Stumbling and Mumbling: Why I like abject bastards

July 11, 2005

Why I like abject bastards

Chicken Yogurt calls Brit Hume an "abject bastard" for profiting from the stock market fall on 7/7. And Brit, it seems, was not alone.
Despite this ignoble money-grubbing, I find stock markets a fascinating place. And I think everyone else should too, because they serve a terrifically useful, and much overlooked, function.
This function is not that stock markets are a way for firms to raise cash. Except for the bubble years of 1999-2000, equity issues have typically accounted for less than a quarter of firms' capital spending in any year.
Nor is it that the stock market is a good discipline on company managers. It's not.
Instead, I love stock markets because they are a great laboratory for studying human nature. They show us that people can behave irrationally even when they have incentives not to. In investing, unlike in most areas of life, there's a neat and incontrovertible measure of performance - share returns - against which we can judge rationality or irrationality.
So, here are some lessons of stock markets that might have a wider application:
1. Groups perform worse than individuals; Brad Barber (all of whose work is fascinating) has found that investment clubs under-perform individual investors (pdf).
2. People over-react to long streams of information (pdf).
3. People are overly optimistic about things they believe (wrongly) they know well
4. Expert opinion herds together (pdf) professional investors buy the same stocks as each other, regardless of their real merits.
5. What people choose is strongly influenced by the way the choice is presented, rather than by purely rational considerations. Richard Thaler (whose work is compulsory reading) and Shlomo Benartzi have found that even highly qualified professionals choose a pension fund weighted towards bonds if they are offered lots of bond funds, but an equity-weighted pension if they are offered lots of equity funds (pdf).
Naturally, these examples are controversial; there are, arguably, rational explanations for behaviour like this. But there are many other examples I could have chosen.
What's important to me is that there's no reason to suppose that irrationalities like these are confined to the stock market; I suspect you can think easily of how they apply to other areas of life.
And herein lies what for me is the key lesson. Stock markets teach us that people can (arguably) be irrational even when they have clear incentives to be clever, and immediate feedback. And if we are irrational in these conditions, how much more irrational will we be in areas- such as politics - where such conditions are weaker?

July 11, 2005 in Markets | Permalink

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Stumbling and Mumbling

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July 11, 2005

Why I like abject bastards

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