Seeking Alpha, Finding Omega

Institutional Efficiency?

Having hopefully now established that behavioural bias in finance isn’t a figment of various researchers’ fevered imaginations we still need to think about whether the total market might, possibly, be a bit efficient. For even though psychological maladaptation seems to be everywhere we look this still doesn’t show that markets might not be basically sensible under the covers.

Consider that in the US over 50% of the monies invested in markets aren’t under the control, even by proxy, of demented, short-term private investors. No, in fact the majority of investment funds are under directed by a relatively small number of people – so-called plan sponsors – who are responsible for how institutional groups invest their cash. As they’re responsible for over six trillion dollars worth of investments these people matter – a lot – but fortunately, as they’re professionals, we can sleep comfortably knowing that markets are basically in safe hands.

That’s a joke. Kind of. Sort of. Ha ha.

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Mayhem with M&A;

Insane Acquisitions

Most company acquisitions generate significant benefits. Unfortunately these accrue almost exclusively to the shareholders of the companies being bought, rather than the owners of the acquiring corporation. Time and again major mergers and acquisitions fail to work yet this doesn’t seem to stop the cycle of value destruction. Yet again, something in the corporate world seems to be a bit broken.

The problem is that generally companies overpay for their acquisitions, diluting the value of their equity and, thus, damage the interests of their shareholders. Yet this is no secret, so company executives are persisting with their problematic purchases in the face of almost certain failure. Being insanely overoptimistic seems to be part of the human condition but being dementedly stupid isn’t an obvious precondition for managing major corporations. So what gives?

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Monty Hall Economics

God and the Economists

Apparently the Monty Hall test is one that Wall Street firms commonly use to see if potential applicants are suitable material for the madness that is a trading desk in the heartlands of financeland. In so using the test these corporations are, knowingly or not, addressing some of the most hard to overcome behavioural biases that often defeat legions of unprepared investors.

In fact, this particular test has been a source of delight for grant seeking academics of all persuasions. The thing is that the Monty Hall test can be explained in many different ways, most of them simultaneously contradictory. However, it does increasingly look like this blatantly irrational behaviour is hard-wired into our neurons. It seems God really doesn’t like economists.

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In Markets Bad Stuff Happens – Frequently

Numbers and Stories

We’ve seen before that investors are generally attracted to a good story and tend to shy away from the hard problems associated with analysing numbers. Worse, even if people do look at the numbers they tend to be swamped by information to the extent of not knowing what’s important and what’s not. Although generally this is only obvious in retrospect, anyway.

However, there are strong suggestions that our inclination to follow a good and particularly interesting story isn’t simply stuff that happens. It looks as though this is built into our processing centres and is a driving force behind a lot of what we do on an everyday basis. We’re simply misapplying the lessons of life.

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CEO Pay – Because They’re Worth It?

Poor Chief Executives

In the United States CEO pay dropped by an average of 2% in 2009. Still, ordinary workers needn’t shed too many tears as the average total compensation for an S&P500 CEO hovered around the $11 million mark. Perhaps more significant is the gap between the average CEO’s and the average worker’s pay. From CEO’s earning 42 times more than employees in 1980 this soared to a factor of 525 in 2000 before declining to a still eye-watering 319 times in 2009. Here in the UK we find a similar discrepancy between the boardroom and the shop floor.

This doesn’t automatically mean that CEO’s are overpaid, although there’s no evidence either way that they’re providing 319 times more value than their underlings. Indeed, it’s hard to see how you could ever disentangle the various causes and effects to determine this. What we can do, however, is look under the covers at why CEO rewards may be so high: and, as you might expect, it looks like this is less to do with performance and more to do with psychology.

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Recency: Hot-Hands and the Gambler’s Fallacy

Behavioural Biases (6): Recency

Recency is a great trouble to us, being a particularly tricky sort of behavioural bias that’s rather difficult to overcome. It works thus: you overfocus on the most recent events you’ve experienced and neglect to worry about older information. We don’t so much integrate new information with the old as use it to overwrite our memories.

For investors recency may have a couple of different effects. Positive recency makes you a momentum trader, a sort of living incarnation of a goldfish, forever surprised by the same piece of seaweed. Negative recency makes you a contrarian investor, solidly heading away from anything exciting, looking for where the action isn’t. Either way you’d better be damn sure you know what you’re doing because both approaches more or less guarantee under-diversification.

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Do Behavioral Funds Work?

No. Maybe.

For all the impressive research on behavioural finance the acid test is ultimately whether it can yield better returns for investors. A few intrepid souls have set out to discover whether there’s any evidence that investing along behavioural lines can produce such returns and have re-emerged from the mutual fund jungle, somewhat battered and worse for wear, with the broad answer of, err, “No, it doesn’t”.

Of course, there’s a bit of a puzzle behind the research because the concept “behavioural investing” is somewhat amorphous. It would be unsurprising, given the parasitic mutational qualities of the financial sector, if the rise of behavioural finance didn’t attract managers who see it as the next destination of hot money. It’s enough to make your head spin: behavioural finance itself could be the next behavioural finance anomaly.

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Unpredictably Rational

Common Sense

As we go about our everyday lives we don’t spend a lot of time reflecting on the irrationality of the people around us. Certainly from time to time people do stupid things, but by and large most of us make it through most of our days without driving the wrong way up roads, roasting our dogs in microwaves or buying stocks in stupid companies. Even when we do odd things there’s usually some recognisably rational reason for us doing them.

This version of human rationality is virtually unknown to all brands of economics which largely insist on defining rationality in an irrational way and then sniggering at the human race when it fails to live up to the standards that some rather over-focused economists think it should. The problem for them is that we’re not the irrational ones, they are. The problem for us is that the people that matter listen to them, not us.

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In the Beginning Were The Accountants

Genesis in a Ledger

In the beginning were the accountants. Mostly people think it was the dinosaurs, or bacteria or bread mould or something. Well, it was all of those things. But mostly it was the accountants.

Despite all the efforts that scientists put into making protons and neutrons go really, really fast in order to achieve the quickest acceleration from nought to sixty, the truth is actually that they’re on a hiding to nothing. The fundamental secret of the universe doesn’t lie hidden in elementary particles. No, it’s in full view for anyone who wants to look: it’s in double-entry bookkeeping.

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