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Sunday 21 June 2009

Akerlof's Lemons: Risk Asymmetry Dangers for Investors

The Failure of Markets

Ever since Adam Smith identified the raw stuff of market economics and David Ricardo explained the concept of comparative advantage genuine new ideas in economics have been as rare as a vegetable in a child’s dinner. However, market economics doesn't always work - as Hardin showed, in The Tragedy of the Commons, where resources are shared then market economics breaks down – which may be a disaster when the common resource is the air we breathe.

In 1970 George Akerlof came up with another mechanism to disturb the most rampant of free-marketeers, demonstrating that there are times when markets fail even when there are both willing buyers and sellers. His work suggests that similar problems may dog investors as they try to make an honest turn on the markets through small cap stocks or mutual funds.
Akerlof’s Lemons

In his now famous paper The Market for Lemons: Quality Uncertainty and the Market Mechanism Akerlof showed that there are situations in which asymmetry of knowledge between sellers and buyers – specifically where the former have the advantage – may result in mutually beneficial transactions failing to happen. His example – oft-quoted – is of used cars. Here the seller will know whether the car is of good quality or if it’s not – if it’s a “lemon” - but mostly the buyer won’t have a clue. Especially if, like me, their assessment of a car is mainly based on colour.

This asymmetry of information means that, while a seller won’t sell a good quality used car for less than it’s worth, a buyer won’t buy at more than the average price, fearing that they’re purchasing a lemon. So a situation develops where there’s no market for good used cars – leading, inevitably, to a breakdown in the market mechanism.

More Lemons

Once you start looking around more markets that are dominated by this issue of asymmetric knowledge become apparent. Health insurance is a classic example: the insurer takes the view that anyone who wants insurance isn't someone they want to insure and whacks up the premiums. The problem is that the person wanting the policy knows if something is wrong with them but the insurer doesn’t. The result is to scare off anyone who just wanted some cheap cover in case something goes wrong.

A similar market problem occurs with tradesmen of all kinds. Ever experienced that moment when the plumber blows out his cheeks, shakes his head and turns to you with a look of concern in his eye? True or bluff: how would you know? Auto repair shops are another classical asymmetric situation – as undercover media investigations continually uncover, these people often use their knowledge of wishbone suspension systems and planetary gearsets to take advantage of the unwary. Frequently the good tradesman will be driven out by the bad, to the detriment of purchasers.

Morgenstern and von Neumann

Akerlof’s theory harks back to one of the seminal approaches to risk management – the so-called utility optimisation processes developed out of game theory by Morgenstern and von Neumann. Yes, that’s the same von Neumann who invented the architecture of the microprocessor, helped discover quantum mechanics and created bits of the atom bomb. Smart ass.

Using game theory – a branch of mathematics developed by (guess who?) von Neumann – they attempted to explain how humans rationally make choices. Game theory assumes that there are multiple competing parties – think of a game of cards, or an auction. Their idea was to define the rational decisions an individual might make to maximise their returns.

The problem with this is, as you might guess, the assumption of rationality. As behavioural psychology has shown again and again humans simply don’t behave in the way that rational economists would have us believe. In fact rational economists don’t behave that way, either, as we'll see one day.

Psst, Want a Used Bank?

The thing is, of course, that the used car market does work, after a fashion. Despite the problems identified by Akerlof it somehow functions - there’s more going on here than simple rationality. A clue to why this might be can be found in another area and another era.

Before the days in which any bank loss was met by anxious government advisors on secondment from the banks with a bailout in hand people took a real risk in depositing their money in banks. They went bust with worrying regularity and some bankers were even known to abscond with their depositors’ savings. Couldn't happen in these better regulated days, of course.

Despite this, people still deposited their savings with banks and, for the most part, managed to do so with the ones that didn't run off with their money. Yet this was a classic asymmetric problem – the bankers knew if their banks were sound - or not - but the depositors didn’t, yet still generally managed to identify the safest institutions. At root this was because the banks were are adept at providing signals to help guide savers.

Signalling Mechanisms

Firstly, these were times in which depositors understood that the bank offering the highest savings rate was the riskiest. Whereas these days people seek the highest interest rate regardless of risk, safe in the knowledge that their government will bail them out, a hundred years ago a high interest rate was a red flag. Moral hazard be hanged.

Secondly, banks had others ways of signalling permanence. Back street organisations with no intention of hanging around have no reason to invest in premises or in infrastructure. On the other hand reputable institutions have every reason for doing so – palatial offices and impressive officials (remember those?) are ways of signalling to depositors that they’re dealing with an organisation with gravitas, likely to be around for the long haul.

These sorts of signals can be used to guide people on the wrong side of the asymmetric information divide – after all, a reputable dealer in used cars has no reason to rip people off, quite the opposite if it wants repeat business and recommendations. Of course, the same signalling mechanisms can be used to gull the unwary. Setting up expensive facades to promote scams is not unknown – indeed it was one of the marketing premises behind the South Sea Company.

When Banks Get Nervous

If, however, the signalling mechanisms break down then everyone is lost. Something similar happened late in 2007 and throughout 2008 as banks became unwilling to lend money to each other. They knew that there were horrible losses lurking on some balance sheets but none of them knew exactly where. The market broke down as the lending banks assumed that the ones that wanted to borrow had the worst problems and weren’t a safe risk while the ones that didn't want to borrow were OK. Classical banking behaviour of course – they’ll lend you an umbrella when the sun’s shining and take it away when it starts raining.

Was this rational man thinking or behavioural fear triggering? Probably a bit of both – rationally knowing that there were huge losses out there made banks unwilling to lend. However, the failure of banks to lend to each other threatened the whole financial edifice and put all of them at risk. Paralysis by analysis resulted, which has only been slowly recovered from as regulators have forced more transparency and less asymmetry upon the financial sector.

Individual Investors Beware

Any individual stockmarket investor faces the same problem – investing in companies or funds in which they can, at best, see through a glass darkly is an issue of asymmetric risk. Fortunately there’s a legal and regulatory framework in place which means all investors should have the same access to information. Moreover, large institutional investors are apt to start throwing their weight around in cases where there’s clear evidence of insider dealing – although less so if managements start to reward themselves perversely.

This is not so with small companies – there the individual’s asymmetric information weaknesses are often exploited unmercilessly: witness the explosion in small dotcom companies in 1999 and small commodity companies in 2003 – how many of these companies were real? Now, as capital becomes scarce, many smaller companies are abandoning their small shareholders and leaving the markets. Similarly with mutual funds – how many investors understand the survivorship effects and other biases used to skew historical fund return figures in the funds' favour?

In general, private investors should avoid situations where the insiders have it all their own way. Small companies without institutional investors and poorly transparent mutual funds are two typically dangerous situations where identifying the lemons is often possible only in the rear view mirror. They can turn out very well for investors who are prepared to really do their own scuttlebutt but otherwise don’t believe it’s because of better information than the insiders, it’s not.

The Undercover EconomistAnimal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism (New in Paper)Game Theory: A Nontechnical Introduction

Related articles: The Psychology of Scams, Survivorship Bias in Magical Mutual Funds, The Tragedy of the Financial Commons, The Death of Homo economicus

1 comment:

  1. Brilliant post. Incidentally, it was a banker who explained to me why banks always traditionally looked like small churches or fortifications. It seemed strange to me, as clearly the safe was where the action was. Why the unanimity in heavy stone and vaulted ceilings?

    The irony was of course that he was telling me this in a bank that had been converted into an All Bar One.