Utility, The Deus Ex Machina of Economics

The St. Petersburg Paradox

An economic problem posed over 250 years ago still causes angst for economists, investors and actuaries today; largely because it’s never been satisfactorily solved, probably because it can't be. Despite this, the resolution posed all those years ago has travelled down the ages, insinuating itself into every nook, cranny and other archaic crevice of finance you care to mention, like an elasticated thong on an overweight man.

The problem, posed by Nicholas Bernoulli, is known as the St. Petersburg Paradox after the city of residence of his cousin, Daniel Bernoulli, who was the first person to propose an answer to it. Daniel’s great idea – and it was a truly great idea – is known as utility. Without the concept of utility it’s doubtful that any of us would be here to debate this issue, yet the findings of behavioural finance show that it’s almost certainly wrong. The Paradox of St. Petersburg has plenty of life left in it yet.

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Save Our Short-Sellers

Short Selling Scapegoats

Whenever there’s some kind of major market crash and people start looking for handy scapegoats the usual line-up of suspects will include a preponderance of short-sellers, accused of unpatriotically selling stocks they don’t own in order to make windfall profits. It’s as though making a profit when everyone else is losing money suddenly becomes wrong. When times are tough it seems everyone’s a bleeding heart socialist.

Instead of banning short-selling regulators ought to be focusing on what measures they could take to make it more popular. If you want markets to be roughly efficient and not to fly off on some behaviourally induced flight of fancy then you need intelligent investors to be able to short-sell over-valued stocks. Waiting until everything goes wrong and then artificially distorting the markets in order to apply a tiny band-aid to a market holed below the waterline by a bloody great iceberg of behavioural bias is to invert cause and effect. Short-selling doesn’t cause market crashes, people do.

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Investor Decisions – Experience is Not Enough

Economic Paradoxes

At the heart of Prospect Theory, the seminal approach behind behavioural finance, lies a puzzling paradox. Although the theory argues that people overweight the chances of unlikely events occurring – so, of instance, we worry much more than we ought to that our children will be kidnapped – the evidence from the field suggests exactly the opposite.

So, it seems we have a dilemma at the centre of the behavioural universe. Either way traditional economics gets it wrong but so, it seems, does the newfangled psychological kind. Given that we start the analysis with only three choices – that people correctly weight rare events, underweight them or overweight them – then it’s a bit disappointing that the two main branches of economics manage to slightly miss the correct answer.

That’s “slightly” in the sense of “completely and utterly”, of course.

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Volatility, the Last Anomaly

Jitterbugging Markets

As we’ve previously seen many of the strange anomalies that affect investors have a nasty habit of disappearing, just as soon as people recognise that they exist. This wantonly random behaviour gives fuel to the last remaining adherents of the efficient markets hypothesis who can point out that despite the best attempts of behavioural financiers the evidence keeps on vanishing.

Despite the mysterious case of the missing anomalies there’s one that resolutely refuses to go away, squatting in the middle of the markets like a recalcitrant and extremely ugly toad. Rather ungraciously stocks continue to bounce around like a jitterbugger on speed. Regardless of everything else it’s volatility, the last anomaly, that keeps on giving. And then taking away. And then giving back again.

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Investing By Jerks

Punctuated Equilibrium

Back in the early 1970’s a couple of young biologists came up with an suggestion that profoundly annoyed many of their colleagues and has continued to divide their subject ever since. The idea was called “punctuated equilibrium” and argued that evolution doesn’t develop smoothly and continuously over time but proceeds with long stops and short starts, thus making the chances of finding intermediary forms in the fossil record vanishingly small.

The opponents of this, to non-biological eyes, non-controversial extension to evolutionary theory responded sarcastically that this was “evolution by jerks” invoking the rejoinder that the alternative was “evolution by creeps”. Clearly, the world of the evolutionary life sciences is populated by some seriously adult people. However, the idea of punctuated equilibrium is a powerful one and its applicability to other systems characterised as evolutionary, like the world’s economy, is replete with possibilities. After all, can investing by jerks be any worse than everything else we’ve witnessed?

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The Opportunity of a Lifetime – Again

In People We Trust, Not

In 1907 there was a nasty credit crunch. Then there was a financial crisis during the World War I and its aftermath, followed by the Wall Street Crash and the Great Depression. After World War II there was another market slump as everyone expected a repeat of the crashes after the US Civil War and World War I.

This was followed by the rise and fall of the Nifty Fifty, an eighteen year long market hiatus with an oil supply crisis thrown in, the unexplained crash of 1987, the Asian Crisis, the Long Term Capital debacle, the dot com crash and, with neat symmetry, another credit crunch. With clockwork precision an investing opportunity of a lifetime has arisen once a decade, if not more often.

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Value in Mean Reversion?

Many shall be restored that are now fallen; and many shall fall that are now in honour (Horace, Ars Poetica)

From Horace to Graham and Doddsville

The quote above is now a couple of thousand years old but was used by Ben Graham and David Dodds in their seminal book on value investing, Security Analysis, a term invented by the book's title. At root it’s a simple plea for understanding that current market conditions, no matter how placid or tempestuous, will pass. The job of the conscientious investor is, at worst, to ignore the short-term forecasts or, at best, to take advantage of them.

Some psychological quirk means that a small subset of humanity latches onto this concept instantaneously and holds to it, like an investing life preserver, through thick and thin. The rest of us either learn the slow, hard and painful way or, more likely, continue to be storm-tossed. Occasionally someone gets washed up on a tropical paradise and is accounted a genius but mostly we drown, quietly, where no one can see us waving.

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Trust Is In the Eye of the Beholder

Is Beauty More Than Skin Deep?

There’s been quite a bit of debate down the years about so-called beauty biases. Various bits of research have suggested that us humans have a bit of a soft spot for other humans who are easy on the eye, to the extent that we tend to attribute abilities to them that they haven’t got. Merely looking attractive is enough to help you get on in life, it seems.

However, there are usually potentially confounding problems with these experiments, in particular the possibility that lovely looking people might actually be better at stuff than the rest of us ugly has-beens. Fortunately a combination of the banking crisis and the proliferation of the internet has offered a glorious opportunity for field experimenters to conduct a bit of real-world research. Even better, it’s suggesting that automating risk management removes a vital layer of protection for lenders and that scammers can play on these traits to defraud us. So are the beautiful also brighter?

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Finance: Where The Law Of One Price Doesn’t Apply

Differentiating Financial Products

Even the smartest amongst us can be fooled by the pricing structures of relatively simple financial products. In any normal industry we would expect the law of one price would be prominent – in efficient markets all identical goods must have only one price.

Now whether or not the market for financial services is efficient or not is a moot point but the industry’s ability to create a vast swathe of differentiated products could almost have been designed to prevent the law of one price from operating. With the documentation for even simple financial products running into several pages of hieroglyphics in a convoluted and slightly sinister attempt to promote “clarity” the chances of anyone actually recognising that any two products are identical is minimal. In such a situation efficiency is a pipe dream.

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Putting Down the Credit Cards

Deviant Cards

Credit cards are one of the modern era’s great financial innovations, and have benefited the financial institutions that issue them terrifically. Unfortunately many of the people who use them get rather less rewards, mainly because of the unconscious biases that compel their every conscious move.

One of the few manifest and practical advantages of credit cards, though, is that analysis of their use is a practical primer in many of the behavioural biases which so entrance us on these pages and of the way in which ill-considered legislation magnifies their effects. Credit cards are a marvellous mechanism for a study of our deviant debt-laden ways and the ineptitude of our legislative representatives. However, they’re also the thin end of a very dangerous wedge.

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