Posts tagged ‘Richard Thaler’
Market Inefficiencies Give Black-Eyes to Classic Economists
Markets are efficient. Individuals behave rationally. All information is reflected in prices. Huh…are you kidding me? These are the beliefs held by traditional free market economists (“rationalists”) like Eugene Fama (Economist at the University of Chicago and a.k.a. the “Father of the Efficient Market Hypothesis”). Striking blows to the rationalists are being thrown by “behavioralists” like Richard Thaler (Professor of Behavioral Science and Economics at the University of Chicago), who believes emotions often lead to suboptimal decisions and also thinks efficient market economics is a bunch of hogwash.
Individual investors, pensions, endowments, institutional investors, governments, were left sifting through the rubble in the aftermath of the 2008-2009 financial crisis because common beliefs were thrown out the window. Experts and non-experts are still attempting to figure out how this mass destruction occurred and how it can be prevented in the future. Economists, as always, are happy to throw in their two cents. Right now traditional free market economists like Fama have received a black eye and are on the defensive – forced to explain to the behavioral finance economists (Thaler et. al.) how efficient markets could lead to such a disastrous outcome.
Religion and Economics
Like religious debates, economic rhetoric can get heated too. Religion can be divided up in into various categories (e.g., Christianity, Islam, Judaism, Hinduism, Buddhism, and other), or more simply, religion can be divided into those who believe in a god (theism) and those who do not (atheism). There are multiple economic categorizations or schools as well (e.g., Keynsians, monetarists, libertarians, behavioral finance economists, etc.). Debates and disagreements across the rainbow of religions and economic schools have been going on for centuries, and the arrival and departure of the 2008-09 financial crisis further ignited the battle between the “behavioralists” (behavioral finance economists) and the “rationalists” (traditional free market economists).
Behavioral Finance on the Offensive
In the efficient market world of the “rationalists,” market prices reflect all available information and cannot be wrong at any moment in time. Effectively, individuals are considered human calculators that optimize everything from interest rates and costs to benefits and inflation expectations in every decision. What classic economists fail to account for are the emotional and behavioral flaws made by individuals.
Claiming financial market decisions are not impacted by emotions becomes more challenging to defend, if you consider the countless irrational anomalies occurring throughout history. Consider the following:
- Tulip Mania: Bubbles are nothing new – they have persisted for hundreds of years. Let’s reflect on the tulip bulb mania of the 1600s. For starters, I’m not sure how classic economists can explain the irrational exchanging of homes or a thousand pounds of cheese for a tulip bulb? Or how peak prices of $60,000+ in inflation-adjusted dollars were paid for a bulb at the time (C-Cynical)? These are tough questions to answer for the rationalists.
- Flash Crash: Seeing multiple stocks and Exchange Traded Funds (ETFs) temporarily plummet -99% in minutes is not exactly the sign of an efficient market. Stalwarts like Procter & Gamble also collapsed -37%, only to rebound minutes later near pre-collapse levels. All this volatility doesn’t exactly ooze with efficiency (see Making Millions in Minutes).
- Negative Interest Rates: Plenty of so-called pundits are arguing that equity markets are expensive, but what about the $8 trillion in negative interest rate bonds? Prices for many of these bonds are astronomical. Paying someone to take my money doesn’t make a lot of sense, but trillions in speculative investments are still being made today.
- Technology and Real Estate Bubbles: Both of these asset classes were considered “can’t lose” investments in the late 1990s and mid-2000s, respectively. Many tech stocks were trading at unfathomable values (more than 100 x’s annual profits) and homebuyers were inflating real estate prices because little-to-no money was required for the purchases.
- ’87 Crash: October 19, 1987 became infamously known as “Black Monday” since the Dow Jones Industrial Average plunged over -22% in one day (-508 points), the largest one-day percentage decline ever.
The ever-growing list of nonsensical anomalies only makes the rationalists’ jobs that much tougher in refuting the illogical behavior. Risk aversion has been alive and well in the post financial crisis environment as wild swings have resulted from a wide range of concerns, including: the U.S. debt downgrade; Arab Spring; potential Greek exit from the EU; Sequestration; Fed Taper Tantrum; Obamacare implementation; Russian invasion of Ukraine; Gaza conflict; Fukashima disaster; Ebola outbreak; Ferguson tensions; Paris/San Bernardino/Brussels terrorist attacks; China recessionary fears; oil price volatility; Mideast turmoil – ISIS expansion; Federal Reserve rate increases; and many other worries. Often, the human lizard brain is what leads to sub-optimal decision making. Maybe the rationalists can use the same efficient market framework to help explain to my wife why I ate a whole box of Twinkies in one sitting?
Rationalist Rebuttal
The growing list of market inefficiencies has given the rationalists a black eye, but they are not going down without a fight. Here are some quotes from Fama and fellow Chicago rationalist pals:
On the Crash-Related Attacks from Behavioralists: Behavioralists say traditional economics has failed in explaining the irrational decisions and actions leading up to the 2008-09 crash. Fama states, “I don’t see this as a failure of economics, but we need a whipping boy, and economists have always, kind of, been whipping boys, so they’re used to it. It’s fine.”
Rationalist Explanation of Behavioral Finance: Fama doesn’t deny the existence of irrational behavior, but rather believes rational and irrational behaviors can coexist. “Efficient markets can exist side by side with irrational behavior, as long as you have enough rational people to keep prices in line,” notes Fama. John Cochrane treats behavioral finance as a pseudo-science by replying, “The observation that people feel emotions means nothing. And if you’re going to just say markets went up because there was a wave of emotion, you’ve got nothing. That doesn’t tell us what circumstances are likely to make markets go up or down. That would not be a scientific theory.”
Description of Panics: “Panic” is not a term included in the dictionary of traditional economists. Fama retorts, “You can give it the charged word ‘panic,’ if you’d like, but in my view it’s just a change in tastes.” Calling these anomalous historic collapses a “change in tastes” is like calling American Idol judge Simon Cowell, “diplomatic.” More likely, what’s really happening is these severe panics are driving investors’ changes in preferences.
Throwing in White Towel Regarding Crash: Not all classic economists are completely digging in their heels like Fama and Cochrane. Gary Becker, a rationalist disciple, acknowledged the blind-siding of the 2008-2009 financial crisis when he admitted, “Economists as a whole didn’t see it coming. So that’s a black mark on economics, and it’s not a very good mark for markets.”
Settling Dispute with Lab Rats
The boxing match continues, and the way the behavioralists would like to settle the score is through laboratory tests. In the documentary Mind Over Money, numerous laboratory experiments are run using human subjects to tease out emotional behaviors. Here are a few examples used by behavioralists to bolster their arguments:
- The $20 Bill Auction: Zach Burns, a professor at the University of Chicago, conducted an auction among his students for a $20 bill. Under the rules of the game, as expected, the highest bidder wins the $20 bill, but as an added wrinkle, Burns added the stipulation that the second highest bidder receives nothing but must still pay the amount of the losing bid. Traditional economists would conclude nobody would bid higher than $20. See the not-so rational auction results here at minute 1:45.
- $100 Today or $102 Tomorrow? This was the question posed to a group of shoppers in Chicago, but under two different scenarios. Under the first scenario, the individuals were asked whether they would prefer receiving $100 in a year from now (day 366) or $102 in a year and one additional day (day 367)? Under the second scenario, the individuals were asked whether they would prefer receiving $100 today or $102 tomorrow? The rational response to both scenarios would be to select $102 under both scenarios. See how the participants responded to the questions here at minute 4:30.
Rationalist John Cochrane is not fully convinced. “These experiments are very interesting, and I find them interesting, too. The next question is, to what extent does what we find in the lab translate into how people…understanding how people behave in the real world…and then make that transition to, ‘Does this explain market-wide phenomenon?,’” he asks.
As I alluded to earlier, religion, politics, and economics will never fall under one universal consensus view. The classic rationalist economists, like Eugene Fama, have in aggregate been on the defensive and taken a left-hook in the eye for failing to predict and cohesively explain recurring market inefficiencies, including the financial crash of 2008-09. On the other hand, Richard Thaler and his behavioral finance buds will continue on the offensive, consistently swinging at the classic economists over this key economic mind versus money dispute.
See Complete Mind Over Money Program
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in PG and certain exchange traded funds (ETFs), but at the time of publishing had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Decision Making on Freeways and in Parking Lots
Many drivers here in California adhere to the common freeway speed limit of 65 miles per hour, while some do not (I’ll take the 5th). In the vast majority of cases, racing to your destination at these faster speeds makes perfect sense. However, driving 65 mph through the shopping mall parking lot could get you killed, so slower driving is preferred in this instance. Ultimately, the specific environment and situation will dictate the rational and prudent driving speed. Decision making works in much the same way, and Daniel Kahneman, a Nobel Prize winner, has encapsulated his decades of research in psychology and economics in his most recent book, Thinking, Fast and Slow.
Much of Kahneman’s big ideas are analyzed through the lenses of “System 1” and “System 2” – the fast and slow decision-making processes persistently used by our brains. System 1 thinking is our intuition in the fast lane, continually making judgments in real-time. Our System 1 hunches are often correct, but because of speedy, inherent biases and periodic errors this process can cause us to miss an off-ramp or even cause a conclusion collision. System 2, on the other hand, is the slower, methodical decision-making process in our brains that keeps our hasty System 1 process in check. Although little mental energy is exerted by using System 1, a great deal of cerebral horsepower is required to use System 2.
Summarizing 512 pages of Kahneman’s book in a single article may be challenging, nevertheless I will do my best to summarize some of the interesting highlights and anecdotes. A multitude of Kahneman’s research is reviewed, but a key goal of the book is designed to help individuals identify errors in judgment and biases, in order to lower the prevalence of mental mistakes in the future.
Over Kahneman’s 50+ year academic career, he has uncovered an endless string of flaws in the human thought process. To bring those mistakes to life, he uses several mind experiments to illustrate them. Here are a few:
Buying Baseball: We’ll start off with a simple Kahneman problem. If a baseball bat and a ball cost a total of $1.10, and the bat costs $1 more than the ball, then how much does the ball cost? The answer is $0.10, right? WRONG! Intuition and the rash System 1 forces most people to answer $0.10 cents for the ball, but after going through the math it becomes clear that this gut answer is wrong. If the ball is $0.10 and the bat is $1 more, then that would mean the bat costs $1.10, making the total $1.20…WRONG! This is clearly a System 2 problem, which requires the brain to see a $0.05 ball plus $1.05 bat equals $1.10…CORRECT!
The Invisible Gorilla: As Kahneman points out, humans can be blind to the obvious and blind to our blindness. To make this point he references an experiment and book titled Invisible Gorilla, created by Chritopher Chabris and Daniel Simons. In the experiment, three players wearing white outfits pass a basketball around at the same time that a group of players wearing black outfits pass around a separate basketball. The anomaly in the experiment occurs when someone in a full-sized gorilla outfit goes prancing through the scene for nine full seconds. To the surprise of many, about half of the experiment observers do not see the gorilla. In addition, the gorilla-blind observers deny the existence of the large, furry animal when confronted with recorded evidence (see video below).
Green & Red Dice: In this thought experiment, Kahneman describes a group presented with a regular six-sided die with four green sides (G) and two red sides (R), meaning the probability of the die landing on green (G) is is much higher than the probability of landing on red (R). To make the experiment more interesting, the group is provided a cash prize for picking the highest probability scenario out of the following three sequences: 1) R-G-R-R-R; 2) G-R-G-R-R-R; and 3) G-R-R-R-R-R. Although most participants pick sequence #2 because it has the most greens (G) in it, if one looks more closely, sequence #2 is the same as #1 except for sequence #2 has an additional green (G). Therefore, the highest probability winning answer should be sequence #1 because sequence #2 adds an uncertain roll that may or may not land on green (G).
While the previous experiments described some notable human decision-making flaws, here are some more human flaws:
Anchoring Effect: Was Gandhi 114 when he died, or was Gandhi 35 when he died? Depending how the question is asked, asking the initial question first will skew the respondents answer to a higher age, because the respondents answer will be somewhat anchored to the number “114”. Similarly, the price a homebuyer would pay for a house will be influenced or anchored to the asking price. Another word used by some for anchoring is “suggestion”. If a subliminal suggestion is planted, people’s responses can become anchored to that idea.
Overconfidence: We encounter overconfidence in several forms, especially from what Kahneman calls the “Illusion of Pundits,” which is the confidence that comes with 20-20 hindsight experienced in our 24/7 media world. Or as Kahneman states in a different way, “The illusion that we understand the past fosters overconfidence in our ability to predict the future.” Driving is another example of overconfidence – very few people believe they are poor drivers. In fact, a well-known study shows that “90% of drivers believe they are better than average,” despite defying the laws of mathematics.
Risk Aversion: In Kahneman’s book, he also references risk aversion studies by Mathew Rabin and Richard Thaler. What the researchers discovered is that people appear to be irrational in the way they respond to certain risk scenarios. For example, people will turn down the following gambles:
A 50% chance to lose $100 and a 50% chance to win $200;
OR
A 50% chance to lose $200 and a 50% chance to win $20,000 .
Although rational math would indicate these are smart bets to take, however most people decline the game because humans on average weigh losses twice as much as gains (see also the Pleasure/Pain Principle). To get a better understanding of predictive human behavior, the real emotional costs of disappointment and regret need to be accounted for.
Truth Illusions: A reliable way to make people believe in falsehoods is through repetition. More exposure will breed more liking. In addition to normal conversations, these repetitive truth illusions can be witnessed in propaganda or advertising. Minimizing cognitive strain also reinforces points. Using bold, colored, and contrasted language is more convincing. Simpler language rather than more complex language is also more credible.
Narrative Fallacies: We humans have an innate desire to continually explain the causation of an event due to skill or stupidity – even if randomness is the best explanation.People try to make sense of the world, even though many outcomes have no straightforward explanation. Often times, a statistical phenomenon like “regression to the mean” can explain the results (i.e., outliers revert directionally toward averages). The “Sports Illustrated Jinx,” or the claim that a heralded cover story athlete will be subsequently cursed with bad performance, is used as a case in point. Actually, there is no jinx or curse, but often fickle luck disappears and athletic performance reverts to norms.
Kahneman on Stocks
Many of the principles in Kahneman’s book can be applied to the world of stocks and investing too. According to Kahneman, the investing industry has been built on an “illusion of skill,” or the belief that one person has better information than the other person. To make his point, Kahneman references research by Terry Odean, a finance professor at UC Berkely, who studied the records of 10,000 brokerage accounts of individual investors spanning a seven-year period and covering almost 163,000 trades. The net result showed dramatic underperformance by the individual traders and confirmed that stocks sold by the traders consistently did better than the stocks purchased.“Taking a shower and doing nothing” would have been better than the value destroying trading activity. In fact, the most active traders did much worse than those who traded the least. For professional managers the conclusions are not a whole lot different. “For a large majority of fund managers, the selection of stocks is more like rolling dice than like playing poker. Typically at least two out of every three mutual funds underperform the overall market in any given year,” says Kahneman. I don’t disagree, but I do believe, like .300 hitters in baseball, there are a few managers that can consistently outperform.
There are a lot of lessons to be learned from Daniel Kahneman’s book Thinking, Fast and Slow and I apply many of his conclusions to my investment practice at Sidoxia. We all race through decisions every day, but as he repeatedly points out, familiarizing ourselves with these common mental pitfalls, and also utilizing our more methodical and accurate System 2 thought process regularly, can create better decisions. Better decisions not only for our regular lives, but also for our investing lives. It’s perfectly OK to race down the mental freeway at 65 mph (or faster), but don’t forget to slow down occasionally, in order to avoid mental collisions.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Crisis Delivers Black-Eye to Classic Economists
Markets are efficient. Individuals behave rationally. All information is reflected in prices. Huh…are you kidding me? These are the beliefs held by traditional free market economists (“rationalists”) like Eugene Fama (Economist at the University of Chicago and a.k.a. the “Father of the Efficient Market Hypothesis”). Striking blows to the rationalists are being thrown by “behavioralists” like Richard Thaler (Professor of Behavioral Science and Economics at the University of Chicago), who believes emotions often lead to suboptimal decisions and also thinks efficient market economics is a bunch of hogwash.
Individual investors, pensions, endowments, institutional investors, governments, are still sifting through the rubble in the aftermath of the 2008-2009 financial crisis. Experts and non-experts are still attempting to figure out how this mass destruction occurred and how it can be prevented in the future. Economists, as always, are happy to throw in their two cents. Right now traditional free market economists like Fama have received a black eye and are on the defensive – forced to explain to the behavioral finance economists (Thaler et. al.) how efficient markets could lead to such a disastrous outcome.
Religion and Economics
Like religious debates, economic rhetoric can get heated too. Religion can be divided up in into various categories (e.g., Christianity, Islam, Judaism, Hinduism, Buddhism, and other), or more simply religion can be divided into those who believe in a god (theism) and those who do not (atheism). There are multiple economic categorizations or schools as well (e.g., Keynsians, monetarism, libertarian, behavioral finance, etc.). Debates and disagreements across the rainbow of religions and economic schools have been going on for centuries, and the completion of the 2008-09 financial crisis has further ignited the battle between the “behavioralists” (behavioral finance economists) and the “rationalists” (traditional free market economists).
Behavioral Finance on the Offensive
In the efficient market world of the “rationalists,” market prices reflect all available information and cannot be wrong at any moment in time. Effectively, individuals are considered human calculators that optimize everything from interest rates and costs to benefits and inflation expectations in every decision. What classic economics does not include is emotions or behavioral flaws.
Purporting that financial market decisions are not impacted by emotions becomes more difficult to defend if you consider the countless irrational anomalies considered throughout history. Consider the following:
- Tulip Mania: Bubbles are nothing new – they have persisted for hundreds of years. Let’s reflect on the tulip bulb mania of the 1600s. For starters, I’m not sure how classic economists can explain the irrational exchanging of homes or a thousand pounds of cheese for a tulip bulb? Or how peak prices of $60,000+ in inflation-adjusted dollars were paid for a bulb at the time (C-Cynical)? These are tough questions to answer for the rationalists.
- Flash Crash: Seeing multiple stocks (i.e., ACN and EXC) and Exchange Traded Funds (ETFs) temporarily trade down -99% in minutes is not exactly efficient. Stalwarts like Procter & Gamble also collapsed -37%, only to rebound minutes later near pre-collapse levels. All this volatility doesn’t exactly ooze with efficiency (see Making Millions in Minutes).
- Negative T-Bill Rates: For certain periods of 2008 and 2009, investors earned negative yields on Treasury Bills. In essence, investors were paying the government to hold their money. Hmmm?
- Technology and Real Estate Bubbles: Both of these asset classes were considered “can’t lose” investments in the late 1990s and mid-2000s, respectively. Many tech stocks were trading at unfathomable values (more than 100 x’s annual profits) and homebuyers were inflating real estate prices because little to no money was required for the purchases.
- ’87 Crash: October 19, 1987 became infamously known as “Black Monday” since the Dow Jones Industrial Average plunged over -22% in one day (-508 points), the largest one-day percentage decline ever.
The list has the potential of going on forever, and the recent 2008-09 financial crisis only makes rationalists’ jobs tougher in refuting all this irrational behavior. Maybe the rationalists can use the same efficient market framework to help explain to my wife why I ate a whole box of Twinkies in one sitting?
Rationalist Rebuttal
The rationalists may have gotten a black eye, but they are not going down without a fight. Here are some quotes from Fama and fellow Chicago rationalist pals:
On the Crash-Related Attacks from Behavioralists: Behavioralists say traditional economics has failed in explaining the irrational decisions and actions leading up to the 2008-09 crash. Fama states, “I don’t see this as a failure of economics, but we need a whipping boy, and economists have always, kind of, been whipping boys, so they’re used to it. It’s fine.”
Rationalist Explanation of Behavioral Finance: Fama doesn’t deny the existence of irrational behavior, but rather believes rational and irrational behaviors can coexist. “Efficient markets can exist side by side with irrational behavior, as long as you have enough rational people to keep prices in line,” notes Fama. John Cochrane treats behavioral finance as a pseudo-science by replying, “The observation that people feel emotions means nothing. And if you’re going to just say markets went up because there was a wave of emotion, you’ve got nothing. That doesn’t tell us what circumstances are likely to make markets go up or down. That would not be a scientific theory.”
Description of Panics: “Panic” is not a term included in the dictionary of traditional economists. Fama retorts, “You can give it the charged word ‘panic,’ if you’d like, but in my view it’s just a change in tastes.” Calling these anomalous historic collapses a “change in tastes” is like calling Simon Cowell, formerly a judge on American Idol, “diplomatic.” More likely what’s really happening is these severe panics are driving investors’ changes in preferences.
Throwing in White Towel Regarding Crash: Not all classic economists are completely digging in their heels like Fama and Cochrane. Gary Becker, a rationalist disciple, acknowledges “Economists as a whole didn’t see it coming. So that’s a black mark on economics, and it’s not a very good mark for markets.”
Settling Dispute with Lab Rats
The boxing match continues, and the way the behavioralists would like to settle the score is through laboratory tests. In the documentary Mind Over Money, numerous laboratory experiments are run using human subjects to tease out emotional behaviors. Here are a few examples used by behavioralists to bolster their arguments:
- The $20 Bill Auction: Zach Burns, a professor at the University of Chicago, conducted an auction among his students for a $20 bill. Under the rules of the game, as expected, the highest bidder wins the $20 bill, but as an added wrinkle, Burns added the stipulation that the second highest bidder receives nothing but must still pay the amount of the losing bid. Traditional economists would conclude nobody would bid higher than $20. See the not-so rational auction results here at minute 1:45.
- $100 Today or $102 Tomorrow? This was the question posed to a group of shoppers in Chicago, but under two different scenarios. Under the first scenario, the individuals were asked whether they would prefer receiving $100 in a year from now (day 366) or $102 in a year and one additional day (day 367)? Under the second scenario, the individuals were asked whether they would prefer receiving $100 today or $102 tomorrow? The rational response to both scenarios would be to select $102 under both scenarios. See how the participants responded to the questions here at minute 4:30.
Rationalist John Cochrane is not fully convinced. “These experiments are very interesting, and I find them interesting, too. The next question is, to what extent does what we find in the lab translate into how people…understanding how people behave in the real world…and then make that transition to, ‘Does this explain market-wide phenomenon?,’” he asks.
As alluded to earlier, religion, politics, and economics will never fall under one universal consensus view. The classic rationalist economists, like Eugene Fama, have in aggregate been on the defensive and taken a left-hook in the eye for failing to predict and cohesively explain the financial crash of 2008-09. On the other hand, Richard Thaler and his behavioral finance buds will continue on the offensive, consistently swinging at the classic economists over this key economic mind versus money dispute.
See Complete Mind Over Money Program
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in ACN, EXC, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Investing Caffeine 
