Risk := ON

Quantitative Squeezing

As the immediate fears of market immolation have faded the switch in investors’ heads marked “Risk” has moved to the OFF position. All those little signs of uncertainty, the mass synchronisation of share price movements, the endless twittering and wittering about the imminent end of the known world have faded, to replaced by the normal measures of complacency in the face of unimagined dangers.

It’s likely that the relief generated by the Eurozone’s ability to stitch together a patchwork quilt of compromise to keep Greece from defaulting and the general resilience of corporate profits is only temporary. A reckoning must come when quantitative squeezing replaces quantitative easing. Getting this right requires finessing on a grand scale by the lords of finance; not impossible, merely very, very difficult.

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Do Stocks Always Outperform (in the Long Run)?

Funny Futures

The equity premium puzzle is one of the longest standing anomalies in finance: the finding that stockmarket investing outperforms other types of investment by a significant amount. Generally you’d expect the price of shares to rise until this advantage was cancelled out, but this hasn’t happened and has made quite a lot of futurologists look rather silly.

It turns out, though, that the equity premium puzzle may be even more puzzling than it first appears. Basically researchers aren’t exactly sure how large it is, or even if it exists at all. So is the idea that stocks always outperform other investments in the long run just another market myth used to cajole unwary investors into parting with their hard-earned cash?

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Craving a High: Trading on Dopamine

Pathological Investors

“A pathological gambler dies and thinks he is in heaven because he wins every time he plays. Very quickly after constantly winning his wagers, he requests to be sent to hell, only to find out that he is already there.”

Sapra and Zak, Neurofinance: Bridging Psychology, Neurology and Investor Behavior

Neuroeconomists, that breed of behavioral researchers seeking to link actual brain function to real human behavior, are fascinated by people who exhibit what they refer to as excessive risk taking and whom the rest of us refer to as “scary”. Whether this behavior is pathological gambling, compulsive shopping or simply eerily unworried stockmarket trading, there seems to be an underlying theme: risk takers crave the buzz of novelty and are turned on by the uncertainty it generates, not by the outcomes.

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Caught in a Rat Trap: Jevons’ Paradox

Depleted

As natural sources of fuel deplete there is, not unnaturally, a concern to introduce more efficiency, to conserve our resources. The idea is that by producing more efficient cars, heating systems or whatever we’ll decrease fuel use and buy ourselves more time to do whatever it is we need to do: melt the polar icecaps, most likely.

Unfortunately, this is exactly wrong. If we make more efficient use of fuel we will use it faster and probably do more damage than if we stagger along in our current fashion. This is the Jevons’ paradox, a mode of market failure that should make grown environmentalists weep, if they weren’t too busy saving the few remaining penguins by smothering them in oil retardant chemicals.

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Hubble, Bubble, Index Trouble

Consequences, Consequences

In a world in which our behavioral biases are continually encouraging us to stray into temptation, or at least into the grasping hands of the securities industry, we have to look for whatever small mercies we can find. Not the least amongst these is the humble index tracking fund, an asset type specifically created to minimise the opportunity for self-inflicted mischief.

Yet such is the nature of the financial business that even in the world of the behaviorally inert, passive index tracker we can’t avoid the dead hand of unintended consequences and cognitively induced misadventure. In becoming popular index tracking funds have simultaneously created their own behavioral problems: because whenever too much money imbued with too little intelligence chases too few assets the only possible outcome is a bubble. And we all know what happens with bubbles.

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Manifesto For a Low-Growth World

Escher Economics

Trying to find a way out of the economic trap that we currently find ourselves in is like attempting to escape from one of those Escher drawings in which stairs spiral round on themselves forever and you find yourself walking up a staircase, upside down. Multiple generations of people have experienced nothing but economic growth, fuelling a consumption frenzy that our rulers are still trying to keep going but, without the vital elements of either growth or debt, we have, temporarily at least, reached the end of the cycle and the bills have to be paid.

The pain that this is engendering amongst consumption minded electorates is seeing political parties thrown out of power for being in the wrong place at the wrong time, and replaced by those that have no better ideas. The key, however, lies not in economic growth but in focusing minds on relative wealth. Being wealthier than your brother-in-law keeps you happy, and happiness is the vital issue in the new world of behavioral economics.

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Salience is Golden

New Frames

As so often in the past Warren Buffett has stirred up a swarm of annoyed investors, this time by explaining why he thinks gold as an asset class isn’t so much overvalued as irrelevant. He’s done this in a way typical of the man, by changing our frame of reference, to give us an entirely new perspective on the issue.

This gives us an insight not just into gold's current status as an investment class but also into why Buffett is almost unique as an investment guru. He doesn’t rely on the old arguments about what’s important by drawing on existing ideas of what’s salient, but develops new ones, based on his own models. He changes what’s salient, and that’s real gold for investors.

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How to be a Bad Manager: The Pygmalion Effect

“A unique characteristic of superior managers is the ability to create high performance expectations that subordinates fulfil … Subordinates, more often than not, appear to do what they believe they are expected to do.”

(Daido and Itoh)

Bad Vibes

One of the most powerful – and frightening – research programs in social psychology was that conducted by Robert Rosenthal into the Pygmalion effect.  Named after an ancient Greek  who fell in love with a statue he'd carved,  it found that a student’s success is directly related to a teacher’s belief in their ability.

This is not simply a finding about children in the classroom, it seems to be a general truism.  Good managers get more out of their people by believing in them, and letting them know it.  Bad ones create bad vibes and bad results: a CEO that only bullies and never encourages will run a bad company, or at least a less good one than it could be.

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