This quote is from Jonathan Pain’s paper, delivered at a conference I attended in Sydney in February this year.
The conference was a full day affair, with 13 very intelligent people talking about the end of quantitative easing and what effect that might have on investment markets. However, Jonathan Pain’s statement set me thinking about the all too human biases that affect human decision making and often cause markets to move in ways that at times seem irrational.
The fact that we are talking about irrational thinking deserves some explanation. In the years following World War II, there was a fierce debate within economics about how they should treat human decision making. The debate was largely won by the neo-classicals, who assumed that we are all human computers who take in a vast amount of data about prices, products, services and whatever else we are buying, then do a superfast calculation before deciding to act in the way that will maximize our own financial position. No room for doubts or emotions to cloud judgement. These assumptions permeated much of finance and economists built more and more complex models, all highly mathematical, and all ignoring the more human elements.
It is no surprise that this approach has come under fire since the GFC and behavioural economics is making a comeback. Behavioural economics has a sizeable element of psychology about it. Practitioners kept beavering away during the dark years when the neo-classicals reigned supreme and now they have come more to the forefront.
Biases
Behaviourists have identified a number of biases that affect human decision making and often draw us off the straight and narrow. Here, I want to look at two (I will look at more in future).
Herding
Herding occurs when people start blindly following others into the market, with no thought as to the fundamental value of investments. People jump in and follow the crowd. Values are pushed to extreme highs that can’t be justified on any fundamental analysis and bubbles soon form. Examples are the housing booms in places like the US, Ireland and Spain prior to the GFC, when houses were being built at rates way in excess of anything that could be justified by population growth. Other examples abound in shares, commodities and just about anything you can think about.
But why do people suspend logic and behave in this way? And it is not just ordinary people like you and me who get caught but some of the greatest minds the world has seen. One was Sir Isaac Newton. Newton was a certifiable genius credited with discovering gravity, inventing calculus, making big discoveries in astronomy and running the Royal Mint (what he did in his spare time, I don’t know). He lost his entire fortune (estimated at about £30 million in today’s values) in the South Sea bubble in 1720. Afterwards, he reportedly lamented: “I can calculate the movement of stars but not the madness of men.”
Apart from stating the obvious (eg we are all human), how can we account for this? Well, evolutionary psychologists such as Nigel Nicholson have identified “status and hierarchy” as one of nine basic human instincts that drive human behaviour. It could be that, as we see others around us getting rich out of a boom, we are prepared to suspend logic in order not to be left behind. Interestingly, another basic instinct is “loss aversion” and this opens up the thought of a primal tug-of-war between these two instincts. Maybe “boom” and “bust” can be attributed to whichever one is winning at a point in time?
Then there is the whole question of “logical decisions” and the notion that the mind is some logical, calculating machine, which is separate from our body and can function almost on its own. John Coates, who is an economist by training, a Wall Street trader and, more recently, a physiologist, disputes this notion of mind and body being separate and independent. In his book, The Hour Between Dog and Wolf, he tracks the fate of bond traders during booms and crashes and shows how stressful situations change body chemistry, which changes decision making. The ability to act rationally goes out the window in times of great stress when everybody around you is panicking.
Recency Bias
Recency bias refers to the tendency to give much greater weight to recent events than we should. We focus too narrowly on things that have happened recently when we should be looking further afield. Examples include putting too much emphasis on changes in a company’s last profit announcement when we should be looking deeper to understand if it represents a fundamental shift or is due to one-off factors. Are changes in the bond rate due to fundamental shifts or are they one-off?
Recency bias is not limited to financial matters but occurs in all sorts of areas. New York has had a series of mild winters but this year has been a shocker. But, because of the series of mild winters in recent years (recency bias), the authorities reduced the amount of salt they stored (they scatter salt on roads and footpaths after it snows to stop people and cars sliding and slipping all over the place). The result was that some areas ran out of salt when it was needed most.
Back to the Conference
Opinions about the future outlook varied greatly, ranging from the very optimistic to the extremely cautious. Nevertheless, there were some areas of agreement:
1. The whole issue of tapering (ie central banks winding back the rate at which they buy assets from the public) is overblown in the press. By itself, tapering is a minor issue.
2. However, what will be important is the future course of interest rates. For the US Fed and other central banks to successfully engineer an exit from the extraordinary policies of the last few years since the GFC, it is necessary for them to keep interest rates low.
3. Any sustained rise of interest rates (mainly medium and longer term rates not directly controlled by the central banks), especially if associated with a rise of inflation, would see a big drop in bond values, with an associated destruction of wealth. Complicating the whole issue is the fact that inflation is driven more by public expectations of price rises in the future than anything else. If everybody believes prices will go up, they probably will. And vice versa. Here are those biases again. If everybody believes prices will rise, the herd might start running and recent evidence will be taken disproportionately into account.
4. Any major meltdown in China would have serious consequences – but we all knew that. Also, we are talking about a major meltdown, not just fluctuations in monthly data.
Conclusion
For now, it seems that the recovery is well on track. The thing to keep an eye out for is any substantial and sustained rise in inflation and interest rates – especially in the USA. And be mindful of the biases. However, if serious inflation and rising longer-term interest rates look like taking hold, it will be time to review strategy, and re-weight portfolios.
Next Newsletter
Next time I will address something a good deal simpler but of interest to many retirees. We will look at pending changes to the way Centrelink calculates income from allocated pensions when assessing how much age pension you are entitled to.
References
1. Coates, John, 2012. The Hour Between Dog and Wolf: risk taking, gut feelings and the biology of boom and bust, Penguin Press.
2. Nicholson, Nigel, 2000. Managing the Human Animal, Texere Publishing.
3. Montier, James, 2010. The Little Book Of Behavioral Investing (How not to be your own worst enemy, John Wiley and Sons.
