In January I posted an analysis of panic, contagion and mass market movements in which I suggested that what actually happens in these is a shift from an outcome being “theoretically possible” to being “actually possible” needing only a precipitating event to make it real and therefore widespread. I asked then: “Has major Western government default become actually possible in the market’s eyes– or are we still just flirting with a theoretical possibility?”
It is now without a doubt “actually possible”. That warning sign is flashing red. Here’s one example of many: “Fifteen months ago when we started looking at this, we said it was unthinkable,” said Heiner Leisten, a partner with the Boston Consulting Group in Cologne, Germany, who heads up its global insurance practice. “It’s not impossible or unthinkable now.” (NY Times, 9/2/2012). He was speaking of Greece being forced to leave the Euro zone, but he may as well have been speaking, as many are today, of sovereign nation default.
Be clear: I am not referring just to the truly terrifying structural linkages by which, say, default by Greece would inevitably take down numerous European banks and probably a few other countries. These are “hard-wired” into the system and only require occurrence of the initial unthinkable event to set them off (and many, including the European banking system and BCG’s clients, have been scrambling to disconnect linkages and shore up defenses against such collapse – perhaps to some good effect.) I am suggesting that a mass market movement in response to these events is now virtually certain.
I have no inside information about when or whether Greece or anyone else may default. As a citizen I sincerely hope we dodge this particular bullet. But make no mistake: the unthinkable is now not only thinkable. It is rapidly on the way to being seen as inevitable.
It might be wise to invest accordingly.
Sixteen years ago I wrote down the above title on my “Work in Process” list, thought about it for a few minutes, and put it at the bottom priority. Granted, it was a complex and poorly understood topic for which I intended to offer a new formulation – but it was hardly a burning issue. To find familiar examples I would have had to reach back to the Great Depression of the 1930’s, or the post-war hyper-inflationary periods in Germany and Hungary – historical curiosities that had no perceivable relevance to our world in 1996. Common wisdom and expert opinion agreed: We were beyond all that.
But here we are in 2012 and all that has changed. We have seen the unthinkable occur, again and again: a major investment bank going bankrupt, housing prices plunging across the board and staying down, a global near financial meltdown, people actually paying serious attention to Nassim Taleb – and now we face the imminent possibility of default on sovereign debt by major European nations, and perhaps even the collapse of the Euro.
The topic now seems, if anything, too timely. Every second article in the financial press seems to be about when the next break in the global economy will come, how far it will spread and how rapidly. Rest assured, this is not yet another Chicken Little post. The economic sky may in fact fall, but that’s for others to predict.
What I’m interested in here is: What actually happens with individual investors that results in panic, contagion and mass market movements, and how can we spot it before it comes crashing down around us? Continue reading Panic, Contagion and Mass Market Movements
“Sunk cost” is tricky stuff.
It is a standard accounting term, referring to the investment already made in an asset or project. When deciding how to value the asset currently, or whether to invest further in the project, we are firmly admonished to ignore “sunk cost”, and to make our evaluations based on its current market value (or expected future value). This is sound advice, rational to the core, and is perfectly in accord with classic economic theory.
So what’s the rub? To the consternation of accountants, economists and financial advisors everywhere, when we look at actual investment decisions, people routinely do NOT ignore sunk costs. What they have already invested is typically a factor – sometimes a determining factor – in what they decide to invest now. Talk about “irrational”! And since behavioral economists do talk about “irrational” they account for this and many other common deviations from rational practice by invoking the “Endowment Effect.”
In the first post of this series, “Take the Cash and Let the Credit Go”, we saw how “loss aversion” is an ad-hoc account of research data that merely labels the phenomenon but in no way explains it, and gave an alternative formulation that actually predicts the research findings. In this post we will subject the “Endowment Effect” to the same treatment, with an interesting twist: exactly the same conceptual structure that predicts loss aversion also predicts the Endowment Effect! This is our first solid clue that we are on to something really different and powerful here. (And there’s a good deal more where these come from, as we shall see as this series unfolds.) Continue reading What’s Really Going on With “Sunk Cost”
Behavioral science research reminds me of the fabled Rocky Mountain oil shale deposits: Both are reservoirs of tremendous potential value, locked up in a framework that makes tapping that potential next to impossible.
Solving the oil shale problem seems to require better and stronger technology; solving the behavioral science research problem requires better and stronger conceptualization. Fortunately, that conceptualization is available and well-developed, in the powerful conceptual net called Descriptive Psychology. What is called for now is a thorough reconsideration of behavioral science research, to create a fresh understanding of what has been discovered that unlocks the value in the findings.
Let me be clear: since at least the 1970’s an enormous body of sound empirical research has been accomplished in behavioral science, including, among many other domains, behavioral economics, social psychology, cognitive psychology and neuroscience. I take these findings as given. It is not my intention to question the findings; rather I intend to question the explanations researchers have given of their findings, and to offer other, more plausible and considerably more powerful explanations in their place.
As Omar Khayyam said in a different context, I intend to “Take the cash, and let the credit go.”
Here’s a specific example: Continue reading Take the Cash and Let the Credit Go
Economists talking about “incentives” remind me of a scene from the classic film “Cool Hand Luke.” Luke (Paul Newman), a prisoner on a southern chain-gang, stands up to the corrupt prison authorities. For his efforts he is badly beaten by the guards and thrown into a ditch. From the top of the levee the Captain (Strother Martin) looks out at the chain gang and proclaims this immortal line: “What we’ve got here, is a failure to communicate.”
Well, OK. You could put it that way. But in doing so you are entirely distorting the reality of what is going on (and of course that was the Captain’s intention.) Unfortunately economists seem unaware of just how badly their talk about “incentives” distorts the realities they are talking about. Continue reading Incentives?
I have launched a series here on behavioral economics that makes sense of some material in Dan Ariely’s two bestselling books on behavioral economics: Predictably Irrational, and The Upside of Irrationality. In these posts I have some pretty critical things to say about this work, so I want to be clear from the start:
The critique is of the work, not the man. Continue reading Dan Ariely: An Appreciation
Research in behavioral science is hard.
Self-report is notoriously unreliable; rigorous observation of actual behavior is very difficult to get right; creating comparable experimental and control groups takes more than a little ingenuity – and then you have the problem of replicable results. Researchers who find methods that even partially steer around these known difficulties become heroes in their fields; their methods become standards, and genuine scientific knowledge can result.
But sometimes this ingenuity results in denying the obvious, and then we get silly science leading to bad theory. Some behavioral economics experiments, alas, fall into that category. They embody the Wizard of Oz fallacy: insisting that experimental subjects “Pay no attention to the man behind the curtain” when the curtain is standing open for all to see. Continue reading Pay Attention to the Man Behind the Curtain
A recent research study turned up some delightful results that are both not intuitively obvious to a five-year-old, and absolutely at odds with the predicted rational utility-maximizing behavior of homo economicus.
As reported in the January 14, 2010 edition of The Economist, Tanjim Hossain of the University of Toronto and John List of the University of Chicago “… worked with the managers of a Chinese electronics factory, who were interested in exploring ways to make their employee-bonus scheme more effective … At the beginning of the week, some groups of workers were told that they would receive a bonus of 80 yuan ($12) at the end of the week if they met a given production target. Other groups were told that they had “provisionally” been awarded the same bonus, also due at the end of the week, but that they would “lose” it if their productivity fell short of the same threshold.
“Objectively these are two ways of describing the same scheme.” But as it turned out, “The fear of loss was a better motivator than the prospect of gain (which worked too, but less well). And the difference persisted over time: the results were not simply a consequence of workers’ misunderstanding of the system.” Continue reading What people really do instead of maximizing utility
Homo economicus – that autonomous utility-maximizing creature of ancient lore – has been dead for a long, long time. Economists today drag its rotting corpse through textbooks and academic studies and econometric models in a kind of Wealth of Nations and Zombies mash-up because – well, because that’s what economists do. It’s time and then some to give the poor creature a decent burial and a proper epitaph: “Here lies Homo Economicus: Not a Bad Start, But Fatally Flawed .”
This is hardly a new or radical observation. A quick examination of the works of Ludwig Von Mises, Murray Rothbard, Herbert Simon and Gary Becker show that both the critique of homo economicus and substantive alternatives have been around in the works of respected economic theorists for over 50 years. Behavioral economists such as Amos Tversky and Daniel Kahneman have been expanding the model of the economic person since at least the 1970’s. And as New York Times columnist David Brooks points out, the economic events of 2008-2009 “exposed the shortcomings of the whole field. Economists and financiers spent decades building ever more sophisticated models to anticipate market behavior, yet these models did not predict the financial crisis as it approached. In fact, cutting-edge financial models contributed to it by getting behavior so wrong — helping to wipe out $50 trillion in global wealth and causing untold human suffering.” (March 25, 2010) Continue reading Economics Redux