Confirmation Bias, The Investor’s Curse

Behavioral Biases (7): Confirmation Bias

The problem of confirmation bias – the tendency of people to seek evidence confirming an already held opinion and to avoid looking for that which might upset their carefully constructed mental models has attracted a lot of attention from researchers. It occurs across all domains of human endeavour and triggers all sorts of implausible behaviour, yet investors and institutions remain in its thrall.

We find examples in law courts and doctor’s surgeries, in scientist’s laboratories and the lairs of legislators. So we shouldn’t be surprised to find it coursing through the veins of economists and investors, colouring their every thought and structuring their every idea. Of course a rational market participant, faced with a theory built on a crumbling cornerstone will abandon their ideas and look for some new ones. As you’d expect, therefore, we do no such thing, clinging irrationally to the wreckage of our dreams as they collapse around us.

Disconfirming Science

Science is perhaps the area in which we might expect confirmation bias to be least effective. After all, the processes of science are built around the institutionalisation of disconfirmation. New ideas have to run the gamut of envious colleagues who generally hate nothing more than a smart ass and take great pleasure in proving them wrong. Despite this scientists have generally proven remarkably reluctant to give up discredited theories. Indeed science has often proceeded for decades on the basis of ideas that could easily have been disconfirmed had anyone been sufficiently motivated to do so.

So, for instance, the idea that the universe is stable and unchanging was held way into the twentieth century despite the fact that Newton’s laws of gravitation implied something different. To be precise, they suggested that unless the universe was actually expanding gravity should be causing all the bits of matter in the cosmos to hurtle together towards a central point in a manner calculated to render discussions of globalisation, polar bear populations and national debt levels redundant. Yet when Einstein’s theories also predicted an expanding universe he simply made up a special constant, which he later had to ruefully remove, to stop this unwanted behaviour so ingrained was the assumption of a universe in stasis.

See this excellent paper by Raymond Nickerson for a review of the history and guises of confirmation bias. From ancient number mysticism, through witch hunting to government policymaking, medicine, judicial decisions and science Nickerson traces the ubiquitous course of this insidious curse.

A Paradigm Buster

So even when disconfirming evidence is present beyond all reasonable doubt scientists are wary of abandoning a theory in which they’ve invested a lot of time and effort. In fact usually scientists’ first approach is to modify their existing theory just enough to accommodate the anomalous data. Eventually an accumulation of such anomalies forces some people to acknowledge that there’s probably something a tiny bit awry with the underlying concept, opening the way for a paradigm shift – a radical change in the way that a idea is thought about.

Now given that science is the one area of human endeavour where you might expect confirmation bias to be conquered this doesn't bode well for less well policed disciplines. To take this idea to its extreme conclusion there’s even a suggestion that researchers into confirmation bias are themselves selectively choosing their theories to fit the evidence.

The standard explanation for these biases is motivational – people are motivated to find facts to fit their own theories, to maintain consistency of their internal concepts. Yet an alternative view is that people make these mistakes because their cognitive capabilities are limited – we’re only capable of thinking about one thing at a time, and we just don’t have the bandwidth to handle alternatives.

While both these factors probably have some involvement it seems to me that a trait like this which tends to bias people in favour of things they're attached to like a political party, a religion, a sports team or a nation would have an adaptive advantage in generating social cohesion. Anything that made people stick together in a social group is likely to have been beneficial to proto-humans in a dangerous world.

Wason’s Rule Discovery Test

The classic confirmation bias task is the Wason Rule Discovery Test. In this participants are presented with a series of numbers, told that they follow a certain rule and asked to figure out what it is by choosing further sequences of three numbers. The sequence given is 2, 4, 6: what’s the rule?

Pretty much everybody forms some hypothesis and asks questions to confirm it but very few people end up figuring out the correct answer which is any three numbers in ascending order. The reason this is so difficult is that most people don’t ask questions to disconfirm their hypothesis because they’re not trying to break their own rules. This seems to be a fundamentally difficult thing for humans to do, and this difficulty has implications for every area of human activity, not the least of which is investing.

Cocooned CEO's

Many executives of companies, cocooned in their own little worlds and rarely receiving negative feedback, develop their own intransigent views that are impervious to disconfirming evidence. Stuart Sutherland in Irrationality has a telling anecdote:

"I gave an oral presentation of my results to a party from the distiller's company, which was headed by the managing director ... When I said anything with which he agreed, he would turn to his colleagues and announce ..."Dr Sutherland's a very smart man. He's absolutely right. When, however, my findings disagreed with his own views, he said, "Rubbish, absolute rubbish." I need never have undertaken the study for all the notice he took of it".

We’ve all met people like this and the more remote they are from the real world and their customers the more likely they are to behave like complete idiots. Managements that completely isolate themselves from their end users should be treated with caution – nothing keeps you grounded like an annoyed customer.

Disconfirming Economics

Economics itself is suffering from a paradigm shift as traditional economics tries to adjust to the onslaught of behavioural psychology. Many of the old theory’s defenders prefer to point out the failings of the new approach – which are many and manifest – yet leave unanswered the very real issues that the errors of economic policies have engendered. To argue, as they do, that behavioural finance isn’t founded on any underlying theory and that it’s often contradictory is fair enough. To suggest that this is grounds for ignoring it isn’t.

Traditional economists are attempting to rescue their discipline in the age old fashion, by tweaking their models to attempt to accommodate the new data. The difficulty with this approach is that if the underlying ideas of behavioural finance are even roughly correct this attempt to save the old models is bound to fail. Behavioural biases such as confirmation bias will inevitably cause people to behave in non-Bayesian (that is, non-rational) and, even worse, unpredictable ways as the plastic brain adapts to the ever-changing world.

The inability of behavioural finance to generate predictions on a grand scale is one of the accusations levelled at it by its detractors. However, the fact traditional approaches do generate predictions isn’t a saving grace, given that these predictions usually turn out be horribly wrong just when you need them. Better a model that doesn’t give you false confidence in the road ahead than one that continues to confidently send you across the shaky bridge of debt over the chasm of economic doom.

Beating Bias, Being Biased

Individual investors can, at least, attempt to counter confirmation bias. A simple grasp of decision trees is a useful tool which at least force people to consider some alternative scenarios. Another approach, as we’ve discussed before, is to build feedback mechanisms into your investing techniques.

Of course, the perceptive readers of this journal will note that its pursuit of a theory that economists from the traditional background are plagued by the incommodious effects of a confirmation bias against behavioural finance is itself evidence of confirmation bias. To deny this is futile, guilty as charged. But of course, just as sometimes there really is someone out to get the paranoid so sometimes the irrationally confident really are right. Often it’s better to be lucky than smart.


Previous Article: Recency: Hot Hands and the Gambler's Fallacy

Related Articles: A Sideways Look At ... Behavioral Bias, So What's Behavioural Finance Ever Done For Us?, Bulletin Boards Are Bad For Your Wealth

Gambling, From Iowa to Soochow

Bodies and Brains

One of the more convoluted and, to the majority of the world, boring arguments among psychologists is around the extent to which we use our brains to learn. Of course a commonsense view has it that brains are fairly essential things for learning type activities but there’s also a view that bodies have a part to play as well.

Through a series of convoluted jumps this takes us from William James' research on phantom limbs, through the Somatic Marker Hypothesis and onto the odd findings of the Soochow Gambling Task. On the other, less invisible, hand it might be better for all of us if I simply skip to the nub of the problem: investors are addicted to gains, so much so that they’ll happily make overall losses just as long as they make lots and lots of small wins along the way.

From James to Damasio

To cover some history, albeit briefly, the idea that there’s more to life's experience than simply triggering activity in the brain has been around since before William James wrote The Consciousness of Lost Limbs in 1887. The sheer number of American Civil War amputees experiencing phantom limbs suggested to James that the body was more than simply a complex vessel for carrying about the brain – the body was, in effect, the way the brain experienced the world and, if the brain decided that it didn’t like the way the world was being experienced it was liable to change the way it regarded it.

Antonio Damasio is probably the most famous modern exponent of such theories and his Somatic Marker Hypothesis is, to cut a very long story short, a modern day neuroscientific version of James’ ideas. The body and the brain are intimately linked – the body experiences the world, the brain interprets the experiences and lays down so-called somatic markers which bias future interpretations and the body reacts. Emotions are the result of the combination of the experiences and the interpretation and, as Damasio has shown, people who don’t have emotions – usually because of brain injuries – don’t behave in ways we’d consider rational.

The Iowa Gambling Task

Rationality is, as usual, at the heart of this but the idea that people behave less rationally when they’re less emotional is, well, odd. As we’ve seen before, in Unemotional Investing is Best and Get an Emotional Margin of Safety, Damasio has shown that emotionally damaged people make better investing choices under ambiguous conditions than their uninjured counterparts. However, this comes at a price – in the real world such people are also likely to fail to appreciate situations of real danger. Somehow emotion is integrated with rational behaviour – which is a bit of a surprise really when we consider how emotional responses tend to destroy investors’ returns.

The classic experiment demonstrating this mind-body link is known as the Iowa Gambling Task. Participants are given a wad of cash to gamble with and need to take a card from one of four decks. Two of the decks are “bad” in that if you choose from them consistently you will lose $250. Two of the decks are “good” in that if you choose from them consistently you will win $250. Note, however, that the way you win or lose your $250 differs – deck A (loser) and deck C (winner) have 5 gains and 5 losses while deck B (loser) and deck C (winner) have 9 gains and 1 loss.

The results seem clear cut – the uninjured participants learn, after about 40 draws, to avoid the bad decks. The brain damaged participants don’t ever really learn. In addition the participants were wired up to a lie detector, measuring their physiological reaction to making a choice. The uninjured participants started showing a reaction to choosing from a bad deck after only 10 card flips but could only consciously report this after 50 card flips. Overall, this seemed to show that emotional responses are needed to help make decisions under risky conditions and that the bits of the brain that signal risk are engaged way before we are consciously aware of them.

From Iowa to Soochow

Now, if you’ve been following this journal you’ll probably have an uneasy feeling that there’s something not quite right about this, but not be able to put your finger on it. Largely, no doubt, because there are no free lunches in behavioural finance and partly because the ability of uninjured participants to learn to anticipate risk doesn’t seem to accord with the findings of Prospect Theory and Mental Accounting: normally investors are short-sighted, yet the Iowa Gambling Task suggests that they’re looking at long term outcomes.

You’d be right, of course.

More detailed analysis of the results revealed that the experimental design was potentially flawed. Although the overall results showed uninjured participants preferring the winning decks in aggregate the singly most preferred deck was one of the losing ones: deck B with 9 wins and 1 loss, but with the loss a mammoth one. So, is there anything else we can think of that resembles lots of small wins, alternated by the occasional whopping loss?

The Soochow Gambling Task

A group of Taiwanese researchers analysed and modified the Iowa Gambling Task in what’s now known as the Soochow Gambling Task (see also this research) and proposed an alternative explanation to Damasio’s hypothesis – one that is nothing to do with somatic markers and everything to do with the relative frequencies of wins and losses. The relative preponderance of wins in deck B was biasing people towards it. In simple terms, the more times they won from that deck the more likely they were to stick with it. The researchers went on to confirm their results in a later study.

This, of course, looks a hell of a lot like the typical loss aversion biases associated with stockmarket investors, a suggestion confirmed by a study of decision learning models by Ahn and colleagues. Typical loss aversion sees investors selling winners for small amounts and holding losers for large losses – both behaviours due to an attempt to avoid losses. Perhaps even more relevant are myopic loss aversion tendencies where investors discount the probability of extreme rare events to zero and then see years of small gains wiped out by a single, catastrophic market crash for which they’re psychologically unprepared.

Fascinatingly even when they pointed out the potential problems with high frequency winning decks participants continued to insist that they’d choose cards from those decks. Again, this seems uncannily like the behaviour of stockmarket investors choosing to chase gains knowing that they're bound to go wrong eventually but expecting, or hoping, to flip their winners before calamity strikes.

Accidental Behavioural Finance?

The especially interesting thing about the outcome of the Soochow Gambling Task is how it appears to validate behavioural finance completely by accident – an experiment originally designed to look at the difference in rational analysis between people with and without certain types of brain injury has produced evidence pointing in a completely different direction.

Although the original Iowa Gambling Task has led us away from the result originally expected – and noting that the alternative explanations are not without their critics – there is still plenty of evidence linking decision making and emotional states. It couldn’t really be any other way, we’re emotional in order to aid real-life decision making, not to prevent it. As long as our emotions help us get it right more often than not – and leaving aside what ‘right’ means in this context – then that’s as good as it gets. Just don’t expect your emotions to help you be a better investor, they won’t: the stockmarket is not real-life as we're designed to expect it.


Related Articles: Get an Emotional Margin of Safety, Loss Aversion Affects Tiger Woods, Too, Unemotional Investing is Best

Freedom Of Financial Choice Is A Myth

Finance Isn't Child's Play

As we’ve navigated the nether regions of investing folklore like a drunken Frankenstein’s monster in search of a late night high cholesterol snack you may have formed the opinion that this author is somewhat sceptical of all investment processes that don’t explicitly guard against human psychological perversity and highly doubtful that those that do can overcome ingrained biases and an industry dedicated to causing us to do exactly the wrong thing at exactly the wrong time. Still, scepticism isn’t cynicism, and along the way we’ve found one small chink of light in the gloom; the finding that if you give people a financial education early enough in life it improves their money management.

Well, for all you folks out there preparing to send little Jimmy and Jemima to financial summer school don’t bother, because you’d be better off giving them your credit cards and dropping them at the nearest mall for a day. Sadly educating our kids about money doesn’t improve their investing decision making. In fact there's a pretty strong argument that nothing does and it's time to stop blaming people for allowing themselves to be exploited: the idea that everyone can be a financial expert is a myth. Time for a different approach?

Does Educating the Under 16's Help?

Back in Financial Education Doesn’t Work we looked at the research showing that training in financial matters doesn’t improve peoples’ money management. Indeed, sometimes it makes things worse. However, some of the research in this area suggested that if you can give under 16’s some economics education the long-term effects of this are strikingly beneficial.

The key research in this area was from Bernheim, Garrett and Maki who showed that mandates requiring schools to provide personal finance education were correlated with higher levels of savings later in life. Teasing this information out wasn’t easy because we’re talking about periods of decades between the education being provided and the savings being accumulated. Such long term research, known as a longitudinal study, is notoriously difficult to run simply due to the elongated periods over which it must be conducted and the likelihood of the participants doing odd and unreasonable things like dying or developing an obsession about the end of the world and hiding out in a mountain cave with enough baked beans to float a balloon.

Education Doesn't Help Financial Literacy

In contrast to the Bernheim, Garrett and Maki findings the Jump$tart Coalition for Personal Financial Literacy has run surveys of US high school seniors since 1997 and have shown a distressing fall in financial literacy. In essence, the financial education which is supposedly fresh in the minds of those groups of young people about to launch themselves into adulthood doesn’t seem to have stuck. This is a replication of a finding seen in other contexts – most notably that the financial understanding of economics students declines following financial training. The summation of the findings is provided in this report by Lewis Mandell, who also provides a much more detailed review of the work in this area than I have space for.

Now the Jump$tart findings clearly matter because if we can’t find a way of educating people about financial matters then we’re pretty much stuck when it comes to improving the financial services industry. If humans can’t understand the basics of compound interest, credit card costs, index tracker fees and variable rate mortgages then they’ve absolutely no chance of grasping the essence of mean reversion, stock valuation and exotic derivatives. Although, to be frank, it’s not actually clear that anyone really understands the latter: the suspicion is that many of these acronymic weapons of wealth destruction are generated by a computer programmed to spit out random numbers and are fronted by actors with weird hair who specialise in misdirection. Seems to have worked so far.

Financial Education Can't Work

In fact there’s worse to come, because if we can’t find a way to educate people and we can’t overcome the implicit biases within the financial advisory industry then we’re more or less forced to go back to the drawing board and start redesigning financial products so that people can’t make mistakes. Lauren Willis in Against Financial Literacy Education puts it thus:

"The gulf between the literacy levels of most Americans and that required to assess the plethora of credit, insurance, and investment products sold today—and new products as they are invented tomorrow—cannot realistically be bridged. Educators would need to impart a sophisticated understanding of finance because rules of thumb are not useful for decisions about complex products in a volatile market. Further, high financial literacy can be necessary for good financial decision making, but is not sufficient; heuristics, biases, and emotional coping mechanisms that interfere with welfare-enhancing personal finance behaviors are unlikely to be eradicated through education, particularly in a dynamic market. To the contrary, the advantage in resources with which to reach consumers that financial services firms enjoy puts firms in a better position to capitalize on decision making biases than educators who seek to train consumers out of them."

Bascially, the average human being doesn’t stand a chance in today’s complex financial markets and financial education isn’t going to solve the problem. Willis’ paper is brutal about the financial education model believing that it enshrines a myth about consumer self-reliance that then allows those self-same consumers to be blamed for their greed when everything goes wrong. If this model is fatally flawed because people can’t learn this stuff then the whole idea of consumer self-sufficiency in financial markets needs to be rethought, which ultimately leads to some pretty serious questions about the nature of those markets and their regulation. Perhaps most cuttingly Willis observes:

"That [the financial] industry supports financial literacy education is, while indirect, perhaps the strongest evidence that this education is not effective in improving consumer financial decisions"

Factors in the Failure of Financial Education

Four main factors preventing the success of financial education programs are identified:

1. Information Asymmetries and Chasing Moving Targets. Put bluntly, there’s simply too much choice in the marketplace, and the development of niche targeted products worsens the problem as they’re marketed to people outside of their original niches. No one can possibly cope with the complexity of the range of financial products in the market.
2. Insurmountable Knowledge, Comprehension and Numeric Skill Limitations. People simply don’t have the basic skills needed to even begin to understand the nature of the products that they’re being offered. For example, Willis quotes the research showing that after 40 years of use only 10% of consumers have any understanding of what an APR is.
3. Poor Conditions for Debiasing. Cognitive biases, as we’ve repeatedly seen, drive people into wealth destroying behaviours and the nature of financial markets provides a poor environment for overcoming these. Indeed, financial education can create an illusion of control and lead to unwarranted overconfidence in financial decisions, with predictable results.
   
4. Reaching Consumers at Teachable and Vulnerable Moments. A “teachable moment” is one at which a person is particularly receptive to the education on offer. For financial education this would normally be when an important decision is being made – buying your first house, acquiring your first credit card, etc. Willis argues that these moments are the points at which lifelong preferences are generated and then that they’re more likely to be set by the deep pockets of the financial services industry than by educators.

Don't Bother With Financial Education

The conclusion is depressing:

"Given the foregoing, the failure to find any empirical evidence that the financial literacy education model works is not surprising. In light of the velocity of change in the consumer credit, insurance, and investment marketplace, the innumeracy of much of the population, the prevalence of decision making biases, and the financial advantage held by sellers of financial products, financial literacy education should not be expected to work."

Given all of this what should we do? Well that’s a question for another day, but if interested parties want to avoid blaming the financial industry for the screwing up of pretty much everything then their only route out is through financial education – because only then can they continue to censure individuals for their mistakes, rather than acknowledging the widespread deceit that lies at the heart of the problem. Fact is, swamping people who have low levels of financial literacy – which is the majority of us – with a vast array of over-complicated products designed to feed their innate biases is just a cast iron way of ensuring another financial crisis is lurking just around the corner.


Related Articles: The Lottery of Stockpicking, Financial Education Doesn't Work, Save More ... Tomorrow

Pulling Up The Intellectual Property Ladder

Tragedy of the Anti-Commons

Human ingenuity has been behind much of the economic boom that the world's undergone since the late eighteenth century. Sparked by the rise of reason in the form of deepening scientific knowledge and backed by increasingly large flows of capital there’s been an ever increasing range of ideas and inventions, some of which have even added to the sum of human happiness. I was particularly taken by the motorised ice-cream cone.

Behind this sparkling cascade of cleverness lies the ability of inventors to temporarily protect their inventions from competition by use of intellectual property rights – patents, copyrights and so on. Unfortunately, as we move forward, these monopoly rights may, in some cases, actually result in a slowing of progress as we increasingly face the Tragedy of the Anti-Commons.

From Monopolies to Patents

The development and evolution of patent laws stretches back hundreds, if not thousands, of years. We know that the Ancient Greeks granted temporally limited monopoly rights on particularly tasty recipes which seems to suggest that the modern cult of the celebrity chef isn’t so modern after all. By 1331 we find Henry VI of England granting John Kempe and his Company a patent in respect of the textiles industry. In fact this appears to have been an early attempt to attract skilled foreign workers to England rather than a reward for genuine innovation. Nearly seven hundred years on we're still bribing scarce overseas workers to come here rather than fixing our education system.

Something like the first proper patent was granted in 1422 in Florence to the architect, genius and key Renaissance figure Filippo Brunelleschi for a barge with hoisting gear. In 1449, in England, John of Utynam received a 20 year monopoly to make stained glass and in the following year the Republic of Venice created the modern patent, mainly to protect its native glassblowing industry, presumably to stop England pinching all of its skilled workers, another continuing trend.

Patents were systematically abused by money-grabbing monarchs, particularly in England where the rulers were always short of money, granting monopolies for even commonly used stuff like salt and coal. Eventually the English, as is their wont, revolted and forced the introduction of the Statute of Monopolies in 1601, which is really the start of the modern patent system, as it enshrined the novel concept that the idea had to be new, rather than simply purloined, in order to be awarded a patent.

Monopoly Rewards

That patents and other intellectual property rights have had a beneficial impact on economic growth is beyond dispute. By ensuring that an inventor has a limited time to exploit their idea the system rewards innovation, encourages exploitation and eventually gives the rest of the world free access to the accumulated wisdom of the ages. However, as we can see, patents are closely entwined with monopolies and anti-trust issues, which means that these rights need to be carefully managed if we’re all to benefit properly.

Underlying the awarding of patents is the idea that they’re a public good – the benefit of the temporary monopoly outweighs the downside of monopolist price gouging. This isn’t always an easy coupling – particularly as we’ve seen with large pharmaceutical companies demanding first world prices of third world countries for treatments for diseases like AIDS. On one hand, without the excess profits that come from patent exploitation these corporations have no reason to invest the billions of dollars that they do. On the other, denying millions of sick people drugs that could usefully extend their lives is morally objectionable.

There isn’t an easy solution to the problem and the resulting mess where governments have effectively forced the drugs companies to sell to them cheaply will almost certainly result in less investment in treatments for diseases targeted at those countries. It’s not a happy situation.

The Tragedy of the Anti-Commons

However, there’s another more insidious problem with patents and the ever-increasing pace of innovation. This was first pointed out by Michael Heller, who’d been puzzling over why there were so many empty stores in ex-communist countries despite the fact there was obviously huge demand for retail space. Drawing on Hardin’s idea of the Tragedy of the Commons, where property owned by no one is ruthlessly exploited to the detriment of all – think overfishing of deep sea stocks or pollution of the air we breathe – he postulated the idea of the Tragedy of the Anti-Commons.

The problem in Moscow and other Eastern European cities, it turned out, was that the ownership of the property rights for the stores was widely distributed between lots of different groups each with different agendas. The sheer difficulty of getting these disparate parties to agree on something that would have been beneficial to all of them meant that the stores stayed empty while open air booths sprung up in front of them.

Technology Patent Anti-Commons

Since Heller postulated this idea it’s been suggested that a similar problem exists for modern corporations attempting to develop new technologies. The issue comes because, increasingly, any new device requires the use of hundreds and possibly thousands of patented inventions: even the humble CD player requires at least a dozen licences, a microprocessor needs thousands. It only takes a single hold-out to prevent the possibility of a useful advance in technology.

As the pace of technological innovation has increased the sheer impossibility of avoiding patent infringement has increased. The dispute that nearly shut the Blackberry network down is caused by a single disputed patent in a device which uses thousands. Nokia is now suing Apple over ten patents on the iPhone – no doubt they’ve been trawling their patent library for months to find these and, doubtless, there are many more to be found around the world.

Biomedical Patent Anti-Commons

Another area where the spectre of anti-competitive problems arise due to anti-commons issues is in biomedical research, particularly where commercial organisations are patenting human gene fragments and other fundamental biological intellectual property. This is likely to prevent further useful exploitation of these discoveries because in order to test the effectiveness of any treatment it may be necessary to test the whole spectrum of the human genome. By splitting it up into ever greater groups of patents owned by differing parties it may become impossible to effectively conduct medical research.

While we might expect that the market would find a way of solving these issues – say as the music industry has by developing groups holding copyright for lots of artists – simple behavioural biases may restrict their development. Hewson and Eisenberg suggest that the problem we have estimating the likelihood of low probability events of high importance to us and the associated issue of tending to overvalue stuff we’re committed to – essentially facets of the availability heuristic and commitment bias – may prevent the effective resolution of anti-commons intellectual property disputes.

Basically the problem is that any patent which leads to a new treatment for something important – cancer or AIDS, say – will obviously be immensely valuable and the patent holder won’t want to give this up cheaply. Unfortunately no one can know in advance which patents will be valuable and which won’t so you end up with asymmetric valuations on the part of patent holders and potential licencees. The result being deadlock.

The Growth of Patents

The pace of patent creation is increasing – it took 18 years for the first 250,000 patents to be filed under the global Patent Co-operation Treaty, a further four years to double that and a further four years to double it again. Anti-commons issues are only going to grow and as patents and other intellectual property are central to the economic progress of the planet anything that can impede it is a cause for concern.

However, using patent disputes to disrupt parts of the global telecommunications network that people rely on, or to control access to parts of the human genome, may bring the system into disrepute if not handled carefully - a case of the owners pulling up the Intellectual Property Ladder behind them to the detriment of all. It's often suggested that we're in an age in which information is power and certainly the ownership of critical patents is going to be increasingly valuable to corporations and individuals. Learning to exploit that power wisely may be the biggest challenge of the Information Age.


Related Articles: The Tragedy of the Financial Commons, Black Swans, Tsunamis and Cardiac Arrests, Akerlof's Lemons: Risk Asymmetry Dangers for Investors

Basel, Faulty?

Containment, Not Cure

The international banking regulations known as the Basel II Accord have come in for some stick, given the fallout from the banking crisis of 2008. This is, on the face of it, a bit unfair given that Basel II hasn’t yet been fully implemented in most countries and anyway was designed to try to head off some of the problems that have occurred.

Still, most observers reckon that Basel II wouldn’t have prevented the crisis and the tendency of regulators, like generals, to fight the last war means that proposed changes won’t help. Whatever causes the next crisis it won’t be the same as the last one and while regulators are busily building a Maginot Line to stop one kind of problem they’re unlikely to notice that they’re also incentivising banks to invade Belgium, or at least find a way to go around the new regulations. We need a new kind of regulation, one that recognises we can’t stop the disease, but that it can be contained if we act quickly enough.

Predicting the Future from the Past

Basel II aims to monitor risk using models like Value-at-Risk (VaR), which provides a way of estimating the probability and size of a potential loss in a given period. Individual banks are required to report their daily VaR’s to regulators and need to undergo back-testing of their VaR models to ensure that their actual returns are within scope of what they predicted. Failure to get this right leads to requirements to hold additional capital.

Generally banks hate being made to hold additional capital because it reduces the amount they can lend and therefore reduces their profits or, to put it another way, increases their costs. This is also a drag on economic growth as less lending implies less investment. So banks have every reason to try and avoid Basel II capital penalties. And therein lies a problem, because where there’s an incentive there’s an opportunity for a loophole.

The Scale of the Crisis

Leaving loopholes aside for a moment, the scale of the recent financial crisis underlines the problem with using risk models like VaR baselined against historical data. The figures are genuinely extraordinary. In the 58 years prior to the recent financial crisis the S&P500 had only experienced 4%+ gains on 24 days yet in the six months afterwards there were another 12. Prior to the crunch the index had lost over 4% on only 18 occasions but during it there were no less than 15 further drops of 4% or more. Do we really need any more crises to prove that history is a truly rotten way of assessing risk?

As we’ve seen before, disaster myopia means that we continually discount the probability of rare events to zero. Clearly the probability isn’t zero and that means that historical data doesn’t give us a great insight into what will happen tomorrow when it really matters. The fact that Basel II wasn’t in place mandating the use of VaR didn’t make much difference, because most banks were using it anyway, thus helping to co-ordinate their failures. On top of this backtesting of different VaR models shows significant variation over time in their success rates - some models perform better under normal conditions, others under stressed conditions. So all we have do now is detect when normal turns into stress and we're OK.

Of course, if we knew that we wouldn't need the models. D'oh.

Dealing With The Aftermath

The trouble is that these types of crises are always just around the corner and the emphasis in financial regulation in trying to stop them happening is necessary but nowhere near sufficient. As the researchers here argue, having Basel II with VaR forecasting in place, and all of the other paraphernalia it specifies, wouldn’t have prevented the financial crisis and may have exacerbated it. Whenever regulators put rules in place that imply a cost to the regulated then the latter will be incentivised to find a – legal – way of circumventing them.

No, the real challenge for financial regulators is how they deal with the aftermath of a financial crisis. They can’t stop them happening because they’re behaviourally induced and you can’t regulate human nature. However, they can mitigate them once they’ve occurred – with the right sort of regulation.

Leverage and Capital

Although the latest crisis can be traced to issues of excessive leverage, much of it designed to get around regulatory requirements to hold risk capital, and perverse incentives for executives and managers, it’s been the problems that occurred after the first onset of trouble which have created the wider financial crisis. Oddly enough it was the application of regulatory rules that fuelled these after-the-event problems – financial regulation designed for a placid environment helped to fuel the storm when things got rough.

At issue is the need for banks to hold capital in reserve to offset loans. This is perfectly sensible – all banks need to have a buffer of ready cash or equivalents in case of the need to pay it out. The larger the loan book, the larger the cash reserve needed. Unfortunately when banks suffer losses this eats into their capital reserves. At this point they have two options. Firstly they can raise more capital through equity markets. This, unfortunately, is a difficult and expensive option when they’re making losses and can further undermine confidence – the last thing a struggling bank needs.

The second option is that they can reduce their lending base – or sell risky assets, which amounts to the same thing. In the short-term wake of a financial crisis this is usually the option taken, but it has two significant and very nasty knock-on effects.

Exporting Externalities

The first of these is termed the fire-sale externality. In desperation a bank sells its risky assets to raise capital and manages to stabilise its financial position. However, this has a knock-on effect because the effect of the fire-sale is to reduce the value of the assets being sold, which will reduce the value of other banks' assets, placing their capital position in jeopardy. A domino effect can then ensue.

The second knock-on effect is termed the credit crunch externality. If the bank needs to shrink its capital requirements it may do so by reducing lending to parties far removed from the initial problems. So, for example, small business lending may be restricted. Well managed businesses may be forced to forego viable projects or even fail entirely for lack of funding.

In such ways the bank’s problems are exported to innocent third-parties and the costs of this behaviour, although directly traceable to the bank’s failures, are borne by these external entities. Hence, why they’re called “externalities”. For a wider, and thoughtful discussion of these issues, take a look at Rethinking Capital Regulation, by Anil Kashyap, Raghuram Rajan and Jeremy Stein: it's a lucid and wry analysis of the issues before, during and after the crunch of 2008.

Managing The Market Failure

It’s fairly easy to see that from the point of view of the entire market and, indeed, the wider economy the best thing for the bank to do when faced with this kind of crisis is to recapitalise – to go to equity markets and raise fresh capital, diluting existing shareholders. This prevents the crisis from being externalised and ensures that the costs of the problem falls where it should – on the shareholders who’ve failed to keep a handle on the mismanagement of their company by its executives. However, this comes with its own problems, due to reputational risks and the real possibility of a run on a compromised bank.

Unfortunately this type of market failure is one that classical financial regulation quite fails to address – and indeed, it even encourages it, by focussing almost exclusively on ensuring that banks have sufficient capital to remain solvent while ignoring the wider agency costs of how they go about doing this. Alongside this is the problem that any capital regulatory scheme promotes incentives to find ways around it. For example Collateralised Debt Obligations were successful precisely because they enabled banks to avoid onerous capital requirements: the low cost of capital ensured that they were excessively profitable which, in turn, encouraged executives to push this particular boat out until it pretty much sunk the world economic system.

Regulate for Containment

Modifications to Basel II are being made and these are doubtless needed to reflect the learnings of the latest debacle: tools like VaR have their place, as long as we don't end up relying on them unthinkingly like many senior bank executives did prior to the last crisis. However, significantly increasing the capital requirements on banks would have the effect of making the current problems worse, draining much needed liquidity from the global economy.

More is needed and it’s needed in different places. History tells us, beyond all reasonable doubt, that there will be more financial crises afflicting banks in the future. It also tells us that we don’t have a clue how or why these disasters will occur other than it will come through some unexpected combination of financial innovation and human behavioural bias.

But when the next crisis does happen we do know what banks will do. They’ll sell assets and shrink lending and export the crisis to other parties as fast as they can, generally acting with less social responsibility than a dodgy Torquay hotelier. This is where the regulators and legislators need to look: force banks to pay the price of their own ineptitude and make sure they can’t easily externalise their problems. Next time let’s use financial regulation to contain the crisis, not fan the flames: let's aim to fight the next war, not the last.


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Adam Smith’s Monkey Business

The Theory of Moral Sentiments

Before Adam Smith got round to inventing economics in The Wealth of Nations he invented social psychology in The Theory of Moral Sentiments. Under Smith’s synthesis it’s sympathy that’s the glue that brings people together, underpins human morality and drives the engine of economic progress. Without fellow feeling there’s no basis for any kind of exchange, whether of simple gifts, bodily fluids or physical goods.

Smith, of course, was a man way ahead of his time. However, it’s still rather remarkable to discover it’s taken to the twenty first century to uncover the evidence that his intuition was not just correct as a theory of economics but is actually built into the structure of our brains. If you’ve ever bounced out of a feel-good film, full of effervescent vim you’ll know exactly what Smith was on about: we’re designed for sympathy and thus built for trade.

Morality First, Economics Second

It’s perhaps a bit of a surprise to find the father of modern, blood-on-the-streets, every man for themselves capitalism writing a book about morality but for Smith there was a clear path from the way people regard each other in a moral sense to the way they interact with each other in an economic one. He would have been appalled by the modern craze for attempting to put an economic value on everything, recognising that the human willingness to offer assistance out of sympathy was the underpinning of the business of trade. Economics is built out of moral sympathy not the other way around: morality isn't accountable to markets.

We can adduce the path of Smith’s thought through the simple observation that Moral Sentiments was written first, the necessary precursor to understanding Wealth. Without an appreciation of why people do what they do, out of self-interest and driven by sympathy, it’s impossible to understand the true meaning of the latter book. It’s not a peon of gung-ho, every man for themselves raw blooded capitalism but a natural extension of the basic moral instincts arising from within each of us.

The idea of sympathy with others is founded in self-interest, one of the driving principles of Smith’s philosophy. Innate sympathy, the ability to empathise with the emotions of others, is not opposed to self-interest but helps to fuel it. Recognising the desires of others we can exchange favours or gifts to encourage social relationships which may benefit us in the future. Through the same approach we can develop business relationships which capitalise on the same feelings and form the basis of mutually beneficial trade.

The Invisible Hand

It’s unsurprising, therefore, that it’s in Moral Sentiments that the idea of the invisible hand first appears, as Smith explains how pure self-interest leads to the benefit of all of society:

“... In spite of their natural selfishness and rapacity, though they mean only their own conveniency, though the sole end which they propose ... be the gratification of their own vain and insatiable desires, they divide with the poor the produce of all their improvements. They are led by an invisible hand to make nearly the same distribution of the necessaries of life, which would have been made, had the earth been divided into equal portions among all its inhabitants, and thus without intending it, without knowing it, advance the interest of the society.”

From an unreconstructed socialist we might regard such statements as utter nonsense but coming from the father of capitalism it gives pause for thought. Underpinning this is the idea that humans have the ability to instinctively project their own feelings onto other people, in order to understand and sympathise with them. We have an uncanny capability to read the minds of others, albeit imperfectly, using what psychologists call “theory of mind”. People without this ability are generally socially inept and often unable to operate effectively in society – autism is, perhaps, the most extreme example of such problems.

Mirror, Mirror, In the Mind

So, somehow, we have the ability to mirror the feelings of others, or, as Smith put it “... is the impressions of our own senses only, not those of his, which our imaginations copy. By the imagination, we place ourselves in his situation.” Which, of course, is a fantastic analogy. Only it turns out it’s not really an analogy, because we really do mirror the emotions of other.

Back in the early 1990’s Giacomo Rizzolati and colleagues were experimenting with monkeys using electrodes embedded in their brains to figure out how and when certain motor neurons fired when the animals picked up food. This is perfectly understandable – when you physically move then the neurons fire in order to create the stimulus to make the motion. What surprised the researchers is that the neurons also fired when the monkeys observed someone else eating – this “mirror neuron” system was recognising the action and firing – in sympathy.

You can see where this is going now, right?

Human Mirroring Systems

There is now lots of research about mirror neuron systems which have been extensively studied in monkeys, who are frankly getting fed up with people chasing them around trying to stick electrodes in their heads, regarding this as demonstrating a lack of sympathy with monkeys. However, less intrusive scanning systems have now shown similar patterns of human neuron activation analogous to those in monkeys implying – although not proving – that we use similar methods to model the feelings of others: a real-world implementation scheme for theory of mind.

Like so much of neuroscience this isn’t uncontroversial. It’s one thing to demonstrate a neurological effect but entirely another to map this onto complex higher functions, so there’s lots of debate about how mirror neurons work, how they acquire their mirroring capabilities and even whether they exist at all. Psychologists have long ago learned to be suspicious of functional descriptions being imputed from limited physiological evidence – back in the nineteenth century scientists were happily measuring head size to show that men were more intelligent than women, white people were smarter than coloured folk, northern races more highly evolved than southern ones and rich people more gifted than poor ones.

Funnily enough all of the researchers were rich, northern, white males. Strangely the data usually proves whatever point the theorist wants proved.

Monkey Business

Nonetheless (note carefully the big step in a single word) investigations on understanding intentionality and empathy by multiple researchers implicate the mirror neuron mechanism. These are the very functions Adam Smith adduced way back in 1759. Intentionality and empathy are the components of sympathy that make us able to recognise the needs and aims of others. Through our own self-interested natures we take these basic features and build our concepts of social justice, interaction and, of course, trade and therefore business.

That it took the best part of 350 years for us to even gain an insight into how this theory might actually work tells us a couple of things. Firstly we still have a lot to learn from the father of economics about the mechanisms of why we engage in business at all. Secondly we maybe need to unpick some of the more extreme economic ideas that assume that the value of everything can be measured with a price. Some things are invaluable and sacrificing our feelings of moral sympathy to the great god of market capitalism is to invert Smith’s great idea. People are here to guide markets, not the other way around.


Related Articles: Stocks Aren't Snakes, Moral Corporations, An Oxymoron?, When A Dollar's Not Just A Dollar

The Psychology of Dividends

Dividends Can’t Matter - Rationally

One of the more amusing failures of classical economics is its inability to explain why companies pay dividends. The Miller and Modigliani (1958, 1961) synthesis shows that rationally dividends are irrelevant to a corporation’s valuation: after all, if you give investors some of the company’s earnings then the company should be less wealthy to the same degree that investors are more, so there’s no net gain for shareholders.

Which is all nice and theoretically sound in the hermetically sealed world of rational economics but, unfortunately, when companies cut dividends their valuation usually drops, often quite dramatically, and when they raise them significantly the opposite happens. As usual, out in the real-world, it’s what people do, not what economics dictates, which rules.

Give and Take

The rational analysis of the irrelevance of dividends is perfectly grounded in straightforward economics. If I own a share which gives me access to $2 of a company’s earnings and the company gives me $1 directly then the company’s share price should drop by $1 and I will be $1 personally better off (minus taxes). So all things being equal a dividend should be irrelevant.

In fact dividends may well be damaging to a company’s prospects. If instead of giving me $1 the company invested it in product innovation, or marketing or an earnings enhancing acquisition (no laughing, please) it will be able to grow its earnings more quickly. I, the shareholder, benefit with a more rapidly increasing share price. If I want some of this for my own personal consumption I sell some stock.

Of course, large and mature companies may not be able to find sufficient earnings enhancing opportunities and so, all things still being equal, may decide that returning excess earnings to shareholders is the best thing. Again dividends aren’t the only way of doing this, although as we discussed in Buyback Brouhaha the main alternative – stock buybacks – is shrouded in managerial deceit and accounting opaqueness in a way that dividends aren’t. Although buybacks may be more tax efficient, depending on your taxation jurisdiction.

Dividend Signalling

So there are valid reasons for dividends, even if the classical view states that this won’t benefit shareholders directly. At least returning cash to shareholders allows us to redeploy these into other opportunities with better earnings prospects – although, as has often been pointed out, we can do that by selling one company’s shares and buying another’s.

Overall, then, it’s not at all obvious why companies should be overly concerned about dividends. However, they are, because they spend a great deal of effort manipulating dividends and giving indications about future dividend policy. And they’re right to do this because surprises in terms of dividends tend to cause significant share price movements in spite of what classical economics tells us should be the case. One of the possible explanations about why dividends persist in spite of economists saying they shouldn’t is their signalling effect.

So, a change in dividend policy may often indicate a change in the company’s fortunes. A cut in dividends will often signal reduced earnings – although it sometimes indicates that there are better earnings enhancing opportunities around. Similarly an unexpectedly raised dividend will often see a share price surge – even though this often indicates that the management have run out of ideas about how to deploy their spare cash, which isn’t exactly a positive sign.

Desperate Dividends

However, to argue that the only reason dividends exist is to give managements a way of showing their confidence or lack of seems, well, desperate. After all management could rather more simply tell us directly that they have low visibility of future earnings – they’ve been doing that rather a lot recently. No, the real explanation seems to be that investors often prefer dividends: so why might investors have a preference for higher taxed dividends over internally reinvested earnings?

Well, firstly, returning free cash to shareholders removes from management the temptation to waste it on pet projects. It also has the rather odd effect of disciplining managements because they will more often have to raise additional capital in the market. Strange though it is, companies that pay out dividends are often simultaneously tapping the markets for additional capital. That additional capital costs the company money in fees, dividends cost the shareholders money in taxes and the total result is a significant reduction in earnings available to the company’s owners.

We live in a strange world.

The Psychology of Dividends

There are also multiple behavioural reasons why investors might prefer dividend paying stocks over non-dividends. Firstly, receiving an income stream means that investors don’t need to sell stock to receive an income, which can often be a source of regret (which we discussed in ... err ... Regret) if the company subsequently does well. Of course, investors could have reinvested their dividends in the stock but this is a sin of omission, as opposed to a sin of commission, and is far more easily ignored, as suggested by Shefrin and Statman.

Secondly, the problem of self-control that we discussed in Retirees, Procrastinate at Your Peril is far easier to manage if investors decide to spend only their dividends. Although the research suggests quite strongly that the only stock market growth available for long periods is through dividend reinvestment investors will often spend the “interest” on their dividends anyway. By avoiding any sale of capital it’s easier to control the urge to spend the lot. This is Mental Accounting again, of course.

Finally there’s a case that a stock paying a high dividend today is perceived as a better bet than one that may provide greater earnings and price increases in future. This is known as the “bird-in-the-hand” fallacy.

Residual Dividend Policies

One of the odder findings in research on dividend paying stocks is that those companies which follow a so-called residual dividend policy – essentially paying out their entire free cashflow to investors as dividends – are generally more financially sound than companies paying out less of their earnings. Explaining this isn’t easy, but it’s possibly worth noting that these higher dividend payers tend to be larger and find it easier to raise external capital.

It’s certainly a counter-intuitive idea for investors to look for larger companies with lower free cashflow, but those companies with residual dividend policies tend to have longer term outlooks than others. In essence these companies don’t actually aim to run with low free cashflow but instead set dividend policy based on expected long-term earnings, rather than adjusting based on the short-term winds of fortune. So perhaps this finding is simply stating that those companies whose managements take a long term view and want to maintain a stable shareholder base are likely to be better aligned with their long-term owners than others.

Note, though, that "alignment" means understanding shareholder psychology and playing to it, attending to the lessons of behavioural finance. This isn't necessarily the same as maximising shareholder value as promoted by more orthodox economic theories. We'll revisit this issue, soon.

Dividends Are Not Enough

However, it’s fairly clear that deciding on an investment policy purely on the basis of dividends without regard to the nature of the underlying corporation is a pretty stupid idea and one that’s founded in behavioural fallacies. The behavioural tricks and twitches that make people adopt this kind of approach regardless of the underlying robustness of the institutions involved is simply another facet of the psychological blindness that many investors have with regards to stockmarket investment.

In the end, there’s none so foolish as those that are blinded by their own behavioural failings. Most of us can recognise the psychological problems of stockmarket investing in others yet the majority of people will still fail to acknowledge their own issues. Dividends are simply the tip of a very a large problem. Still, on the positive side, well managed dividend payers are amongst the best bets in the market. Just don’t forget to reinvest the dividends while you can, otherwise you’re spending the majority of your future wealth.


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When a Dollar’s Not Just a Dollar

Reciprocity Rules

If you have nothing and someone offers you a dollar you’d take it, right? But what if you’ve just seen your aunt give your cousin $100 and told to share it between the two of you? After all, a dollar is still a dollar more than you had a moment ago.

What studies of so-called reciprocity in humans show, time and again, that while we’ll accept the dollar in the first situation we’ll refuse it in the second. Our sense of fairness is offended and, it turns out, that given half a chance half the population will seek revenge on the perpetrators of this swizz and take pleasure in it. So, sometimes, a dollar is not just a dollar.

Inveterate Non-Maximisers

The study of reciprocity has engaged and intrigued researchers for decades. The findings simply aren’t in accordance with people maximising their own utility in the form of wealth. In the above situation the person refusing to accept an extra dollar is doing themselves down. As Falk, Fehr and Fischbacher showed in On the Nature of Fair Behaviour in experimental situations when the proposer has the opportunity to offer either an equal or unequal distribution of rewards the unfair offer is rejected 44% of the time. Interestingly even when the proposer is given no choice but to offer unfair proportions this is still rejected 18% of the time, suggesting that there’s some inbuilt aversion to inequality.

All of which has puzzled economists and psychologists mightily, and they’ve spent years plaguing people with variations on these themes. A rough idea has been that the older, less evolved parts of the brain are interfering with the newer, higher functions and disrupting rational analysis. Which sounds ever so reasonable, us being all highly evolved and all and leads to the supposition that if you take the newer brain functions out of the equation we would behave even more irrationally as the dumb old irrational bits of the brain take charge.

However, when Daria Knoch and Ernst Fehr started inhibiting the newer brain functions using transcranial magnetic stimulation (T.M.S.) the rate of acceptance of the unfair offers went up, although recognition that they were unfair was undiminished. So in everyday life it appears that the newer, more “rational” processes are overriding the older parts of the brain which would quite happily take a single dollar, figuring out that a buck in the hand is better than none in the primeval swamp. Now all we have to figure out is how T.M.S. works.

Lizard Economics

All of which suggests that our higher brain functions aren’t particularly interested in selfish maximising and are more concerned with less concrete concepts like social justice. The powerful nature of social behaviour in making economic decisions comes as no surprise to many psychologists, especially those who work with children, but seems to be a shock to economists whose preferred modes of social interaction are far removed from the dirty reality of everyday life. Yes, it’s the street kids who are using their evolved frontal cortex while it’s the refined economists who are relying on lizard logic.

Once we recognise that the human brain’s new functions are mainly concerned with quickly figuring out what other people want, do and want to do rather than complex economic modelling tools then financial phenomena get displayed in a whole new light. We don’t baseline ourselves against absolute values – the fact we don’t have any money and a dollar’s better than nothing – but against relative, social ones. What matters is whether Harry next door has a bigger car not whether our twenty year old mini will get us from A to Z in a perfectly serviceable manner.

Altruistic Networkers

Casting the searchlight on stockmarket movements and assuming for a moment that people are more interested in what each other are doing than in the absolute intrinsic valuation of the market or individual stocks then we can rapidly generate an ad-hoc theory about why markets go mad. People are simply gauging the correctness of their actions by the behaviour of those around them, and those around them are doing the same. The kind of cascading network effects we saw in Sexual Trading can help with the rest as everyone tries to make sure that their portfolio is bigger than Harry’s.

Such a theory about why humans behave as they do helps to explain other things that have puzzled psychologists for years. Take altruism for example – why would anyone help another person if it doesn’t directly benefit their reproductive fitness? Evolution works by trial and error, figuring out what helps an animal improve its survival rates and breed more. It doesn’t make careful future calculations about the benefits of being nice to other creatures.

The answer, seemingly, lies in the human need to create and maintain social networks. This may be biologically mediated or simply learned behaviour passed down from generation to generation, but the benefits of sharing resources – food, water, etc – with other humans in order to create tightly bonded social groups would be an obvious benefit for a lightly armed and completely unprotected ape surrounded by hungry carnivores. Our feelings of slighted reciprocity when offered less than we think is fair seem to lie in this calculation: if I accept this then I am obliged to repay you and it’s not enough for me to want to expend energy on such a bargain.

The Power of Gifts

The nature of social reciprocity may also underpin some of the stranger behaviour of people - the mere receipt of a gift, however pathetic and pointless can trigger reciprocal tendencies. This is partly why the rising internet concept of giving things away for “free” can create viable business models: as Daniel Caldini relates in Influence, the Hari Krishna have long used such techniques to elicit donations from people who’d really rather not give them anything other than a wide berth.

Personally, I find training myself to say “No, go away before I hit you with this handy piece of street art” a lot easier than engaging in the kind of elaborate avoidance strategies erstwhile victims of “free” are inclined to use. Someone selling you something is not your friend. Unless, of course, they are your friend in which case refusing them is almost impossible – hence the wild success of Tupperware parties. Nothing, but nothing, sells like friendship.

Neuroeconomics

To drop in yet another piece of the behavioural finance jigsaw, the decision to reject a dollar on the grounds of unfairness rather than to accept it on the grounds of an increase in overall wealth is clearly a framing effect. Framed in terms of overall wealth we should accept the offer but in terms of the relationship with our stingy git cousin, to whom our idiot and frankly senile aunt has given the $100, we shouldn’t. This, of course, raises the question of how frames are constructed in our wetware. The idea that we socially frame situations and then act within them on the basis of social economics rather than rational maximising would make economics a branch of social psychology. Somehow that doesn’t sound like a marriage made in heaven.

However, the study of how economics is actually created out of brain processes – so-called neuroeconomics – is in its infancy. As yet we can barely figure out which bits of the brain and which mechanisms are involved in the simplest of economic actions. Given the plasticity of the brain as soon as we do figure out how to model reciprocity it’ll reorganise itself on some other grounds.

One further finding – if men are targeted by unfair offers they will seek revenge and get pleasure from it. Women are equally offended but are less motivated by getting their own back. Hell hath no fury like a vengeful man and good negotiators will be careful to avoid triggering these effects if they think they’re going to have a long term relationship.

In the meantime, however, the lesson for sales people is easy: give stuff away for free and make sure it’s personal. Sod economics, social psychology will do the rest.


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Money Can't Buy Happiness

Wish Carefully For You May Receive

Often the quest for the illusory bird of happiness is equated with the accumulation of ever increasing amounts of money. If only we had more wonga, moula, spondoolies we’d be so much more cheerful. Only when we get the extra dough our partners find that we’re still the same miserable gits that we were before and elope with the gardener, most of our money and the garden gnome collection.

Worse, not only does money not equal happiness, it seems that offering people money for doing things that they would otherwise do out of the goodness of their hearts can destroy their generosity. Money may not make you happy but it can sure as hell make you a miserable son of a bitch.

Framing and Focussing

A curious feature of studies that investigate happiness is that whether you think you’re happy or not is very dependent on the order in which you’re asked questions. Given that we usually think of happiness as being a state that we can independently report on this is peculiar, to say the least. Consider the two questions:

1. How happy are you with your life in general?
2. How many dates did you go on last month?

In Would You Be Happier If You Were Richer? Daniel Kahneman and colleagues have found that if you ask question 1 first the results of the two questions are virtually uncorrelated – whether or not you’d recently been out painting the town red made no difference to whether you felt happy or not. Reverse the question order, however, and the correlation rises to 66% - two thirds of people suddenly seem to reckon that getting lucky with a partner was important to their happiness. The other third, presumably, were happily married...

So what it looks like is that happiness is not something that we can report on independently of context – by causing the respondents to focus on one particular area the researchers can change their state of mind. This is the focusing illusion, a specific form of the behavioural bias known as framing that we looked at in Investors, You've Been Framed, where putting people in different frames can cause them to provide different answers to the same question. It's just lucky that marketeers and politicians don't like using these techniques to manipulate our behaviour.

You can stop laughing now.

Focussing and Relativity

Generally studies show a reasonable correlation in people’s minds between happiness and money. However, as you might guess, these studies draw people’s attention to the positive benefits that more money will bring – a bigger house, more holidays, better healthcare and so on. This triggers the focusing illusion which doesn’t catch the downsides – the longer working hours, greater stress, the misery of seeing your stocks fall or the lack of proper leisure time: which is possibly why more money doesn’t actually end up making people happier.

An alternative explanation is that money is relative: you compare yourself with your peers and don’t concern yourself with those not in your salary bracket. This, of course, is a perfect explanation for the one-way ratchet effect of CEO’s salaries as they compete against each other for the satisfaction of the biggest pay packet like kids squabbling over the games console.

Fancy A Nuclear Waste Site In Your Backyard?

However, this bias has other effects as well that detract from our happiness. Back in 1997 Bruno Frey and Felix Oberholzer-Gee published a paper called The Cost of Price Incentives. They used a Swiss referendum on where to locate waste sites to run a real-world experiment. Just over 50% of the people polled were willing to have the site situated in their area, recognising that the dump had to go somewhere, even though they didn’t like the idea very much.

The researchers also asked a second group how much they would need to be paid to accept the dump. Now we should expect that this second group would be more likely to agree to the dump since not only did they have the public duty responsibility of the first group they also had the lure of some loot, in rock solid Swiss francs to boot. Of course, we’d be wrong: only 25% of people accepted this offer, in spite of increasingly high rewards.

Working out exactly what’s happening here is a bit of a challenge but a reasonable guess is that the monetary question is triggering the focusing illusion. Instead of thinking about the wider social issues people get focussed on the specific financial ones and simple human altruism goes out the window. In another paper the researchers call it the "bribe effect".

Quantitative Valuation and Social Policy

Now when we consider that economists everywhere are busily constructing social policy on the basis of the economic value of any particular activity this is a major concern. Essentially behavioural finance is being used to ask questions exactly like the one the researchers asked the Swiss in order to get a quantitative valuation of any social policy. The trouble is that if you only ask people questions on a monetary basis you only get answers on a monetary basis: the idea that people will willingly give up things for free when properly engaged simply doesn’t factor into these models.

As programmers are wont to say: garbage in, garbage out. What the Swiss study shows is that while you can put a price on things money is not the only way of judging the value of something. As the researchers themselves put it:

"First, where public spirit prevails, using price incentives to muster support for the construction of a socially desirable, but locally unwanted, facility comes at a higher price than suggested by standard economic theory because these incentives tend to crowd out civic duty. Second, the use of price incentives needs to be reconsidered in all areas where intrinsic motivation can empirically be shown to be important."

Which, of course, brings us, neatly, back to happiness.

More Money, More Stress

If anything more money brings us less happiness in terms we’d really associate with feelings of contentment. Higher salaries mean longer working hours, longer commutes, more stress, less time to stop and deadhead the flowers and socialise with our friends. These aren’t the things we think of when we’re asked about whether more money would make us more cheerful.

Behavioural psychology can tell us a lot about the things we do to deprive ourselves of monies we should earn from markets but it can also point us in different directions. Acquiring great wealth in a spurious quest for happiness is a pointless and pathetic occupation. Assessing all human needs purely on a financial basis is equally corrosive.

The Value of Altrusim

The study of evolution struggles to explain the origin and nature of human altruism. In a world beset by competition altruistic behaviour should have been bred out of us: but it hasn’t been because, one presumes, the nature of co-operation has given the human being an advantage in nature’s great journey. It would be a shame if, having come so far, the culturally learned ambition to acquire more and more money destroyed our natural altruism in favour of market led solutions.

Of course, if we want to follow this approach by putting a monetary price on everything we should carefully evaluate the cost of accepting a higher salary or spending our days seeking greater returns out of stockmarkets. How much money is it worth to spend your life with an ear clamped to a Blackberry, your ass to a plane seat, your fingers to a keyboard and your eyes on a real-time ticker list? How much money is your happiness really worth?


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