Mar

9

Once again, we see the common meme whenever there is a big down day. From various email lists, to chat boards, to news sites, and to TV, the commentary is all the same: What went wrong? This is usually followed by posts about how this or that system that is supposed to prevent the market from going down didn't work.

Never is there consideration that the movement might have been random, or that in fact the move was in fact an act of the capital markets efficiently pricing in new information.
Noticeably absent, of course, is the lack of "what went wrong" statements whenever the market goes up big.

Why? I offer two explanations, and the answer is likely a combination of both.

First, human psychology. It is well known that people tend to assign their winnings to skill and their losses to luck, malfeasance, someone's part, or a system breaking. Most likely there is a large issue at play regarding people refusing to view events logically when the event itself is negative. Perhaps Dr. Dorn could comment.

The other explanation is a mistaken view of the role of capital markets, specifically the stock market, in an economy.

The role of capital markets in an economy is, at its most basic, to serve as a meeting place for those with surplus capital and those with a shortage of capital. The primary market in equities consists of those with excess capital wanting to buy shares in companies who are in need of capital.

The secondary markets then serve to offer liquidity to those who purchased equity in the primary markets. The secondary market is critical to the success of the primary market. Without the liquidity of the secondary market, investors would take a liquidity discount on what they are willing to pay in the primary market.

In order to entice investors to invest in common equities, they must offer a risk adjusted return that is above other more secure investments. If there was no risk adjusted return, people wouldn't invest in the secondary markets, and thus people wouldn't invest in the primary markets.

For most of the century, the figure needed to keep the equity markets chugging along has been around a 10% annual return.

The pricing in the equity markets also sends resource allocation signals to the economy as a whole.

Now, most people don't see that as the purpose of the stock market. Most see the purpose of the stock market being "to go up." Therefore, when it goes down they think that something has gone wrong.

But, the purpose of the stock market is neither to go up nor go down. For it to serve its purposes, it must go up over time, but going up is not its purpose in and of itself.

In short, the market went down today. If you lost money, it is nobody else's fault but your own. If you made money, there's a good chance it was luck.

Janice Dorn writes:

In partial response to Professor Haave's insightful commentary, I have a several minute-long video which I made on January 24. 2007, discussing what is known as the self-attribution cognitive bias. If I am able to send it to the list, I will. Until then, perhaps this will be of some assistance, perhaps not.

Human beings are fragile as regards the whole situation of self-esteem. This is much more detailed than the small paragraph or two, but perhaps it captures some of the essence.

The human brain has many ways of protecting against assaults on the fragility of self-esteem. In psychoanalytic literature and much of the psychiatry literature, these protective tactics (which are, in large part, little or big lies we tell ourselves) are called defense mechanisms. In the language of behavioral neurofinance, they are called cognitive biases.

The self-attribution bias manifests as a tendency for good outcomes to be attributed to skill, and bad outcomes to be attributed to just plain hideous bad luck.

A decision matrix for self-attributional bias looks something like this:

                             GOOD OUTCOME             BAD OUTCOME

Right Reason                  Skill ( or luck)         Bad luck

Wrong Reason                Good Luck                Mistake
 

Among the questions that follow from this very brief discussion of self-attribution are:

  1. When are we lucky and when are we skillful?
  2. Are we right for the "right" reason, or are we right for some other reason.
  3. Does it matter, as long as we are right?
  4. How do we measure and "fess up" to mistakes, i.e. recognize mistakes as mistakes by taking personal responsibility and accumulating regret?
  5. Is it important to do this, and why?
  6. How do we learn from this and what do we learn from this?
  7. How important is it to learn from this?
  8. What about all the other cognitive biases and how they impact self-attribution?

The essence of the self-attribution bias is: Heads was skill, tails was bad luck, with all and every due apology to any long tails who may or may not be listening in!

Art Vandalay writes:

This article is two months old but very important in my opinion. It will be the main driver this year.


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