A Sideways Look At … Retirement

Retirement on the Psy-Fi Blog

For one reason or another retirement has figured large on PSB over the past few months. It’s probably my fixation about retirement being the main objective of stockmarket investing for most people. The idea of getting old is bad enough without the thought of being poor as well. Although on the bright side you can pretend to be deaf and then be rude to people all you like.

Anyway, here’s a brief summary of the Psy-Fi Blog’s thoughts on retirement …

Old? Prudent? You’ve Been Bilked!

The sheer scale and effrontery of the banks’ reactions to government bail-outs are enough to drive anyone to outright sarcasm …

“In fact it’s only non-working savers who will lose out and let’s face it, they don’t have much say in the matter anyway. It’s a small price to pay that we’re taking from the prudent to bail out the profligate but frankly most of these people are quite old and would probably have died quite soon anyway.” >> Read More

Of course, providing you don’t eat very much, don’t require heating or shelter and can avoid healthcare costs you’ll probably be OK. Here in the UK we’re preparing to legalise euthanasia. This is almost certainly a coincidence. Probably.

The basic demographics of developed nations virtually guarantees that some nasty decisions lie ahead. Of course we can always agree to allow more immigration to pick up the slack of absent taxpayers. That’s always popular with electorates.

The End of the Age of Retirement

When Otto von Bismark introduced pensions it was on the understanding that most people would die before they got one. Unfortunately people promptly decided that if they were going to be paid to be old then they’d hang about to do so. That’s not quite so stupid as it sounds – there’s good evidence that people manage to delay their deaths to benefit from taxation changes.

Anyway, the average lifespan of a male in London in 1900 was only about 40, now it’s nearly double that. State pension schemes paying out today’s taxes to today’s pensioners are bust if you look at future liabilities. Future pension and healthcare benefits can’t possibly match the expectations of the middle aged and may not even see the already retired through safely. Pension ages are already increasing …

“For those of us in middle age there’s at least some time to take note of the demographic trends and prepare ourselves. Assuming that we’ll retire at Bismarck’s 65, pick up inflation protected benefits and be able to sell our houses for enough money to fund a golden age of cruises, holiday homes and golf club memberships isn’t very wise. Doing some sensible paying down of debt and investing in the stockmarket in a way that will guarantee capturing the maximum returns for the minimum risk is a better bet. ” >> Read More

The only problem with this being that most people are more likely to chase the latest investing trend and lose their savings in hopeless gambles than they are to invest safely. In fact most people will simply fail to make a decision at all because it’s all too difficult. Usually they’ll go off and spend their retirement savings on some new clothes and a nice holiday rather than thinking about retirement.

Retirees, Procrastinate At Your Peril

The art of not making a decision, choosing short-term pleasure over long term gains and generally operating on the basis of tomorrow never coming is pretty much the status quo when it comes to retirement planning. Most people simply don’t get around to doing it because it’s not fun. Those who do often fail because they can’t decide what to do for the best, give up and go bowling instead:

“The odd, but inevitable conclusion, from this research is that when figuring out what to do about the tricky business of retirement investing people may never get around to doing it because it’s too important. It’s hard to know what’s worse – a mass of pleasure seeking, live for the moment hedonists ignoring their retirement problems because of lack of self-control or the responsible and thoughtful folks who are paralysed by analysis.” >> Read More

Time to call for an expert advisor?

Disclosure Won’t Stop A Conflicted Advisor

Well, sadly not. Advisors only give unbiased advice if you pay them directly and most people don’t want to pay them at all. Advisors paid by commission on the products they sell will sell you the wrong thing. If they tell you that they get commission on the products they’ll do even worse stuff.

“Possibly the biggest problem, however, is that a disclosure of a conflict of interest by an expert often requires an expert to evaluate it. If you go to a doctor about a difficult medical problem and the physician tells you that you need an expensive drug but that she’s being paid by the pharmaceutical industry to plug it how do you respond? Does this disclosure help you make the decision or not?

Well, not, as it happens.” >> Read More

So trusting advisors isn’t usually a good option, either. Perhaps we should learn how to invest for ourselves – better get some training.

Financial Education Doesn’t Work

Only, it turns out, we’re awful at learning about finance. When we do learn anything we usually end up drawing the wrong conclusions:
 

There is one type of training that does seem to improve the situation – the so-called stockmarket game in which students actively participate in their learning approach. This produces a 6 to 8% improvement. Researchers seem to be puzzled by why this might be the case but there’s plenty of psychological research around that shows how active involvement in learning situations improves student ability to use the training afterwards.

Regardless, the stockmarket game success turns out to be a pyrrhic victory because the successful students then go on to save less  than their peers. The (unsubstantiated) hypothesis is that they learn that they can make up for failing to save by taking additional risks on the markets. Which is of course, what happens when you treat people like lab rats – they figure out how to get the cheese for as little effort as possible: proponents of ‘Nudge’ techniques beware. >> Read More

In fact the only thing that does seem to work is abandoning your sense of responsibility by opting out of the decision altogether.

Save More … Tomorrow

Yes, it’s been shown that the people who save most are the people who make a decision up front and then refuse to think about it. Being inherently lazy and utterly bored by the topic if we decide to invest an ever-increasing percentage of our salary in our pensions, increasing as our salaries increase, then we end up saving more than pretty much anyone else. It’s a rare case of behavioural finance actually helping us rather than pointing out exactly how stupid we are. Unfortunately there are likely to be downsides:
 

“As the same article points out, however, there is a problem in using these methods. We know that they work but we don’t know exactly why. And therein lies an issue, because when we nudge people in one direction we’re likely to find that although we may get the desired outcome, we may also cause them to do other things we don’t expect: consumers who save more for retirement in automatic schemes will be consuming less and buying fewer financial products, for instance.” >> Read More

It Ain’t What You Save, It’s What You Do With It

Of course, many people will argue it’s what you do with your savings that matters, rather than the amount you save. Sadly the evidence is not on their side. The vast majority of people who try to think their way through the thicket of the investment jungle end up doing worse than a cross-eyed monkey armed with a set of darts and a copy of the Wall Street Journal.

Although, of course, the monkey’s more likely to use the paper for other purposes than investment. Still, that’s true intrinsic value for you …

Puke: Don’t Invest In The Familar

Sauce-Bearnaise Syndrome

If you’re unfortunate enough to eat something that violently disagrees with you, so much so that you end up vomiting, you’ll likely find yourself suffering from Sauce-Bearnaise Syndrome. Otherwise known as taste aversion, it causes us to associate the taste of the food we’ve puked up with the illness that caused it to such an extent we’re unable to face eating it again.

As I can personally attest, this effect is incredibly strong even when the food in question has nothing to do with the illness. Even knowing this doesn’t help because the primacy we place on personal experience over all others is so strong. However, while this may be of great survival value when grazing forest floors it’s less helpful in investing, where personal experience is often the worst possible guide to the best strategy.

Adaptive, Involuntary and Subjective Investors

The adaptive value of Sauce-Bearnaise Syndrome is pretty obvious. If you’re a hungry semi-evolved simian wandering around a primeval forest and you happen upon a tasty looking mushroom then eating it may make you extremely sick. Assuming you survive the experience it’s a darn good evolutionary trick to find a way of stopping the stupid ape from making the same mistake again – so automatically triggering an aversion to the taste is nature’s way of keeping us alive. Of course, if we ate the other sort of mushroom we’d probably spend a day dreaming of kaleidoscopic antelopes and evolve to become an investment analyst.

However, when I became sick after eating my favourite Indian curry it was nothing to do with the food, but a bug I’d picked up on a skiing trip with a host of plague ridden kids. It took a year and a lot of red wine to overcome the aversion, despite knowing exactly what the problem was. The S-B effect is involuntary and powerful and entirely subjective.

Pavlov’s Investors

The persistence of effects like this is a warning that we’re controlled by all sorts of evolutionary contrivances that we’re not really aware of most of the time. These safety valves are, like the S-B Effect, triggered by our personal experience of something and we value such experiences much more highly than any amount of book learning or observation.

So it’s not hard to explain why we rely heavily on our own experiences as we navigate through life. Unfortunately, as in so many other things, investing is one area where personal experience is more likely to lead us astray than guide us straight. The superpower effect of monetary reinforcement seems to be almost as powerful as the automated conditioning of stuff like the S-B Effect: it causes investors to value their own experiences over and above the wisdom of the ages.

Teenage Investors

Investors who overweight their personal experiences are the teenagers of the investment world. Just like proto-adults they overweight their own experiences over and above the sage advice offered by their long-suffering parents. Although, when they get dumped by their latest hot stock at least they don’t usually throw shoes at their dad, scream “I hate you” and lock themselves in the bathroom for hours on end. Well, not always.

The propensity of investors to place undue stress on personal experience is likely to lead to non-optimal investing strategies, particularly when one of the market’s not infrequent upsets occurs. However, it’s also likely to lead to other basic mistakes by inexperienced investors – to invest in stocks that are familiar to them rather than ones that offer the best value. Worst of all it may lead them to weight their portfolios towards the worst possible selection as far as risk goes – their own employers.

Employee Investors

Enron employees found out the hard way that it’s one thing to lose your job but entirely another one to simultaneously lose all your savings. Yet research on the effect of the very public debacles at Enron, Kmart and so on showed that this very visible and public experience had no effect on the retirement savings plans of workers in other US corporations, who continued to overweight their own company’s stock. As the researchers put it, with wry understatement:

“Real-life lessons about under-diversification risks do not seem to translate well into action.”

Failing to draw the fairly obvious lesson that their company underperforming was likely to be correlated with share price falls and layoffs is at least irrational, although not something we should be too surprised about. The researchers also note that education doesn’t seem to make any difference either, something we’ve seen previously.

The difference in impact on behaviour between indirectly observed events, including education, and actually experienced ones has been replicated many times in many different contexts. In effect people systematically overweight directly experienced information. It doesn’t take much imagination to see how this can affect both individual investors and the wider investment industry.

Individuals are likely to follow ad-hoc heuristics based on purely random events, while the industry has preferred to use models which assume that all information is treated identically by all investors. Combine the two and you’ll likely get a market that looks like the offspring of King Kong and Godzilla: a giant hairy dinosaur with a penchant for destroying everything in its path, climbing vertical cliff-faces and then falling off suddenly.

Familiar Investors

Still we needn’t just expect this elementary mistake from private investors: there’s plenty of evidence that fund managers do so too. Coval and Moskowitz (1999) showed that managers of U.S. investment funds hold above average quantities of companies with local HQ’s. Meanwhile private investors overwhelmingly prefer to hold stock in companies domiciled in their own countries, despite the plentiful observable evidence that this reduces performance.

The preference for the familiar over the unfamiliar is likely to be yet another ingrained trait – it’s clearly adaptive for people to prefer their own group over that of others. Yet to overweight the familiar like this in investment is potentially hugely damaging since investing in your own employer, your own local companies and even your own country will simply deny you access to a world of opportunity.

Conditioned Investors

However, it’s not just the familiar which triggers investors into making mistakes. We might also expect that personal experience of success and failure in actual investing may bias people’s behaviour. This has been shown in a study of investor behaviour in Finnish Initial Public Offerings (IPO’s) which provided a beautiful real-world showcase for the experiment. An individual investor’s behaviour in respect of future IPO’s turns out to be predictable on the basis of their experience of previous ones: forget analysis of the likely returns of the company, it’s all about whether you did well or badly previously.

Kustia and Knüpfer’s “Do Investor’s Overweight Personal Experience” shows simply that the returns an investor gets on previous IPO’s significantly influences their likelihood of investing in the next one. They propose reinforcement conditioning – the kind of thing we discussed in B.F. Skinner’s Stockmarket Slot Machines – as the most likely explanation for this. You do something, it works and feels good, so you do it again. It feels bad and you don’t. Sensible behaviour in the pre-industrial past maybe, but very dangerous in stockmarkets which habitually subject us to miserable experiences in between climbing ever highwards.

Reprogramming Investors

Reinforcement conditioning is a step away from avoiding food because it tastes like your recent memory of puke, but not a big one. By and large investor attachment to the familiar gained through personal experience is an error but one we’re hardwired to make. Overcoming that programming requires hard work and a willingness to learn by observation rather than at first hand.

Of course, some people never seem to learn by personal experience either: but that’s a story for another day. Anyway, it’s time for dinner. Curry, anybody?


Related Articles: Investors, Embrace Your Feminine Side, Don’t Lose Money in the Stupid Corner, B.F. Skinner’s Stockmarket Slot Machines

Buffett and Munger on the BBC

The BBC’s Evan Davis talks to an avuncular Warren Buffett and a waspish Charlie Munger.

A few snippets below with links to the interviews.

Interview with Munger

Q: How worried are you by the declines of the share price of Berkshire Hathway?

CM: Zero. This is the third time Warren and I have seen our holdings in Berkshire Hathway go down, top tick to bottom tick, by 50%. I think it’s in the nature of long term shareholding of the normal vicissitudes, of worldly outcomes, of markets that the long-term holder has his quoted value of his stocks go down by say 50%. In fact you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.

Q: Munger and Buffett’s checklist for picking a company to invest in.

CM: We have to deal with things that we’re capable of understanding and then, once we’re over that filter we need to have a business with some characteristics that give us a durable competitive advantage and them, of course, we would vastly prefer management in place with a lot of integrity and talent and finally, no matter how wonderful it is, it’s not worth an infinite price. We have to have a price that makes sense and gives a margin of safety considering the normal vicissitudes of life It’s a very simple set of ideas and the reason that our ideas have not spread faster is they’re too simple. The professional classes can’t justify their existence if that’s all they have to say. It’s all so obvious and so simple what would they have to do with the rest of the semester?

Interview with Buffett

Q: Buffett on the trouble with stockmarkets.

WB: The very liquidity of stockmarkets causes people to focus on price action. If you buy an apartment house, if you buy a farm, if you buy a MacDonald’s franchise you don’t think about what it’s going sell for tomorrow or next week, or next month, you think about how is this business going to do. But stocks with this huge liquidity suck people in and they turn what should be an advantage into a disadvantage … You are focusing on the right thing if you look at the stream of income that an asset is going to produce over time.


Related Articles: The Buffett-Munger Paradox, Investing Like Berkshire Hathaway, Is Intrinsic Value Real?

The Business of Capital is Bust

Investment Bankers Aren’t Hairdressers

In a recent Financial Times article one of their feature writers opined that the main problem the world has with investment banker bonuses is jealousy rather than the unfortunate fact we’re going have to sell our children to pay off the debt their antics have mired us in. She goes on to expound on how these monetary geniuses offer unique services that deservedly command huge fees by way of an extended metaphor about hairdressers who are able to charge £300 for a haircut that doesn’t require blow-drying for a quarter. I have a local barber that does the same for £295 less. It’s called a crew cut.

The discourse of jealousy is rife in financial circles at the moment, it being an easy way for poor put-upon bankers to justify and defend themselves to themselves. The reality’s more complex and deserves a properly serious treatment because investment banking is a vital function in the modern world. The business of capital needs a proper defence, not half-baked childish psychological theories which merely justify the status-quo and irritate the hoi-polloi without addressing the real, underlying problems.

Good Capital, Bad Capital

If we needed evidence of how important the business of capital is to our economies then the problems of the past couple of years, when the availability of investment capital has suddenly been choked off, should be sufficient. Without massive, free flows of capital our world doesn’t function very well and those people who are able to create, manage and direct those flows are incredibly important. Whether we like it or not such people will make vast amounts of money as they levy their tolls on the passing financial traffic.

However, there’s good capital and there’s bad capital and it’s fiendishly difficult to tell the difference (although when it’s directly borrowed from taxpayers at century low interest rates it’s a bit easier to spot). Unfortunately the downside of the creation of bad capital takes time to become clear and if we reward the purveyors of it in the same way as we reward the managers of the good stuff we create perverse incentives for quick-rich merchants to dig a huge financial black hole for taxpayers to backfill – see Perverse Incentives Are Daylight Robbery and Gaming The System for a more extended discussion of this.

It’s inevitable that those people able to generate huge amounts of capital will come in for a certain amount of opprobrium since they’re the embodiment of the destructive processes of capitalism. They oft-times make huge fortunes by destroying the livelihoods of others but, in so doing, open up new investment and business opportunities that would otherwise have languished in abeyance due to the lack of investment capital. That’s capitalism for you – the guys in the black hats win every time but the Lone Ranger gets to trade in Silver for a T-Bird and a winter condo in Florida.

Michael Milkin, Capitalist Hero

Take Michael Milkin, the junk bond trader who eventually spent time in a US penitentiary for securities violations. Milkin is popularly regarded as the embodiment of greed and as an essentially destructive force. His ability to raise huge quantities of capital was a major factor behind the rise of the leveraged buyout (LBO) which saw many well known businesses getting taken over by sharp pencilled financial specialists whose main aim was to generate excess returns on previously moribund capital by gearing up balance sheets to generate yet more capital for further corporate actions.

Ultimately this process extended into so-called ‘greenmail’ where potential takeover victims found themselves on the end of phantom takeovers where the aggressor was able to use Milkin’s promise to raise capital to fund the takeover as leverage to force capital reconstruction. In common parlance this meant that the target companies had to take on debt to return capital to shareholders – including the greenmailers.

Efficiency at the Point of a Knife

While all of this is vaguely unsavoury and clearly impacted ordinary workers in the target companies, many of whom lost their jobs as a result of the efficiency improvements needed to fund the corporate activities, there is an economically important benefit to such actions. Done properly these types of activities release capital tied up in old, inefficient and slow growth businesses to invest in new, efficient and high growth ones. Arguably without Milkin there’d be no internet. Unfortunately, once a financial bandwagon starts rolling it’s hard to avoid every greedy copycat in the vicinity jumping on board.

So it was with LBO’s as the levels of leverage being applied to takeover victims grew steadily higher and higher. With such mounting debt came ever more dubious justifications from the investment industry, ending with the analogy that excessive debt made managers more careful, like a driver with a dagger mounted on the steering wheel, pointing at their heart. As Warren Buffett wryly observed, that just means that the smallest pothole is fatal. So it proved of the most highly geared companies. And Michael Milkin, hero of the capitalist system, went to jail.

Excessive Gearing

It’s in the nature of the business of capital to overreact in this manner and the system of incentives that lies behind it is a major factor in these swings. By rewarding the creators of bad capital just as heavily as the creators of good there’s every reason for every individual to chase the capital dog to the very limit – which usually means the creation of excess gearing.

The breakdown in world finances that the world has suffered since 2007 is largely due to the investment banking industry finding ever more creative ways of generating capital. We saw in It’s Not Different This Time that the excess returns made by banks since the early 1990’s are almost entirely attributable to increases in leverage of their balance sheets rather than a reward for skillful and intelligent risk taking. Which is what you get when you reward people for generating capital without regard for its pedigree.

An Anthropologist on Wall Street

Part of the problem for the financial industry is that it deliberately sets out to generate insecurity, because in movement and instability lies opportunity. If there’s no corporate activity then there’s no money being generated. This insecurity drives to the very heart of the investment business as the individuals within it seek to maximise their returns in the minimum time available, before they themselves are reorganised.

As Karen Ho, in her anthropological study of Wall Street, has observed, this restlessness translates into the need to create corporate instability outside of the financial industry and has major implications for workers in industries with no experience or capability of dealing with the levels of insecurity this causes. The ordinary employee simply doesn’t have the skills to cope with the type of seismic change that investment bankers habitually live with.

Greedy and Responsible?

It’s little wonder that when the folks on Main Street think of investment bankers it’s not as the lubrication that makes the free, capitalist world go round but as a bunch of overpaid, greedy and remote technocrats with little understanding of the real world. Which is probably not too far from the truth, even if it’s a bit one-sided.

However, the business of capital is far too important to the world to leave it at that. The investment banking industry needs to reform itself from within: there are no people better situated to flag the difference between good capital and bad and to create incentivisation schemes that differentially reward the purveyors of each. A socially responsible capital creation industry is probably a bit too much to hope for, but a system of delayed incentives based on the generation of real returns as opposed to simply rewarding the creation and movement of capital will go a long way towards creating an industry and a global economy subject to less inherent instability.

Reform or Be Reformed

It’s already clear governments are going to enforce changes which, mostly, will end up damaging the capital generation capabilities of the world. This is because, external to the industry, no one can differentiate between bonuses for good capital and those for bad – so you get a “one size fits all” solution which suits no one and will lead to subdued global growth for years to come. The natural inclination of the denizens of the world of capital creation is to grab as much as they can now, ignoring the fact that this money has been spirited away from consumptive children, poorly puppies and impoverished pensioners to prevent an even greater crisis.

For the sake of the industry, and the world, it would be better if the investment banks addressed their own problems rather than simply moaning about the irrelevant jealousy of the masses because, unless they do, the business of capital will be bust for a generation. The world can do without £300 hairdos but it can’t survive without good investment banking: it’s time to take a razor to both.


Related Articles: Moral Corporations: An Oxymoron?, Hedge Funds Ate My Shorts, Gaming The System, Perverse Incentives Are Daylight Robbery, It’s Not Different This Time

Save More … Tomorrow

Stop Lecturing, Start Helping

The investment maze we need to navigate gets ever more difficult. We’ve seen that investment advisors are unconsciously biased against us (Disclosure Won’t Stop A Conflicted Advisor) and that financial training isn’t much help (Financial Education Doesn’t Work). We’ve been told that long term passive investing in stocks is a bad idea (40 Years Of Bonds Beating Equities) and worst of all we can’t even trust ourselves, because we’re likely to goof off rather than spend time managing our investments (Retirees, Procrastinate At Your Peril).

All told, it’s not a happy situation for the majority of people who’d like a comfortable financial future. Given that behavioural biases are inadvertently responsible for many of the problems that beset us it would be nice if the psychologists stopped telling us what’s going wrong and came up with some useful suggestions. As it turns out they’re already on the case, the only problem being that we don’t, such is the law of unintended consequences, have a clue what the result of this intervention will be.

Positive and Negative Freedom

Mostly free market democracies like to offer free market democratic solutions to problems. The invisible hand of the market is presumed, all other things being equal, to find the best possible solution in a world of difficult trade-offs. The least good solution is usually regulation that seeks to make people behave in their own best interests.

This “least good” option isn’t simply rhetoric. The philosopher Isaiah Berlin elaborated the concepts of Positive and Negative Freedom in his lecture Two Concepts of Liberty. Positive Freedom is the freedom to do whatever we want as long as it doesn’t harm anyone else. Negative Freedom is the freedom that comes from being compelled to act in our own best interests – think fluoride in drinking water, DNA databases to catch future perps or forced retirement savings.

Unfortunately if you give a legislator an opportunity they’ll start doing what they think they do best – introducing more and more laws to protect us. Here in the UK we’re wilting under a plethora of Health and Safety regulations and Anti-Terrorism laws that are intended to save us from nasty things and horrible people. In consequence these regulations are simultaneously depriving us of many of our traditional freedoms and rights: this may be inevitable, but the creep of Negative Freedom is not without its dangers.

Berlin was one of the twentieth century’s more passionate advocates for Positive Freedom. As he pointed out, the century’s more despicable dictators rose to power on a wave of regulations which ended in coercion and dictatorship. Loosely fettered capitalism is a heady bulwark against such trends but the actions of financial engineers over the past decade have placed these freedoms in doubt.

Forcing Retirement Saving

In such an environment it’s unsurprising that the idea of coercing people into saving for their own retirements has become popular. If people won’t voluntarily do what’s in their best interests then we should make them is, in essence, the argument. The difficulty is, of course, that coercing people into effectively taking a salary cut isn’t a universally popular idea so governments have tended to put off the decision in favour of more enjoyable activities like spending the next generation’s tax revenues to ensure that bankers get paid their bonuses in the US or making sure politicians can afford homes for their ducks in the UK. Never let it be said that Britain’s global ambitions have waned since the end of Empire.

Fortunately behavioural psychology has come to the rescue of our conflicted leaders with useful evidence showing that turkeys can be made to vote for Christmas or Thanksgiving just as long as you make sure that their attendance at the ceremonial dinner is the default option. Government advisors are all over this idea, as you can probably imagine.

Default Options Work

Leaving aside the questionable issues of freedom and coercion for the time being, the idea of making people elect out of things they might otherwise choose not to do is a trick commercial companies have been using for years, as the heap of pseudo-junk marketing mail that arrives by snail mail and email each week is testament to. In terms of retirement savings, however, the idea of making the default option something to be automatically opted in to has been shown to have a positive effect on scheme enrolment.

The problem is that this is a one-off intervention. Simply agreeing to invest a fixed value or even a fixed percentage of your salary each month may not be sufficient, especially if the starting amount is small. The ideas of Richard Thaler and Cass Sunstein are at the heart of many of the new initiatives, sparked by their popular book Nudge, which explains how people’s behavioural biases can be used to persuade them to act in their own best interests.

Save More Tomorrow

Thaler’s already shown that these ideas can be put into effective practice through his Save More Tomorrow(tm) scheme. In this he and Schlomo Benartzi have neatly used a number of biases to persuade people to behave better. The design of the scheme is simple: when people enrol they agree that as and when they receive salary rises the amount subscribed to their retirement savings is automatically incremented, by an amount that grows in percentage terms.

This may not sound like much but the impact is remarkable. In the initial study there were two groups – one group that agreed to contribute a higher percentage earnings to start with and who needed to make further decisions to invest more and a second group with lower initial investments but which had agreed – by failing to opt out of the option – to contribute a rising percentage of their future salary rises. Three years and four rises later the Save More Tomorrow(tm) group was contributing significantly more than their counterparts.

What the scheme is doing is taking advantage of a number of behavioural traits that normally militate against long-term savings. Firstly there’s inertia – the tendency to let the status quo continue. So once opted in most people can’t be bothered to opt out. Secondly this overcomes the effects of lack of self control and procrastination – the tendency to prefer short-term immediate rewards over longer-term, uncertain ones. Thirdly there’s loss aversion – people don’t like seeing a cut in their take home pay. The scheme overcomes this because when a salary rise occurs people still see more money in their wage packet so they don’t suffer the disappointment of ‘losing’ money by opting to save it.

Nudge, Nudge

These concepts have got government advisors everywhere busily figuring out how they can ‘nudge’ people in the direction of current policy. There’s plenty of evidence that default options work – as noted in this fascinating recent Undercover Economist article the organ donor base varies by nearly 80% between the culturally similar Austria and Germany: Austria requires citizens to opt out, Germany to opt in.

As the same article points out, however, there is a problem in using these methods. We know that they work but we don’t know exactly why. And therein lies an issue, because when we nudge people in one direction we’re likely to find that although we may get the desired outcome, we may also cause them to do other things we don’t expect: consumers who save more for retirement in automatic schemes will be consuming less and buying fewer financial products, for instance.

Be Careful What You Wish For

We may think these are generally desirable outcomes but we don’t know what the effect will be of governments globally nudging their citizens in any particular way. We need to be careful what we wish for. This isn’t a new idea – Thaler and Sunstein have addressed the issue in Libertarian Paternalism is Not an Oxymoron. Here they argue that guiding people to better decisions by using their behavioural weaknesses against them is morally justified.

Isaiah Berlin would probably have disagreed, seeing any form of coercion as the thin end of a long wedge. If we could keep the areas of application of these ideas limited – to retirement savings opt-ins and healthy food choices, for instance – then maybe this would be OK. Unfortunately, the chances of governments limiting their interference to such straightforwardly uncontroversial areas is minimal. Look out for automatic opt-in clauses with everything – after all, it’s all in our best possible interests.


Related Articles: The End of The Age of Retirement, Investors, Embrace Your Feminine Side, O Investor Why Art Thou Rational?

Property Rights and Wrongs

It Begins: The Magna Carta

In 1215, at Runneymede in England, King John set his seal upon the document known as Magna Carta and thus kicked off nearly a thousand years of property madness. The charter was the result of the King’s ruthless trampling over the rights of existing nobles and, extracted from him at the point of a sword, gave all freemen of England certain, inalienable rights.

One of these was the right not to be unlawfully deprived of their property and, such is the way of these things, this was to lead to the Anglo-Saxon obsession with housing which has been at the heart of so many recent financial debacles. It may be that “an Englishman’s home is his castle” but mistaking a heavily mortgaged property for a safe financial haven isn’t the cleverest bet you’ll ever make. Although it may still be better than investing in the stockmarket for most people.

Property Rights

At the heart of the Magna Carta were a number of provisions that echo down the ages:

“No free man shall be seized or imprisoned, or stripped of his rights or possessions, or outlawed or exiled, or deprived of his standing in any other way, nor will we proceed with force against him, or send others to do so, except by the lawful judgement of his equals or by the law of the land.”

The document is, to be fair, rather a rambling read and at points gets oddly excited about making the King give back all the stuff he’d stolen from Wales including “the son of Llywelyn”. Quite why King John had such a liking for the Welsh isn’t recorded, but they clearly weren’t happy with the attention. According to the charter he’d also acquired the sisters of the King of Scotland on his travels, so he seems to have been an inveterate Celtic kleptomaniac.

Although the charter enshrined a lot of rights, many of which are traceable into important future constitutional documents like the American Declaration of Independence, the English more or less observed it in the breech for a few hundred years. Kings may have nominally been as one with everyone else before God but in practice they had the biggest armies, the most secure dungeons and an awful lot of nasty looking torture implements.

Edward Coke and the Common-Law

By the sixteenth century, however, the jurist Edward Coke was using the Magna Carta as justification for the development of some of the most important aspects of the English common law – the haphazard set of case studies that determine precedent and hence guide judges and jurors. Coke in many ways wrote the book (actually four books) of common-law but is perhaps best known for refusing to kneel in the presence of the King, arguing that no man was above the law. Charles I later slung him in the Tower of London, which suggests that the authority of the law was somewhat more limited than Coke would have liked.

Anyway, between them Coke, the Magna Carta and common-law established many of the rights we hold dear today including the protection of real property rights. These are a critical issue for the development of democracy and capitalism – the Soviet Union thoughtfully provided us with a seventy year study of what happens when you deprive people of such rights: bad dentistry, rotten cars and a secret police state George Orwell would have been proud of. Despite all the other trappings of modernity the system buckled: when no one owns anything what incentive does anyone have to improve themselves?

Shakespeare’s Property Ode

In England, however, this had some odd consequences. For reasons that might escape us in these more modern times were it not for the fact that they haven’t changed very much, mostly the English didn’t trust their government very much. In fact when annoyed they regularly rioted and strung up a few representatives to keep the others in their place. Way ahead of their time, they didn’t put much trust in bankers or ye olde financial advisors either. It’s amazing how little the world changes over the centuries.

On the other hand, the rights that the common-law protected provided everyone with a strong incentive to own a property. Unlike gold or coins a house was pretty darned difficult to steal during the night (although they did have a nasty tendency to burn down from time to time) and, to boot, could be relied upon for an income. William Shakespeare, for instance, invested his earnings extensively in property – including the then enormous sum of £320 for land in Stratford-upon-Avon in 1602 and £140 for the gatehouse of an old priory in London in 1613.

Empire and Housing

The English fascination with property gained a wider foothold as the spread of Empire took with it the English language and the common-law. Looking around the world at where home ownership is most popular and property booms most frequent you’ll find a pretty decent overlap with British historical involvements. Japan, of course, is the ultimate exception, but that’s what you get when an outsized population meets an undersized land mass. And, of course, the post-war Japanese constitution was modelled on the British system.

The Anglo-Saxon obsession with property means that many private investors prefer housing to stocks. People feel that they understand how to value a house whereas the movements of the stockmarket are unfathomable. Additionally there’s the added ‘benefit’ that a house is a hugely tangible thing, unlike shares. The visibility and speed with which share prices can move is frightening to the uninitiated, while the difficulty of valuing property makes the drop less scary: until such time you need to realise the investment when, as many people have been finding out, the downside can be pretty horrible.

Gearing, Property and Shares

The main advantage and downside of property over shares for the unsophisticated investor is gearing: by borrowing money to buy the effects of price gains and losses are magnified. In typical behaviourally biased fashion most people will buy in while markets are surging, not realising that prices can fall sharply and painfully. As usual (due to issues we saw in Retirees, Procrastinate At Your Peril) the short term focus on immediate costs over future ones leads buyers to worry only about the initial affordability rather than the long term liability.

In the end, of course, if property is undervalued compared to shares then the rational investor will sell shares and buy property. The problem is that unlike shares, where re-pricing can occur rapidly, it can take a very, very long time for house prices to adjust after either a boom or a bust. This too is simple behavioural bias – loss aversion triggering (as discussed in Loss Aversion Affects Tiger Woods, Too), meaning people won’t sell at less than some anchoring point: their purchase price, or the selling price achieved by the family next door at the height of the boom.

Behavioural Benefits of Housing

On the other hand the unwillingness of people to sell below their anchor price and the opaqueness of pricing does have the benefit that most home owners won’t get panicked into selling at the bottom, unlike many stock holders. In both cases there’ll be unfortunate forced sellers at the worst possible moment but generally if you have to hold one or the other most private investors would – psychologically – be better off holding housing.

Even so, at the height of the latest Anglo-Saxon inspired housing boom many ‘investors’ were buying second and third homes on which the rental income couldn’t even cover their mortgage costs. Just like with shares, relying on short-term capital appreciation to make an investment worthwhile is a dangerous gamble. A rental property with earnings that more than covers its costs is a safe bet no matter what markets do: if investors applied the same principles to shares they’d be a lot better off, in the main.

As Safe As Houses?

There is strangely little research into behavioural finance effects on the property market, although it’s quite clear that the same sorts of biases that affect stockmarket investors also impact property speculators. What little there is, is surveyed in this this paper by Rohit Kishore. It’s noteworthy, if not especially surprising, that the price achieved at the end of a negotiation is nearly always anchored on the initial price proposed. This isn’t an especially remarkable finding, given that this is usually what the sellers are demanding, but it does suggest that getting your bid in first is the critical thing. However, the caveat is that if the price is set too high there are no offers at all – as many people have found out to their cost, recently.

Those eleventh century barons who were only interested in protecting their own rights have a lot to answer for, but at least the only thing depriving us of our homes these days is our own behavioural incompetence. Sadly no amount of legal precedent is likely to overcome that.


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Ambiguity Aversion: Investing Under Conditions of Uncertainty

Uncertainty Is Not Risk

A huge amount of effort in financial circles is spent trying to measure and manage risk. Basically risk that can’t be quantified isn’t really risk, because unless you can put a number on it, it doesn’t really exist. Perhaps we should apply the same idea to budget deficits.

Way back in 1921 the economist Frank Knight dismissed such ideas as deluded. As far as he was concerned any system involving humans was far too unpredictable to be hedged and hemmed by numbers. What Knight identified was the difference between measurable risk and unmeasurable uncertainty. However it took a man with a bunch of balls and couple of jars to shown exactly how deeply ingrained into the human psyche the fundamental nature of uncertainty is.

Extrapolate If You Dare

By all accounts Knight was deeply cynical about human nature, to the point where he dismissed the attempts of most economists to develop forecasting techniques on the basis of historic data as futile. Extrapolating from the past to the future was always bound to end in failure, he believed, because some things – especially those involving people – are inherently unpredictable. Specifically Knight distinguished between risk – which you can measure – and uncertainty – which you can’t.

For the most part investors ignore uncertainty. Which isn’t surprising, because so does most of the investment industry. Generally people operate on the basis that there’s a measurable risk in investment but that if you’re reasonably careful in how you invest you can mitigate against this. Tomorrow’s conditions will be the same as yesterday’s so we can operate on the basis that what worked yesterday will also work tomorrow.

When this all changes, however, and uncertainty rears its wild head we find ourselves lost. The historical signposts are suddenly spirited away in the middle of night and we, in the jargon, find ourselves investing under conditions of uncertainty. Our reaction to this is rather interesting and goes a long way towards explaining stockmarket plunges. It turns out that most of us are hugely adverse to the ambiguity such situations throw up and our preferred option is to run away as quickly as possible.

Urns ‘R Us

The classic experiment demonstrating this was reported by Daniel Ellsberg in 1961. The experiment is simple but the explanation is convoluted. So bear with this.

Ellsberg offered his participants a choice of two urns each of which contained 100 balls. Urn A contained 50 red and 50 black balls. Urn B contained an unknown mixture of red and black balls. Each person was asked to make two decisions – firstly to choose which colour ball they wanted to pick and secondly to choose which urn they wanted to pick it from. Be clear: both decisions were under the control of the subjects.

A significant majority of the participants chose Urn A, the one with an equal number of red and black balls. Yet this creates a paradox, which is the sort of thing that gets psychologists very excited and requires the tranquillisers to be administered by the men in white coats – to the men in white coats.

Ellsberg’s Ambiguity Paradox

Let’s say you chose red and then chose Urn A. You know that you have a 50% chance of getting a red ball. Logically this means you think that if you chose Urn B then you would have less than a 50% chance of getting a red ball. However, this means that if you chose Urn B you think you would have a greater than 50% chance of getting a black ball. Which means that you should have chosen black and Urn B, not red and Urn A. At which point the paradox asserts itself.

Our brains strain against seeing this as a paradox – the majority of people will choose Urn A and insist that it’s less risky to do so. But it isn’t: the probability of selecting a red ball from Urn B is exactly the same as the probability of selecting a red ball from Urn A. The risk is the same, what’s different is the uncertainty.

It turns out that humans are extremely disinclined to operate in conditions of uncertainty unless absolutely necessary. We much prefer a defined risk to an undefined one. Generally this is referred to as ambiguity aversion.

Less Uncertainty, Same Result

Rather than simply accept the findings and throw away their nice models economists have proposed a number of hypotheses to rescue the classical approaches to risk. One is that people naturally expect deceit on the part of the experimenters, so they assume that Urn B is rigged against them. Another is that people simply can’t work out the probabilities of Urn B because there’s too much data and opt for the ‘safe’ choice.

In Size Doesn’t Really Matter Pulford and Coleman set out to investigate these ideas. Remarkably their experiment shows that ambiguity aversion applies even when each urn contains only two balls. This suggests quite strongly that the only factor involved in this is human hatred of the uncertainty involved in the choice.

Dynamic Urns, Dread Markets

Nice and theoretical though this is one might reasonably wonder what it has to do with the real world business of investing or, indeed, life. The answer is, roughly speaking, everything. Our hatred of uncertainty can drive us into all sorts of outwardly irrational behaviour when the hidden ambiguity inherent in many decision making processes is suddenly made clear.

Unlike Ellsberg’s urns the real world of stock investment is a dynamic process in which the balls we draw from the jars are constantly replaced. In normal conditions if we withdraw a red ball a new red ball replaces it. In time we come to expect a certain proportion of red and black balls – winners and losers. We’re instinctively modelling risk but we’re doing so under assumed conditions of certainty. Red ball out, red ball in. We sample the past and forecast the future.

When the randomness that is uncertainty strikes our instincts serve us badly. Suddenly our red ball is replaced randomly by something else. Our initial reaction to this is to assume that it’s a mistake and to continue to operate as though our internal models are still working. However, as it becomes clear that our assumptions of certainty have broken down then ambiguity aversion kicks in: we hate uncertainty and we run from it. Cue stockmarket wobble and then collapse.

Ambiguity and Overconfidence

Even experienced investors may fail to recognise the onset of uncertainty. The stockmarket collapses of the 1970’s as the world reeled under multiple crises certainly seem to have been such a situation. The sudden recognition of problems that had previously not been evident – oil supply worries, corrupt world leaders, flared trousers and glam rock – led to a whole host of reactions including, ironically enough, the first attempts to build risk management models to protect against such future events. The irony, of course, is that these models have themselves ended up contributing to the problems because they don’t – because they can’t – capture the nature of uncertainty.

Interestingly the studies of ambiguity aversion show a clear and consistent balance between those who choose the certain urn A and the uncertain urn B. Roughly 20% to 30% of people embrace the uncertain option: there are people who instinctively see opportunity in uncertainty and rush to take advantage of it. Studies of entrepreneurs, for instance, show that they tend to be much less worried about operating in conditions of uncertainty than the rest of us. Of course, it may be that they’re just significantly more over-confident and deluded than everyone else, but the research is silent on this.

Certainty Is An Illusion

The idea that the future is unknowable goes against the last four hundred years of human progress, much of it built on the idea that we can predict and therefore control what is yet to happen. Nonetheless if it were otherwise our lives would be much less rich in terms of experience. Knowing with certainty what tomorrow will bring would be rather dull, don’t you think?

As for investors, well, we need to learn that uncertainty and ambiguity dog our every step. For it is when we are at our most certain that we are at most risk. Find that in a risk management model.


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The Ig History of Modern Economics

Giggle and Ponder

The Ig Nobel Prizes are awarded for “ideas that first make you laugh and then make you think”. Many of them simply point out random behaviour that might better have been consigned to the dustbin of bad ideas before anyone spent any time on them, but there’s a serious side as well and the annual award ceremony is regularly attended by winners graciously accepting their prizes and real Nobel Prize Winners presenting them.

Our interest here is in the Ig Economics Prize which yields a surprising insight into the world of investment over the past two decades, tracking with vague accuracy the surging ups and considerable downs of the world’s economic system. Not to mention some really remarkable inventions that could have changed the world but – fortunately – didn’t.

1991-1992: Junk and Insurance

Back in 1991 the very first prize went to the junk bond trader Michael Milkin “to whom the world is indebted”. For those too young to remember Mr. Milkin popularised the use of the junk bond in loading up perfectly good companies with debt and then letting them loose to fail as soon as the global economy hit a pothole. Which it did, pretty much immediately. Mr. Milkin, meanwhile, was manipulating the system to his own personal advantage and consequently spent some time incarcerated at the expense of the US government for securities violations.

In 1992, the award went to the investors in the 300 year old insurance market Lloyds of London for attempting to redefine the concept of “insurance” by trying to renege on their obligations to make payouts on genuine claims. At the time Lloyds was mainly funded by private investors, so-called “Names”, many of whom were know-nothings attracted by the high rates of return.

Like so many investment novices the Names failed to understand that the high returns were the consequence of high risk – in this case unlimited liability which, in effect, meant they pledged all their personal assets as surety on the policies. When, as is the way of the world, all the Black Swans landed at once and they found themselves facing ruin they squealed and tried to run away. Unsuccessfully. Cue personal bankruptcy.

1993-1995: Depression and Derivatives

The following year the prize was more focused, targeting the largely forgotten economist Ravi Batra. Mr. Batra was honoured for his single handed – and as retrospectively seen – successful efforts to prevent world economic collapse through the sales of his books on the “Great Depression of 1990”. Look out for numerous similarly named tomes in a bookshop near you soon: little changes other than the name on the flyleaf.

In 1995 the Ig’s moved from the trivially amusing to the monumentally eye-popping by rewarding Jan Pablo Davila, a futures trader from Chile. Mr. Davila, in a moment of absent mindedness, instructed his computer to buy instead of sell and found himself staring down the barrel of some rather nasty losses. Rather than admitting the problem and taking his punishment he set out on a course of increasingly and spectacularly badly judged trades which ended with total losses equivalent to 0.5% of Chile’s Gross National Product. A truly magnificent effort and a shining example of how one person can make an unexpected and unforseeable difference to an otherwise sound investment – no matter how careful your research.

As we moved through the middle years of the last decade of the last century the awards committee was presented with an embarrassment of riches and hedged their bets between two stunning efforts on different sides of the world. Through a series of awesomely bad derivatives trades, and aided by a system of oversight so lax it can only be described as “non-existent”, Nick Leeson of the 230 year old London based Barings Bank and Robert Citron of Orange County, California managed to bankrupt their respective institutions. The lesson – that where derivatives are concerned the unthinkable is merely tomorrow’s starting point – has yet to be properly learned a decade or so later.

1996 – 1997: From Gum Disease to Virtual Petting

If all of these trends weren’t worrying enough, investors’ teeth started to fall out. Yes, in 1996 Dr. Robert J. Genco received the award for research into the effect of financial stress on gum disease. Although as smoking is the most likely cause of such problems it might also serve as a study of illusory correlation. After all “financial stress causes people to smoke” might fall into the category of “bloody obvious”.

With the world moving through a reasonable period of financial stability the prize givers turned their attention to people generating new types of business model. Specifically to Akihiro Yokoi and Aki Maita, inventors of the infuriating Tamagotchi. These virtual pets, requiring almost constant attention to make sure they didn’t start beeping at you and dying in inconvenient ways, were responsible for the loss of thousands of hours of otherwise productive time as people frantically tapped away on their stupid little plastic cases thus proving that you can get people to do any damn thing as long as you make it cute and a little less boring than their everyday lives.

1998-2001: Of Clones, Mass Marriage and Tax Avoidance

Fortunately if you set a challenge someone, somewhere in the world will rise to it. Indeed the next recipient, the fortuitously named Dr. Richard Seed, was up to it many times and was awarded the prize for his unceasing efforts to clone himself and others, presumably to replace all of the people wasting their time playing with plastic pets.

So boringly successful was the world of economics as the dotcom boom took off that no prize was given in 1999. The following year the Reverend Moon of the Unification Church was honoured for his self-reported efficiency improvements to the marriage industry as he moved smoothly from a 36 couple wedding in 1960 to a 36,000,000 couple wedding in 1997.

With a neat sense of symmetry the awards committee gave the next award to Joel Slemrod and Wojciech Kopczuk who showed that Americans hate paying tax so much that they will put off dying if it leads them to qualify for a lower inheritance tax rate. That’s taking no taxation without representation to the outer limits. Spooky.

2002 – 2003: Auditors and National Entreprenurism

As the world economy went for a slide down the wrong side of the rollercoaster in 2002 the prize was shared by a whole host of organisations for “adapting the mathematical concept of imaginary numbers for use in the business world” – aka, the spectacular use of creative accounting techniques. There were too many recipients to mention all of them by name but think Enron, Global Crossing and Arthur Anderson. Remember: never trust an auditor further than the length of their propelling pencils.

Entrepreneurial enthusiasm on a national scale was rewarded in 2003 as Karl Schwärzler and Liechtenstein opened up the whole 63 square mile country as a venue for weddings and other celebrations. Mr. Schwärzler became the first recipient of the prize to personally attend the ceremony, probably because he was one of the few not in jail at the time.

Warming to the theme the next award went to another miniscule sovereign state: to the Vatican for its groundbreaking efforts in support of globalisation through outsourcing … of prayer to India. Disappointingly the Pope didn’t opt to receive the award personally.

2005-2007: Timekeeping and Thief-Catching

More economically important inventiveness received its just desserts in 2005. Quite rightly Gauri Nanda received the award for his invention of a productivity enhancing alarm clock. Despised by a whole generation of teenagers and work-shy employees, but loved by employers everywhere, when the clock goes off it also runs away and hides itself. Repeatedly. Mr. Nanda’s clock ensured he got to the ceremony on time.

Disappointingly nothing interested the panel enough to be bothered to give an award in 2006 but in 2007 the prize went to a six year old invention by Kuo Cheng Hseih for catching bank robbers. In essence the invention is a net, scooping up the master criminals as they attempt to make their getaway, presumably pausing only to wonder why someone has drawn a large ‘X’ on the floor. This unique piece of inventiveness, not previously seen since Wile E. Coyote repeatedly attempted to catch Roadrunner with an Acme ™ Roadrunner Trap back in the 1950’s, was awarded a US patent. Despite their best efforts the Ig organisers were unable to locate Mr. Hseih until after the ceremony. Presumably he’d been tied up somewhere.

2008-2009: Lapdancers and Icelanders

In 2008 some genuinely interesting research got its reward as Miller, Tybur and Jordan showed that ovulating lap dancers get higher tips than their colleagues. As human males supposedly can’t tell when females are at their most fertile this is a puzzle, but the stats don’t lie: we males know, even if we don’t know we know. The question now is: do females know we know, even if they don’t know that we know, even though we don’t?

Coming right up to date the latest awards rightly celebrated the magnificent achievements of bankers everywhere in proving that there’s no such thing as a stable and safe economy. The directors, auditors and executives of the largest four Icelandic banks were honoured for their role in making their tiny banks really, really big and then transforming them back again, while taking the entire national economy with them. Always remember: a trend is not a prediction, it’s merely an opening gambit.

We Don’t Know What We Don’t Know

The Ig’s are a quirky microcosm of the financial world over the past nineteen years, sometimes relevant and sometime not. If they tell us anything, however, it’s that there’s no such thing as certainty in economics or markets or, indeed, any system that has human beings as a component part. Whatever you think is going to happen almost certainly won’t. So don’t worry about the things you know you don’t know, worry about the things you don’t know you don’t know.

OK?


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Financial Education Doesn’t Work

Education? Slowly Does It

Many people, myself included, have felt that a good dose of financial education may be just what the world needs to save itself from monetary predation. After all, the nature of capitalism is that companies will seek to maximise their profits at the expense of the ill-prepared: so training people seems like a sensible counter to this position.

Unfortunately it seems we’re wrong and that educating people about money works slowly, if it works at all. That doesn’t mean we shouldn’t make the effort, but for the majority of people it’s not an answer because they forget all they’ve been taught just as soon as some spiv in a suit comes along waving around cheap money. Most people just can’t help themselves from helping themselves to new stuff now, no matter what the future cost.

Money Dumb

The level of financial innumeracy in developed nations is quite staggering if we’re to believe the research. 80% of people in the UK, for instance, have no idea what the true cost of a loan is. Mostly they just look at the initial cost; which of course is why teaser rates on mortgages are so effective – it’s just the psychological bias of discounting the future cost of things in favour of getting hold of something you really want now appearing in a different form.

Research on US consumers by Lusardi and Mitchell (2006) simply backs up the evidence from elsewhere. They find that only a third of older Americans – those who should be most concerned about retirement savings – are able to answer these three relatively simple but important questions.

1. Suppose you had $100 in a savings account and the interest rate was 2% per year. After 5 years, how much do you think you would have in the account if you left the money to grow: more than $102, exactly $102, less than $102?
2. Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 year, would you be able to buy more than, exactly the same as, or less than today with the money in this account?
3. Do you think that the following statement is true or false? “Buying a single company stock usually provides a safer return than a stock mutual fund.”
   

Low Standards, Globally

You might well feel that being able to answer these questions constitutes a pretty low standard for financial literacy – the ability of a consumer to make financial decisions in their own best interests – but these findings have been replicated across other developed nations. An OECD study in 2005 showed that people acting dumb when it comes to money is a truly globalised phenomenon across Europe, Australia and Japan in addition to America. Still, it’s nice to know we all have something in common apart from global warming.

Anyway, unsurprisingly, it seems that those people who can’t calculate compound interest very well are far less likely to save enough to retire on being apt to spend any money they can get their hands on as quickly as possible on nice, shiny new things. They’re also less likely to invest any money in the stockmarket which, of course, may not be a bad thing: if you’re too dumb to figure out the real cost of your new TV you’re probably not going to be very smart at stock picking. Frankly, it’s a wonder they can figure out how to use the remote.

So Educate Them?

One solution to this, you might think, is to provide financial education. From a government perspective this might have a couple of beneficial effects. Firstly future pensioners would save properly and be less of a burden, so that the legislators would have more money to pay themselves gold-plated, index-linked retirement benefits. Secondly, it would obviate the need to enact laws to make financial institutions behave themselves, which is difficult when they’re likely to be your next employer, such is the revolving door between governments and the money men. Unfortunately the evidence suggests that not only are we not very good at doing our investment sums but also we’re not very good at learning about doing our investment sums either.

Some decent research shows that basic education is a determinant of financial literacy. Van Rooij, Lusardi and Alessie (2007) carried out a complex study of these issues in the Netherlands. In amongst a wide set of findings, many of which are seriously thought provoking – including the possibility that the higher levels of stockmarket investments in older age groups is a facet of the fact that richer people tend to live longer – they show that an economics education in under 16’s, but not after, is predictive of higher levels of financial literacy and greater investment in stocks.

Lab Rats

The evidence from various studies on whether targeted financial education on adults improves financial literacy is, at best, inconclusive. As Mandel (2009) reports:

“In four of the surveys [from 2000 to 2008], including the 2008 survey, students who took a full semester course in money management or personal finance actually had slightly lower mean financial literacy scores than all students. “

Which is depressing, even if it’s not definitive.

There is one type of training that does seem to improve the situation – the so-called stockmarket game in which students actively participate in their learning approach. This produces a 6 to 8% improvement. Researchers seem to be puzzled by why this might be the case but there’s plenty of psychological research around that shows how active involvement in learning situations improves student ability to use the training afterwards.

Regardless, the stockmarket game success turns out to be a pyrrhic victory because the successful students then go on to save less than their peers. The (unsubstantiated) hypothesis is that they learn that they can make up for failing to save by taking additional risks on the markets. Which is of course, what happens when you treat people like lab rats – they figure out how to get the cheese for as little effort as possible: proponents of ‘Nudge’ techniques beware.

The Epistemological Puzzle

There is another possible answer to some of the puzzles in this area related to epistemology – the study of knowledge. Psychologists generally make a distinction between two types of ‘knowing’. There’s ‘knowing about’ things: so we know that Washington is the capital of the USA and that 2 + 2= 4. However, there’s also ‘knowing how to’ do things – such as how to operate a word processor or how to calculate compound interest.

Mandel’s research suggests that the most financially literate college students are not economics or business graduates who ‘know about’ financial matters but engineers and scientists who ‘know how’ to solve problems. Which suggests you’d be better off taking financial advice from the guy who designed your tax return software rather than the one that filled it in for you.

The Dangerous Trap of Financial Education

The research also notes that, although financial literacy doesn’t seem to be improved by education, financial behaviour – in terms of saving, for instance – is. Which, of course, may actually make things worse: financially illiterate but savings oriented consumers are the perfect fodder for the next Ponzi scheme merchant, a dangerous trap if there ever was one.

Broadly speaking, then, financial education appears to only have a marginal effect on people’s financial capability, although it does seem to promote more efforts to prepare for the future. This being the case, however, it’s unlikely that we can rely on better training to improve the global problems with financial literacy. With less and less government retirement provision and less and less generous company pension schemes (not to mention ever decreasing job security) this is no longer a looming problem.

It’s already loomed, and we’ve now got to figure out how to deal with it.


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The Case of the Delusional Investor

In which Sherlock Holmes demonstrates that closely following markets is bad for your health and your investments, derides the popular press and other tipsters and argues that market values in the short-term are determined by unpredictable psychological forces rather than foreseeable trends. And Dr. Watson discovers that following others is rarely a successful strategy and that his wife is unexpectedly loquacious in the morning.

“Ah Watson,” said Sherlock Holmes, “I see your stocks have declined in value once more”.

“Good heavens, Holmes,” I expostulated, “However did you know that? I don’t believe I’ve ever discussed my investments with you? To be honest I never thought you would be interested. Although I do have this interesting tip about the 4.3% Consols …”

Holmes waved my best intentions away impatiently.

“You, I deduce, prefer to engage in risky stratagems for increasing your savings with no regard for the possible downside,” he said, gravely. “As a newly married man I’m surprised that you have so little regard for your wife. Or the child she carries that you have hurried here to inform me of”.

I admit that I dropped my copy of the financial paper in shock.

Holmes crossed the room with two strides of those long legs and folded himself into the armchair by the roaring fire. He gazed at me with amusement, his dark eyes twinkling at me from the deep recesses behind that aquiline nose; as they often did when he was musing over some personal triumph at my expense.

“Unlike you, Watson, I have no time for financial speculation. My savings are safely invested for the long-term on the best modern principles. With each fee I simply add a little more to my fund, at the lowest cost possible, without regard for the market’s undulations and I shall not call upon it until I retire to a little cottage on the South Downs”.

“Through the simple act of companies compounding their retained earnings and reinvesting dividends I will acquire sufficient savings to see me through my retirement,” he added, carelessly, “regardless of whether markets outperform or not”.

“But how …,” I started.

“How do I know your investment habits?” Holmes shrugged. “Consider the copy of that paper you habitually carry. No one with regard for the long-term nature of investment bothers with the financial news. It should have as little effect on one’s investment behaviour as the migration pattern of the swallow”.

“By Jove,” I exclaimed, “Selling on the sight of the first swallow and buying on the departure of the last is the very latest technique. I was reading about it in the Bow Street Tipsheet just the other month. Although it doesn’t seem to have worked very well this year”, I added, sadly, thinking of the remarkable boom in stocks since I had sold most of my holdings earlier in the year, on the best advice of many of the country’s most prominent financial experts.

Oddly enough most of these distinguished gentlemen now seemed to have forgotten their earlier recommendations and were discussing the great market recovery as though it had always been the most obvious thing in the world. It was extremely puzzling, but I was eagerly following their latest words of wisdom in order to determine the next best steps.

Holmes rolled his eyes and drew hard on his pipe. Swathed in smoke he waved a monograph on railway timetables at me, angrily. I thought gloomily about how badly my investments during the great Railway Mania had turned out despite the great hopes and claims of the promoters.

“Tipsheets, Watson, tipsheets. Do you mean your family to live in penury?” he scowled, “The people who can outperform the markets, if these mythical creatures exist, are not offering penny tipsheets to unwary souls such as yourself. They are investing silently, using other people’s money to accrue great fortunes. The last thing they will do is reveal their secrets to the great masses who will destroy them in their haste to take advantage”.

“Why aren’t these tipsters investing themselves if their investment knowledge is of any worth? Mark my words, Watson, these people are no better than travelling fortunetellers. Pah!”

“Gosh, Holmes”, I said brightly, “apparently there’s this stock tipping soothsayer over on Grays Inn Road that everyone says is remarkably good.”

Holmes threw his timetable extravagantly in my direction. I ducked with difficulty and turned to face Holmes who was now pointing a red-hot poker at me. On one hand I remembered the disappointments with my investments in the new Bessemer Steel processes. On the other he did have my full attention.

“Your risky strategies are easily implied from the way in which the price pages of your newspaper are always well thumbed. Only someone unable to fully apprehend the value of their investments and therefore constantly in need of reassurance about their prices would bother checking so regularly. It is a mercy that there is no way for you to get constant price updates since I fear you would spend all day following the random twitches of the markets instead of tending to the malformed flock who grace your surgery”.

“Well now you mention it I’ve just ordered one of those new stock ticker machines for the office. I thought it would give me an advantage over the majority of investors”.

Holmes had dropped the poker and was busily preparing his morning fix as I said this. He now turned and thrust his wad of Chinese opium at me angrily. My mood darkened, as I recalled the hope with which I had invested in the promise of the East. More pounds turned to pennies.

“If you install that machine”, he hissed, “I shall visit you and break it myself like a modern day Luddite. You have duties – to your patients, your wife and your unborn infant.”

“Yes,” I said, remembering, “About the baby …”

“Yes Watson, you need to develop a different approach to investing now that you are a man of responsibility. Mark my words, one of these days the modern approach to risky investment will lead to the ruin of the world. Put not your trust in the probity of your fellow man or the trustworthiness of governments.”

He put his arm around me, a gesture I found strangely touching, tinged only with concern about the blood flowing from his puncture wounds staining my suit and the tip of his syringe alarmingly waving around under my nose. He gestured at the bookshelves that constituted the walls of his study, floor to ceiling full of learned tomes on all the subjects he deemed important to his calling.

“Look here. How many books do you see on investing?”

I peered around me, daunted by the sheer volume of volumes. I shrugged.

“Precisely none. I need none because I know that the prices of stocks and consols are driven not by any of the endless changes generated by the ceaselessly restless and ingenuous financial business in its search to extract every last fee from the pockets of people like yourself. No, Watson, the key to successful investment is psychology, not finance”.

“Psychology? I’m sorry, Holmes, I’m not sure what that is. Do you mean the strange writings of the Viennese professor, Freud?”

“Poppycock!” exclaimed Holmes, whirling his arms in animated exasperation, “No I talk of the inestimable writings of the mentalist Dr. William James and the naturalist Mr. Charles Darwin, who between them have offered us an insight into the truth of human nature”.

“Darwin tells us that we are descended from apes, does he not?”, I said, trying hard not to picture the baboons we had seen at London Zoo the previous weekend, engaging in acts that I felt were not suitable for the eyes of my good lady whom I’d hurried away to an exhibition of the latest in communications technology given by the inestimable Italian inventor, Guglielmo Marconi, in whose company I had unhesitatingly invested on the Monday morning. In hindsight the lack of earnings or actual products was slightly concerning, but his telegraph was surely a world beating technology destined to dominate global communications for centuries.

“We are cousins, certainly. But we share many biases which are in-built and from which we can escape with only the greatest of difficulty. We run from danger and flock with the crowd for safety, actions which are of the greatest benefit to us in the course of our normal lives. Yet these are traits of the utmost danger in investment, where the beliefs of the masses are close to delusional. And Dr James explains that our world is constantly in flux and our emotions in flux with it, lessons most stock speculators should heed”.

“Gosh Holmes”, I frowned, “It sounds rather difficult.”

“Difficult!” exploded Holmes, “Have you learned nothing from your years as my faithful assistant? What could be simpler – we are all habitually controlled by inner urges we understand nothing of and influenced unconsciously by the people we spend our time with? These are the fundamentals of my trade, Watson, and you of all people should know this”.

“Well, I suppose so”, I mumbled, “but I still don’t understand …”

“If you invest on the basis of short term tips and hints, if you spend your time watching your investments instead of earning an income through your skills, if you spend your money on whims and fanciful speculations and if you persist in acting upon your investments on the basis of the words of people whom you know not then you will end up in the gutter. Is that so hard to understand?” Holmes pointed a long finger at me, “Trust me on this, as a friend”.

“No, no”, I said, “I trust you implicitly old man. It’s just I still don’t know how you knew my good lady was with child. That’s astonishing”.

“Oh that”, said the Great Detective carelessly, “Well, your beloved met my housekeeper at the bakers this morning and she couldn’t keep a secret I’m afraid”.

Holmes suddenly smiled and offered me his hand. “Congratulations. Come, a new day beckons”.

And so saying, he threw my paper upon the fire and stood there, warming his hands upon the bonfire of my vanities.


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Econophysics, Consciousness and Cosmic Karma

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.

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