Irrational numbers

I’ve sat in two doctoral level investment classes for my degree. It’s not one of my fields because I just don’t want to take the derivatives seminar.  I actually have a lot of disdain for the field now that I’ve done the proofs on the major models.  My ex husband worked 20 years for an insurance company in their investment department doing the real thing.  It was one of the reasons I actually left him.  I find the entire field pretty insufferable.  Unfortunately, it’s also one of the highest paying fields you can have as an academic.  It’s much easier to get big publications in Finance than Economics. That’s basically because there really isn’t an awful lot of theory in finance.  It’s mostly data mining looking for some kind of theory.   As you can  probably tell by now, I’m not really popular with the Investment professors.  They don’t understand me primarily because I’m not out to make money. (Well, that and I refuse to call Eugene Fama God)  My research is always based on contrariness about the current asset pricing models we teach.  I especially disdain the ones that we teach to MBAs and Finance majors.

A lot of Finance is based on two assumptions that I can’t buy. One is that the market follows a random walk.  (This is Fama’s big contribution for which he expects to get a Nobel, but hasn’t managed to date.)  A lot of time is spent looking at the equity markets saying you can’t beat the market or really forecast it because it’s a completely random series.  The second is that the investor is a rational being.  Most of the field total ignores the old Keynesian idea of ‘animal spirits’.  That’s the idea that the market can get a herd mentality and spook at various events and move like a bunch of scared cows.

There’s a field in Finance that’s beginning to get a little bit of respect but still is considered a little out there. That’s probably, why it’s the only parts of Finance and Investment theory that intrigues me.  It’s called Behavioral Finance.  It looks for anomalies in the market and tries to find the reasons for them based more on human psychology rather than trying to just call them odd events.  That’s why I was happy to read this account,  Irrational everything,  written by Guy Rolnik on  Prof. Daniel Kahneman.  Kahneman’s a collector of stories of irrational behavior when it comes to people and finance decisions.  His voice would really add some flavor to the current collapse of modern finance.  Here’s a non finance example that just tickles me every time I read it.

But the story Kahneman recalls when asked about the economic models at the root of the current financial crisis is actually taken from history, not an experiment. It concerns a group of Swiss soldiers who set out on a long navigation exercise in the Alps. The weather was severe and they got lost. After several days, with their desperation mounting, one of the men suddenly realized he had a map of the region.

They followed the map and managed to reach a town. When they returned to base and their commanding officer asked how they had made their way back, they replied, “We suddenly found a map.” The officer looked at the map and said, “You found a map, all right, but it’s not of the Alps, it’s of the Pyrenees.”

According to Kahneman, the moral of the story is that some of our economic models, perhaps those of the investment world, are worthless. But individual investors need security – maps of the Pyrenees – even if they are, in effect, worthless.

Kahneman and his colleague, the late Amos Tversky,  used to search for evidence that people do not make financial decisions rationally which  led to the current field of  “Behavioral Finance”. They are most famous for the idea of investors using  ‘anchors’ in making economic/finance decisions.  Anchors are the security represented by the wrong map in the above example.  It’s the investor’s security blanket.

Kahneman and Tversky found that people do not gather data in a systematic or statistical way, but usually make economic decisions based on “rules of thumb” – heuristics, to borrow the term they used.

For example, let’s take two groups of people and ask the first if the tallest tree in the world is taller than 300 meters. Then let’s ask them how tall the tallest tree in the world is. Then we repeat the exercise with the second group, asking them whether the tallest tree in the world is taller than 200 meters, and then how tall it is. At the end of the experiment, we find that the first group’s average answer to the second question is, around 300 meters, and the second’s is around 200 meters.

Why? Kahneman and Tversky say this is “anchoring”: People tend to latch on to a certain “anchor” – usually one they come across by chance – instead of trying to use a more rational way to gather and process data and make economic decisions.

Kahneman won the Nobel Prize in Economics in 2002.  His theory of irrational decision making is considered an essential  part of economics and is always discussed in risk and consumer theory.  His work has not been integrated, however, into investment decision making to the same degree.  It’s still considered too out there.

Kahneman and Naseem Talib, the mathematician well known for the Black Swan theory, are known to share ideas these days.  Both feel that financial/economic models have no validity during crisis times.  Kahneman’s ideas about the financial crisis are very germane but have not appeared in the press.  Talib, on the other hand, has been thrust into the spotlight. That’s why I was pleased to find Kahneman’s comments in the link provided above.

From Kahneman’s point of view, the most important moment of the recent economic crisis came when Alan Greenspan admitted at a congressional hearing that his theory of the world had been mistaken. “Greenspan expected financial firms to protect their interests, because they are rational companies and the market is rational, so they would not take risks that would threaten their very existence,” Kahneman says.

“Where did he go wrong? Because he did not distinguish between the firms and their ‘agents’ [their managers]. There is a huge gulf between the companies and their agents. Firms take the long view, while agents have short perspectives and take the short view. The compensation models of the corporation and their agents are different. The executives did not commit suicide when they took risks; it was the corporations managed by these agents that committed suicide.

“People are always asking me: ‘Are the people who got caught up in the financial crisis idiots?’ The answer is, the bank managers were not complete idiots. Greenspan’s admission speaks for itself: The theory that a bank is some sort of rational agent that protects the public’s interest is wrong. The assumption of rationality is a fallacious one in the first place, and in the second place, the assumption that a bank should be seen as a single, rational player is irrelevant. One must look at who is managing the bank – management that receives incentives to do things that are not connected to anybody’s interests.”

I can’t possibly cover every thing said in this wonderful interview but would suggest you read the entire thing yourself.  There are many gems of wisdom on many things. This includes his thoughts on what we can learn from the crisis.

So how do we deal with this? What are the lessons to be learned from this crisis?

“I think that in the future there will be rules obligating lenders to give much more information to borrowers. Financial firms’ problems are less interesting from a psychological point of view. These are problems of agents and companies that economists already understand. The interesting psychological problem is why economists believe in their theory, but this is the problem with the theory, any theory. It leads to a certain blindness. It’s difficult to see anything that deviates from it.”

We only look for information that supports the theory and ignore the rest.

“Correct. That appears to be what happened with Greenspan: He had a theory under which the market operates, and that the market would correct itself.”

A personal question. When you look at your own behavior in the world of economics, do you feel you make the same mistakes, or that you are aware and thus consider yourself immune?

“I am not immune, I am a coward. That’s something else. Several years ago, I decided that I should not take any risks, that I want a European retirement, linked to the cost-of-living index. In the United States, there is no such thing. I asked an investment counselor to look into whether she could arrange a European retirement for me, something linked to the cost of living, without any risk. She threw me out of her office; she considered it something incompatible with American values.”

I would also suggest you read this:  Would you be happier if you were richer?  A focusing illusion. It’s a paper published in May 2006 by the Princeton University Center for Economic Policy Studies.  It’s a fascinating look at the transitory nature of happiness (life satisfaction) brought on by being wealthy.  It’s another good read for times of financial crisis.

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