Overcoming Bias

Bad News Ban Is Very Bad News

The SEC ... said in a statement early Friday morning it is halting short selling on 799 financial stocks. The ban, which is effective immediately, is set to last for 10 days, but could be extended for up to 30 days.

That is, they have banned speculators from giving bad news about 800 finance companies.  Which seems to me to be very bad news about those companies - sell!  If not for the first amendment, would they also ban TV, newspapers, etc. from saying anything bad about these companies? 

Who To Blame

Since I'm an economist, people ask me who to blame for this finance mess.  I'm with Michael Lewis:

Christopher Cox ... [is] chairman of the Securities and Exchange Commission, and so has the job of regulating these companies that helped make it possible for every poor American to get a mortgage and are now, as a result, falling apart. ... He went as far out of his way as he could to enable the brokerage firms by harassing the small group of informed financial people who have been trying to tell the truth to the markets: the short sellers. They bet against the stock price of a company and so have always had a bad reputation with the public. But in this case, they are the closest thing we have to heroes.

A man named David Einhorn is a case study. He runs a hedge fund called Greenlight Capital, which sells short some stocks and buys others. That is, he doesn't just bet against companies but for them, too. Still, for some time now, he's been standing up in front of large audiences, announcing that he was short Lehman Brothers stock, and then explaining in great detail its dubious accounting practices. The SEC responded by demanding to see his firm's e- mail, hinting darkly that he was part of some conspiracy to drive Lehman Brothers out of business, and generally making him feel that he'd pay a price for telling the truth.

Hat tip to Hopefully Anonymous.

Added: Far from being sorry, they are working hard to make things worse!

Federal regulators yesterday took measures aimed at reining in aggressive forms of short-selling that were blamed in part for the demise of Lehman Brothers and that some feared could be used against other vulnerable companies in a turbulent market. ... In a further move, SEC Chairman Christopher Cox said he planned to ask his four fellow commissioners to consider on an emergency basis a new rule that would require hedge funds and other large-scale investors to disclose their short positions ... Critics say the SEC action comes too late to stem a tide of short-selling attacks that have felled huge, venerable companies. They want a prohibition on all naked short-selling.

Putting more restrcictions on short than on long trades is trying to shoot the bad-news messenger.  If we had instead been encouraging people to come forward with bad news, maybe we could have dealt with this problem earlier, when it was a smaller. 

Money Is Serious

Finances are on everyone's mind this week.  Consider that just hearing money mentioned changes our behavior dramatically:

Participants reminded of money were less helpful than were participants not reminded of money, and they also preferred solitary activities and less physical intimacy. On the other hand, reminders of money prompted participants to work harder on challenging tasks and led to desires to take on more work as compared to participants not reminded of money.

It seems we'll all be working harder, and getting less, this week.  And I guess I should take my wife's frequent money reminders as indicating she'd rather I worked harder even if that makes me less helpful, social, and intimate. 

This seems another important clue to understanding seriousness vs. silliness.

Banning Bad News

Bad news often has self-fulfilling prophesy effects.  Tell a student his work is bad and he might give up.  Telling friends someone is unpopular makes her even less popular.  Tell a sport team they will lose and they might not try as hard.  Tell customers a product is bad and they might look at it more carefully for flaws or switch products, and with fewer customers the producer has fewer resources to improve the product.  Tell people a bank is in trouble and they withdraw their deposits, stressing the bank further.

But most of us think it crazy to therefore ban bad news.  Sure some might maliciously spread negative rumors to hurt a rival, but this hardly means we should forbid anyone from ever talking negatively about anything!  We should instead rely on listeners treating rumors skeptically and listening less to those they find to be unreliable sources.

Alas, all this common sense goes out the window when bad news comes via financial markets.  When we buy stock observers reasonably interpret that as our saying we have good news about that stock, while selling is reasonably interpreted as bad news.   And so the US SEC is doing more to ban bad news: 

Overconfident Investing

I was watching the 1966 classic film, A Man For All Seasons, about the Thomas Moore's principled stance in opposition to Henry VIII's grab for power. Ultimately, Moore is found guilty of treason, and in the final scene, after giving his executioner the customary tip for a clean blow, tells him, 'don't worry, you are sending me to God'. Considering the fear of death is one of the greatest anxieties for a conscious being, what a fabulous delusion!  Clearly, biases can be helpful if looked at in a broader context, in this case, the belief in God is not evaluated based on evidence of God's existence, but rather, the effect it has on the believer. 

One particular area where the cognitive bias of overconfidence can be helpful is in entrepreneurship or investing.  Keynes hypothesized in The General Theory that if "spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die". Indeed, if you look at the data on stock picking, or investing with professionals, it is a puzzle why people don't merely all use passive indices because their average alpha is negative, and further, the average returns to highly undiversified C-corps or partnerships, seems woefully insufficient to justify their significant volatility   But over-confidence of entrepreneurs is helpful because it offsets the underestimation in other benefits of investing or entrepreneurship. Basically, the totally rational investor won't count what he can't quantify, but much of the value in investing, or entrepreneurship, comes from an option value that is impossible to quantify. I know someone who built a product based on an optimization routine for superior investment strategy—the flagship idea failed, it never had a chance, but his system is now a popular risk management tool. I know someone else who created a system to consolidate earnings expectations in order to beat the market—it too failed, but his database of earning expectations was put together thoughtfully, and it became successful platform for disseminating this data. Actions affect one's knowledge, reputation, and contacts in ways extremely difficult to quantify, because you can't really define the probability state space.  But the idea is simple, that people often get into some field to find gold, but then make their fortune selling shovels. 

Experience Increases Overconfidence

The latest Journal of Prediction Markets has a lit review on overconfidence, with a to-me surprising result: financial overconfidence increases with age, experience, and success.  Here are three investment experiments:

Kirchler and Maciejovsky (2002) .... demonstrated that subjects were overconfident in late trading periods ... [but] underconfident during other trading periods. ... Dittrich et al (2005) ... found that age was positively correlated to overconfidence for complex tasks.  ... Glaser et al (2005) ... [found that financial market] professionals' degrees of overconfidence was higher than that of the student subjects in most tasks, and it appeared that was because the "professionals are biased in job related tasks, such as forecasting real world financial time series."

Also:

A survey of German stock market forecasters conducted by Deaves et al (2005) ... demonstrated that the market forecasters were overconfident in their predictions and that greater market experience and success, measured by correct predictions, increased their overconfidence.  ... Markets are likely to become more overconfident when market returns are high. 

This is disturbing.  If overconfidence is positively correlated with ability, then observers can rationally take overconfidence as a signal of ability, and people can want to appear more overconfident to appear more able.  But to make this story work, somehow it should on average be easier to get away with being more overconfident when one is more experienced and successful.  How can this be?

This all seems to make it more reasonable than one might otherwise have thought to disagree about finance with older, more experienced, more successful folks.

The Future of Oil Prices 3: Nonrenewable Resource Pricing

Oil prices have been climbing rapidly in the past few years, and especially in recent months. Some point to speculation, others suggest that the fundamentals justify high prices. In 2006 I wrote a couple of posts here about how you could predict the future of oil prices. Unfortunately, reality did not align with theory, and my predictions were not accurate. Here is another approach to the problem which aims to look at the fundamentals and determine what is the rational market price for oil.

Oil Scapegoats

Who to blame for rising oil prices?  Why not speculators: 

Hedge funds and big Wall Street banks are taking advantage of loopholes in federal trading limits to buy massive amounts of oil contracts, according to a growing number of lawmakers and prominent investors, who blame the practice for helping to push oil prices to record highs. ... Some Democratic and Republican lawmakers allege that gaps in oversight are allowing deep-pocketed speculators to manipulate prices. ...

George Soros, one of the nation's leading investors, testified in a Senate hearing this week that index funds were contributing to the rapid rise in commodity prices and were possibly creating a bubble. If it were to burst, sending prices tumbling, the fallout could wreak havoc on banks, retiree funds and colleges across the nation. ... Under pressure from voters, lawmakers are pressuring the CFTC to take even more forceful action to regulate the commodity markets.

This is nuts.  "Manipulation" is an action that causes a harmful chain of events that comes back to benefit the actor.  Maybe a large supplier like Saudi Arabia could "manipulate"  by holding back production and to benefit them by raising the price of what they sell.  But hedge funds are not suppliers.  By pushing up prices now via speculation they are betting on higher future prices, not causing them.  If anything, their act causes reduced usage now leaving more oil for the future, which lowers future prices, which hurts them.   They only gain via the chain of events whereby they win their bets and inform the rest of us that oil will be scarcer than we thought, which if true is exactly what we need to hear. 

How to Add 2% to GDP

From a recent Post artice:

Looking at data from every trade made by all investors in Taiwan from 1995 to 1999, Odean discovered that the "aggregate portfolio of individual investors suffers an annual performance penalty of 3.8 percentage points," which includes trading costs. If investors had simply bought the index and not traded at all, they would have done about 3.5 percent better. The amount of money lost was equivalent to 2.2 percent of Taiwan's gross domestic product.

Condemned to Repeat Finance Past

Those who cannot remember the past, are condemned to repeat it. Santayana

I once said:

I'd guess you can get 80% of the improvement that predict markets offer by using a much simpler solution: collect track records.

Case in point - stock investors:

Based on the answers of 215 online broker investors to an Internet questionnaire, we analyze whether investors are able to correctly estimate their own realized stock portfolio performance. We show that investors are hardly able to give a correct estimate of their own past realized stock portfolio performance and that experienced investors are better able to do so.

It is hard to learn from experience if you don't remember what you did and how well that worked.