Why we do crazy things July 11, 2010 at 11:07 am

Rajiv Sethi makes an important and subtle point in a post on Naked Capitalism. He is discussing the behaviour finance literature, and in particular the idea that failure to correctly estimate the probability of bad outcomes leads to the design of unsafe securities that look safe:

…what troubles me about this paper (and much of the behavioral finance literature) is that the rational expectations hypothesis of identical, accurate forecasts is replaced by an equally implausible hypothesis of identical, inaccurate forecasts. The underlying assumption is that financial market participants operating under competitive conditions will reliably express cognitive biases identified in controlled laboratory environments. And the implication is that financial instability could be avoided if only we were less cognitively constrained, or constrained in different ways — endowed with a propensity to overestimate rather than discount the likelihood of unlikely events for example.

Now this is a little unfair in that the authors don’t make the explicit read across from ‘if people are wrong about the likelihood of crashes, then they produce overpriced securities which will fail catastrophically in a crisis’ to ‘overpriced securities which failed catastrophically in a crisis were produced, therefore people mis-estimated tail probabilities’. But certainly the authors invite such a reading, so Rajiv’s comment is reasonable. It is next part of his argument that really resonates though:

This narrowly psychological approach to financial fragility neglects two of the most analytically interesting aspects of market dynamics: belief heterogeneity and evolutionary selection. Even behavioral propensities that are psychologically rare in the general population can become widespread in financial markets if they result in the adoption of successful strategies. As a result, asset prices disproportionately reflect the beliefs of investors who have been most successful in the recent past. There is no reason why these beliefs should consistently conform to those in the general population.

I think that this is right, and it deserves to be better understood. I would even go further, because this argument neglects the explicitly reflexive nature of market participant’s thinking. (Call it social metacognition if you really want some high end jargon.) Traders can both absolutely understand that a behavioral propensity is rare and likely to lead to catastrophe and behave that way: they do this because they believe that other market participants will too, and behaving that way if others do will make money in the short term. Even if you think that it is crazy for (pick your favourite bubblicious asset) to trade that high, providing you also believe others will buy it, then it makes sense for you to buy it along with the crowd. Moreover, worse, you may well believe that they too think it is crazy: but all of you are in a self-sustaining system and the first one to get off looks the most foolish (for a while). Most people are capable of spotting a bubble if it lasts long enough: the hard part is timing your exit to account for the behaviour of all the other smart people trying to time their exit too.

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