Economics & Psychology: Reconciliation?

Continued From Economics & Psychology: The Divorce …

By the early 1970’s, as the long bull market of the post war years collapsed in a welter of unforeseen problems, financial professionals confronted the real meaning of risk on a systemic basis. As markets crumbled in the face of economic uncertainty trading companies turned to economists in academia in the hope of finding a way through the mess, or at least some excuse to get people to buy stocks.

What they discovered was a way of measuring risk that appeared to offer the option of quantitatively managing investments in a rational way, rather than relying on the intuitions of individuals. This approach has come to dominate the securities industry ever since. At the same time, though, a small revolution was brewing in psychology. And it's been fermenting revolution ever since.

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Economics & Psychology: The Divorce

Self-Interest’s Not Interesting

For a long while economists worked hard to cleanse their subject of any trace of psychology which, on the face of it, was rather odd as the main assumption for the subject is that people act in their own self-interest, a psychological principle if there ever was one. The argument in favour of such an approach is that it doesn’t really matter whether the assumption of self-interest is true or not as long as the reality is matched by the theoretical predictions.

Well, as we know, the reality has a nasty tendency to go off and do its own thing and the idea that economics can exist without taking account of psychology has taken a beating in recent years. What’s odd, though, is that the idea was ever even considered. Understanding why that happened is a critical step in creating a new economics, one that actually has some genuine predictive capacity and which can avoid screwing up the world in its efforts to get economists invited to all the best parties.

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Love Your Kids, Not Your Stocks

That Love Thing

Psychologists have about as many theories about love as economists have about investing, and they have about the same success in making predictions based on their ideas. Still, both sets of social scientists plod on regardless, presumably on the basis that if there’s a market for oddball ideas they might as well try and serve it. Or maybe they’re just hoping for a date.

There are plenty of cases, though, in which it appears that investors fall in love with their investments and regardless of how fickle or downright untrustworthy their squeeze's behaviour is they’ll stick with them through thick and thin. Mostly thin. So maybe the psychology of love can tell us something about the psychology of investors?

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Copernicus, Muddling Through

Revolutionary Ideas

The story of how Nicolas Copernicus overturned centuries of dogmatic adherence to an Earth centred cosmos is well known – too well known, perhaps. Copernicus’ ideas didn’t come out of the wide blue yonder in a sudden revelation; they arose out of the careful work of earlier scientists, paving the way for his final proposition.

Although our preferred methods of storytelling give preference to dramatic tales of sudden jumps the truth is nearly always much more gradual. Just as in science, corporations and industries tend to change slowly. Generally when they don’t there’s something either badly wrong or about to go badly wrong. We’re usually at our best when we’re incrementally muddling through, not trying to re-invent the world anew.

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Technical Analysis on Display

Patterns in the Stars

The idea that technical analysis of stocks – the extraction of useful trading data from various charts mapping share prices and other data – is actually anything more than a hangover from pre-computer days is generally scoffed at by those who spend their time number crunching. From these lofty heights chartists are generally regarded with the same distain as scientists reserve for astrologers.

Which may be justified, or not, but there’s one area where the human brain can still outperform microprocessors: the unconscious extraction of patterns from visual information. Is it, in fact, possible that technical analysts are simply using the brain’s unique pattern recognition capabilities to outwit the supercomputers?

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Weird Markets

Animal, Mineral or Vegetable?

Most of economics, and lots of life, revolves around a single concept: that of the "market". Yet despite the untold reams of papers, books and data generated in the name of the subject there’s a hole at the centre. This can be summarised simply: what, exactly, is a market?

This is akin to biologists suddenly recognising that they don’t actually know what an animal is despite the fact that they’ve been studying the behaviour of the things for centuries. If the existence of markets is the core assumption upon which economics exists what happens if either it turns out they’re a figment of the imagination or even simply just one way of many of understanding the world of human financial interactions?

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Trading On The Titanic Effect

Scary Tactics

If you’re sailing icy seas you’d generally want to keep a watchful eye open for icebergs. Unless, of course, you’re in an allegedly unsinkable ship, in which case you’d probably prefer to opt for a spot of partying and an early snooze on the poop deck instead. The craft’s designers will likely not have bothered with wasteful luxury items like lifebelts, emergency flares or lifeboats either: what would be the point?

You have, of course, just fallen foul of the Titanic Effect, one of a number of self-fulfilling behavioural biases where your expectations bias your behaviour and make it more likely that you’ll fall foul of the very problems you think you’ve overcome. Oddly, though, the problem suggests the solution: scare the living daylights out of the crew before you cast off.

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