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Friday 13 March 2009

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.

Behaving Badly is Rational

Of course, most people don’t really behave like this; the world is a far messier place occupied by all sorts of other types of people who aren't economists and whose behaviour is often not in their own best interests. Which isn’t to say that this odd behaviour may not be perfectly rational in some sense. There has been a whole raft of popular science books published in the last few years dedicated to explaining the economic rationale behind what appear to the most illogical pieces of behaviour. See, for instance, The Undercover Economist by Tim Harford. Top book, top blog.

Still, at a general level, we can be reasonably sure that the perfect economically rational person is a phantom because people have many things driving them other than simple economic interest. There’s sex and sport, for instance. So that covers off about half the population. Gender fear, in the shape of my good wife who will proof read this for me, prevents me from tackling the other half.

The Problem for Classical Economics

Anyway, for a few hundred years economists were quite willing to live with the concept of Homo economicus, in spite of the daily evidence all around them, and happily applied it to all sorts of different things including, of course, the stockmarket. Rational people investing rationally meant, clearly, that the prices of stocks on the stockmarket were going to reflect all of the current information which, equally clearly, meant that it was just about impossible for anyone to consistently beat the markets other than by luck.

Since this was self-evidently not the case as a whole cohort of value-oriented, like-minded individuals kept on beating the market year in and year out one would assume that the economists would rethink their models a bit. In general, though, they preferred to carry on attributing any outperformance to luck until it got to the point where if anyone threw heads one more time they threatened to take their model home and refuse to come out to play anymore.

That'll be, uh, ... heads again then.

Prospect Theory

In the meantime other people started investigating the issues a bit more closely and in 1979 Kahneman and Tversky published an alternative proposal, known as Prospect Theory, based on the observation that humans treated different kinds of situation differently even though the actual risks they were dealing with were rationally the same. They showed that people – investors – were more risk adverse when it came to protecting a profit than they were in trying to recover a loss.

So, in effect, if something went wrong with a stock they were holding the theory stated that they would be more likely to sell it if they were in profit than if they were making a loss. This is, indeed, illogical since it’s the same company with the same prospects. If investors were truly rational they would decide whether to sell or not based on the current information – stock history is irrelevant to whether a stock is currently a good investment or not. Yet the evidence suggests that this decision is, in fact, heavily biased by their personal history and, therefore, that the decision is not really a rational one.

Exit Homo economicus: this asymmetric skewing of economic behaviour wasn’t explicable under classical economics and figuring this out was the first step in developing a modern theory of behavioural finance explaining how people really behaved when placed in the position of managing their money. Prospect theory not only explained the disposition effect – the unwillingness to recognise gains by selling at a loss – but also other observed behaviours incompatible with rational economic man.

For example there’s the pseudocertainty effect where by wording a situation with the same outcome differently you can get groups of people to give you completely the opposite answer. It’s a frightening but perfectly repeatable experiment, which should give you cause to scowl deeply the next time you see the result of some opinion poll claiming, well, pretty much anything. These psychological biases run deep and we’re pretty much in denial about them all, all of the time. After all, none of us like to think that we’re anything other than in control of ourselves.

Only we're not.

Getting Out of the Laboratory

Although Prospect Theory certainly tapped into something quite repeatable not everyone is perfectly convinced that Homo prospectus is any more real than Homo economicus. One of the longest running arguments in psychology is between those who believe that the subject should replicate the methods of the hard sciences and those who believe that you can’t take humans out of their real environments and learn anything useful.

The beauty of laboratory based experiments such as those used by Kahneman and Tversky is that you can control for what are known as confounding variables. These are things that might distort the particular traits that you’re interested in investigating. Opponents of the approach argue that this misses the point – if you take a human out of its normal environment it doesn’t behave normally and any findings you get can’t be applied to real-world behaviour.

As Prospect Theory and subsequent research in the same vein have been used to implement real world trading schemes this is not an insignificant point and a number of economists have set out to investigate whether its findings are replicable in normal, everyday society. The evidence is, more or less, that they are – but not all the time. Behind this is a critical lesson for anyone wanting to start trading on the stockmarket.

John List: Are You Experienced?

The economist John A. List is renowned for taking his experiments out of the laboratory and into the real world. He surmised that the behavioural effects being shown by Prospect Theory might, in part, be facets of the unusual conditions under which the experiments were conducted. So he went out and conducted a bunch of experiments outside the laboratory using sports memorablia. Summarising his conclusions – inexperienced traders demonstrate the tendencies shown in the laboratory while experienced ones do not (see, for example (1)). In essence, experience allows you to override the biases that Prospect Theory reveals.

For people starting out investing actively in the stockmarket these are worrying results. Firstly they are at risk of simply making mistakes due to their inexperience. Secondly they’re likely to be at a severe disadvantage to more experienced traders. More or less you should assume that if you make money you’re simply lucky while if you lose it ... well, let’s say you shouldn’t be surprised.

Novices are either Lucky or Poor

I can’t think of many counterarguments to this. Of course, all inexperienced traders started out somewhere but, in most cases I’ve met, successful stockmarket investors received their experience professionally in some sense – not always in the stockmarket but certainly in some related area where they get a grim first-hand understanding that the price you pay for something may not be even roughly equivalent to its real value. It’s best to learn these lessons with other people’s money.

Seriously – I can think of few reasons why anyone should recommend an inexperienced individual to invest actively in the stockmarket. If you have to - start very small, expect to lose everything and don’t think early success is you being clever. Your best bet is a rising tide, it makes us all look like financial wizards.


1 comment:

  1. Is there any reason for an experienced investor to actively invest in the stock market?