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Saturday, 28 August 2010

Studying Economics Makes You Mean

Not Predictable

It’s established by now that economics didn’t help stop some of the more spectacular misadventures of the financial community but it’s a bit less obvious that it was directly responsible for many of the mishaps. It’s all tied up with the dirty fact that economists are basically a bunch of untrustworthy, deceitful bums who shouldn’t be left alone with your child’s piggybank, let alone the world’s economy.

The trouble is that economists have a world-view that sees us all as self-interested moneygrubbers without an ethical thought in our heads. Perhaps that’s because that’s a pretty good description of economists themselves: they act like their models are true, the dirty rotten scoundrels.

Wednesday, 25 August 2010

Economic Value in Aitch-Two-Oh

Odd Water
"The world's supply of fresh water is running out. Already one person in five has no access to safe drinking water. "
Well, so says the BBC. But water’s an odd thing. You can’t live without it but it’s not particularly valuable. In fact the stuff in your faucet is free, it’s just the cost of getting it there that we pay for.

Water is, perhaps, the pre-eminent example of the old truism that price is what you pay but value is what you get. Only thing is, how do you value something that has no market price? Fortunately teams of highly trained thinkers have been working on this, just so we know the price of everything even if we’re not willing to pay it.

Saturday, 21 August 2010

Sexism and the City

Hair-Trigger Traders

It’s long been known that women make better investors than men, although frankly that’s not a particularly difficult thing to do as most of us males have the patience of a small child with a full bladder and a tendency to hair-trigger trading for all sorts of behaviourally induced reasons. However, what’s a bit more surprising is that this difference is seen in professional investment circles as well while at the same time biases against female fund managers ensure they have less money to manage more wisely.

Behind all of this appears to be a basic bit of brain processing evolved to make sure we bond tightly to our social groups and to regard outsiders, en-masse, as strange and potentially dangerous. As so often in investment, though, if we stick to our basic stereotypes we blind ourselves to opportunity.

Wednesday, 18 August 2010

On Incentives, Agency and Aqueducts

Risk Management, Roman Style

There’s an aqueduct in Segovia, in Spain, that’s stood the test of time. A lot of water has flowed over that bridge … two thousand years worth, more or less, since it was built by the Roman Empire. Back then risk management consisted of getting the chief engineer to stand underneath the structure when they removed the supports: now that’s a proper incentive.

Incentives stand at the heart of a lot of human behaviour in corporations but financial theorists have had a great deal of difficulty in understanding that an incentive is not necessarily the same as a financial reward. Although the ideas of psychologists and sociologists are slowly seeping through there’s still a long way to go before there’s a proper appreciation of what motivates people. In the meantime we’re stuck with Agency Theory, the sheer power of grim self-interest: it’s like real life but not as we know it.

Saturday, 14 August 2010

Advertising on the Handicap Principle

Fuzzy Peacock Intuitions

Biologists have been long perplexed by the peacock’s tail, economists by the use of advertising. In both cases the struggle has been to understand why something so self-evidently pointless and potentially damaging can survive in a vicious world of winner-takes-all, loser-goes-extinct natural selection. Meanwhile researchers from both worlds have been closeting themselves ever deeper in an arcane world of computer modelling, where truth can be validated only by mathematics.

Hints of answers to these puzzles have come not from number crunching but from fuzzy human intuitions about the way the world actually works. Peacocks and advertisers have something in common – in both cases it turns out the handicaps they place themselves under send signals to their potential suitors. Behavioral advertisers, who aim to remove these handicaps, take note: a peacock without a stupid tail won’t get a mate and an ad that’s easy to deliver won’t get a customer.

Wednesday, 11 August 2010

James Randi and the Seer-Sucker Illusion

Illusion is not Forecasting

Every morning before he left home the illusionist James Randi used to take a piece of paper and write on it “I James Randi will die today”. He’d then sign and date it and slip it in the pocket of his jacket. Had he died, of course, the world would still be full of credulous believers insisting that he was a genuine psychic seer. We smart investors laugh at such fools, of course.

We shouldn’t, though, because every day we’re the victims of people just as clever as Randi and without any of his good moral sense. Every day, across the world, people forecast the unforecastable and predict that markets will boom, or bust, or stagger sideways like a drunken sailor. Eventually one of their predictions comes true and gullible people everywhere equate this with foresight when, in fact, the forecaster has simply been slipping a note in their pocket each morning. In a world where everyone predicts everything occasionally someone’s going to be right.

The Cowles Study

The evidence that most forecasters are simply practising the illusionist’s sleight of hand has been mounting for a very long time. Way back in 1933 Alfred Cowles published a paper on Stock Market Forecasting which “disclosed no evidence of skill in forecasting”. When he extended this study in the 1940’s he commented:
“The wording of many of the forecasts is indefinite, and it would frequently be possible for the forecaster after the event to present a plausible argument in favor of an interpretation other than the one made by the reader”.
Gosh, do tell.

Cowles’ research used the forecasts as a basis for actually making investment decisions – so a completely bullish forecast was assumed to cause an investor to invest 100% of their funds in the market. Computing the compounded results of acting on these forecasts led to a series of observations, the gist of which is that the forecasters exhibited no aptitude for forecasting. Indeed, they underperformed the market and were consistently, by a factor of 4 to 1, on the bullish side:
“The persistent and unwarranted record of optimism can possibly be explained on the grounds that readers prefer good news to bad, and that a forecaster who presents a cheerful point of view thereby attracts a following without which he would probably be unable to remain long in the business of forecasting”.
A 50-50 Bet

Given that markets were down around as much as they were up in the period under study and that forecasters were nearly always bullish it’s fairly easy to see that they’d be right about 50% of the time. Which is what Cowles found. In fact if you take a view that most forecasters are always bullish you can take a view that most forecasters will look like geniuses in a bull market and bozos in a bear market without exhibiting any particular skill in either direction. Similarly the smaller number of forecasters who are usually bearish will obtain the reverse position. To whit: forecasters forecast nothing, they’re simply signing their death certificate each morning.

In the current environment, therefore, we might expect to see a few consistently bearish commentators looking as though they can outwit the markets. Nouriel Roubini, aka Dr. Doom, has recently pointed out that his s track record of forecasting major moves in the recent past is very good – having called five out of six movements correctly. Only the five called correctly were all downwards and the other one was the mother of all rebounds.

Roubini is, by far, one of the most intelligent commentators on markets, but the point is that trying to figure out whether any recent record of success is attributable to skill or luck is pretty much impossible. So the question is: if forecasters are so useless why do people keep on using them?

The Seer-Sucker Theory

J. Scott Armstrong has come up with The Seersucker Theory to explain this. What he showed, through a wide range of examples taken from finance, psychology, medicine, etc was that forecasting success is not generally related to expertise over and above a pretty minimal level of competance In fact forecasting accuracy seems to drop once people get above a certain level of expertise. It’s not entirely obvious why this is but there are hints that confirmation bias is involved: seers are less likely to look for disconfirming evidence to cross-check their opinions than less confident semi-experts.

Meanwhile the seer-sucker theory states:
“No matter how much evidence exists that seers do not exist, suckers will pay for the existence of suckers”.
Or: for every seer there’s a sucker. One reason for this might be to do with avoidance of responsibility on behalf of the suckers. All too often in situations involving risk and uncertainty “experts” are called in who have no realistic chance of making a better decision than anyone else: that’s the problem with uncertainty. It’s uncertain. It’s unpredictable.

Herds of Analysts

However, Hong, Kubik and Solomon in Security Analyst’s Career Concerns and Herding of Investment Forecasts have proposed an interesting variation of why analyst forecasts aren’t very good in general. Herding – the behavioural trait that causes investors to move in a given direction at the same time – is triggered by career related incentives. This, of course, is not generally a factor for private investors and therefore is often neglected in considerations about why professionals make their recommendations.

What they find is that younger analysts tend to herd more than their more experienced colleagues: less experienced analysts tend to be punished more heavily for getting their forecasts wrong so they have every incentive to stick with the crowd. In contrast older analysts, who have presumably built up their reputations, face less risk of termination. Basically if a younger analyst makes a bold forecast and gets it wrong they’re likely to lose their job, while doing so and getting it right seems to make little difference to their immediate career prospects.

Although the study implies that the more experienced analysts are more accurate forecasters it, unfortunately, doesn’t make clear whether they do any better than chance over long periods. If Cowles’ findings still stack up the probability is not. Either way relying on consensus forecasts by great stampeding herds of perversely incentivised analysts isn’t likely to yield great results. Look for the outliers and then analyse them: still no free lunches, just hints and intimations.

Give Me Stories, Not Facts

Of course, in writing this, I’m well aware that forecasters will carry on forecasting and followers will carry on following: McKinsey have just published another study confirming nothing’s changed. When the inventors of the crop-circle came forward to explain how they’d fooled scientists the world over with a bit of ply-wood they were almost universally ignored. James Randi has made a second career out of debunking mystical charlatans who prey on people’s gullibility. Yet still they believe and often react violently to having their illusions shattered. It’s as though we can’t grow up and face the real world: it seems that fairies, dragons, magic and mysticism are so much more attractive than the grim reality of credit card repayments.

And this is the hidden truth – we find stories more congenial than facts. Markets are driven less by fundamentals and more by tales of derring-do. Forecasters are story-tellers not diviners of the future. Like all authors of fiction we should enjoy them for what they are: just don’t confuse their narratives with proper investing.



Related articles: Investing With a Time Machine, Investment Forecasts: Known Unknowns, Real Fortune Telling

Saturday, 7 August 2010

Tâtonnement: Groping for Stock Equilibrium

Old Saws, New Rocks

One of the oldest saws in the book of economics is the idea of supply and demand; it even pre-dates Adam Smith, with a legacy stretching back to Muslim thinkers of the eleventh century. If people demand the Pet Rock as the next must-have toy but supply is limited then prices of Pet Rocks will go up. If some enterprising rock counterfeiter then floods the market with a supply of good-enough fakes then the demand is likely to fall, and price with it.

This iron rule of economics is actually a bit less rigid than you might think. In fact, it’s rather too wibbly-wobbly to describe it as a rule at all. But at the margins it more or less works which means it’s rather curious that it’s rarely cited as a reason for long-term changes in stock prices. It stands to reason, though, that if lots of people decide they want to buy shares just as companies start to withdraw them from the market that prices should go down. Or does it?

Wednesday, 4 August 2010

Money Illusion

Sleep Soundly

Money illusion is just about the most venerable of all of the behavioural biases that afflict people’s financial good sense. It was recognised back in the early part of the twentieth century, was an integral part of financial theories from thereon and spawned a range of measures that are more or usually less useful to us in everyday life.

Then economists decided that money illusion was … illusory. Which led to various predictable, albeit unpleasant, consequences such as believing “you can’t go wrong with property” or that storing cash in your mattress equates to sensible financial planning. Being poor is one thing, but not being able to get a good night’s sleep is entirely another …