This memo is my attempt to send the markets to the psychiatrist’s couch, and an exploration of what might be learned there. ... One of the most notable behavioral traits among investors is their tendency to overlook negatives or understate their significance for a while, and then eventually to capitulate and overreact to them on the downside. ... “Everyone knew” for years that the Chinese economy had been overstimulated with cheap financing, and that this had led to excessive investment in fixed assets. … One of the most significant factors keeping investors from reaching appropriate conclusions is their tendency to assess the world with emotionalism rather than objectivity. Their failings take two primary forms: selective perception and skewed interpretation. ... The bottom line is that investor psychology rarely gives equal weight to both favorable and unfavorable developments. Likewise, investors’ interpretation of events is usually biased by their emotional reaction to whatever is going on at the moment. ... in the real world, things generally fluctuate between “pretty good” and “not so hot.” But in the world of investing, perception often swings from “flawless” to “hopeless.” ... There is a general sense among my colleagues that investors have gone from evaluating securities based on the attractiveness of their yield (with company fundamentals viewed optimistically) to judging them on the basis of the likely recovery in a restructuring (with fundamentals viewed pessimistically).
As self-help workshops go, Applied Rationality’s is not especially accessible. The center’s three founders — Julia Galef, Anna Salamon and Smith — all have backgrounds in science or math or both, and their curriculum draws heavily from behavioral economics. Over the course of the weekend, I heard instructors invoke both hyperbolic discounting (a mathematical model of how people undervalue long-term rewards) and prospect theory (developed by the behavioral economists Daniel Kahneman and Amos Tversky to capture how people inaccurately weigh risky probabilities). But the premise of the workshop is simple: Our minds, cobbled together over millenniums by that lazy craftsman, evolution, are riddled with bad mental habits. ... Some of these problems are byproducts of our brain’s reward system. ... logical errors may be easy to spot in others, the group says, they’re often harder to see in ourselves. The workshop promised to give participants the tools to address these flaws, which, it hinted, are almost certainly worse than we realize. ... Most self-help appeals to us because it promises real change without much real effort, a sort of fad diet for the psyche. ... CFAR’s focus on science and on tiresome levels of practice can seem almost radical. It has also generated a rare level of interest among data-driven tech people and entrepreneurs who see personal development as just another optimization problem, if a uniquely central one. Yet, while CFAR’s methods are unusual, its aspirational promise — that a better version of ourselves is within reach — is distinctly familiar. The center may emphasize the benefits that will come to those who master the techniques of rational thought, like improved motivation and a more organized inbox, but it also suggests that the real reward will be far greater, enabling users to be more intellectually dynamic and nimble. ... CFAR’s original mandate was to give researchers the mental tools to overcome their unconscious assumptions. ... What makes CFAR novel is its effort to use those same principles to fix personal problems: to break frustrating habits, recognize self-defeating cycles and relentlessly interrogate our own wishful inclinations and avoidant instincts.
Wisdom of crowds is an old concept. It goes back to Ancient Greek and, later, Enlightenment thinkers who argued that democracy is not just a nice idea, but a mathematically proven way to make good decisions. Even a citizenry of knaves collectively outperforms the shrewdest monarch, according to this proposition. What the knaves lack in personal knowledge, they make up for in diversity. In the 1990s, crowd wisdom became a pop-culture obsession, providing a rationale for wikis, crowdsourcing, prediction markets and popularity-based search algorithms. ... That endorsement came with a big caveat, however: even proponents admitted that crowds are as apt to be witless as well as wise. The good democrats of Athens marched into a ruinous war with Sparta. French Revolutionary mobs killed the Enlightenment. In the years leading up to 2008, the herd of Wall Street forgot the most basic principles of risk management. Then there was my little Skittles contest. It was precisely the type of problem that crowds are supposed to do well on: a quiet pooling of diverse and independent assessments, without any group discussion that a single person might dominate. Nevertheless, my crowd failed.
Scientists are beginning to understand why these ‘mini Wall Streets’ work so well at forecasting election results — and how they sometimes fail. ... Experiments such as this are a testament to the power of prediction markets to turn individuals’ guesses into forecasts of sometimes startling accuracy. That uncanny ability ensures that during every US presidential election, voters avidly follow the standings for their favoured candidates on exchanges such as Betfair and the Iowa Electronic Markets (IEM). But prediction markets are increasingly being used to make forecasts of all kinds, on everything from the outcomes of sporting events to the results of business decisions. Advocates maintain that they allow people to aggregate information without the biases that plague traditional forecasting methods, such as polls or expert analysis. ... sceptics point out that prediction markets are far from infallible. ... prediction-market supporters argue that even imperfect forecasts can be helpful. ... People have been betting on future events for as long as they have played sports and raced horses. But in the latter half of the nineteenth century, US efforts to set betting odds through marketplace supply and demand became centralized on Wall Street, where wealthy New York City businessmen and entertainers were using informal markets to bet on US elections as far back as 1868. ... Friedrich Hayek. He argued that markets in general could be viewed as mechanisms for collecting vast amounts of information held by individuals and synthesizing it into a useful data point — namely the price that people are willing to pay for goods or services.
Americans are bad at saving. In an annual survey by the Fed, almost half said they couldn’t come up with $400 in an emergency. The savings rate of the bottom 90 percent of American households hovers just above 1 percent. ... There are many theories for why Americans don’t save, from poverty to debt to conspicuous consumption. But the most enticing comes from behavioral economics: It’s easier not to. Inertia is strong, and putting money away requires overcoming what economists call present bias. ... The good news, according to behavioral economists, is that we can just as easily be tricked into overcoming that psychology with “nudges” that reframe incentives. Just post calorie counts next to unhealthy food, and people won’t order cheeseburgers. Or, make 401(k) plans opt-out, and more people will save money for retirement. Suddenly, with one oh-so-simple tweak, making bad decisions becomes the harder option. ... At every step of the way, the study ran into a web of competing incentives and pesky human flaws that hurt its goal of getting poor people to save money. ... The problem goes beyond a sheer lack of funds. The psychology of poverty is hard to overcome with a dainty nudge. ... the study’s preliminary results were muddy. They suggested that the nudge method did get some people to save more: Deposits increased when people got some kind of reminder. But they didn’t show whether one type of nudge worked better than any other (possibly because of teller error), and they provided no evidence that the savings accounts helped people build up money over time.
Well, the word “behavioral” refers to the introduction of other social sciences into economics: psychology, sociology, and political science. It’s a revolution in economics that has taken place over the past 20 years or so. It’s bringing economics into a broader appreciation of reality. Economics was more behavioral 50 or 100 years ago. At Yale University, where I work, 1931 was the year when the department of economics, sociology, and government was split into three separate departments. ... There are both advantages and disadvantages of this structure. The advantage is that we develop mathematical economics and mathematical finance to a very advanced level — and that’s useful: We have option pricing theory that is very subtle and allows complex calculations that have some relevance to understanding these markets. But it loses perspective on why we have these options anyway. It offers a justification typically that involves rational behavior. ... We tend to look for patterns in the data that we think are representative of history. ... in the economics profession of 20 years or so ago, there were no bubbles. Now people freely say “bubbles,” but it was one of those words that was considered unprofessional by economists because markets are smarter than any of us and anything that happens in the market has a rational explanation.
I’m sure some of the criticism of people who claim to be using data to find knowledge, and to exploit inefficiencies in their industries, has some truth to it. But whatever it is in the human psyche that the Oakland A’s exploited for profit—this hunger for an expert who knows things with certainty, even when certainty is not possible—has a talent for hanging around. ... How did this pair of Israeli psychologists come to have so much to say about these matters of the human mind that they more or less anticipated a book about American baseball written decades in the future? What possessed two guys in the Middle East to sit down and figure out what the mind was doing when it tried to judge a baseball player, or an investment, or a presidential candidate? And how on earth does a psychologist win a Nobel Prize in economics? ... Amos was now what people referred to, a bit confusingly, as a “mathematical psychologist.” Non-mathematical psychologists, like Danny, quietly viewed much of mathematical psychology as a series of pointless exercises conducted by people who were using their ability to do math as camouflage for how little of psychological interest they had to say. ... students who once wondered why the two brightest stars of Hebrew University kept their distance from each other now wondered how two so radically different personalities could find common ground, much less become soulmates. ... Danny was always sure he was wrong. Amos was always sure he was right. Amos was the life of every party; Danny didn’t go to the parties. ... Both were grandsons of Eastern European rabbis, for a start. Both were explicitly interested in how people functioned when they were in a “normal” unemotional state. Both wanted to do science. Both wanted to search for simple, powerful truths.
While some supermarkets are better than others, it's probably not unusual to find a few stray shopping carts littering the parking lot to the dismay of shoppers who may think that a parking spot is open, only to find that it's actually being used by a shopping cart. It seems like a basic courtesy to others: you get a cart at the supermarket, you use it to get your groceries and bring them to your vehicle, and then you return it for others to use. And yet, it's not uncommon for many people to ignore the cart receptacle entirely and leave their carts next to their cars or parked haphazardly on medians. During peak hours, it can mean bedlam. Where does this disregard come from? ... The data above suggests that as a situation broaches on deviance, more people will trend toward disorder; once we have permission to pursue an alternative action, we will do so if it suits us.
In his new book, Adaptive Markets: Financial Evolution at the Speed of Thought, M.I.T. finance professor Andrew Lo attempts to account for the messier, more feeling realities of human behavior. A key premise is that markets evolve, like species, but much faster: “evolution at the speed of thought.” And that this evolution happens in fits and starts, in response to changes in the environment—hence, what he calls the “adaptive” markets hypothesis. It’s during these times of change that human emotions play their biggest role. Lo believes we are in one of those times now and, in his book, he applies biology, psychology, neuroscience, and history toward the goal of improving on the efficient markets hypothesis—which, Lo says, is not only flawed but is becoming increasingly so as the financial environment continues to change. ... The efficient markets hypothesis is a special case of adaptive markets. Markets are efficient if the environment is stable and investors interact with each other and natural selection operates over a long period of time.