It’s How Big, Not How Often, That Counts

Soros' Batting Record

George Soros, one of the greatest investors of the last fifty years, has a fairly poor batting record when you look at the total number of strikeouts he’s had over his career. By his own account he’s been wrong about investments more than he’s been right. However, when he’s been right he’s been right BIG time:

"It's not whether you're right or wrong that's important, but how much money you make when you're right and how much you lose when you're wrong"; 

Unfortunately human behavioral biases make most of us shy away from taking lots of losses and trick us into giving up the potential big winners. Our problem is that our biased brains punish us much more for failure than they reward us for success: so we prefer frequent small wins and few losses to frequent small losses and few wins. And, as Soros proves, our brains are wrong.  Fortunately there are a few simple techniques that guide us right.

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In Markets Bad Stuff Happens – Frequently

Numbers and Stories

We’ve seen before that investors are generally attracted to a good story and tend to shy away from the hard problems associated with analysing numbers. Worse, even if people do look at the numbers they tend to be swamped by information to the extent of not knowing what’s important and what’s not. Although generally this is only obvious in retrospect, anyway.

However, there are strong suggestions that our inclination to follow a good and particularly interesting story isn’t simply stuff that happens. It looks as though this is built into our processing centres and is a driving force behind a lot of what we do on an everyday basis. We’re simply misapplying the lessons of life.

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Investor Decisions – Experience is Not Enough

Economic Paradoxes

At the heart of Prospect Theory, the seminal approach behind behavioural finance, lies a puzzling paradox. Although the theory argues that people overweight the chances of unlikely events occurring – so, of instance, we worry much more than we ought to that our children will be kidnapped – the evidence from the field suggests exactly the opposite.

So, it seems we have a dilemma at the centre of the behavioural universe. Either way traditional economics gets it wrong but so, it seems, does the newfangled psychological kind. Given that we start the analysis with only three choices – that people correctly weight rare events, underweight them or overweight them – then it’s a bit disappointing that the two main branches of economics manage to slightly miss the correct answer.

That’s “slightly” in the sense of “completely and utterly”, of course.

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Pulling Up The Intellectual Property Ladder

Tragedy of the Anti-Commons

Human ingenuity has been behind much of the economic boom that the world’s undergone since the late eighteenth century. Sparked by the rise of reason in the form of deepening scientific knowledge and backed by increasingly large flows of capital there’s been an ever increasing range of ideas and inventions, some of which have even added to the sum of human happiness. I was particularly taken by the motorised ice-cream cone.

Behind this sparkling cascade of cleverness lies the ability of inventors to temporarily protect their inventions from competition by use of intellectual property rights – patents, copyrights and so on. Unfortunately, as we move forward, these monopoly rights may, in some cases, actually result in a slowing of progress as we increasingly face the Tragedy of the Anti-Commons.

From Monopolies to Patents

The development and evolution of patent laws stretches back hundreds, if not thousands, of years. We know that the Ancient Greeks granted temporally limited monopoly rights on particularly tasty recipes which seems to suggest that the modern cult of the celebrity chef isn’t so modern after all. By 1331 we find Henry VI of England granting John Kempe and his Company a patent in respect of the textiles industry. In fact this appears to have been an early attempt to attract skilled foreign workers to England rather than a reward for genuine innovation. Nearly seven hundred years on we’re still bribing scarce overseas workers to come here rather than fixing our education system.

Something like the first proper patent was granted in 1422 in Florence to the architect, genius and key Renaissance figure Filippo Brunelleschi for a barge with hoisting gear. In 1449, in England, John of Utynam received a 20 year monopoly to make stained glass and in the following year the Republic of Venice created the modern patent, mainly to protect its native glassblowing industry, presumably to stop England pinching all of its skilled workers, another continuing trend.

Patents were systematically abused by money-grabbing monarchs, particularly in England where the rulers were always short of money, granting monopolies for even commonly used stuff like salt and coal. Eventually the English, as is their wont, revolted and forced the introduction of the Statute of Monopolies in 1601, which is really the start of the modern patent system, as it enshrined the novel concept that the idea had to be new, rather than simply purloined, in order to be awarded a patent.

Monopoly Rewards

That patents and other intellectual property rights have had a beneficial impact on economic growth is beyond dispute. By ensuring that an inventor has a limited time to exploit their idea the system rewards innovation, encourages exploitation and eventually gives the rest of the world free access to the accumulated wisdom of the ages. However, as we can see, patents are closely entwined with monopolies and anti-trust issues, which means that these rights need to be carefully managed if we’re all to benefit properly.

Underlying the awarding of patents is the idea that they’re a public good – the benefit of the temporary monopoly outweighs the downside of monopolist price gouging. This isn’t always an easy coupling – particularly as we’ve seen with large pharmaceutical companies demanding first world prices of third world countries for treatments for diseases like AIDS. On one hand, without the excess profits that come from patent exploitation these corporations have no reason to invest the billions of dollars that they do. On the other, denying millions of sick people drugs that could usefully extend their lives is morally objectionable.

There isn’t an easy solution to the problem and the resulting mess where governments have effectively forced the drugs companies to sell to them cheaply will almost certainly result in less investment in treatments for diseases targeted at those countries. It’s not a happy situation.

The Tragedy of the Anti-Commons

However, there’s another more insidious problem with patents and the ever-increasing pace of innovation. This was first pointed out by Michael Heller, who’d been puzzling over why there were so many empty stores in ex-communist countries despite the fact there was obviously huge demand for retail space. Drawing on Hardin’s idea of the Tragedy of the Commons, where property owned by no one is ruthlessly exploited to the detriment of all – think overfishing of deep sea stocks or pollution of the air we breathe – he postulated the idea of the Tragedy of the Anti-Commons.

The problem in Moscow and other Eastern European cities, it turned out, was that the ownership of the property rights for the stores was widely distributed between lots of different groups each with different agendas. The sheer difficulty of getting these disparate parties to agree on something that would have been beneficial to all of them meant that the stores stayed empty while open air booths sprung up in front of them.

Technology Patent Anti-Commons

Since Heller postulated this idea it’s been suggested that a similar problem exists for modern corporations attempting to develop new technologies. The issue comes because, increasingly, any new device requires the use of hundreds and possibly thousands of patented inventions: even the humble CD player requires at least a dozen licences, a microprocessor needs thousands. It only takes a single hold-out to prevent the possibility of a useful advance in technology.

As the pace of technological innovation has increased the sheer impossibility of avoiding patent infringement has increased. The dispute that nearly shut the Blackberry network down is caused by a single disputed patent in a device which uses thousands. Nokia is now suing Apple over ten patents on the iPhone – no doubt they’ve been trawling their patent library for months to find these and, doubtless, there are many more to be found around the world.

Biomedical Patent Anti-Commons

Another area where the spectre of anti-competitive problems arise due to anti-commons issues is in biomedical research, particularly where commercial organisations are patenting human gene fragments and other fundamental biological intellectual property. This is likely to prevent further useful exploitation of these discoveries because in order to test the effectiveness of any treatment it may be necessary to test the whole spectrum of the human genome. By splitting it up into ever greater groups of patents owned by differing parties it may become impossible to effectively conduct medical research.

While we might expect that the market would find a way of solving these issues – say as the music industry has by developing groups holding copyright for lots of artists – simple behavioural biases may restrict their development. Hewson and Eisenberg suggest that the problem we have estimating the likelihood of low probability events of high importance to us and the associated issue of tending to overvalue stuff we’re committed to – essentially facets of the availability heuristic and commitment bias – may prevent the effective resolution of anti-commons intellectual property disputes.

Basically the problem is that any patent which leads to a new treatment for something important – cancer or AIDS, say – will obviously be immensely valuable and the patent holder won’t want to give this up cheaply. Unfortunately no one can know in advance which patents will be valuable and which won’t so you end up with asymmetric valuations on the part of patent holders and potential licencees. The result being deadlock.

The Growth of Patents

The pace of patent creation is increasing – it took 18 years for the first 250,000 patents to be filed under the global Patent Co-operation Treaty, a further four years to double that and a further four years to double it again. Anti-commons issues are only going to grow and as patents and other intellectual property are central to the economic progress of the planet anything that can impede it is a cause for concern.

However, using patent disputes to disrupt parts of the global telecommunications network that people rely on, or to control access to parts of the human genome, may bring the system into disrepute if not handled carefully – a case of the owners pulling up the Intellectual Property Ladder behind them to the detriment of all. It’s often suggested that we’re in an age in which information is power and certainly the ownership of critical patents is going to be increasingly valuable to corporations and individuals. Learning to exploit that power wisely may be the biggest challenge of the Information Age.


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The Special Theory of Behavioural Finance

What’s Wrong With Behavioural Finance?

We’ve seen time and again that the standard model of rational financial economics is next to useless at predicting anything at all useful about stockmarkets. Yet despite this the model is retained and used in many forms, often disguised and packaged to look like something new and valuable. Inevitably it turns out to be neither as soon as it’s needed.

Putting to one side the unworthy thought that the world’s major financial institutions are managed by idiots, the fact that these models continue to attract support and investment seems to suggest that there’s something wrong with the alternative. If behavioural finance – the study of how human psychological biases distort markets – is so much better than the models of rational, calculating, utility balancing economic man why do we cling so to the old ways? Although as there are world leaders out there who still use astrology to make decisions perhaps we shouldn’t be too surprised.

One Funeral At A Time

One possible reason is the power of the old guard, protecting the citadel of established economics. It was the scientist Max Plank who pointed out that science advances “one funeral at a time”: it literally requires the old, controlling generation to die before new ideas that threaten their conception of the universe can take hold.

By way of example in 1915, Alfred Wegener pointed out the odd, if obvious fact, that the coastline of eastern South America and western Africa look like they fit together. This wasn’t a unique suggestion, but Wegener was able to bring together a formidable set of evidence from the fossil record, living animals and geology to back his claim. Yet in the absence of an actual mechanism to explain continental drift his ideas were ignored until after his death.

Wegener is far from alone – perhaps the best known recent example is that of Barry Marshall and Robin Warren who correctly identified the bacterium Helicobacter pylon as the cause of stomach ulcers and were then roundly ignored for many years. However, it’s far too simple to characterise this process as science turning a blind eye to new ideas: science is rightly resistant to ideas that challenge the current norm because even wrong old ideas will have significant, if misinterpreted, evidence to support them.

Behavioural Finance is Not a Sideline

To be honest it’s hard to believe that lack of acceptance of behavioural finance is holding back its universal adoption. Since Tversky and Kahneman’s initial Prospect Theory publication back in the seventies there have been thousands of papers, books and presentations on the subject to the point where no one can seriously doubt that behavioural biases are a critical factor in the way markets move.

No, as far as academic psychology is concerned behavioural finance is in the mainstream. It’s in the less rarefied and practical world of investing institutions that efficient market theories still hold sway. We’ve seen this in the Capital Asset Pricing Model, in Value at Risk models and in the Black-Scholes option pricing model. With all of these if you peer closely enough the idea of human rationality re-asserts itself, shorn of all the psychological twitches and ticks that really drive our daily lives.

Now the odd thing about this is that while academics can afford to go off at a tangent, on some pipe dream of a theory, those people who make their money through the practical application of these theories have no such luxury. So why is the “obviously” wrong efficient market hypothesis still dominant amongst institutions?

The Failures of Behavioural Finance

The Efficient Market Hypothesis (EMH) enshrines the spurious quest for precision lusted after by economists – the idea that economics is underpinned by a set of physics-like rules that can be modelled, simulated and used to predict. The beauty of classical financial economics is that it allows just this sort of modelling – once you’ve made the necessary assumptions needed to remove any vestige of real human behaviour.

Behavioural finance, however, offers no such comfort. Worse, it doesn’t allow you to make market predictions because there’s no overall model of human behaviour lying behind it. Many psychological biases pull us in different directions – are we overconfident or loss averse, are we drawn by the availability of information or repelled by fear? Under the investment industry’s prime directive to generate returns the overriding importance of developing models that allow prediction has led to a focus on what can be modelled rather than what is real.

Better an unreal world we can simulate in a computer than a real one that we can’t, they say. Implying that a model that makes wrong predictions is better than one that can’t make any. This, of course, is utter madness but offers a kind of deranged logic that wouldn’t look amiss in a five year planning session of the Soviet Union led by the politburo’s head goat. Truth becomes another variable element in the model, subject to manipulation at the programmer’s fingertips.

Short-Term Returns or Long-Term Stability

At root, of course, these models are all about making money. If institutions believe that they can use the models to generate profits over any period they’ll use them: short term incentives for management will see that longer term problems are ignored. The difficulty for behavioural finance, and one of the reasons that despite the overwhelming evidence that psychological biases dominate market movements, is that unless behaviour based models can be developed to take advantage of these there’s no impetus for the dominant financial organisations to stop using the old models.

As Jay Ritter suggests, the problem seems to stem from the frequency of events in the market. High frequency events – those that occur often – generally behave in line with the predictions of classical economic theory. If asset valuations start to deviate too far from an accepted norm the normal processes of supply and demand will generally act to bring them back in line. This is why most short term trading strategies are doomed to failure.

However, there are also low frequency events which don’t accord with efficient market theories and people simply don’t expect. When these occur the most obvious trading strategies, based on efficient markets, can turn out to be disastrous as the deviations from sensible valuations become ever more pronounced rather than self-correcting at a reasonable level. Rational economic theories can’t explain such events.

The Special Theory of Behavioural Finance

A hypothesis, then, is that behavioural biases effect investors all of the time but while there’s a reasonable balance between different types of investors in the market any deviation in valuation is corrected, leading to a market that exhibits the hallmarks of a standard efficient model. However, this is only correct at the gross level – look under the covers and you’ll find a whole bunch of behavioural biases twitching away but doing so fairly randomly, cancelling each other out.

At some point, though, for some reason external to the market, such as excitement over the internet or the Space Race or railroads or tulips or bronze helmets or fig leaves or something, a majority of investors start to exhibit the same biases – usually starting in the form of people losing their fear of losing money. Markets take off on a roll attracting more and more loose money until such time as the boom can’t be sustained and everything goes into terrified reverse.

This, at least, explains why efficient market theory appears to work a lot of the time and why it then suddenly appears to fail. It’s analogous to the relationship between Newton’s Laws of Gravity and Einstein’s Theory of Relativity. It turned out the former was an approximation to the latter with all the odd stuff about the speed of light taken out: it worked right up until you needed to figure out how to get off a laser beam.

The trouble is that this doesn’t get us any further in figuring out how to predict what’s going to happen next. Mostly EMH works and investing for the long haul is OK but occasionally it all goes horribly wrong and behavioural finance can tell us why but not when. It’s hard to feel sorry for institutional investment houses but you can see why they’re not very interested in behavioural finance. After all, all it tells them is that they’re living on borrowed time. Best to make those bonuses while you can, eh?


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