Friday, May 1, 2009

Analyses Hold Stock Market Warnings to be Heeded

By Arthur Hoffman

(NOTE: This is the latest in a series of articles and commentaries written by Gotham team members that we will be featuring here. This article originally ran in St. Louis Business Journal on April 17, 2009.)

It seems like a very long time ago. But in October 2007, presidential candidate Sen. John McCain said he’d appoint octogenarian, former Fed Chairman Alan Greenspan to lead a review of the U.S. tax system, joking that “if he’s dead, just prop him up and put some dark glasses on him, like ‘Weekend at Bernie’s.’”

McCain made that remark days before Oct. 9, 2007, when the Dow Jones Industrial Average hit its all-time record high close of 14,164.53.

In those heady days, long before the financial system began to come apart, no one questioned McCain’s adulation of Greenspan’s acumen, even dead.

Today, no politician talks about appointing Greenspan — to anything. While Greenspan has rejected the thought that he bears any responsibility for our economic meltdown, he has ruefully admitted that he made “a mistake” in believing that bankers would act in their self-interest to protect their shareholders and institutions. By way of explaining his error, he pointed to “a flaw in the model... that defines how the world works.”

This brings us to Nassim Nicholas Taleb, the author of “The Black Swan: The Impact of the Highly Improbable,” published in 2007 (Random House). Taleb argues that models, like the one Greenspan trusted, are inherently unreliable and, indeed, worthless because they cannot predict the highly improbable, or black swan, event.

As a quant, or expert in quantitative finance, Taleb understands sophisticated mathematics. But Taleb has little faith in highly complex models. Indeed, he cites research by Spyros Makridakis and Michele Hibon of actual forecasts and their conclusion that “statistically sophisticated or complex methods do not necessarily provide more accurate forecasts than simpler ones.”

Taleb also describes the work of psychologist Philip Tetlock involving 300 specialists (one-fourth economists) and thousands of their predictions that showed “an expert problem: There was no difference in results whether one had a Ph.D. or an undergraduate degree.” In fact, those who had a big reputation were worse predictors than those who had none.

How can this be? Taleb speculates that our inherited instincts reflect a relatively primitive environment eons ago in which highly improbable events were limited to encounters with new predators, human enemies or abrupt weather shifts. Today’s global, intensely informational and statistically complex environment bears no practical resemblance to the primitive world in which those instincts were learned.

“Predictably Irrational: The Hidden Forces that Shape Our Decisions” by Dan Ariely (HarperCollins, 2008) expands on human frailties in making even simple decisions. A professor of behavioral economics at Duke University, Ariely devises experiments that prove people do not act according to the assumptions of economics. Instead of making rational decisions based on information, we succumb to a variety of irrational influences from the environment, called context effects, and make predictably irrational decisions.

Many of these influences, like the power of “free,” are well-known to retailers and advertising copywriters. Still other forces Ariely identifies — for example, how pricing affects the efficacy of placebos — are not well-understood outside the world of pharmaceuticals and medical ethics but should be. Also, Ariely’s research on honesty has profound implications, except for the extreme case such as the 30-year fleecing of friends and nonprofits by Mr. Madoff in which societal norms obviously did not influence his behavior.

If we’d read Taleb’s “The Black Swan” in 2007, would we still be mired in the stock market today? I believe the sad answer is yes.

There are many reasons found in both these thought-provoking books. One example: Anchoring, or relativity, is a classical mental mechanism in which a starting reference point, say a Dow Jones of 14,164.53, will mean dismay, or worse, when an investor expects the Oct. 9, 2007, record closing high to continue to be exceeded.

The reality is that the Dow Jones Industrial Average began in May 1896 at 40.94. So, half the index value created in more than a century has been wiped out in less than 18 months. Anchoring to the 14,164 level can lead to depression and perhaps even more irrational behavior.

Both authors write about the power of anchoring or relativity. Ariely says, “We fall in love with what we already have,” and, “We focus on what we may lose, rather than what we may gain.”

This does not bode well for short-term market performance — not to mention investors’ emotional well-being.

But the reality is that most of us stayed in the market well after its October 2007 high, at least in part because of anchoring — and the belief that past trends that demonstrated our genius would continue.

Arthur Hoffman is an executive speech writer and president of Hoffman Creative, Inc. in St. Louis.

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