay the most – money does not equal happiness.

[1] Kahneman, Daniel and Angus Deaton, 2010, “High Income Improves Evaluation of Life But Not Emotional Well-Being”, Proceedings of the National Academy of Sciences.

Early Entry to the Draft

My friend Ani is a huge Kentucky basketball fan and is nervously counting down the days until freshman John Wall makes a decision about entering the 2010 NBA draft or staying in school. If he stays, she’ll be happy because the Wildcats will be automatic contenders for the 2011 Final Four. If he leaves, Kentucky will have to scramble for another great recruiting class to make a run.

Wall’s coach, John Calipari, recently said that Wall was interested in staying at Kentucky, but they’d discuss his options after the season finished. According to the Orphan, Calipari has historically urged his players to move on to the pros, rather than staying in school. I think that’s a phenomenal attitude. Here’s why:

The draft rules stipulate that a player must be one year out of high school, preventing star prep players from jumping straight to the NBA. Instead, they play a year in college, as Wall has this year, before they’re eligible to enter the NBA draft. A player like John Wall, arguably among the best college players in the country, is a first-round draft choice and could easily be selected among the top 5 picks. Even if he stayed in school and developed his game more, he is unlikely to improve his draft stock by playing in college any longer. In fact, it’s conceivable that he could hurt his chances for going pro by suffering a career-threatening injury. (As a player of explosive speed, a significant knee injury could cripple his ability to blow past defenders, severely reducing his value.) Moreover, the rules of the NBA bargaining agreement don’t give a player much room to negotiate their first three-year rookie contract—they’re slotted by draft pick and pre-assigned by the collective bargaining agreement. So even if he developed his skills by staying in school, this additional value would not show up in his contract. It would be a straight up surplus enjoyed by his NBA team.*

Let’s stipulate that a player has a useful career bounded by some unknown age. Some guys have longer careers, others don’t develop and are done sooner. Even if he stays healthy in school, the longer he stays, he foregoes his professional basketball salary. (That is, he doesn’t get a 12-year career after he goes pro—rather he’s done at age 32 regardless of whether he went pro at 19 or 22.) There’s a huge opportunity cost for him to stay in school. Probably something like $2 million per year in guaranteed money plus another $2 million in un-guaranteed money. The sooner he gets through that first contract, the earlier he can negotiate a true free-agent deal. However you slice it, the sooner he gets to the NBA, the more money he earns in his career before he reaches the age boundary.

As with most economic issues, there’s a tradeoff. A player who is not likely a top pick in the current draft might gain enough experience by staying an extra year in college to offset the chance of injury or a regression of skills. But for the top picks in the draft, I’d guess that the opportunity cost of that extra year of salary easily outweighs any additional value from staying in school.

One argument you hear about staying in school is that a player will need something to fall back on after his career. I definitely agree that a retired player needs to have the discipline not to spend his career earnings poorly, but I’m pretty sure that with proper planning and discipline, you can make millions of dollars last a long time. Even so, I’m pretty sure that many players go back to school to earn their degrees. That’s the beauty of college—you can be a student well into your thirties and beyond (example: me!).

Another argument you might make for staying in school is that the school has “committed” to him. It’s offered up a four-year scholarship in exchange for playing ball for the team. But I’m pretty sure any objective observer would agree that in a tradeoff of a year drawing huge crowds to your arena and the TV coverage generated by Wall, versus approximately $25,000 for room, board, and tuition per year, that the university makes out like bandits on the deal. It’s not even close—the marketing alone is probably worth several million dollars to the University of Kentucky. They’re effectively absorbing a huge surplus on a player of Wall’s stature each year he’s playing for the ‘cats.

A college coach, who’s got huge incentives to win, would be hard-pressed not to lean on a great player to stay and help win titles. To hear that Calipari, the Wildcats’ coach, might actively encourage his star players to jump to the NBA suggests that he’s got his players’ best interests at heart. It might make his job tougher and his team might not win as frequently, year-in and year-out, but it suggests that he understands that most of these kids are sitting on winning lottery tickets and should cash them as soon as possible for the maximum value. Calipari is effectively foregoing a small portion of his salary by encouraging his players to jump and that’s sort of admirable. A passionate Wildcat fan might disapprove, because Calipari’s also forcing her to accept a slightly tougher road to the Final Four next year without Wall. But that’s the beauty of sports—you never know how the next year’s going to turn out.


*It’s conceivable, I suppose, that he could develop skills that could he monetize in his first free-agent contract (or associated marketing deals), but that’s probably 3+ years away. The three-year discounted value of that additional salary is probably dwarfed by the opportunity cost of one year of pro salary.