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Monday, 31 August 2009

Science, Stocks and Superstition

Unreliable Science

As we’ve seen – repeatedly – people aren’t particularly good at overcoming the behavioural biases built into our nature by evolution. There’s no real reason we should be – computing the statistical probability of an above average return on the stockmarket over a twenty year period wasn’t of much value for most of human history. This was partly because twenty years was more than the average lifespan of a proto-human but largely because no one had yet got around to inventing money or stockmarkets or stocks. Or ‘years’.

If these biases are inherent and cause us to do stupid things around finance we might expect that they’ll appear in other areas as well where humanity has only recently started to apply its higher cognitive functions. So it’s unsurprising that our basic intuitions about science are about as reliable as those we have about finance. To whit: not reliable at all.

Greek Geeks

Science has been around a lot longer than modern financial theory. The Ancient Greeks developed many concepts that aren’t out of place in the modern pantheon of university science faculties – atomic theory, planetary orbits and toga parties amongst them. Unfortunately they failed to marry their scientific insights to a stable economic system and much of their knowledge was lost for the best part of a millennium. The lesson being, presumably, that disenfranchising women and relying on slave labour is a poor way of building a stable society. Global corporations take note.

During that lost thousand years or so the only real legacy of Greek knowledge in the Western world was a smattering of Aristotle, who was a bloody good thinker but a bit weak on stuff like planetary motion and mathematics. Somewhere along the line Aristotle’s ideas got mixed up with Christianity and resulted in the odd position of the Catholic Church defining God’s word on the basis of the scientific writings of an atheistic Greek who died before Christ was born. We can blame Thomas Aquinas for that one.

The period known as the Renaissance – the rebirth – was marked by a remarkable rediscovery of Ancient Greek thought. Some of this came from the Muslim world, where many ideas and writings had been sustained through the European Dark Ages, and some of it from the libraries of monasteries remote from barbarian incursion where scribes had been dutifully and ignorantly copying scrolls for centuries. Suddenly there was an explosion of ancient knowledge raining down on a world ripe for new ideas.

Childish Superstition

Yet, it’s impossible to believe that this sudden rediscovery of ancient science could wipe out the legacy of evolution. Science always has to be learned, it never comes naturally. Just like the basics of investing the concepts of science are not comfortable to the human mind, they go against the grain and for the vast majority of untrained lay people are foreign and even slightly chilling in their nature. The concept that every idea has to be exposed to public scrutiny, debated and even ridiculed before being accepted doesn’t sit easily with most of us.

In fact, our very survival may depend upon our non-scientific nature. How many amongst us didn’t experience fear of monsters and the supernatural when we were little? That’s easily explicable as an evolutionary adaptation designed to keep us near to our parents in an environment when a stray step could see us eaten by real monsters. Bruce Hood, in Supersense, for instance, reasons along these lines – that the adult human’s propensity for believing in the supernatural is a development of the child's natural ways of reasoning about the world. As he points out, even highly educated people often believe in the supernatural: this doesn’t make much sense unless it’s somehow built into the fabric of our beings.

Of course, if superstition and difficulties in thinking in logical and scientific ways are inherent to our very beings we should see similar effects in financial markets. We should see evidence of people behaving in a stupid, irrational and wholly ridiculous way for no reason other than that’s the way that people behave. This is to go beyond people responding irrationally to the signals of the markets to them responding irrationally to absolutely nothing relevant to the markets whatsoever.

Eclipsed Stocks

Naturally evidence for such behaviour exists: researchers are nothing if not diligent in looking for new ways of spending research grants. Gabriele Lepori in "Dark Omens in the Sky: Do Superstitious Beliefs Affect Investment Decisions?" is the latest in a long line of researchers who’ve looked at the effects of good old superstition on stockmarkets and has shown that markets respond to the imminent arrival of a scientifically predictable eclipse by going into a tailspin, from which they rapidly recover when it turns out the world hasn’t ended. Again.

There is some rationale behind this. As Lepori explains:
"People tend to turn to superstitious practices when dealing with outcomes that are important to them and facing conditions of high uncertainty, competition, and stress"
“High uncertainty, competition and stress” could almost be a job description for many of the financial professionals involved in stockmarkets. It’s hardly surprising that they seem to be highly superstitious and inclined to odd behaviour such as possession of lucky bears, lucky ties or, in one rather distasteful anecdote, lucky underwear. Understandable this may be but you’ve got to ask yourself: do I really want to entrust my future to someone who’s worn the same underpants for a month?

Built to be Irrational

Mostly economists are working on one of two theories. Either humans are basically rational economic theorists and their errors are those of computational accuracy or we’re behaviourally biased and therefore behave irrationally but in a predictable fashion at a statistical level. It’s possible to discern the two sides of economics gradually moving to an accommodation where rational man is so bedevilled by the shortcuts taken by the brain that the result looks like the outcome of behavioural analysis.

However, there’s a third possibility. Maybe people are built to be irrational and their investing approaches are driven by this. Maybe the behavioural biases we’ve been discussing aren’t the main factors that drive the way people deal with stockmarkets. Maybe human irrationality goes way beyond the obvious things that researchers are looking for?

People's lack of understanding of science is daunting - this study from the Californian Academy of Sciences recently suggested that most Americans can't pass a basic science test. If the world's most advanced nation can't do better than this what hope for the rest of us? So if science is the dominant mode of thought across the planet and has lifted billions of people out of total poverty but the vast majority of people don’t understand it and would rather wear lucky pants and consult astrologers where does that leave investing, a much less well understood approach to organising the world yet one that attracts vastly more practitioners?

Insensible and Irrational

There’s little doubt that behavioural biases affect investors most of the time. There’s equally little doubt that it’s the same behavioural biases that cause the runaway feed forward processes that lead to booms and subsequent busts. However, the idea that humans are driven by relatively sensible and predictable behavioural biases is at least questionable. It’s at least as likely that humans are inherently irrational and driven by demons in the dark designed to protect us from the real monsters that lurked in our history as we dwelt in predator infested environments.

The question is not why do markets behave irrationally but why do they ever behave rationally?


Related articles: Bulletin Boards Are Bad For Your Wealth, The Media, Fear and Stockmarket Manias, Don't Lose Money In The Stupid Corner

9 comments:

Rob Bennett said...

even highly educated people often believe in the supernatural: this doesn’t make much sense unless it’s somehow built into the fabric of our beings.

This is a fine article. You dig deep. That's what we need to do to come up with good answers to the puzzles of investing.

I question the statement quoted above. There is an assumption inherent in it that nixes the point supposedly being made.

Could it not be that many highly educated people believe in the supernatural because the supernatural is real? It sure seems so to me.

If you presume that the supernatural is not real, you head down one path in all your subsequent thinking. If you presume that the supernatural is not real, you head down another path. The conclusions all logically follow from the premises. But they are not necessarily accurate. The "findings" were determined at the moment the premise was elected.

I see this in investing all the time. People who believe that timing doesn't work will go into these long convoluted arguments "showing" that their belief is the right one. But if you check you see that the hidden premise that they started with is that timing doesn't work. What a surprise that their "investigations" ended up showing that!

We're idiots, babe. It's a wonder we can even feed ourselves.

Bob Dylan said that.

Rob

timarr said...

Hi Rob

An insightful comment, as usual. You're correct, I think, that I've rather begged the question. However, I would dispute any argument that the supernatural is real - unless by this you're making some kind of post-modern deconstructionist all realities are equally valid type of comment. Which, of course, would be equally non-scientific and equally begging the question.

As a scientist I'd love it if some of paranormal or supernatural phenomena turned out to be true. But as Carl Sagan explained in his masterly "The Demon Haunted World" when tested under controlled conditions every instance of supernatural behaviour has so far failed to be substantiated. So I don't personally presume this, even if the article does.

The analogy with beliefs about investment timing is stretched, I judge. There's a vast amount of data, especially around mutual fund flows, that shows that most people get their investment timing hopelessly wrong so it's clearly the case that timing doesn't work for these people. If the point is that timing can be made to work for everyone, all the time, then you're somehow suggesting that everyone can conquer their involuntary biases. I doubt that. On the other hand if you mean that the small set of people who can come to grips with the psychological demons within can vastly improve their investment timing and performance then I'd agree. However, the rest of us should avoid the issue and invest long-term and passively.

Rob Bennett said...

There's a vast amount of data, especially around mutual fund flows, that shows that most people get their investment timing hopelessly wrong so it's clearly the case that timing doesn't work for these people.

Thanks for your kind words, Timarr.

My view is that the reason why this is so is that most "experts" say that timing doesn't work. If we would all drop the "timing doesn't work" stuff and spend our efforts explaining what kinds of timing work and what kinds don't work, just about everyone would be able to time effectively.

The claim that "timing doesn't work" is circular. Few know how to time effectively today because it is only a small number of "experts" who dare to talk about the realities. But if you ask why more don't talk about the realities, the response you get is "Well, there's no point in doing so because we know that most are not today able to time effectively."

People don't know how to time because we don't tell them! If we told them, the "studies" would tell a very different story.

Rob

Anonymous said...

I would dispute any argument that the supernatural is real

I would like you to dispute the following arguments for the Supernatural:

1) What is the cause for the universe/big bang?
2) Fine-tuning of the cosmos for life on earth. Mathematically the odds look very good for a supernatural mind.
3) DNA – It definitely looks like design. Wouldn’t a rational person be perfectly reasonable to conclude that humans were designed? Why does science run in the opposite direction despite the obvious evidence? (The answer, I believe, leads to the next argument)
4) Moral argument. What is the basis for objective morality?

Science is constantly equated to being intellectual, yet when presented with the arguments listed above science runs in the opposite direction. Why not rule out the obvious first, that being a supernatural mind/creator? That said, I don’t know of any way we can examine or observe the supernatural since science can only examine the natural world. On the other hand, that doesn’t allow us to rule out the possibility of the supernatural because we lack the methodology.

Our personal biases are the greatest hindrance to determining almost anything. Unless a person is willing to admit they are/were wrong more than they are/were right they will be ruled by their personal biases. That is why a person will act irrationally in the face of overwhelming evidence, because they still believe they are right.

For me, the first step of critical thinking is to look long and hard at all information that is contrary to your beliefs. If you can’t find any you haven’t begun the process. (This is perhaps Rob's point above)

Interesting blog...
Kevin

timarr said...

Hi Kevin

Terrific response. But, since you insist :)

1. Science can’t answer questions beyond the limits of the universe – before the Big Bang for instance. It doesn’t deal in initial or final states. That’s why most scientists are agnostic, not atheistic.
2. The fine tuning of the universe can be explained by a Creator or by the possibility of an infinite number of universes of which we happen to live in the right one. Occam’s Razor cuts both ways.
3. DNA might look like design but the nerve paths in a giraffe’s neck suggest otherwise. The existence of long, random and useless parts of the genome indicate random mutation not deliberate intervention.
4. Objective morality is based on co-evolution of social traits not design. It’s only objective from our subjective human position.

From a scientific viewpoint I think the weak point could be 2. By which I mean that I can conceive of a scientific, testable hypothesis that might prove this one way or another.

Much of this depends on whether you believe science is just one way of looking at the universe or the only way of doing so. I think there are more things in the universe than science, but I’d never fly in a plane designed by an artist.

ilene said...

A few quick comments in response to the above arguments:

1. the argument that because science can't explain something (yet) doesn't suggest that a supernatural explanation is correct.
a. initial and final states - our brains measure time linearly but there may be no initial and final states, e.g., the way our brains process information limits our ability to understand way more than we think we know.

2-4. generally agree with Tim

My comment: The irrationality that is a core human trait may have to do with vastly more years spent in the evolutionary process of brain development that came before the newer part of the brain that has capacity for some level of rationality (but still very hard to silence the more powerful input of our irrational selves...)

Ilene
at www.philstockworld.com

Anonymous said...

Some more comments

1) I never stated that the supernatural explanation is correct, but since nothing existed before the big bang a natural explanation is simply not in the cards. The only other option is that the universe is uncaused. The question then becomes what is the best explanation.

As for 2 I agree it's a weak point. As for 3, evolution builds upon a replicating mutator and deals nothing with origins. Point 4 is also quite weak. To say we co-evolved objective morals is equivalent to saying objective morals don't exist. If that is the case Hitler's Germany was fully justified in their campaign.

My argument was that we as humans naturally dismiss evidence simply because of our egotistical bias. Thus weather you think your right or not, the four points I listed above do make a decent case for the supernatural.

If rationality has evolved (as ilene presupposes) how can you trust it? That would make science futile.

Personal biases ruin good people.

ilene said...

1) I never stated that the supernatural explanation is correct, but since nothing existed before the big bang

- don't know that


a natural explanation is simply not in the cards.

- again, who knows - a natural explanation may exist that we'll never understand, discover, explain...



The only other option is that the universe is uncaused.

- why not?



As for 3, evolution builds upon a replicating mutator and deals nothing with origins.

origins for biological replication? how about amino acids?



Point 4 is also quite weak. To say we co-evolved objective morals is equivalent to saying objective morals don't exist.

don't think it's equivalent.

If that is the case Hitler's Germany was fully justified in their campaign.

what you're saying doesn't make sense to me.

If rationality has evolved (as ilene presupposes) how can you trust it? That would make science futile.

the idea would be not to trust your "rationality" - which is not what science is based on.

Personal biases ruin good people.

Agreed.

James said...

Hi
Maybe this conversation has moved on, but I've only just found it...
I have a problem with all of the above arising from the simple fact that the term "supernatural" seems not to have been defined. I think it means "things which happen (or are alleged to happen) by means that are not currently explicable by science."
If you accept a definition of that sort, then you either have to accept that events commonly termed "supernatural" could indeed occur or you have to take the position that the only events remaining for science to investigate and explain are those with which it is already conventionally engaged (such as the less-than-obviously rational search for Higgs' boson). The second of these two options seems to involve an arbitrary limitation of scope - I can see no justification for it.
Science needs to accept the challenge of proceeding in either of two directions: (1) by starting with a theory that predicts a certain behaviour and seeing whether that behaviour actually occurs (2) by starting with an observed phenomenon and "explaining" it with maximal parsimony.
There is a subset of supernatural events which people find impossible to reproduce reliably. This may be because they do not occur. We cannot rule out, however, that these events might be real (or at least no less real than Higgs' boson) and that our difficulties in reproducing anything to study are part of the puzzle. This would in passing explain why so many of us have the subjective conviction that such things are in fact real - they happen, not very often, and we can't make them happen.

For example, I could hallucinate an explanation why ESP is so difficult to reproduce, starting from the idea that human performance is largely state-dependent and observing that the appropriate state for high performance in ESP is probably not elicited by sitting the subject in a lab surrounded by strangers with white coats and clipboards. (Elves are notoriously geek-averse, you know). If something like that were the case, an experimental approach would not get off the ground until it had addressed the need to recreate an appropriate state in the "subject". It is not down to the subject to tell the exprimenter what the state is , nor how to elicit it. So many attempts at AI failed because they proceeded by rule-elicitation from experts, based on the assumption that experts used rules, and that they knew how to explain what they were. These assumptions are now thought to be false, although the experts' expertise did not fall into question along the way.

Investigating hard-to-reproduce phenomena requires a very open-minded approach from the experimenters as to what exactly the nature of the experiment might have to be. I don't know for sure, but I doubt whether much, if any, of the investigation of "supernatural" things proceeds in that way.

In the meantime we are left with something worryingly like the average IT Helpdesk approach to most PC problems. We have no idea whether the problem as reported ever existed, but since they rebooted and it went away, we can (sort of) happily ignore it - until next time.