Dan Ariely is Professor of Behavioral Economics at
and he is head of the eRationality research group at the MIT Media Lab. Duke University
Some established experts called already the death of investing based on mean reversion strategy (because of flatter distribution with fatter tails) following the finance crisis. What is your assertion from the view of Behavioral Investing?
There are couples of different ways to view the behavioural investing. One of them is to identify mistakes people make when they invest and try to prevent them from doing so. For example the role of emotions. We know when people become emotional they think very differently about risk, they think very differently about decisions. Because of that we can say that if we can just eliminate the role of emotions from people’s investment decisions making they will make better decisions. Or there is another example we can say what about looking at your past decisions as a starting point for evaluating your future decisions, we know that if the people look at the prices which they bought some stock that is not good starting point for how to valuate it. If the stock is about 90 and I bought it either at 100 or 80 it doesn’t really matter besides small tax consideration. I should decide about whether I want to keep the stock or sell it looking forward, not looking backward.
There is a class of mistakes people make when they invest that we say lets try and cancel those mistakes. There is an other type of behavioural investing which is capitalizing of other people making mistakes. For example there are big banks which have a strategy that when the stock moves from being triple-rated to double-rated they drop it. So this means you know that some people by a rule have to drop the stock very quickly when it changes its rating status and this means probably good opportunity to buy something.
You can basically think about opportunities. You can say let me not fix rationality but let me assume that other people behave irrationally in a specific and predictable way. Let me take advantage of that. I think the mean reversions are a part of that strategy. You look at what other people are doing and you might think that other people behave irrationally they expect mean reversion way to frequently and you can bet against that. I don’t think that it is dead yet. Because a lot of people have the intuition for mean reversion and therefore it is still looming large in the decision making processes. You can either try to cancel it or you can try to take advantage of it by take advantage of other people.
There was a Housing Bubble back then. But why could the most people not be worried? What lessons emerge from that development ?
I don’t think it is the case that most people are not worried. There is a difference here between the regular people and the bankers. If you believe that the stock markets were 2009 was relatively good year especially after 2008. If you want to believe that the world has not changed in fundamental ways, you can try to use that. And you can try if you are a banker. You can try to justify your salary and you can try to justify your income and the structure of the banks and so on. I think for most regular people who are not in the banking industry the housing bubble has not passed at all. They are still incredibly concerned.
Mostly the people have lost their trust in the banking system for a good reason. 2008 has shown us lots of weaknesses in banking. That time there was a hope there would be a true reform in the banking system in the
and also in US Europe. Of course the reform that has taking place has been relatively minute since than. It is good for people who are actually working in the banking industry, not so good for every body else.
I think we have not finished seeing the downfall of this financial recession. I think it will take a long time before people actually regain trust in the financial system. While people within the financial system want to pretend that nothing really happened and the world is back to normal. This is not the case. We will keep on paying it for many years for this recession in terms of how much of the public trust has been lost.
The Efficient Market Hypothesis (EMH) is now being recognized as one of the most remarkable errors in the history of economic thought. Who should safeguard financial stability?
I think the EMH is an interesting hypothesis. And it is interesting possibility. But of course what it is clear is that there are lots of conditions to take place for it to occur even theory. Those conditions are very unlike to occur in reality.
We need to separate economic ideals from economic practicality. One of the things what always amaze me is that one of the simplest theory in economics not EMH, which is complex, but one of the simples one saying when you compete in a market on a commodity in a competitive market prices should go down to productions costs. Basically margins of profits should be eroded in an approach zero.
Here we have the banking industry which is a commodity as much as you can have a commodity. There is a high competition because there are lots of players in the market. Nevertheless it is hard to claim anyway that prices in this market have been approaching production cost. In fact we know that banks make lots of lots of money. Even in the banking sector have shown very simple theories just don’t play out in the way they suppose to.
To the more complex part of your question: Who should safeguard the financial stability? I think the first thing we need to recognize is that we really don’t understand how the financial markets work. If you believe in the EMH, you at least have a theory how the market work. But if you don’t, you have to recognize how the markets work. So now we are working in a really high area of uncertainty and ambiguity.
Secondly what we need to recognize is that this is the world we can create lots of lots damage for ourselves, like we see now. So what do you do in the world in which you don’t understand and you have potential for creating lots of lots of damage. The answer is you have to be cautious and be carefully. You cannot take crazy risks. If that the case, can we hope the companies would regulate themselves? Can you hope individuals would regulate themselves under those conditions. The answer is no. So I think it is much like driving. We need to have external regulations on the markets prohibit people from taking crazy risks. Roads are dangerous and people can create tremendous damages for themselves and as to others much like the financial markets. Because of that we cannot trust people to do right thing on their own court. Instead we need to create some regulatory frameworks that would limit people’s ability to inflict damages on themselves and on others.
I also think that one of the biggest culprits, one of the biggest contributors to the financial crisis has been conflict of interest. When you pay people a lot of money for surreality in a skewed way because it is good for them, you bet you will be able to do it. This is what happened. We paid people a lot of money to be able to surreality in a skewed way. And somehow unsurprisingly, perhaps, they were able to do that. What we need to do is we need to make sure that people are not motivated to surreality in a skewed and in accurate way. We need to stop paying people in ways that they don’t create dramatic conflict of interest. Unless we do that, I don’t think we will get over the problems. The answer is basically a different regulatory frame work and reduction and hopefully elimination of the conflict of interest in the financial systems.
Thank you very much.
Dan Ariely is Alfred P. Sloan Professor of Behavioral Economics and he is Director of The Center for Advanced Hindsight and Director of eRationality Research Group. His current book „The Upside of Irrationality. The Unexpected Benefits of Defying. Logic at Work and at Home“, in German: „Fühlen nützt nichts, hilft aber: Warum wir uns immer wieder unvernünftig verhalten“, Droemer/Knaur (Sept. 2010).