Wednesday, April 22, 2009

the market is rational, so they would not take risks that would threaten their very existence

TO BE NOTED: From Haaretz:

Irrational everything
Prof. Daniel Kahneman has dozens, perhaps hundreds, of stories about people's irrational behavior when it comes to making economic decisions. It's no wonder, because for dozens of years he and his late colleague Amos Tversky researched human behavior. Many of their studies concerned the making of financial decisions.

But the story Kahneman recalls when asked about the economic models at the root of the current financial crisis is actually taken from history, not an experiment. It concerns a group of Swiss soldiers who set out on a long navigation exercise in the Alps. The weather was severe and they got lost. After several days, with their desperation mounting, one of the men suddenly realized he had a map of the region.

They followed the map and managed to reach a town. When they returned to base and their commanding officer asked how they had made their way back, they replied, "We suddenly found a map." The officer looked at the map and said, "You found a map, all right, but it's not of the Alps, it's of the Pyrenees."

According to Kahneman, the moral of the story is that some of our economic models, perhaps those of the investment world, are worthless. But individual investors need security - maps of the Pyrenees - even if they are, in effect, worthless.

I first came to know Kahneman's work some 17 years ago, when I was studying for my bachelor's degree in economics at Tel Aviv University and took a course on the psychology of economics. At the time, Kahneman's course was considered entertaining and interesting, but marginal compared to "serious" economics courses, in which students learn that individuals make decisions rationally.

Kahneman and Tversky demonstrated, however, after many experiments done over many years, that individuals are irrational. Not only are they irrational, it's even possible to predict the irrational manner in which they will make economic decisions. Kahneman and Tversky found that people do not gather data in a systematic or statistical way, but usually make economic decisions based on "rules of thumb" - heuristics, to borrow the term they used.

For example, let's take two groups of people and ask the first if the tallest tree in the world is taller than 300 meters. Then let's ask them how tall the tallest tree in the world is. Then we repeat the exercise with the second group, asking them whether the tallest tree in the world is taller than 200 meters, and then how tall it is. At the end of the experiment, we find that the first group's average answer to the second question is, around 300 meters, and the second's is around 200 meters.

Why? Kahneman and Tversky say this is "anchoring": People tend to latch on to a certain "anchor" - usually one they come across by chance - instead of trying to use a more rational way to gather and process data and make economic decisions.

My second encounter with Kahneman came at a meeting of the World Economic Forum, in New York, in 2002. I spotted his name on the list of speakers and sent him an e-mail requesting an interview. He replied, "You must be mistaken. I am a professor of psychology, of no interest to anyone." Only after I insisted I knew exactly whom I was addressing, and that I remembered quite well his theory from my economics studies, did he agree to speak with me.

That year Kahneman won the Nobel Prize in Economics; overnight, he became an international star, constantly quoted and cited. Today his theory of irrational decision making is considered an integral part of any discussion about economics.

'Nothing insightful to say'

But when I met him again two months ago at the World Economic Forum in Davos, he was the same modest Kahneman. "The truth is, I have nothing insightful to say," he warned me right off. "Nor am I involved in what they have been discussing at this session of the Forum. I've spent the last three days cloistered in my room writing. This is the first time I've ventured out. I must work."

When I asked him why he even bothered to come to Davos, he said, "I guess because Yossi Vardi kept asking me," referring to the veteran Israeli high-tech entrepreneur.

A few days before Davos, Kahneman appeared jointly with the mathematician Nassim Taleb in Munich. Taleb himself has become a major star during the current financial crisis, thanks to his books claiming that the financial establishment is unprepared to anticipate or handle various sudden events unfamiliar to historical statistics.

Not surprisingly, it turns out that Kahneman met Taleb five years ago in Rome, and the two men hit it off. They have since been exchanging ideas about our strange world, where economic models prove worthless in times of great crisis.

"People ignore the tremendous impact rare events can have on the decisions they make. People are simply unwilling to accept the fact that they are actually taking huge risks," Taleb says. "They prefer to cross the street with their eyes closed. Alan Greenspan, the former chairman of the Federal Reserve Bank of the United States, was driving a bus full of children with his eyes closed while he was in office. When you bet against rare events, over time you are always making a little bit of money. But when the rare event occurs, you lose big."

From Kahneman's point of view, the most important moment of the recent economic crisis came when Alan Greenspan admitted at a congressional hearing that his theory of the world had been mistaken. "Greenspan expected financial firms to protect their interests, because they are rational companies and the market is rational, so they would not take risks that would threaten their very existence," Kahneman says.

"Where did he go wrong? Because he did not distinguish between the firms and their 'agents' [their managers]. There is a huge gulf between the companies and their agents. Firms take the long view, while agents have short perspectives and take the short view. The compensation models of the corporation and their agents are different. The executives did not commit suicide when they took risks; it was the corporations managed by these agents that committed suicide.

"People are always asking me: 'Are the people who got caught up in the financial crisis idiots?' The answer is, the bank managers were not complete idiots. Greenspan's admission speaks for itself: The theory that a bank is some sort of rational agent that protects the public's interest is wrong. The assumption of rationality is a fallacious one in the first place, and in the second place, the assumption that a bank should be seen as a single, rational player is irrelevant. One must look at who is managing the bank - management that receives incentives to do things that are not connected to anybody's interests."

Not just optimism

The worlds of business and finance have long recognized the problem of conflicting interest between companies and executives; the surprising aspect of the world financial crisis, however, has been the behavior of millions of mortgage borrowers and investors. Here's where Kahneman's theory comes in.

"At the lowest level, you have the psychology of the borrowers - those who took out mortgages - who believed that the prices of real estate, of homes, would go up forever. This is an interesting phenomenon. It's not just optimism, it's not just that people believe what they're told; it goes deeper than this," he says.

"Psychology today differentiates between two methods of thinking: There is the intuitive method, and there is the rational one. The intuitive method is characterized by rapid learning, and it concludes very quickly that what has happened the last three times will happen forever, again and again."

Why is it that we believe that if it has happened three times, it will happen again?

"I once told a story about this: We once traveled from New York to Boston on a Sunday night, and we saw a car on fire on the side of the road. A week later, again on a Sunday night, we were traveling and again saw a car on fire in the same place. The fact is, we were less surprised the second time than the first because we had learned a rule: Cars burn at this spot.

"We find this everywhere - the speed at which people create rules, norms and expectations, even when they know it's ridiculous. This is the intuitive method at work. It remains true that whenever I travel, I always look for burning cars at that spot."

Over the last 40 years you have demonstrated that we never employ the statistical method of thinking, just the heuristic one - rules of thumb. Some economists today say the models were indeed based on statistics, but the problem is that they were based on statistics according to which the market goes up, rather than on long-term statistics.

"When it comes to finance, people link risk to volatility, but in reality, there is no connection between the two at all. There is a connection, but not when we're talking about huge risks. Greenspan and others believed that the global system - by virtue of its being global - was ipso facto more stable. Then it turned out that while it might have been more stable, it was also more extreme.

"In the last half year, the models simply didn't work. So the question arises: Why do people use models? I liken what is happening now to a system that forecasts the weather, and does so very well. People know when to take an umbrella when they leave the house, or when it will snow. Except what? The system can't predict hurricanes. Do we use the system anyway, or throw it out? It turns out they'll use it."

Okay, so they use it. But why don't they buy hurricane insurance?

"The question is, how much will the hurricane insurance cost? Since you can't predict these events, you would have to take out insurance against many things. If they had listened to all the warnings and tried to prevent these things, the economy would look a lot different than it does now. So an interesting question arises: After this crisis, will we arrive at something like that? It's hard for me to believe."

The financial world's models are built on the assumption that investors are rational. You have shown that not only are they not rational, they even deviate from what is rational or statistical, in predictable, systematic ways. Can we say that whoever recognized and accepted these deviations could have seen this crisis coming?

"It was possible to foresee, and some people did. There were quite a few smart people with a lot of experience who said bubbles are being created and they have to be allowed to burst by themselves. But it turns out that this bubble did not have to be allowed to burst by itself. I have a colleague at Princeton who says there were exactly five people who foresaw this crisis, and this does not include [Fed Chairman] Ben Bernanke. One of them is Prof. Robert Shiller, who also predicted the previous bubble. The problem is there were other economists who predicted this crisis, like Nouriel Roubini, but he also predicted some crises that never came to be."

He was one of those who predicted 10 crises out of three.

"Ten out of three is a pretty good record, relatively. But I conclude from the fact that only five people predicted the current crisis that it was impossible to predict it. In hindsight, it all seems obvious: Everyone seemed to be blind, only these five appeared to be smart. But there were a lot of smart people who looked at the situation and knew all the facts, and they did not predict the crisis."

Of all the observations and behaviors you have observed over the last 40 years - and you have observed many kinds of irrational behavior - which would you say is most responsible for the current crisis?

"Well, that's a good question, and it can be looked at from the lowest level: the borrowers, those who took out mortgages. What happened to them? They were really convinced that real estate prices would go up forever. How could they have believed such a thing? They believed it because people who had certain interests told them. They were not suspicious enough, and the market permitted it."

Of all your experiments, which demonstrates similar behaviors?

"The general phenomenon of suggestibility - when people believe too much in what is being suggested to them. It's related to the anchoring we saw before. How easy is it to influence people? You introduce a number into their heads, and they attribute importance to it when there really is none. There's a sucker born every minute."

So how do we deal with this? What are the lessons to be learned from this crisis?

"I think that in the future there will be rules obligating lenders to give much more information to borrowers. Financial firms' problems are less interesting from a psychological point of view. These are problems of agents and companies that economists already understand. The interesting psychological problem is why economists believe in their theory, but this is the problem with the theory, any theory. It leads to a certain blindness. It's difficult to see anything that deviates from it."

We only look for information that supports the theory and ignore the rest.

"Correct. That appears to be what happened with Greenspan: He had a theory under which the market operates, and that the market would correct itself."

A personal question. When you look at your own behavior in the world of economics, do you feel you make the same mistakes, or that you are aware and thus consider yourself immune?

"I am not immune, I am a coward. That's something else. Several years ago, I decided that I should not take any risks, that I want a European retirement, linked to the cost-of-living index. In the United States, there is no such thing. I asked an investment counselor to look into whether she could arrange a European retirement for me, something linked to the cost of living, without any risk. She threw me out of her office; she considered it something incompatible with American values."

So in what have you invested?

"Index-linked bonds. I know this is not popular. Many people think it's a mistake, but that's the mistake I make."

You've never owned stocks?

"I used to have a quarter to a third of my portfolio in stocks. Psychology teaches us that people like a combination of something safe and a gamble. I have something like that: a few stocks. But I don't advise anyone else to act that way."

Let's end with your story of the Swiss soldiers and the map of the Pyrenees. I know why the map helped the soldiers: it gave them confidence. But why didn't they use a map of the Alps? Why don't we use the right economic models, ones that are relevant to extreme cases as well?

"Look, it's possible that there simply is no map of the Alps, that there is nothing that can predict hurricanes."

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