December 2008 – January 2009


Feeling lucky

By Gideon Haigh
Feeling lucky

Charles Ponzi (right), whose name became synonymous with the investment scam he created in America. early last century. © Bettmann - Corbis.

What drives economic optimism?

The late twentieth and early twenty-first centuries have been a golden age of conclusions: declamatory, dogmatic announcements of the end of history, faith, work, America, nature, science, oil, ideology. For this boneyard of ideas, the financial crisis has added a host of new candidates for instant interment: greed, materialism, libertarianism and, if not capitalism itself, at least neo-liberalism, that ill-defined collection of economic nostrums somehow more recognisable to its bien-pensant critics than its laissez-faire proponents. In its stead, it might be said, now stands the narrative of hope, vaguer still, but identified with a new American president, empowered by an overwhelming mandate and global goodwill.

Yet there is another way of scrutinising the economic tribulations of the past year, one in which hope - security in the present and the belief in a better tomorrow - is actually a dimension of the problem, rather than a key to its solution. What might be changing is the view of Homo economicus as a rational, profit-maximising actor, replaced by the vision of a guileless optimist oblivious to his or her ignorance.

Any serious stock-market turbulence invites images of flappers, bathtub gin and plummeting stockbrokers: that is, of the Wall Street Crash of October 1929. It makes for compelling extracts from the newspapers of the era, such as this, from the New York Times:

Wall Street's bull market collapsed yesterday with a detonation heard around the world ... It was a day of tumultuous, excited market happenings, characterized by an evident effort on the part of the general public to get out of stocks at what they could get. Individual losses were staggering. Hundreds of small traders were wiped out ... The sales were countrywide. They flowed into the Stock Exchange ... from every nook and corner of the country.

Except that this opening paragraph is from the Gray Lady of 13 June 1928, fully 16 months before the Dow Jones Industrial Average shed more than a fifth of its value over two days. This earlier rout followed the confirmation at the Republican National Conference that Calvin Coolidge, synonymous with Wall Street's giddying rise, would not be standing for re-election. But within a few days, the losses of June were recovered; by August, the market had surged 20%; by November, 50%. And while crashes and panics are dramatically satisfying, what really counts are those preceding periods where disbelief stands suspended and optimism achieves Panglossian concentrations.

Orthodox economics has had relatively little to say about such anomalies - precisely for that reason, that it views them as anomalies. And in lots of ways, economists have done quite well explaining the world. Their problem has been not so much one of complete failure as of near rightness. It was Chesterton who described life as a "trap for logicians": generally sensible but just occasionally otherwise. "It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait."

That waiting wildness inspired behavioural economics, a school of thought at the nexus of economics, psychology and sociology, which argues that a more realistic account of human cognition would make for a less dismal science - although it has also taken practitioners back to some canonical thought. It was Adam Smith, in An Inquiry into the Nature and Causes of the Wealth of Nations (1776), who was the first to observe the phenomenon of overconfidence in commercial decision-making:

The overweening conceit which the greater part of men have of their abilities is an ancient evil remarked by the philosophers and moralists of all ages. Their absurd presumption in their own good fortune has been taken less notice of. It is, however, if possible, still more universal. There is no man living who, when in tolerable health and spirits, has not some share of it. The chance of gain is by every man more or less overvalued, and the chance of loss is by most men undervalued, and by scarce any man, who is in tolerable health and spirits, valued more than it is worth.

What psychologists call optimism bias has been extensively modelled since, and used to explain a variety of behaviours: that 90% of drivers believe they are superior to the average driver, for instance, and that people still wish to marry when it is widely known that half of all marriages in the West end in divorce. Such illusions, moreover, tend to be independent of intelligence: in one celebrated study at the University of Nebraska, 30 years ago, 94% of academics surveyed classified themselves as above average. More recently, rose-coloured glasses have been understood as hard-wired. Last year in Nature, researchers at New York University presented a paper, ‘Neural Mechanisms Mediating Optimism Bias', explaining how they had studied activity in the brain's mood centres while subjects were imagining positive and negative future events: the regions were markedly more active in the act of the former than the latter.

As Smith noted, overestimation of probable success is intrinsic to our dealings with money. Twenty years ago Arnold Cooper, a professor at Purdue, surveyed 3000 new commercial venturers on their hopes for the future. The respondents understood that enterprises like theirs stood a less than 60% chance of success; to their own enterprise, nonetheless, they imputed an average chance of more than 80%. There is optimism in the act of taking on debt - it is a bet on our ability to pay it back. There is optimism in the act of trading a security - it is a statement of confidence in the superiority of our valuation. As Yale's Robert Shiller notes in his classic treatise Irrational Exuberance (2000):

Without such overconfidence, one would think that there would be little trading in financial markets. If people were completely rational, then half the investors should think that they are below average in their trading ability and should therefore be unwilling to do speculative trades with the other half, who they think will probably dominate them in trading.

Indeed, the casual use of the expression ‘sell-off' in the context of recent market behaviour is a misnomer. No market is simply selling: on the buy side of every deal is someone expecting to make money. In one of the shrewdest and pithiest of business books, Where the Money Grows (1911), the journalist Garet Garret coined the idea of The Invisibles, the mysterious counterparts to every transaction. The Speculator, conversing with The Broker in an imagined conversation, describes first a bull market:

Everywhere you go people are buying stocks. You never hear of a man selling anything. Who are the sellers? They exist, but they are invisible. Your telephones are hot. One client wants five hundred Northern Pacific. An invisible seller accommodates him. Another wants three hundred St Paul, and another invisible seller attends to him. You can't send the orders so fast but the invisible sellers will fill them. One hundred of this, please, and there you are; fifteen hundred of that, and here you are; three hundred of something else, quick, and quick it is. Then, when prices are way down, it's the other way. The invisibles are the buyers. Wherever you go, people are selling something. One says to please sell him one hundred Steel common, because the steel business is so rotten, and it comes out on the tape - sold, one hundred Steel common, for the account of your client. Who bought it? Another says please to sell for him one thousand St Paul, because it is going to pass its dividend, and an invisible buyer takes it. I don't know who those invisible sellers and buyers are; I can only guess. I know they exist, and that's bad practice to sell when they buy, or to buy when they sell. I attach great importance to what the invisible man does.

Investor optimism about long-term outperformance through the exercise of logic is relatively new, a result of the rise of the active managed-funds industry, 40 years ago, which made the existence of a class of technicians and seers part of its marketing. You can trace the competition of approaches back to the 1930s, when two seminal primers on investment were published. The first was Security Analysis (1934), by Benjamin Graham and David Dodd, endlessly cited, repeatedly reprinted, presenting investment as a place for hard heads and cool tempers: "Analysis connotes the careful study of available facts with the attempt to draw conclusions therefrom based on established principles and sound logic." The second was The Battle for Investment Survival (1935), by Gerald Loeb, which presents a diametrically opposite view. Loeb says that capital is best deployed "like a rabbit darting here and there for cover", doubts there is "any really ideal medium of permanent investment" and concludes that any wisdom grown conventional is bound to be misleading: "Of course, what everyone knows isn't worth knowing."

Since the mid '60s, the two books have experienced contrasting fates. Security Analysis, famously the bible of investor-as-hero Warren Buffett, continues to exert a thrall. The Battle for Investment Survival has been reprinted just once, with a foreword by John Rothchild, himself the author of a wry book on investment, A Fool and His Money (1988). Why, asked Rothchild, did one book lead, the other languish? Simple:

When Loeb wrote it, the reading public was prepared to believe that investing was a battle where the winners could become losers overnight without warning - they had experienced the Crash of 1929 and were stuck in the Depression. Today, after a [lengthy] bull market in which prices have continued to rise, the reading public is more inclined to believe that investing is an orderly process with predictable results.

The paradox is that very few investors follow precisely logical rules. Optimism bias is just one of a host of cognitive biases (tendencies to error) and heuristics (mental shortcuts) to which they are prone. The findings of behavioural economics, in fact, are that investing on fundamentals comes a poor second to intuition, superstition, time-honoured rules of thumb and, above all, stories - narrative-based decision-making beats quantitative evidence like future earnings or dividends almost every time.

How familiar have we become, for example, with that trope of the television stock-market analyst? BHP rose $1 on record output from La Escondida and predictions of falling copper inventories worldwide. The maverick polymath Nassim Taleb calls this the narrative fallacy: a "vulnerability to overinterpretation" and "predilection for compact stories over raw truths". In The Black Swan: The Impact of the Highly Improbable (2007), he cites reports on Bloomberg News concerning trading in American Treasury bonds in December 2003. At 1.01 pm, a headline ran: ‘US TREASURIES RISE; HUSSEIN CAPTURE MAY NOT CURB TERRORISM'. Half an hour later, the market having continued its fluctuations, the headline appeared: ‘US TREASURIES FALL; HUSSEIN CAPTURE BOOSTS ALLURE OF RISKY ASSETS'. As Taleb observes, "it was the same capture (the cause) explaining one event and its exact opposite."

The classic study of the retrospective explanatory narrative followed a sudden market slump on 13 October 1989, when the Dow fell almost 7%, a tremor sheeted home to the failure of a high-profile leveraged buyout of UAL Inc., the parent company of United Airlines. When Robert Shiller and William Feltus surveyed more than a hundred market professionals, it turned out that only 36% had heard the news before the market dropped. Even professionals whose job it is to assimilate news in a cool and clinical fashion seem incapable of doing so. A number of studies have confirmed that stock analysts systematically overestimate positive news and filter out the opposite: for example, Steven Sharpe, of the US Federal Reserve, found that analysts' expectations of growth in the S&P 500 exceeded actual growth in 16 of the 18 years between 1979 and 1996.

Sometimes this springs from the necessity to tow a particular line; often, it is simply human nature. In Confessions of a Wall Street Analyst (2006), Dan Reingold, a former top analyst at Merrill Lynch, Morgan Stanley and CSFB, explains how he, a dour, principled, nuts-and-bolts number-cruncher, found it almost impossible to keep his head while all about him were so lucratively losing theirs in the telco boom of the late 1990s: he felt, as he puts it, "like a Luddite, stubbornly sticking to the stuff that could be measured as the rest of the world rushed onward".

There was, Reingold confirmed, constant pressure from deal-making colleagues to act as a shill for companies they wanted to work with: he felt a "slow sense of suffocation as the pressure grew from all the various players in the business to conform, to help the bankers, to not rock the boat, to favour companies that might offer a top underwriting or merger-advisory slot". His worst call, however, was a failure to sufficiently downgrade a telco that he had previously lauded. And here the pressure was internal: he saw and apprehended negative intelligence about the company's accounting policies, but could not believe he had been so wrong. "Part of me saw trouble; the other part of me, the value investor, saw a company that still had a lot of valuable assets and was cheap as hell. My gut told me one thing and my brain another. I went with my brain. It was the low-point of my career."

Behavioural economists have modelled such habits as confirmation bias (relying on preferences and preconceptions), anchoring error (working off previous assumptions and calculations) and home bias (favouring nearby investments). These are habits, too, that resist challenge. Conflicting information can actually strengthen a view: the intellectual effort of rationalising a position in the face of opposition appears to shore up prejudices. This behaviour was first glimpsed in clinical psychology 43 years ago, by Stuart Oskamp. For his ‘Overconfidence in Case-Study Judgements', in the Journal of Consulting Psychology, he supplied a group of colleagues with a succession of patient files, each containing a little more information, and found that over time the participants actually grew less receptive to changing their opinion and more adamant about their original diagnosis. Where investment is concerned, Taleb conjectures, "additional knowledge of the minutiae of daily business can be useless, even actually toxic." It begets what he calls "epistemic arrogance" - systematic underestimation of the future's unpredictability, coupled with vast overestimation of "what we think we know".

What chiefly drives investors and finance professionals? The simplest answer seems to be ... other investors and finance professionals. They are impressionable and imitative, descending in hordes, retreating in droves. Shiller calls this a "naturally occurring Ponzi process", named for the infamous pyramid seller Charles Ponzi: "Investors, their confidence and expectations buoyed by past price increases, bid up stock prices further, thereby enticing more investors to do the same, so that the cycle repeats again and again, resulting in an amplified response to the original precipitating factors." Irrational Exuberance incorporates a damning judgement on the dot-com boom, then in progress:

The market is high because of the combined effect of indifferent thinking by millions of people, very few of whom feel the need to perform careful research on the long-term investment value of the aggregate stock market, and who are motivated substantially by their own emotions, random attentions and perceptions of conventional wisdom.

This is a confronting position. Robert Merton, the 1997 Nobel laureate in economics, almost quivers with rage about it: "If Shiller's rejection of market efficiency is sustained, then serious doubt is cast on the validity of the most important cornerstone of modern financial economic theory." But it's not just experts who find Shiller's a counsel of despair. In American Sucker (2004), David Denby's confession of his wild and costly infatuation with the dot-com boom, the New Yorker's film critic describes being infuriated by Irrational Exuberance - it was so pessimistic:

Wait a minute. Just wait a minute. There would be no hope, no market if people didn't take risks, fool themselves, make bets. What is so wrong with that? People invest, flood the market with money, and the companies expand, buy other companies, put money into research and development and create new products. The market needs liquidity. Most of the companies go bust, some investors lose their shirts, but a new industry is created. What he regards as delusion is the lifeblood of capitalism. This irrational activity is one reason we have become a wealthy society. What he calls overconfidence or the willingness to take risks, is absolutely necessary; its opposite is paralysis.

Even at the end of his rather whiney book, when he has lost a packet, Denby becomes petulant at the mere mention of the "saturnine Shiller" who wants to take his "hope" away. He remonstrates that it's "psychologically impossible" to "think of the market going down or staying down forever", and that "this is central to the American temperament and to the longtime successes of the stockmarket, which does, as we know, rise over time." He aphorises: "We can be suckered by apparent success, but the greater fault is to be suckered by loss."

Denby's is a classic post-hoc rationalisation - and this, as John Allen Paulos explains in A Mathematician Plays the Market (2003), is also something for which people have a flair. Describing his own expensive misjudgements, which involved pouring money into Bernie Ebbers' benighted WorldCom, Paulos admits that his first response to the market turning on the doomed telco was to indulge his "a-priori distaste for herdish behaviour" and buy more: "In short, I thought the crowd was wrong and hated the idea that it must be obeyed." Before he realised that he was "catching a falling knife", he performed all manner of internal calculations to rationalise what he was doing, and even afterwards was inclined to exonerate himself.

In my less critical moments (although not only then), I mentally amalgamate the royalties from this book, whose writing was prompted in part by my investing misadventure, with my WorldCom losses. Like corporate accounting, personal accounting can be plastic and convoluted, perhaps even more so since, unlike corporations, we are privately held.

A dollar is not always a dollar: we are all familiar with the concepts of play money, silly money, even shoe money. Categories are particularly plastic where gambling is concerned. An old gambler's tale, the Legend of the Man in the Green Bathrobe, involves a newlywed in Las Vegas who spots a $5 chip on the dresser as he's about to go to bed and decides to see how far it will take him. Dressed in his green bathrobe, he puts the chip on his lucky number on the roulette wheel and wins $175 at 35-1; he bets this stake again and turns it into $6,000; he carries on until his winnings are in the millions, then loses the lot. Later, his wife asks how he went. "Not too bad," he replies. "I lost $5."

When the economists Richard Thaler and Eric Johnson set out to model this behaviour 20 years ago, for a paper in Management Science, they found that the tale is more than a joke: gamblers do take significantly more risks with winnings, or so-called house money. At the time in the US, legalised casinos operated only in Nevada and Atlantic City. Gambling has since undergone huge and irrepressible growth, with global industry revenues approaching US$100 billion annually, and it seems not improbable that people have brought their gambling habits to investing, concluding that gains made there are best ploughed back into the pursuit of further riches, and also to borrowing, behaving more casually with money that was not in the strict sense theirs. A disastrous step, for while gambling and investing are often lazily elided, the two activities are readily distinguishable. Dice, cards, wheels: these involve risk, but not uncertainty; the outcomes may surprise, but the odds are computable. Events beyond the casino and racetrack: these are far less predictable.

Thaler, the author of one of his discipline's most inviting texts, Quasi Rational Economics (1994), has pursued a succession of beautiful experiments on personal accounting. One involved a bunch of Cornell undergraduates: half the students were each given a coffee mug; the other half were invited to examine and bid for them. Those with mugs demanded roughly twice as much to give up their mugs as those without were willing to pay. The experiment was repeated with ballpoint pens, then at another university, and the same effects noted. In behavioural economics, this observation - that people place a higher value on a good they own than on an identical good that they do not - has become known as the endowment effect. The inference for equities investment: once full investment becomes the norm, cashing out becomes disproportionately difficult.

Another factor anchoring investors long after they should logically have taken profits, or at least changed their allocation of assets, is status-quo bias. It is as self-explanatory as it sounds, but perhaps even more perverse. In his new book, Nudge: Improving Decisions About Health, Wealth and Happiness, Thaler imparts some stunning statistics. Thirty per cent of employees in the US eligible to join personal tax-exempt retirement schemes, 401(k) plans, do not; 50% of British employees eligible to join defined-benefit superannuation schemes, which actually require no contribution from them whatsoever, fail to do so. Thaler notes: "This is equivalent to not bothering to cash your pay check."

A study of asset-allocation changes in a pension plan for university professors, meanwhile, arrived at a median of zero: that is, most did nothing. Apparently, Thaler says, losing money is more bearable when it is the result of inaction rather than action: "Passively endured losses induce less regret than losses that follow active investment. Someone who sticks with an old investment that then declines by 25% is less upset than someone who switches in and see it decline by 25%." There is also a startling faith in the power of a single guesstimate, especially if it is an apparently balanced one. Thaler quotes the Nobel laureate Harry Markowitz, founder of the modern theory of asset allocation within portfolios, who once admitted that even he preferred rules of thumb to science when investing: "I should have computed the historic covariances of the asset classes and drawn an efficient frontier. Instead ... I split my contributions fifty-fifty between bonds and equities."

For borrowed money, meanwhile, there also seems to be a whole different array of behaviours. Eight years ago, for example, the economists Drazen Prelec and Duncan Simester studied the spending habits of people bidding for Boston Celtics tickets. Their conclusions, that people were prepared to pay twice as much with credit as with cash, were published in Marketing Letters under the title ‘Always Leave Home Without It', a droll spoof of American Express's famous slogan. As yet, we know less than we probably should about people's behaviour with money that isn't theirs; chances are that we are about to be availed of a great deal more empirical data.

What seems peculiar about the economic straits into which we have strayed is the relative benignity of conditions: low interest rates, low inflation, electoral continuity, a general sense of prosperity and unexampled degrees of financial literacy in members of the public. Not a lot needed to go wrong, it seems, for everything to go wrong. What happened to our sense of risk?

One explanation is offered by what the sociologist Gerald Wilde has called risk-homeostasis theory, which holds that "people accept a certain level of subjectively estimated risk to their health, safety and other things they value, in exchange for the benefits they hope to receive from that activity." Wilde's particular fascination, explored at length in Target Risk (1994), is road accidents: he found that the response of drivers to improvements in their safety, like street lighting and anti-lock brakes, was to court proportionately greater dangers. He discerned similar long-term patterns for infrastructure construction in dangerous areas:

Improved impoundment and levee construction did make certain areas less prone to flooding. But, as a consequence, more people settled in the fertile plains, because these now appeared "safe enough". The end result was that subsequent floods, although fewer in number, caused more human loss and more property damage.

A related phenomenon was dubbed the lulling effect by W Kip Viscusi, in a classic 1984 study of the Food & Drug Administration's introduction of childproof lids on selected medicines - an innovation followed, to the alarm of its champions, by a substantial increase in the per-capita rate of fatal accidental poisonings in children. Viscusi's conclusion has been an admonishment for regulators ever since: "It is clear that individual actions are an important component of the accident-generating process. Failure to take such behaviour into account will result in regulations that may not have the intended impact." If this argument is taken generally, then the perceived safety and ease of borrowing, and the growing accessibility and familiarity of investment markets, became a kind of trap when combined with our own predisposition to optimism.

Everyone, too, lives by a range of restrictions, taboos, delayed indulgences and self-denying ordinances; their development is fundamental to maturation, and also to good fortune in later life. Forty years ago, the psychologist Walter Mischel conducted his renowned marshmallow experiment, where he studied preschoolers given a marshmallow but promised a second if they could delay eating the first: those exhibiting greatest self-control went on to achieve better academic results and experience fewer difficulties in socialisation. Yet learnt behaviours can be unlearnt, too. When banks essentially offered as many marshmallows at once as anyone could eat, apparently anachronistic but decidedly useful inhibitions in the operation of credit went by the board. In Nudge, Thaler describes the rise and fall of Christmas clubs: a species of account that operated for decades, whereby families put away money that could not be touched until the brink of Christmas. Why did people patronise inflexible, illiquid, zero-interest accounts with such exorbitant transaction costs? Because, Thaler observes, they realised the need for precautions against their predisposition to instant gratification. The end of the Christmas club was the rise of the credit card, despite the punitive rates of interest for late payment - which optimistic customers never expected to pay, and which shrewd banks had every incentive to exploit.

The election of Barack Obama has been accompanied by an outbreak of high-altitude opinionating about the need for leadership in troubled times, and the suitability of his gravity to the climate of earnestness. Certainly, it's hard to imagine him repeating the sentiment of Herbert Hoover when a group of church leaders visited the White House in June 1930, to talk about the hardships of the poor: "You are too late, gentlemen. The depression ended six weeks ago."

Behavioural economics, though, doesn't set great store by the shadow play of politics: the decisions that matter are the personal adjustments we make, consciously and unconsciously, individually and collectively, in times of change. One residually hopeful position would be that there is no deflating deluded expectation or changing unsustainable habits in bull markets - it requires harsher economic realities. But one apparent corollary of optimism bias is that we find negative events disproportionately damaging: according to some studies of loss aversion, we brood twice as deeply on loss as we celebrate an equivalent gain. At the moment, the mavens of global finance are like the Wall Street bluebloods and their Nobel-winning partners whose mathematically majestic models vapourised the mighty hedge fund Long-Term Capital Management ten years ago, and are vividly described by Roger Lowenstein in When Genius Failed (2000):

Outsiders would later comment on how the group held together, but it was their only palatable choice. The deeper their fix, the less the partners wanted to be with anyone else and the more they closed ranks. They suppressed, for the moment, their resentments and bitter dislikes; they avoided recriminations and blame. Grim and determined, they got to the office at dawn and worked late into night, as if their physical presence alone could stop the haemorrhaging. They stayed on the phone for hours, trying to liquidate trades, stroking old investors, seducing new ones, fending off bankers ... The partners continually retreated to the conference room, always with the curtains drawn to block out prying eyes, to hash out their problems in secret.

But they will have to come out eventually.

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