Jeff Sparrow accuses the left of being smug elitists who dismiss ordinary people as being dopes and fools. I don’t doubt that there is an element of superciliousness within the left. But there needn’t be. We can believe that people are misled by ideology into supporting the right without believing that they are stupid slack-jawed yokels.
Let’s start with behavioural finance. This is the idea that investors – including professional ones - fail to optimize because they are prone to many cognitive biases. This doesn’t mean they are idiots: even doctors (pdf) make similar mistakes. It just means none of us are Godlike Bayesians who always make the right decisions. Instead, we are – as the title of Meir Statman’s fine book says – just normal people. There’s a close analogy between some of the biases we see in behavioural finance and some we see in politics. This is why I can shift easily from writing about behavioural finance in the day job to writing about ideology in this blog: the two have much in common. For example:
- Anchoring. Kris-Stella Trump has shown that our perceptions of what is fair are anchored by actual distributions. This means that as inequality increased, so too did our perceptions of how much inequality is acceptable. But we also see anchoring in finance. Before the crisis, years of stability anchored bankers’ ideas of how risky their assets were, with the result that they took on too much risk and subsequent losses came as a shock (pdf) to them.
- Prospect theory. When people have lost, they tend to gamble in an effort to break even. I suspect this helps explain support for Trump and Brexit; people who felt that the country had lost out to globalization and to the elites were willing to gamble on risky prospects. We see a similar thing in financial markets. People hold onto badly performing shares in the hope they’ll come good. And they have traditionally paid too much for lottery-type stocks (pdf) such as Aim shares which offer the small chance of great returns.
- Under-reaction. People stick too strongly to their prior beliefs. In politics, this means too many people think the Tories are good custodians of the economy despite austerity, Brexit and Johnson’s “fuck business” remark. In finance, it gives us (or contributes to) the momentum effect – the tendency for assets which have done well recently to continue doing so.
- Wishful thinking and the optimism bias. These cause people to over-estimate their future incomes and to believe that austerity won’t affect them. It thus creates a bias against high taxes and welfare spending. Again, we see a similar thing in finance; investors over-estimate their ability to pick good stocks or funds.
These are not the egregious errors of idiots. Instead, they are – as Statman says – very often good shortcuts that sometimes lead us awry; we are often right to cleave to our priors, and a little wishful thinking is necessary to get us through the day. We are all prone to some of these mistakes sometimes. And if we commit them in finance where the incentives to think clearly are high, aren’t we more likely to commit them in politics where the incentives are weaker, non-existent or even perverse?
Now, I know that some of you are sceptical about the explanatory power of behavioural finance. Sometimes I suspect it is less of a positive project aimed at explaining the world than a normative one – a way of warning us against some common mistakes. Nevertheless, I suspect it does have some explanatory power. Insofar as this is the case, isn’t it also likely that the same mechanisms which cause poor investment decisions might also cause poor political ones? And both arise not necessarily from stupidity but from the fact that our cognitive resources are limited.