The Return of Homo economicus
The failures of efficient market theories notwithstanding, the great problem for behavioural finance is its inability to offer useful predictions about the future direction of the stockmarket. One of the reactions to this has been the expansion of economics into so-called econophysics – the development of models of stockmarkets based on the fundamental concepts of physics.
What’s rarely clear in discussions of econophysics, which often look and feel like behavioural finance models, is that they generally rely on the fundamental assumption of humans as rational agents. Underlying econophysics is our old friend, Homo economicus. Only humans aren’t rational and they aren’t simply particles: we have consciousness and we’re bloody determined to misuse it in any way we see fit.
Bachelier, Forgotten Hero
The interaction of physics and economics has a long history, reaching back to the sixteenth century with Daniel Bernoulli’s utility models. More recently the work of Louis Bachelier at the turn of the twentieth century produced a model that – eventually – had major ramifications for both subjects. Bachelier identified the random walk processes behind the phenomena of Brownian motion – the arbitrary movements of elementary particles – which also happens to be the underpinning of efficient market theories.
Bachelier’s work predated Einstein’s breakthrough on the same subject by a full half a decade but, as is science's somewhat arbitrary way, was ignored at the time. In fact it was over half a century before a researcher happened upon some of Bachelier’s later work in the library at Yale and started asking colleagues whether they’d ever heard of him. Over at MIT Paul Samuelson went looking and discovered the Frenchman’s original 1990 work: here, already formed, lay the basis of the Efficient Market Hypothesis.
Mindless Agents, Beautiful Minds
It should, hopefully, be fairly obvious where the difficulty in modelling an economy as a set of particles bouncing around in a random fashion lies. The basic elementary unit of physics is a mindless, unthinking atom. Tempting as it is to complete the analogy the reality is that the elementary unit of an economic system is a mindful, conscious human. We make plans and decisions and generally operate in ways that atoms would find pretty distasteful. Although at least we don’t arbitrarily switch between particle and wave form every time we walk through a door.
The main reaction of econophysicists to the awkward tendency of humans to be imperfectly rational is to ignore it. The so-called theory of rational choice is the main way in which this rather odd approach to economics is modelled, based around the concept of a Nash equilibrium where non-cooperative but rational humans end up in a position of economic stability. Unfortunately such a system is unrealistic in the real-world, but that hasn’t stopped researchers spending a great deal of time developing models to show how it would work if it wasn’t unrealistic.
Bounded Rationality and Zero Intelligence
Alternative econophysics approaches involve the ideas of bounded rationality and zero intelligence agents. Bounded rationality assumes that people are basically rational but with limitations and has the great virtue, so econophysicists think, of being parsimonious – that is, it uses a few basic ideas to generate a complex model. Zero intelligence agents are also rationally bounded, the idea being to start with completely random elements – think atoms – and then gradually introduce bits of intelligence to see if this produces more or less realistic behaviour.
While all of this physics based modelling is interesting, and especially so for those looking for repeatable models of the way economic systems work in order to make money out of them, they all face the unenviable problem that the fundamental particle of their system is the recalcitrant human being. And underlying this creature is the so-far unfathomable nature of consciousness.
Reductionism
Pretty well all models based on physics rely on the concept of reductionism – the continued and repeated breaking down of physical properties to their smallest element. So, the physics of physical properties has gradually been reduced into smaller and smaller elementary particles until physicists have ended up with a model of everything which doesn’t seem to work very well unless you assume that the majority of matter in the universe has gone on an extended holiday in search of cosmic karma. The current quest for the so-called God particle – the Higgs Boson – is the outcome of this process.
Regardless of the current state of the unified model of everything the process of reductionism, allied to a scientific method which, as outlined by Karl Popper, requires all hypotheses to be testable and falsifiable has led to four centuries of unparalleled discovery in the physical sciences. However, the science behind consciousness currently seems to have created the scientific equivalent of cognitive dissonance.
When science runs into a dead end philosophers take over. Philosophers are like scientists without the need for empirical proof or, often, the need to take the real universe into account. From time to time, to make a point, they extrapolate to universes that don’t actually exist but could exist if only the current one, annoyingly, didn’t. Unsurprisingly if you put two philosophers in a room you tend to get a catfight, without any of the attendant rules.
The Origins of Consciousness
Arguments about consciousness tend to generate lots of heat and little light. Clearly, at root, human self-awareness is somehow grounded in the physical properties of the brain but equally clearly it’s pretty obvious that the various atoms, electrons, quarks and bosons that constitute our wetware don’t possess consciousness in and of themselves. Somehow consciousness emerges from the way that this all fits together.
Some philosophers like Daniel Dennett believe that an understanding of consciousness is simply a matter of understanding the underlying physical properties of the brain. Dennett stands firmly on the side of reductionist science. Others believe that consciousness is an emergent property, somehow based on the sum of the parts being greater than the individual neurons. Yet others believe that consciousness is learned. Julius Jaynes in his magisterial The Origin of Consciousness in the Breakdown of the Bicameral Mind suggests that early humans operated not on the basis of consciousness but through schizophrenic instructions from the right side of the brain and only gradually learned to stop hallucinating. Well, most of the time anyway. This isn’t exactly a mainstream view, but it is entertaining reading.
Given the lack of agreement on what consciousness is, let alone where it comes from, it’s unsurprising that we can’t develop models around it. Psychologists are, at best, statisticians relying on measurements of group behaviour under given conditions. None of this is very helpful in trying to predict the fluctuations of stockmarkets when conditions keep on changing and so most of the attempts to model economic systems tend to ignore the wanton ability of investors to attempt to think for themselves.
Think, Don’t Follow
Worse, we know that much human behaviour is triggered by unconscious biases – although we can override most of our worst tendencies we generally don’t, preferring to be swept along in crowds and reacting to our guts rather than our heads. Arguably accurate models of consciousness would simply generate idealised rather than accurate behaviour.
Even economists aren't very happy with the results of econophysics. Worrying Trends in Econophysics sets out the case for the prosecution and McCauley that for the defence. The odd thing about these papers is the lack of any reference to actual people. Ultimately any proper definition of economic behaviour must somehow simulate the way that brains work, under different conditions. Simplified, parsimonious econophysics will always go wrong at some point: worse, it’s impossible to predict when. Relying on it is like relying on a plane with faulty landing gear. You know it’s going to end badly, you just hope you’re not on board when it does.
Given the current limitations on understanding how and why people really behave the way they do the safest approach is to assume that all models, however persuasive, are wrong because the ideal of rational man is lurking somewhere deep inside the workings. Rather than relying on others simulating consciousness we’re better off engaging our own.
Related Articles: Mandlebrot's Mad Markets, Science, Stocks and Superstition, Bacteria, Boids and Market Instability
The failures of efficient market theories notwithstanding, the great problem for behavioural finance is its inability to offer useful predictions about the future direction of the stockmarket. One of the reactions to this has been the expansion of economics into so-called econophysics – the development of models of stockmarkets based on the fundamental concepts of physics.
What’s rarely clear in discussions of econophysics, which often look and feel like behavioural finance models, is that they generally rely on the fundamental assumption of humans as rational agents. Underlying econophysics is our old friend, Homo economicus. Only humans aren’t rational and they aren’t simply particles: we have consciousness and we’re bloody determined to misuse it in any way we see fit.
Bachelier, Forgotten Hero
The interaction of physics and economics has a long history, reaching back to the sixteenth century with Daniel Bernoulli’s utility models. More recently the work of Louis Bachelier at the turn of the twentieth century produced a model that – eventually – had major ramifications for both subjects. Bachelier identified the random walk processes behind the phenomena of Brownian motion – the arbitrary movements of elementary particles – which also happens to be the underpinning of efficient market theories.
Bachelier’s work predated Einstein’s breakthrough on the same subject by a full half a decade but, as is science's somewhat arbitrary way, was ignored at the time. In fact it was over half a century before a researcher happened upon some of Bachelier’s later work in the library at Yale and started asking colleagues whether they’d ever heard of him. Over at MIT Paul Samuelson went looking and discovered the Frenchman’s original 1990 work: here, already formed, lay the basis of the Efficient Market Hypothesis.
Mindless Agents, Beautiful Minds
It should, hopefully, be fairly obvious where the difficulty in modelling an economy as a set of particles bouncing around in a random fashion lies. The basic elementary unit of physics is a mindless, unthinking atom. Tempting as it is to complete the analogy the reality is that the elementary unit of an economic system is a mindful, conscious human. We make plans and decisions and generally operate in ways that atoms would find pretty distasteful. Although at least we don’t arbitrarily switch between particle and wave form every time we walk through a door.
The main reaction of econophysicists to the awkward tendency of humans to be imperfectly rational is to ignore it. The so-called theory of rational choice is the main way in which this rather odd approach to economics is modelled, based around the concept of a Nash equilibrium where non-cooperative but rational humans end up in a position of economic stability. Unfortunately such a system is unrealistic in the real-world, but that hasn’t stopped researchers spending a great deal of time developing models to show how it would work if it wasn’t unrealistic.
Bounded Rationality and Zero Intelligence
Alternative econophysics approaches involve the ideas of bounded rationality and zero intelligence agents. Bounded rationality assumes that people are basically rational but with limitations and has the great virtue, so econophysicists think, of being parsimonious – that is, it uses a few basic ideas to generate a complex model. Zero intelligence agents are also rationally bounded, the idea being to start with completely random elements – think atoms – and then gradually introduce bits of intelligence to see if this produces more or less realistic behaviour.
While all of this physics based modelling is interesting, and especially so for those looking for repeatable models of the way economic systems work in order to make money out of them, they all face the unenviable problem that the fundamental particle of their system is the recalcitrant human being. And underlying this creature is the so-far unfathomable nature of consciousness.
Reductionism
Pretty well all models based on physics rely on the concept of reductionism – the continued and repeated breaking down of physical properties to their smallest element. So, the physics of physical properties has gradually been reduced into smaller and smaller elementary particles until physicists have ended up with a model of everything which doesn’t seem to work very well unless you assume that the majority of matter in the universe has gone on an extended holiday in search of cosmic karma. The current quest for the so-called God particle – the Higgs Boson – is the outcome of this process.
Regardless of the current state of the unified model of everything the process of reductionism, allied to a scientific method which, as outlined by Karl Popper, requires all hypotheses to be testable and falsifiable has led to four centuries of unparalleled discovery in the physical sciences. However, the science behind consciousness currently seems to have created the scientific equivalent of cognitive dissonance.
When science runs into a dead end philosophers take over. Philosophers are like scientists without the need for empirical proof or, often, the need to take the real universe into account. From time to time, to make a point, they extrapolate to universes that don’t actually exist but could exist if only the current one, annoyingly, didn’t. Unsurprisingly if you put two philosophers in a room you tend to get a catfight, without any of the attendant rules.
The Origins of Consciousness
Arguments about consciousness tend to generate lots of heat and little light. Clearly, at root, human self-awareness is somehow grounded in the physical properties of the brain but equally clearly it’s pretty obvious that the various atoms, electrons, quarks and bosons that constitute our wetware don’t possess consciousness in and of themselves. Somehow consciousness emerges from the way that this all fits together.
Some philosophers like Daniel Dennett believe that an understanding of consciousness is simply a matter of understanding the underlying physical properties of the brain. Dennett stands firmly on the side of reductionist science. Others believe that consciousness is an emergent property, somehow based on the sum of the parts being greater than the individual neurons. Yet others believe that consciousness is learned. Julius Jaynes in his magisterial The Origin of Consciousness in the Breakdown of the Bicameral Mind suggests that early humans operated not on the basis of consciousness but through schizophrenic instructions from the right side of the brain and only gradually learned to stop hallucinating. Well, most of the time anyway. This isn’t exactly a mainstream view, but it is entertaining reading.
Given the lack of agreement on what consciousness is, let alone where it comes from, it’s unsurprising that we can’t develop models around it. Psychologists are, at best, statisticians relying on measurements of group behaviour under given conditions. None of this is very helpful in trying to predict the fluctuations of stockmarkets when conditions keep on changing and so most of the attempts to model economic systems tend to ignore the wanton ability of investors to attempt to think for themselves.
Think, Don’t Follow
Worse, we know that much human behaviour is triggered by unconscious biases – although we can override most of our worst tendencies we generally don’t, preferring to be swept along in crowds and reacting to our guts rather than our heads. Arguably accurate models of consciousness would simply generate idealised rather than accurate behaviour.
Even economists aren't very happy with the results of econophysics. Worrying Trends in Econophysics sets out the case for the prosecution and McCauley that for the defence. The odd thing about these papers is the lack of any reference to actual people. Ultimately any proper definition of economic behaviour must somehow simulate the way that brains work, under different conditions. Simplified, parsimonious econophysics will always go wrong at some point: worse, it’s impossible to predict when. Relying on it is like relying on a plane with faulty landing gear. You know it’s going to end badly, you just hope you’re not on board when it does.
Given the current limitations on understanding how and why people really behave the way they do the safest approach is to assume that all models, however persuasive, are wrong because the ideal of rational man is lurking somewhere deep inside the workings. Rather than relying on others simulating consciousness we’re better off engaging our own.
Related Articles: Mandlebrot's Mad Markets, Science, Stocks and Superstition, Bacteria, Boids and Market Instability
Given the current limitations on understanding how and why people really behave the way they do the safest approach is to assume that all models, however persuasive, are wrong because the ideal of rational man is lurking somewhere deep inside the workings.
ReplyDeleteYou're missing the point of looking at valuations, Tim.
When stocks are overvalued, prices are not rational. That's by definition. If the price was rational, stocks would be properly valued, not overvalued.
The P/E10 value is the magic tool that tells you the extent to which models employing a Rational Man assumption are wrong. Once you know what adjustment to make to the strategies suggested by the Rational Man model, you've got a model that works. Passive Investing (a Rational Man model) PLUS valuations (P/E10) works in a way that no Rational Man model ever could.
We don't need to build new models from scratch. We just need to factor in the irrationality element. And P/E10 (or any other good valuation metric) does that. Overvaluation is irrationality. Those are two words for the same phenomenon.
Rob
Hi Rob
ReplyDeleteEmpirically you're correct. Well, we could debate the precise definition of 'overvaluation', but you know what I mean.
However, seeking a model that explains why this is so isn't irrational, even though it may not help investors immediately. Failing this, though, developing what Charlie Munger calls a "latticework of mental models" by calling on multiple disciplines - physics, biology, psychology, philosophy, etc - will at best arm investors against the slings and arrows of outrageous investment strategies and at worst make them better dinner party guests (true, I have low standards of dinner party conversation).
It's a bit like the invention of the laser: no one knew what it would be good for, it was just an interesting thing to do. Sometimes interesting things to do turn out to be profitable, sometimes not. There are more things in heaven and markets than money :)
timarr - Sometimes your writing reminds me of Douglas Adams - a great compliment to be sure!
ReplyDeleteOvervaluation and undervaluation are both evidence of 'irrationality' in my view. We can profit from both in limited proven ways. Mainly by selling and refusing to purchase overvalued securities and by purchasing undervalued securities or at least not selling them.
It seems to me that the attempts to explain social phenomena by using econometric and phycial models don't seem to be terribly successful although at times interesting.