Predicting the Information Markets

Circular Markets

As we saw in Weird Markets it can be remarkably difficult to pin down the idea of a “market”.  Markets are what economists study, economists study markets; a perfectly circular relationship.  On the other hand, markets do seem to be a fine way of deciding how to allocate scarce resources: economics is built on this singular, empirical observation.

Given this it’s not a huge jump to recognizing that markets may be a better way of making predictions about all sorts of things than relying on the kind of dubious expert forecasting we've met numerous times as in Forecasting a Financial Earthquake.  Prediction markets have suddenly become interesting because they work; which probably means they’ll shortly stop working, because they’re now interesting.  Tricky stuff, this reflexivity.

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Bayesian Unreason in the Modern World

Unintuatively Rational

Most economic theories make an assumption that humans are rational, but this definition is a peculiarly drawn one as it assumes that we all operate on the basis of Bayes’ Theorem, an idea which is freely bandied about but which very few people can actually describe.  There’s a good reason for this – it’s profoundly unintuitive, which makes you wonder if we do think the way the theorem suggests we ought to.

Unintuitive or not every investor should have a working appreciation of the ideas behind Bayesian reasoning, because it’s another one of those mental models we can use to assess the usefulness, or otherwise, of our ideas.  And oddly enough, it may be even more fundamental than we think.

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The Emergent Rationality of Markets

Frogs and Philosophers

In Games People Play we alighted upon the germ of an idea that bears further investigation – that although individual investors may themselves be as mad as a box of frogs on mescaline their combined behavior can somehow result in relatively rational markets.  The idea is that, somehow, rational markets arise out of irrational traders doing stupid things.

Odd though this may seem as an idea the possibility of new properties emerging from systems made up of complex component parts isn’t new, although it does serve to make a lot of scientists and philosophers extremely annoyed.  Which is a good reason for pursuing the idea, is it not?

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Games People Play

Nobel Games

Game Theory is a theory of human decision making, and one that’s very popular in the dismal science: no less than thirteen of the forty four Nobel Prizes in economics have been awarded to practitioners in the area.  And, indeed, Game Theory is a powerful tool for researchers in many fields, the only problem being that if you give a man a powerful tool they’re likely to want to wave it around and use it on everything, regardless of taste and applicability.

Thus we find that Game Theory and behavioral economics collide in odd ways, which turns out not to surprising as the former is built on the foundations of the standard economic approaches.  Even so, a basic appreciation of the mysterious workings of economic gamers is an essential part of any investor’s kitbag of mental models.

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On the Invariant Nature of Investor Ineptitude

Behavior is Forever, Not Just For Life

One of our themes here is the unchanging nature of human behavior across time and space.  It doesn’t much matter whether we’re in 1^st century Rome, 17^th century Holland, 18th century Britain or 21^st century America, if you put large groups of people in the same situation they’ll tend to behave the same way when they have money at stake: irrationally.

There’s plenty of evidence from history that this thesis is true, but a recent paper on the seventeenth century’s equivalent of a behavioral finance blogger helps to emphasise the point.  We were irrational then and we’re irrational now, and three hundred plus years of technical advance hasn’t improved this situation one iota.

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