Sunday, October 22, 2017

Investor Psychology, Part I: Using Time, Scaling and Inflation to Frame Data (and Mislead Readers)

Summary:  How data is presented has a significant affect on the conclusion a reader will draw. Behavioral economists call this framing: "what you see is all there is." Presented below is a mental trick used to mislead readers.

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Over the past 85 years, the S&P stock index has grown 35,600%. The rise looks parabolic. The conclusion appears to be that it is unsustainable (data from Robert Shiller).



Two benign factors account for the parabolic rise.

First, this astounding growth is a product of the long time period being used. Accounting for time, the rate of growth is a more reasonable sounding 7.2% per annum (compounded). A logarithmic scale helps account for the long time period.



Second, inflation also has a substantial influence on growth. During these 85 years, the value of $1 has, through inflation alone, grown 2100%, equalling an additional growth of 3.7% per annum (compounded). Without inflation, annual growth is just 3.5%.



How data is presented has a significant affect on the conclusion a reader will draw. The first chart makes the price rise look parabolic and unsustainable; the second two charts show that the rise has been relatively constant and uncontroversial.

Behavioral economists call this framing: "what you see is all there is." If the author's objective is to show a parabolic rise in price, he/she will use a long time series, a linear scale and nominal prices, leaving the reader to make the mental effort to adjust for benign factors like time and inflation. It's a trick intended to mislead readers.



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