Behavioral Bias 101: #3 Curse of Knowledge

Know What?

We're often told that knowledge is power. However, in reality, knowledge may be unexploitable leading to the paradoxical situation that high quality goods get overpriced and low quality ones underpriced. Insiders, it turns out, are often burdened by the curse of knowing too much.

Part 3 of 101 Ways To Lose Money

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Trimmed by the Hedge Funds

Secrecy and Suspicion

The increasing importance of hedge funds in the market has attracted attention, especially since they've become every politicians' favorite target when discussions move to market stability and manipulation. The secrecy associated with their activities arouses both mystique and suspicion.

New research suggests that this secrecy is important to hedge fund outperformance and, counterintuitively, argues that the attempts to maintain that secrecy are partially responsible for the outperformance. It also does nothing to quench the concerns that covert manipulation by fund managers is occurring, at the cost of obscuring real market signals. So, are we being trimmed by the hedgies?

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Are IPO’s Bitter Lemons?

In Used Car Dealers We Trust

The Initial Public Offering (IPO) market exposes investors to a classic problem of asymmetric information: there’s not much doubt that the insiders know far more about the true worth of their company than do potential purchasers. So, as outlined by George Akerlof in his classic treatise on the used car market, we would expect that the only companies on offer in this market should be the ones you really don’t want to buy; companies with sticky accelerators and malfunctioning brakes.

Traditionally there’s a way around this impasse, the use of trusted intermediaries whose skill and judgement can be relied on by potential investors to overcome the urge of company owners to maximise their gains and who can distinguish the dross from the jewels. Bizarrely the result of this intervention supposedly sees companies floating at valuations below their real value but, unfortunately, this comes with the ever-present risk of abuse by trustees. Situation abnormal, as usual.

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Akerlof’s Lemons: Risk Asymmetry Dangers for Investors

The Failure of Markets

Ever since Adam Smith identified the raw stuff of market economics and David Ricardo explained the concept of comparative advantage genuine new ideas in economics have been as rare as a vegetable in a child’s dinner. However, market economics doesn't always work – as Hardin showed, in The Tragedy of the Commons, where resources are shared then market economics breaks down – which may be a disaster when the common resource is the air we breathe.

In 1970 George Akerlof came up with another mechanism to disturb the most rampant of free-marketeers, demonstrating that there are times when markets fail even when there are both willing buyers and sellers. His work suggests that similar problems may dog investors as they try to make an honest turn on the markets through small cap stocks or mutual funds.

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