The Psy-Fi Pages

Monday, 1 February 2016

When Comfort Blankets Go Bad: Risk, Perception and Investing Theater

Investing as Performance Art

The security analyst Bruce Schneier describes many of the security measures on public display as  “security theater”: a meaningless set of rituals designed to provide a comfort blanket. He argues that these measures provide no useful protection and mainly serve to make our lives more difficult, increasing the risks we have to take while simultaneously restricting our freedoms.

I’d argue that much of the performance art we see around investing serves much the same purpose - and with much the same outcome. Box ticking regulations don't actually do much for investors other than make their lives more confusing and difficult; but with a lot of thought, and a bit of investing theater, we might be able to better align real risk and perception to everyone's benefit.

Regulating Stable Doors

Here’s how Schneier describes the problem:
“Security theater refers to security measures that make people feel more secure without doing anything to actually improve their security ... the propensity for security theater comes from the interplay between the public and its leaders. When people are scared, they need something done that will make them feel safe, even if it doesn't truly make them safer. Politicians naturally want to do something in response to crisis, even if that something doesn't make any sense.”
Underlying this is the issue is that security theater can actually make things worse. By responding to the last threat we divert resources away from the difficult task of figuring out what the next one is.  This, of course, is the classic problem of financial regulation. Regulators still haven’t managed to fully implement the Frank-Dodd law passed in 2011 to deal with the problems encountered in 2007-2008. Today, our money is mainly being stolen by pimply hackers in dingy bedrooms. One can expect a regulation about this sometime in 2032.

Bad Attitudes

The tendency to engage in knee-jerk security theater promotes exactly the wrong psychological attitude. Terrorists want to undermine our societies and destroy our freedoms – introducing stupid laws that target extremely specific situations which simultaneously limit our liberty is doing exactly what they want. 

And all of this has limited value – what this box ticking mentality does is ensure that the terrorists can figure out which rules they need to meet in order to carry their bombs through security checks. This is exactly the issue that lay behind the failures in the sub-prime mortgage market – agents figured out how to game the system to ensure no proper oversight was carried out. The regulatory approach to these issues is as biased as everything else, and increasingly opts to introduce stupidly targeted laws, demand pointless form filling or to simply ban people from investing in certain securities that they’re deemed too dumb to understand.

Salience

In fact, the mental impact of security theater can lead to more deaths not less. As Gerd Gigerenzer has described, in the wake of 9/11 there were about 1500 additional deaths caused by people opting to drive rather than fly. Per mile, flying is far safer than using the roads, but the psychological impact of massively publicized terrorist attacks is to make the risks salient – which can trigger responses that cause us to increase the risks we take, while simultaneously agreeing to reduce our freedoms by introducing a whole bunch of measures that wouldn't even have stopped the original atrocity. That’s a win-win for the terrorists.

Similarly the impact of seeing banks collapsing and markets falling is to send people running for the cover of the nearest government backed bond. With interest rates still at staggeringly low levels compared to most of the last century this is simply a way of people getting poor slowly. And governments are in a bind – they need the revenues from the sale of bonds, but they also want people to invest in opportunities that might lead to higher growth.

Operating Errors

One thing is reasonably clear – the psychological biases that underpin our tendency to reach for the security blankets of theatrical reactions to events are not going to disappear any time soon. This isn’t something you can change via education – not that anyone wants to pay for that anyway – it’s simply built into the way that we operate.

In The Psychology of Security Schneier has looked at the behavioral issues behind our attitudes to risk and has found, unsurprisingly, that a lot of the research from behavioral finance reads across:
“The truth is that we’re not bad at making security trade-offs. We are very well adapted to dealing with the security environment endemic to hominids living in small family groups on the highland plains of East Africa. It’s just that the environment of New York in 2007 is different from Kenya circa 100,000 BC. And so our feeling of security diverges from the reality of security, and we get things wrong ... 
... Why is it that, when food poisoning kills 5,000 people every year and 9/11 terrorists killed 2,973 people in one non-repeated incident, we are spending tens of billions of dollars per year (not even counting the wars in Iraq and Afghanistan) on terrorism defense while the entire budget for the Food and Drug Administration in 2007 is only $1.9 billion?”
But the bitter truth is that if we’re not prepared to pay the real costs in terms of eternal vigilance then we have to give up something else.

The Titanic Effect

The other problem with introducing lots of safety nets, whether for security or investment, is that it can encourage us to take the wrong kind of risks: the Titanic Effect, you don’t need to be too careful about avoiding icebergs if they can’t sink your ship. Similarly introducing seatbelt laws can increase reckless driving and bringing in deposit protection can cause investors to take excessive risks. 

If those safety nets actually are just flimsy stage props which provide little or no real protection then the end result is to encourage people to take unjustified risks: we’re at our most safe when we’re properly vigilant of the real level of risks in our environment.  

Auto-Analysis

However, there’s another side to this. Sometimes a bit of low-cost theater can be all we need to make the right choice. And we make the right choices involving risk when our perceptions of risk come close to matching the actual risks. If our perceptions are knocked askew by some massively salient event then it may, sometimes, be worth introducing an element of theater to persuade people to behave more rationally.

And I think this is a clue to how we can use the findings of behavioral psychology to encourage people to invest sensibly rather than stupidly. We need to make sure they don’t think they have an all encompassing safety net. Investors don't have that much protection, but this frequently comes as a surprise. Secondly we need a class of automatic analysis tools – e-advisors if you like – that can provide feedback on the risks in any given portfolio.

Thirdly we need to make the risks salient, and this needs to be done at the point where it can have the maximum impact – usually after some kind of market upheaval. None of this is simple, but where government is providing some kind of tax benefit – usually coming with some kind of ugly acronym – including this kind of functionality really didn’t ought to be beyond the wit of a few bright developers.

Balancing Risk and Perception

Would this be any more effective than introducing restrictions on air travel? Well, possibly: the challenge is to get the balance right. Simply hitting people with messages all the time is not an effective approach, we rapidly become desensitized to their effects. But if triggered on specific events – market falls, individual stock price changes, sector analysis, evidence of overtrading, indications of consistent under-diversification – then it will make people at least consider their actions. Do this often enough and even the dumbest investor may start to get the message.

Of course, even aligning the perception of risk with the actual risks is fraught with danger, our world is full of the results of the law of unintended consequences. But as Bruce Schneier says:
“Of course, security theater has a cost, just like real security. It can cost money, time, capabilities, freedoms, and so on, and most of the time the costs far outweigh the benefits. And security theater is no substitute for real security. Furthermore, too much security theater will raise people’s feeling of security to a level greater than the reality, which is also bad. But used in conjunction with real security, a bit of well-placed security theater might be exactly what we need to both be and feel more secure.”

1 comment:

  1. As a corollary we should also take into account The Eastland effect, where additional safety measures introduced in response to a failure actually make the new state more unsafe.
    “The 1912 sinking of the Titanic gave rise to a "lifeboats-for-all" movement among international marine safety officials. In the United States, Congress passed a bill requiring lifeboats to accommodate 75 percent of a vessel's passengers… After the Eastland rolled, 844 passengers died on a sluggish urban river, 20 feet from the dock. Seventy percent of them were under the age of 25… The blame, Hilton concluded, rested in a poorly designed boat that had been rendered top-heavy as a result of the post-Titanic safety measures.”
    http://www.smithsonianmag.com/history/eastland-disaster-killed-more-passengers-titanic-and-lusitania-why-has-it-been-forgotten-180953146/

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