Pssst … Wanna Invest in a Conspiracy?

The Great Con

There is a great, massive, hideous conspiracy at the heart of modern financial system, designed to steal the ordinary person's money.  Like all of the best conspiracies, it's hidden in plain sight.

And the conspiracy is this: there is no system, no one knows what's going on and no one knows what's going to happen next. Fortunately we can now prove this, although perhaps not quite in the way intended.

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Your Financial Horoscope

Using the latest in IP address geo-detection and profiling technology we’re delighted to bring you your personalized horoscope:

You have a great need for other people to like and admire you. You have a tendency to be critical of yourself. You have a great deal of unused capacity which you have not turned to your advantage. While you have some personality weaknesses you are generally able to compensate for them. Your sexual adjustment has presented problems for you. Disciplined and self-controlled on the outside, you tend to be worrisome and insecure on the inside. At times you have serious doubts as to whether you have made the right decision or done the right thing. You prefer a certain amount of change and variety and become dissatisfied when hemmed in by restrictions and limitations. You pride yourself as an independent thinker and do not accept others’ statements without satisfactory proof. You have found it unwise to be too frank in revealing yourself to others. At times you are extroverted, affable, sociable, while at other times you are introverted, wary, and reserved. Some of your aspirations tend to be pretty unrealistic. Security is one of your major goals in life.

Trick or treat?

Cargo Cults

In the Second World War many remote Pacific islands found themselves occupied by warring forces. This often led to an unexpected windfall for the primitive islanders as the troops were supplied from the air with unimaginable luxuries like corned beef, custard powder and anti-aircraft guns. When the war ended and the troops went home the planes stopped coming so, naturally, the islanders hatched a cunning plan to make them come back again.

They created the rudiments of the apparatus that the ground crew had used – paddles to welcome the aircraft, fake headsets for the radio operator, fake landing lights – and engaged in the same strange ritual ceremonies, behaviour generally known as a cargo cult. Yet no matter how they adjusted the ceremony they couldn’t get it quite right and the planes never came back. It would be crass simplicity to suggest that the same kind of magical thinking pervades the world of investment. Only it does, of course.

Paranormal Beliefs

The curiously enduring nature of belief in the paranormal is one of the mysteries of the modern age. Less than 50% of the world’s population believes in evolution despite copious evidence in its favour, much of it propping up the nearest bar, yet a majority happily accept the probable existence of invisible, incorporeal and undetectable entities of which science can find not the slightest trace. This isn’t explicable under the normal definition of “rational”.

Many practitioners of magic argue that this widespread belief in things that go bump in the night is de-facto evidence that there must be something “out there”. Only almost certainly there isn’t, but there’s definitely something going on inside our heads: we’re infinitely suggestable. This factor, combined with our desire to seek forms of control in situations of extreme uncertainty is a powerful driver of behaviours that we’re apt to label as “irrational” when, in fact, they’re nothing of the sort.

When the Irrational Isn’t

The smoking gun that leads to the redefinition of “rational thinking” was discovered in the Trobriand Islands. The anthropologist Bronislaw Malinowski noticed that the islanders engaged in elaborate rituals when they went deep sea fishing but not when they were fishing inshore. He surmised that the open seas superstitions were an attempt to protect themselves from danger in a fundamentally uncertain environment.

This tendency to attempt to exert some form of control, no matter how illusory, in the face of great uncertainty, seems to be part of the human condition. Various studies, including this one on the superstitious behaviour of baseball players, back the theory up. The evidence is that people attempt, always, to put themselves in a position where they feel they have control of the situation, regardless of the reality: the so-called “illusion of control”.

Magical Investment Thinking

Now, boys and girls, can we think of another situation where people are essentially at the mercy of random and unpredictable events and spend a lot of time developing ritual behaviours to make them feel as though they have control of the unfolding events? Admittedly, the stockmarket is an extreme example of the genre – a global manifestation of a belief in magical forces leading to the mass delusion that we can predict the movements of individual stocks, markets and economies.

While primitive tribesmen have mystical seers, priests and soothsayers we have investment analysts; while they have chicken entrails, hallucinogenic drugs and animal sacrifice we have multi-year earnings forecasts, better hallucinogenic drugs and occasional executive bloodlettings. Simply clothing the magical rituals in a smart suit and a well formatted report doesn’t make the outcome any more predictable and the rituals any less pointless, but it does make us feel better when things go pear shaped and we go looking for reassurance.

Logical or Astrological?

In fact if this theory is correct we should see an increase in such magical behaviour during conditions of extreme market movements; a greater reliance on divining the future using essentially random techniques, and indeed we do. In times of uncertainty many people abandon any pretence of higher cognitive functioning and head off in search of their nearest soothsayer.

For instance, if you type “investment astrology” into Google you’ll get over 2 million hits. The survival of astrology into the modern age is itself remarkable but huge swathes of the world’s population still conduct their lives according to the prophetic divinings of invisible, undetectable and unmeasurable forces that enmesh us at birth and mark us for life. Apparently.

Yet, as has been repeatedly demonstrated, the evidence for astrology actually working is decidedly thin away from areas of human suggestability. So, for instance, those people who believe in astrology tend to have personalities that conform to their astrological signs while people who don’t, don’t. Belief is a powerful weapon in human systems but it sadly doesn’t mean that magical thinking can actually have an effect on the physical world around us.

Supernatural Stockmarkets

Only, of course, the stockmarket isn’t the real world. It’s an artefact of human construction and is therefore open to manipulation through all of the kinds of things that we let affect us. In theory the performance of stocks on the market is determined by fundamental factors like earnings, competitive advantage and marketing. In the long-run this is generally true, but in the short-term magical modes of thinking can easily overwhelm more fundamental factors.

Still, you’d assume that if astrology, charting and other magical modes of prediction were completely useless then their repeated failure would eventually persuade people to give them up in favour of something more rational like chain-saw juggling or duck weaving. However, it’s far from being that simple because we’re all subject to being fooled by a behavioural trick called the Barnum Effect.

Roll Up, Roll Up, Get Things Wrong

This was first demonstrated in 1949 by Bertram Forer who constructed the fake horoscope at the head of this article using the most general astrological statements he could find. He presented this to his students, explaining that it had been customised for each of them when, in fact, he gave everyone the same reading. When he asked them if it accurately represented them they virtually all agreed that it did. This trait – to see insightful information in the most general rubbish – is the stock in trade of all magicians, astrologers and other sayers of soothes:

“It was pointed out to them that the experiment had been performed as an object lesson to demonstrate the tendency to be overly impressed by vague statements and to endow the diagnostician with an unwarrantedly high degree of insight. Similarities between the demonstration and the activities of charlatans were pointed out”.

Everyone is prone to the Barnum Effect and it works because we think the same way. We read into things whatever we want to: again, it’s not that there’s anything “out there”, it’s all inside our heads.

Stocks that go Bump in the Night

The idea that most investment is driven by magical thinking underpinned by psychological tricks like the Barnum Effect is disquieting, but once you start looking for examples it becomes all too easy to find them. Astrology is simply the most obvious outward sign of this, but sneering at astrological investment techniques while continuing to faithfully follow more orthodox but equally magical processes ignores that this is the way most of us deal with uncertainty.

For children Halloween comes once a year but many investors spend their entire lives trick or treating. Sadly most treats are just tricks and most tricks are just illusions that we fool ourselves into believing. Trouble is we can only see this with hindsight – and that’s if we ever figure it out at all.


Related articles: Science, Stocks and Superstition, O Investor, Why Art Thou Rational?, Don’t Lose Money In The Stupid Corner

Science, Stocks and Superstition

Unreliable Science

As we’ve seen – repeatedly – people aren’t particularly good at overcoming the behavioural biases built into our nature by evolution. There’s no real reason we should be – computing the statistical probability of an above average return on the stockmarket over a twenty year period wasn’t of much value for most of human history. This was partly because twenty years was more than the average lifespan of a proto-human but largely because no one had yet got around to inventing money or stockmarkets or stocks. Or ‘years’.

If these biases are inherent and cause us to do stupid things around finance we might expect that they’ll appear in other areas as well where humanity has only recently started to apply its higher cognitive functions. So it’s unsurprising that our basic intuitions about science are about as reliable as those we have about finance. To whit: not reliable at all.

Greek Geeks

Science has been around a lot longer than modern financial theory. The Ancient Greeks developed many concepts that aren’t out of place in the modern pantheon of university science faculties – atomic theory, planetary orbits and toga parties amongst them. Unfortunately they failed to marry their scientific insights to a stable economic system and much of their knowledge was lost for the best part of a millennium. The lesson being, presumably, that disenfranchising women and relying on slave labour is a poor way of building a stable society. Global corporations take note.

During that lost thousand years or so the only real legacy of Greek knowledge in the Western world was a smattering of Aristotle, who was a bloody good thinker but a bit weak on stuff like planetary motion and mathematics. Somewhere along the line Aristotle’s ideas got mixed up with Christianity and resulted in the odd position of the Catholic Church defining God’s word on the basis of the scientific writings of an atheistic Greek who died before Christ was born. We can blame Thomas Aquinas for that one.

The period known as the Renaissance – the rebirth – was marked by a remarkable rediscovery of Ancient Greek thought. Some of this came from the Muslim world, where many ideas and writings had been sustained through the European Dark Ages, and some of it from the libraries of monasteries remote from barbarian incursion where scribes had been dutifully and ignorantly copying scrolls for centuries. Suddenly there was an explosion of ancient knowledge raining down on a world ripe for new ideas.

Childish Superstition

Yet, it’s impossible to believe that this sudden rediscovery of ancient science could wipe out the legacy of evolution. Science always has to be learned, it never comes naturally. Just like the basics of investing the concepts of science are not comfortable to the human mind, they go against the grain and for the vast majority of untrained lay people are foreign and even slightly chilling in their nature. The concept that every idea has to be exposed to public scrutiny, debated and even ridiculed before being accepted doesn’t sit easily with most of us.

In fact, our very survival may depend upon our non-scientific nature. How many amongst us didn’t experience fear of monsters and the supernatural when we were little? That’s easily explicable as an evolutionary adaptation designed to keep us near to our parents in an environment when a stray step could see us eaten by real monsters. Bruce Hood, in Supersense, for instance, reasons along these lines – that the adult human’s propensity for believing in the supernatural is a development of the child’s natural ways of reasoning about the world. As he points out, even highly educated people often believe in the supernatural: this doesn’t make much sense unless it’s somehow built into the fabric of our beings.

Of course, if superstition and difficulties in thinking in logical and scientific ways are inherent to our very beings we should see similar effects in financial markets. We should see evidence of people behaving in a stupid, irrational and wholly ridiculous way for no reason other than that’s the way that people behave. This is to go beyond people responding irrationally to the signals of the markets to them responding irrationally to absolutely nothing relevant to the markets whatsoever.

Eclipsed Stocks

Naturally evidence for such behaviour exists: researchers are nothing if not diligent in looking for new ways of spending research grants. Gabriele Lepori in “Dark Omens in the Sky: Do Superstitious Beliefs Affect Investment Decisions?” is the latest in a long line of researchers who’ve looked at the effects of good old superstition on stockmarkets and has shown that markets respond to the imminent arrival of a scientifically predictable eclipse by going into a tailspin, from which they rapidly recover when it turns out the world hasn’t ended. Again.

There is some rationale behind this. As Lepori explains:

“People tend to turn to superstitious practices when dealing with outcomes that are important to them and facing conditions of high uncertainty, competition, and stress”

“High uncertainty, competition and stress” could almost be a job description for many of the financial professionals involved in stockmarkets. It’s hardly surprising that they seem to be highly superstitious and inclined to odd behaviour such as possession of lucky bears, lucky ties or, in one rather distasteful anecdote, lucky underwear. Understandable this may be but you’ve got to ask yourself: do I really want to entrust my future to someone who’s worn the same underpants for a month?

Built to be Irrational

Mostly economists are working on one of two theories. Either humans are basically rational economic theorists and their errors are those of computational accuracy or we’re behaviourally biased and therefore behave irrationally but in a predictable fashion at a statistical level. It’s possible to discern the two sides of economics gradually moving to an accommodation where rational man is so bedevilled by the shortcuts taken by the brain that the result looks like the outcome of behavioural analysis.

However, there’s a third possibility. Maybe people are built to be irrational and their investing approaches are driven by this. Maybe the behavioural biases we’ve been discussing aren’t the main factors that drive the way people deal with stockmarkets. Maybe human irrationality goes way beyond the obvious things that researchers are looking for?

People’s lack of understanding of science is daunting – this study from the Californian Academy of Sciences recently suggested that most Americans can’t pass a basic science test. If the world’s most advanced nation can’t do better than this what hope for the rest of us? So if science is the dominant mode of thought across the planet and has lifted billions of people out of total poverty but the vast majority of people don’t understand it and would rather wear lucky pants and consult astrologers where does that leave investing, a much less well understood approach to organising the world yet one that attracts vastly more practitioners?

Insensible and Irrational

There’s little doubt that behavioural biases affect investors most of the time. There’s equally little doubt that it’s the same behavioural biases that cause the runaway feed forward processes that lead to booms and subsequent busts. However, the idea that humans are driven by relatively sensible and predictable behavioural biases is at least questionable. It’s at least as likely that humans are inherently irrational and driven by demons in the dark designed to protect us from the real monsters that lurked in our history as we dwelt in predator infested environments.

The question is not why do markets behave irrationally but why do they ever behave rationally?


Related articles: Bulletin Boards Are Bad For Your Wealth, The Media, Fear and Stockmarket Manias, Don’t Lose Money In The Stupid Corner