Economics & Psychology: Reconciliation?

Continued From Economics & Psychology: The Divorce …

By the early 1970’s, as the long bull market of the post war years collapsed in a welter of unforeseen problems, financial professionals confronted the real meaning of risk on a systemic basis. As markets crumbled in the face of economic uncertainty trading companies turned to economists in academia in the hope of finding a way through the mess, or at least some excuse to get people to buy stocks.

What they discovered was a way of measuring risk that appeared to offer the option of quantitatively managing investments in a rational way, rather than relying on the intuitions of individuals. This approach has come to dominate the securities industry ever since. At the same time, though, a small revolution was brewing in psychology. And it's been fermenting revolution ever since.

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Sharpshooting the Investment Gurus

Hitting a Barn Door

Take a rifle and randomly spray bullets at the side of a barn. Invite some gun-toting friends around to see your handiwork and accept their lavish praise as a dead-eyed sharpshooter, knowing all the while it’s an illusion. The trick is to paint the targets after you’ve made the bullet holes.

This, the Sharpshooter Effect, is essentially how many business gurus and investment analysts make their living. Worse, the effect affects statistical analysis of data that are genuinely important, like clusters of birth defects. The problem is that we’re not very good at distinguishing randomness from order and this causes us no end of grief as we pursue illusory patterns in the belief that we’re being smart.

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A Brief History of Behavioural Finance

The Nobel Prize for Psychology

Noble Prize winning committees aren’t renowned for consistency. Giving Barack Obama the Peace Prize for not being George W. Bush is a triumph of hope, but hardly based on rational analysis. We might also wonder if the selection panel got its wires crossed when it awarded the Economics prize to a psychologist.

But it wasn’t just any old shrink who got the bauble. It was Daniel Kahneman, half of the dynamic duo that invented the whole topic of behavioural finance. The other half, Amos Tversky, died in 1996. Between them, Tversky and Kahneman pump primed a change in the way we expect stocks to behave. Outside credit rating agencies, it’s no longer enough to assume we can predict market movements on the basis of number crunching on a grand scale. Now we need to take our own mental confusion into account.

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The Death of Homo economicus

Active Stockmarket Investment is not for the Inexperienced

Economists and political philosophers from Adam Smith to John Stuart Mill long held fast to the idea of the human being as a rational creature, one wishing to maximise their own self-interest at least effort and risk to themselves. This creature – dubbed Homo economicus by its opponents – is some kind of perfect calculating machine, weighing up risks and rewards and making logical choices in its own self-interest.

Basically it’s what an economist imagines themselves to be. Like Mr. Spock without the ears, green blood, mind melding and curious eyebrows.

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