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Tuesday, 3 March 2015

I Don't Know What I Like (And I Don't Know What It's Worth, Either)

Axiomatic

One of the fundamental axioms of economics is that we know what we like: we have preferences, they're consistent across time and they can be revealed by careful experimentation. This, of course, is utter nonsense. Yet it's not just a guiding principle of economics but is also a rough and ready rule we live our lives by. We make decisions and then we justify them, after the event, because to do otherwise would make a mockery of our choices.

But because we do actually make decisions we must, in a sense, really know what we like, even if we're habitually inconsistent. Unfortunately, outside of our own specialised areas of expertise we don't know how to absolutely value things and all too often we assign a value based on entirely superfluous data intermingled with a bit of relative valuation, reckoning that a Porsche 911 Carrera is worth more than a child's teddy bear. We exhibit coherence but in an arbitrary fashion - a behavior known, rather unoriginally, as coherent arbitrariness.

Teddy Girl

Of course, a Porsche generally is worth more than a child's teddy bear - unless the bear happens to be Teddy Girl, a 1904 Steiff model that fought its way through World War II at the side of Colonel Bob Henderson and sold at auction in 1994 for a cool $170,000. Rules of thumb don't always work even in obvious areas, but in those requiring a bit of expertise they can go horribly wrong.

There are legion examples of people getting confused over what price to pay for something that they don't know much about. Robert Cialdini famously tells the story of the shop assistant who accidentally doubled instead of halving the prices of slow selling jewellery in a tourist spot, only to discover that the stuff sold out almost instantly: because people were using the price as a signal to indicate quality, lacking any other means to make that judgement.

Arbitrary

Another famous experiment carried out by Dan Airely, George Loewenstein and Drazen Prelec - "Coherent Arbitrariness": Stable Demand Curves Without Stable Preferences -  showed how people can be primed to re-base their estimates of an item's worth. They got participants to write down the last two digits of their social security numbers and then got them to bid for various items. It turned out that the participants with the highest two digit numbers bid significantly more than those with the lowest. As Airely puts it:
"What were we trying to prove? The existence of what we called arbitrary coherence. The basic idea of arbitrary coherence is this: although initial prices are “arbitrary,” once those prices are established in our minds they will shape not only present prices but also future prices (this makes them “coherent”). So, would thinking about one’s social security number be enough to create an anchor? And would that initial anchor have a long-term influence? That’s what we wanted to see."
And so it proved: in the absence of real anchors the participants used the arbitrary ones provided to them. Of course, the people involved insisted that the social security numbers made no difference to the prices they were willing to pay: but they were wrong, as we so often are about our own motivations.

Tom Sawyer

In a further set of experiments detailed in Tom Sawyer and the construction of value, the same researchers showed that they could manipulate peoples' preferences in a similar fashion: using social security numbers as an anchor they were able to show that participants preparedness to attend a poetry recital was dependent on a valuation based on those numbers.

In the first condition participants were asked how much they had to be to paid to attend the recital, and 63% agreed to do so if paid the dollar equivalent of the anchor, but only 9% were then prepared to attend for free. In the second condition a different set of participants were asked how much they would be prepared to pay to attend the recital and only 20% were willing to pay the amount specified by their anchor - but 49% were prepared to attend for free.

Manipulated

So, not only do we value things arbitrarily albeit coherently, but our preferences for those things are determined by those arbitrary valuations. As Airely, Loewenstein and Prelec express it:
"If one was willing to pay $x for company Y’s stock yesterday, then today’s announcement of an unexpectedly profitable quarter should make one willing to pay more than $x. Such a sensible decision-making heuristic, however, tells us nothing about whether yesterday’s valuation was reasonable. Economists observe responsiveness to incentives and conclude that individuals are making choices based on fundamental valuation, much as they would if they observed our experiment without awareness of the initial manipulation. "
But what if we're not making choices based on fundamental valuation, but on a curious mix of guesswork and relative valuation? What if we're buying stocks based on gut feel or what other people are saying or selling because everyone else is?

Well, if we're unconsciously affected by arbitrary coherence we will tend to price or judge things relatively to some anchor. However, as anchors can be arbitrary or may be influenced by external parties or just plain irrelevant our judgements may be wrong, sometimes extremely wrong. This is never more true than when investors start trying to judge the value of stocks by comparisons with other stocks.  Although that's probably better than trying to judge the value of a stock by comparison to the anchor price of what we arbitrarily bought it at, or the most recent high point.

Cost of Capital

One of the notable features of the great investors is that they tend not to be heavily influenced by sentiment or by the current mental state of the market: they don't generally pay a lot of attention to relative valuation, but are primarily concerned about the underlying ability of a corporation to generate a return significantly in excess of its cost of capital. Sometimes this is expressed through the use of a system - Ben Graham was an early example of this type of investor - but I suspect that these systems are actually expressions of an unusual type of personality, one that is less concerned about the opinions of others than is usual.

If that's right then the system won't really work when separated from the personality. In steady state conditions, when everyone's unstressed, then it'll work fine - if arbitrary coherence in the face of uncertainty is the norm then the system can help reduce the uncertainty, which makes the anchor less arbitrary. But when the next crisis hits having the mental strength to maintain your belief in the system is entirely another matter when the rest of the world is screaming about the latest set of arbitrary reference points.

The alternative to spending your life randomly buying teddy bears in the hope you might one day be able to afford a Porsche is to actually learn about how to really value teddy bears. Or Porsches. Or both. Because if you don't you'll likely just end up with a portfolio of expensive stuffed toys and broken down supercars that no one else wants very much.

Arbitrary coherence  added to The Big List of Behavioral Biases.

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