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Tuesday, 10 March 2015

The Emperor's New Markets


Markets often exhibit behavior bordering on the delusional - frequently from the wrong side of the border. Investors seem unable to disassociate specific investment opportunities from broader economic realities - how many corporations in the history of the world have ever justified a P/E of over 100? Yet, from time to time, people will fall over each other to invest in these "opportunities", seemingly oblivious to the enduring nature of competition in markets.

Of course, financial markets are just a peculiarly public forum for demonstrating this irrationality, and one in which it's possible to quantify the scale of it, albeit only in hindsight. But human mass delusional behavior isn't confined to markets, it's just other social settings make it more socially acceptable.  To be human is to be be mad, but we don't have to be poor as well.

Moral Tales

We probably all know of Hans Christian Anderson, the nineteenth century Danish weaver of fairy tales with moral undertones, at least by reference to his stories. Many of these are now embedded in Western culture - The Ugly Duckling, The Little Mermaid, Thumbelina and many, many more. One of the most famous, though, is The Emperor's New Clothes - in which a couple of chancers manage to persuade the Emperor and his court that they can weave fine cloth out of thin air.

The point of the story is that belief can become contagious, as no one wants to admit that the Emperor's new clothes are an illusion - apart from the child at the end of the story, who points out the blindingly obvious, that the Emperor is wandering around stark naked. In the words of Jens Ulrik Hansen, everyone is demonstrating pluralistic ignorance:

A situation where "no one believes but everyone believes that everyone else believes"
Think and Drink

So, for instance, a study by Deborah Prentice and Dale Miller in 1993 showed that many college students enjoy drinking alcohol less than they think the average student does. Which means, of course, that the actual average student enjoys drinking less than the imagined average student - which causes students to drink more than they otherwise would, for reasons of social conformity.

The Emperor's New Clothes is another example of pluralistic ignorance -
No one personally believes the Emperor to have any clothes on. They do, however, believe that everyone else believes the Emperor to be clothed. Or, alternatively, everyone is ignorant to whether the Emperor has clothes on or not, but believes that everyone else is not ignorant.
Not only can pluralistic ignorance have widespread social effects it can also have devastating local consequences. The bystander effect, where many individuals fail to come to the assistance of someone who needs help, is one potential outcome - no one comes to the aid of someone in need because everyone assumes everyone else knows more than they do.

Mass Delusions

Pluralistic ignorance is closely related to the Emperor's New Clothes syndrome, an argument that when belief structures have no evidence to support them they can only survive because of mass agreement to maintain the illusion. It's an argument often deployed to undermine religious belief systems, the idea being that any system that can only be maintained by denying observable evidence is ultimately dependent on believers continuing to insist that it makes sense.

Anyone who's spent any time investing will recognise both of these conditions. Mass delusional behavior is often observable both in wider markets and also in specific stocks. Pluralistic ignorance abounds: all too often everyone thinks that although it's obvious to them that markets are over or undervalued no one else has recognised this: so it makes sense to invest on the basis of what we think other people think, rather than on the basis of what passes for objective reality in investment.

Follow this through and you descend into a fantasy world of delusional behavior: although you and I may believe that prices are stupid we choose to believe that everyone else is deluded, and we invest on that basis. Of course, everyone else thinks we're deluded, and they invest accordingly. And we end up with the Emperor's new markets, in which no one wants to admit that we're all wandering around naked. Warren Buffett's aphorism that you only find out who's naked when the tide goes out has never been more apposite.


The idea behind this approach is derived not from economics or psychology, but from sociology (see, for example, Arbitraging Embeddedness). The standard argument behind market overvaluations at the extreme end is about some form of collective delusion. However, there is an alternative explanation that argues that bubbles are caused by an active minority against which the dissenting majority is unable to response, because the rational response is to short-sell and there are major downsides to doing so (see Save Our Short-Sellers for a discussion of this issue).

Beyond this, however, there is yet another proposal - a so-called dancing model. In dancing models dissenters not only do not act against the popular delusion by shorting the market, but actually join in and start dancing. The rationale is simple, as Catherine Turco and Ezra Zuckerman explain in So You Think You Can Dance? Lessons From The U.S. Private Equity Bubble:
"In liquid markets—where investors can move in and out of positions quickly and without affecting prices— paying inflated prices may be rational if investors expect to resell at even higher prices. This strategy is the market equivalent of dissimulation in other cases of distorted valuation: investors’ behavior suggests they endorse the public valuation, yet they privately dissent from it."
This is wonderful: perfectly rational investors rationally decide to ignore the nakedness of the Emperor on the grounds that doing so allows them the opportunity to skim profits off the gullibility of others. And, in so doing, they appear to be deluded themselves, while being no such thing.


Given that most of behavioral finance is focused on explaining why we make mistakes in assessing valuations then a theory that suggests we do no such thing but are, instead, attempting to cynically exploit the delusions of our fellow investors at the same time as they're trying to do the same to us, is at least worthy of a bit of consideration. After all, how often have you invested in something you think is a tad expensive on the basis that everyone else seems to be doing so?

The Turco and Zuckerman study focuses on Private Equity, a market with its own dynamics, but one also populated by some smart and sophisticated investors. The collective failure in this market led to a situation where:
"The smart money was too smart by half - that is, with limited visibility into the market, they applied the wrong investment strategy despite knowing the right valuation."
Pluralistic ignorance writ large.

Investing Naked

Frankly, I doubt that there are few readers here who won't recognise this behavior.  A situation where we, as investors, can reasonably assess markets or stocks as expensive - perhaps excessively expensive - but in which we still choose to invest is really investing without a margin of safety. And in the end, it's that margin of safety that ensures we're not investing naked.

Maintaining discipline when all about us are losing their heads is theoretically wonderful, but practically very difficult when the bozo down the road is making money hand over fist.  Which is why, probably, the really great investors don't care much for relative valuations: in the end there are eternal virtues in investment and, of these, the greatest will always be patience.

Pluralistic ignorance and Emperor's New Clothes Syndrome added to The Big List of Behavioral Biases.

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