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Wednesday, 9 March 2011

Market Confidence, Tricks and Placebos

Shotguns and Phantasms

We hear, frequently, about how important “confidence” is for markets. Clearly this is true: when people are confident in the future they make investments and when they’re not they hunker down under the bed with a stash of cash and a shotgun.

Unfortunately confidence is a self-fulfilling prophesy and we are, it seems, particularly prone to living out our fantasies, no matter how stupid they may seem in retrospect. You see, confidence is a psychological trick of the mind, a phantasm evolved to lure us into unwise investments, as wicked a behavioural bias as you’ll find in a long list of the usual suspects.

Clever Hans

In the late 1800’s Germans were enthralled by the advent of a new mathematical genius, one who helped to change our understanding of the way that that science works. However, while Einstein was still beavering away as an unknown patent clerk his countrymen were entranced by the genius of a horse called Clever Hans.

As it turned out the horse was smart, but not in the way most investigators originally thought. In fact anyone dealing in human behaviour needs to protect themselves against so-called Clever Hans Effects but, unfortunately, most of us don’t do so – including many of the people who run the economies of the world. As is so often the case we’re defeated not by the markets but by our own brains.

Horsing About

Here’s the conundrum that faced the investigator charged with understanding the mystery of Clever Hans:
"A horse that solves correctly problems in multiplication and division by means of tapping. Persons of unimpeachable honor, who in the master's absence have received responses, and assure us that in the process they have not made even the slightest sign. Thousands of spectators, horse-fanciers, trick-trainers of first rank, and not one of them during the course of many months' observations are able to discover any kind of regular signal".
The reason that no investigator could figure out the signals used to make Clever Hans discern the answers to the problems posed was dead simple: there weren’t any. The horse was able to correctly answer quite complex arithmetic questions without direction from its handler.

Eliminating the Obvious

Having eliminated the probable, analysts proceeded to come up with a range of increasingly improbable and frankly stupid ideas. Some came to the conclusion that Hans was demonstrating rationality, others discerned that the abilities were purely mechanical and required no sentience: a kind of clockwork horse. Still others determined that the horse’s ability was evidence for cross-species telepathy. Mostly everyone disagreed with each other without being able to produce a shred of evidence for any theory that they might have come up with. Much like investment theorists, in fact.

What was actually happening was far simpler, far more interesting and far more important than anyone supposed. When some thoughtful people started properly experimenting with Hans they discovered that he needed visual contact with the questioner to get the answer correct. Then they discovered something even more intriguing: that Hans could only get the answer right if the experimenter knew what it was. Hans was no mathematical prodigy, but he was a damn fine mind-reader.

This ability, to read unconscious signals from the questioner, entirely bypassed all of the less careful experimenters who had studied Hans previously. All of these were looking specifically for some form of signal from his owner and all completely missed the unconscious cues that he must have been giving off yet which the horse was picking up on.

Double Blinds

The recognition of the Clever Hans Effect was an important milestone in social science research, because it demonstrated exactly how easy it is for a researcher to influence the results that they’re trying to achieve. This is yet another example of a self-fulfilling bias, like the one we saw in Trading on the Titanic Effect.

To cope with this researchers designed the double blind trial. In such experiments participants are split into two groups, the control group and the experimental group, and neither the researchers nor the participants know which is which to prevent any subjective biases from impacting the results. This is the typical trial form for drug testing, with the control group receiving a placebo – essentially a fake drug – and the experimental group the real thing.

Placebo Effects

Just to be awkward, humans quite often get better when they’re given a placebo anyway – the so-called Placebo Effect – which means that double blind tests aren’t quite as perfect as we might like. In fact our ability to create self-fulfilling prophesies is astonishing: placebos work better in double blind trials than in single blind trials where the researchers know who’s receiving the fake drug. Even though they don't know they're doing it the experimenters are somehow giving off signals that participants are picking up on.

Indeed, as Clever Hans showed, the power of experimenters and participants to bias their results is potentially so overwhelming that it throws into doubt whether we can ever successfully conduct experiments in the behavioural sciences: no matter how much we try to avoid interfering in the process it’s almost inevitable that we do. In fact some people idly wonder whether the same problem applies to the harder sciences, but that's a question for another day.

Consumer Placebos

Now, of course, the problem with placebo effects generally is one of confidence. While people believe in the efficacy of the placebo it has a remarkable power to cure them. Once they learn that the wonder drug is a sugared pill the miracle dies, and so sometimes does the patient. There is, unsurprisingly, a direct read across into markets and confidence. As Otoo and others have found, positive stock market performance tends to predict boosts in consumer confidence, but not the other way around, but, consumer confidence is generally predictive of economic trends. This is Clever Hans writ large.

The interaction between market behaviour and human confidence is important, to the extent that market commentators scrutinise every verbal tick of central bankers for some sign that they know what they're doing and governments are willing to throw trillions at the problem. Of course, this is one hell of a placebo but the limited research available suggests that there are good reason to bailout banks in times of crisis. However, this also has an interesting side-effect.

Banking Crises

Osili and Paulson have looked at the effects of direct experience of a banking crisis on confidence and concluded that it can have a permanent impact on the way that people treat banks if, and only if, they actually suffer losses. As long as people don't actually lose money they eventually regain confidence and come back for more. As the researchers state:
“The findings suggest that reduced investor confidence following a crisis is an important component of the cost of a systemic banking crisis and can make recovery more challenging. Once investor confidence is shaken, it appears quite difficult to restore. On a more optimistic note, having deposit insurance in place before prior to the onset of a banking crisis appears to be an effective way to protect investor confidence”.
In short, the self-fulfilling prophesy of markets is a confidence trick, which depends on the continued belief of investors in a happy and successful future. Just like the observers of Clever Hans, people believe what they want to believe and, in believing it, create the very markets that they expect to occur. Only when the evidence is overwhelming will they change their opinion and in doing so their confidence may be so shaken it never recovers.

Contrarian Psychologists

Just because market confidence is a placebo and just because commentators and investors are permanently suffering from Clever Hans Effects doesn’t mean that we, as investors, should regard these as unimportant. In fact they’re so important we should be very concerned about them but in a contrarian way. When confidence fails, markets fall and real opportunities present themselves.

Recognising that confidence in markets is a self-fulfilling prophesy that taps into some of our deepest mental processes is critical for longer-term, patient investors. Inevitably there will be times when uncertainty rises, confidence falls and markets tumble. These are times when you don’t need to be a genius to invest wisely, just knowledgeable about the underlying mental processes. Remember, Clever Hans was no good at mathematical analysis but succeeded because he was a whizz at human psychology.

Related Articles: Contrarianism, Volatility, the Last Anomaly, Trading on the Titanic Effect

1 comment:

  1. Thanks for the food for thought! It is always great to step back and take a reality check