The book, Investing Psychology: The Effects of Behavioral Finance on Investment Choice and Bias (Wiley Finance), is a review of the current state of behavioral finance for the non-expert – a task born out of hope as much as expectation, I should add, as the subject moves almost as fast as you can research it – and a plea for investors to take care, to avoid the less-than-well-signposted traps. Finance is a world dominated by people whose relationship with the truth isn't so much tenuous as trivialized. And a bull market attracts bull merchants like no other.
Our world is awash in financial commentary. Journalists are at it, academics are at it, financial services professionals are at it, politicians are at it, traders are at it, bloggers are at it ... In the extreme it seems like the whole damn world is at it. And the vast majority of what is written is pure, unmitigated bullshit.
I don’t use this term in a scatological sense, mind you, but with the strict meaning that it is comment produced without regard or relationship to the truth. Harry Frankfurt’s 1986 paper on the topic is the point of departure for any discussion on the subject, and he neatly summarizes the issues facing most commentators on matters financial:
Bullshit is unavoidable whenever circumstances require someone to talk without knowing what he is talking about. Thus the production of bullshit is stimulated whenever a person’s obligations or opportunities to speak about some topic are more excessive than his knowledge of the facts that are relevant to that topic.
Which covers the vast majority of commentary on financial markets, not to mention the entire content of a number of popular cable channels.
The nature of bull in the financial services industry has been dissected in a marvelous paper by Douglas Allen, Richard Allen and Elton MgGoun:
As a species, we may not have evolved to the point of making optimal probabilistic decisions in the stock market, as behavioral finance consistently illustrates, but we‘ve certainly evolved enough to bullshit about it.
In Bull Markets and Bull Sessions they point out that both truth-tellers and liars have a relationship with the truth but that the bullshitter has no regard for it whatsoever. On the face of it this isn't an especially useful behaviour but, as my book points out time and again, maladaptive financial behavior often arises from what are otherwise valuable adaptations to everyday life.
The gestalt psychologist Erving Goffman propounded a view of humanity that we are actors, forever presenting different views of ourselves to different people. So when we talk or act we’re not necessarily presenting a true view of ourselves, but we’re trying to convince people to view us as we want to be viewed.
So bull is not necessarily bad, because it helps to grease our path through everyday life: in situations where truth is less important than social interaction – in an interview, on a date, at a drinks party – it may be a positive boon. But, as usual, a usefully adaptive behaviour in social life may become a dangerously risky one in finance, because markets – eventually – reward truth rather than perception.
For example, if we look at the vast majority of financial sector punditry, the huge swathe of information that flows through the multi-media channels that dominate our world, it’s hard to escape the conclusion that most of it is pure bull. As Allen, Allen and McGoun put it about such commentary:
All of the [advisers] in the formal and informal, professional and amateur financial advising industry are not lying. Rather, they express opinions, offer advice and predict the performance of markets, mutual funds, stocks, etc. without regard to the actual facts—that nobody has been able to foretell the future and consistently outperform the market in the long run.
Of course, does this matter? Is this simply entertainment or does anyone take any of this seriously?
Well, I reckon quite a lot of people do act on some of what’s written or spoken about. We've seen plenty of evidence that people become better investors with more experience (see Investor Decisions: Experience is Still Not Enough) but if there’s one thing a bull market does it’s suck in new traders with little ability to differentiate between hard analysis and soft bull. To take a single, simple example, there’s a definite “Cramer Bounce” after the celebrated pundit makes a tip. As the researchers note in Market Madness: The Case of Mad Money, in a tone of puzzled incredulity:
We … find little evidence that Cramer has skill in selecting stocks, so it is unclear why the market responds at all to his recommendations.
Well, I don’t think it’s that surprising. In situations where we have little of our own expertise we habitually defer to those we regard as experts: you’d not expect a qualified and registered doctor to go on TV and start recommending quack remedies, so why should a non-expert investor be able to anticipate that the greatest and the good of the financial services industry would be happy to parlay their knowledge in the services of entertainment? (see: You Can't Trust the Experts With Your Money). Or that reputable media channels would pay them for this?
The researchers propose a couple of possible explanations for the popularity of financial bull. Firstly, it may be that the increasing demands on individuals to look after their own finances in a world full of confusing and contradictory commentary leads to a form of satisficing, where people simply search for something that makes sense to them and then apply it. This is Herb Simon’s bounded rationality in action – we don’t have the processing power to make fully informed decisions so we do the best we can (see Behavioral Finance's Smoking Gun).
Alternatively attribution theory suggests that we congratulate ourselves for our successes and blame other for our failures. In the vast deadweight of pointless predictions there’ll be something we can finger as an explanation for our latest financial calamity. This is self-serving bias in action, and we’re all guilt of it from time to time (see Where Two Strangers Never Meet: Self-Serving Bias).
Personally I’m not convinced. Proper financial analysis is hard, and managing our biases is even harder. It’s far easier to find some credible talking head spouting believable nonsense and take it as gospel. One of the ideas propounded by the Allen paper is that we’re attuned to detecting bullshit, that it performs a social function and we’re quite comfortable living with it. I’m afraid I don’t think that’s true, at least not in areas where some level of expertise is needed to interpret information.
Of course, this blog and the various associated books are part of the world I’m criticizing. Physician heal thyself, and all that. But here at least there’s some attempt to back ideas up with whatever rigor the academic community can bring to bear on the topic. The brutal truth is that good investors are aware of their limitations. Mostly we get that way by bitter experience, sometimes we get to learn through the experience of others, but we will never do so by listening to the opinions of people who don’t even pay lip service to the facts.