Challenges of Behaviouralists

Challenges of Behaviouralists

Even when the rationalist model was on the ascent in the world of economics and finance, the not-so rational aspects of human nature began to find its ways into economics. The major challenges emanating from behavioural economics were in the form of:

• Deviation from Rationality
• Possibility of Beating the Market
• Divergence between Market Prices and Fundamental Values
• Pervasiveness of Irrational Forces
• Misleading Signals from the Market Forces

Deviation from Rationality

By the mid-1950s, economists in general accepted von Neumann and Morgenstern’s expected utility and Henry Savage’s statistical axioms as gospel truth and built their models on these foundations. In 1950s, Herbert Simon, an economics maverick at Carnegie Tech’s Graduate School of Industrial Administration (GSIA), who later got Nobel prize in economics, argued that people don’t have the brainpower and time to make decisions so they take shortcuts and rules for them. People don’t “optimise,” but “satisfice” (a combination of “satisfy” and “suffice”).

Since Simon was a leading light at GSIA, the economists there listened to him, but chose to ignore him. As Simon wrote in his memoirs, “I heckled the GSIA economists about their ridiculous assumptions of omniscience and they increasingly viewed me as the main obstacle to building ‘real’ economics in the school.”

Simon led a project on decision making process in a paint factory in Pittsburgh, following his “satisficing” approach in which he enlisted fellow faculty member Franco Modigliani and Modigliani’s student John Muth. No sooner was the study over, Muth fought back: “It is sometimes argued that the assumption of rationality in economics leads to theories inconsistent with, or inadequate to explain, observed phenomena, especially over time… Our hypothesis is based on exactly the opposite point of view: that dynamic economic models do not assume enough rationality.” Muth argued that even though every individual or corporation need not make rational guesses about the future, on average, they were similar to the predictions of the most sophisticated models.

This “rational expectations” hypothesis was akin in spirit to the efficient markets hypothesis, although it had a broader sweep and less evidence to support it. Initially, it went nowhere, but as Keynesian economic policy faltered in the 1970s, several scholars, notably Robert Lucas, propagated it. With amazing rapidity, rational expectation model became the credo at the Chicago Economics Department. Even Paul Samuelson admitted that if compelled to choose between the “two extreme archetypes” of old-style Keynesianism and Lucas’s rational expectations, he would choose the latter.

While Herbert Simon’s disputes with mainstream economists triggered the rational expectations hypothesis, Daniel Kahneman and Amos Tversky built upon Simon’s ideas to challenge mainstream economics and its reliance on von Neumann and Morgenstern’s version of decision making under uncertainty.

Daniel Kahneman, a psychologist, felt that human statistical reasoning might not accord with the models used in economics. He along with Amos Tversky began conducting experiments which revealed gaps between the tenets of decision making and actual decision making by even experts. They wrote “People rely on a limited number of heuristic principles which reduce the complex tasks of assessing probabilities and predicting values to simpler judgmental operations.

In general, these heuristics are quite useful, but sometimes they lead to severe and systematic errors.” Put simply, people follow shortcuts and rules of thumb that sometimes work and sometimes don’t.

Kahneman and Tversky argued that von Neumann and Morgenstern’s description of decision making under uncertainty was not correct. How do then people really assess uncertain prospects? Kahneman and Tverksy provided the answer in their article on “prospect theory” published in Econometrica, perhaps the most mathematical of the major academic journals in economics.

The article was rigorous and filled with equations and hence, appealed to mathematically- inclined economists and the choice of Econometrica turned out to be very propitious as it attracted the attention of economists. As Justin Fox put it, “It had just what it took to become a hit among economists who were getting more and more interested in asking subversive questions but didn’t want to lose their chance at tenure by sounding too much like psychologists.”

Richard Thaler was the first and most eager among the economists who were deeply influenced by the work of Kahneman and Tversky. Hersh Shefrin, Meir Statman, and Werner De Bondt and a few other adventurous young economists at other schools joined this movement which came to be called behavioural economics, despite its moorings in cognitivenot behavioural-psychology. Among established economists, George Akerlof of UC-Berkeley was probably the most supportive.

In his famous 1954 essay on economic methodology, Milton Friedman dismissed the use of questionnaires (that psychologists employ) and experiments (of hard sciences) for economists. The former were too silly, and the latter not feasible. Behavioural economics challenged the first judgment and experimental economics sought to overturn the second. Edward Chamberlin of Harvard and his student, Vernon Smith, pioneered the development of experimental economics. In 2002, Vernon Smith shared the Nobel prize in economics with Daniel Kahneman.

The growing body of evidence documenting systematic departure from the dictates of rational economic behaviour prompted a Chicago conference on “the behavioural foundations of economic theory.” Stars from both sides of the rationalist divide, including the redoubtable Merton Miller, were present. In his paper, Miller admitted that cognitive psychology might explain why some individual investors and individual corporations might depart from rationality.

But finance was not about such explanations. He argued “That we abstract from all these stories in building our models is not because the stories are uninteresting, but because they are too interesting and thereby distract us from the pervasive market forces that should be our principal concern.” The market, he asserted, was rational because the “pervasive market forces” pushed security prices toward their correct, fundamental values.

Possibility of Beating the Market

To commemorate the fiftieth anniversary of Security Analysis, Columbia Business School hosted a conference in 1984. The book which became the bible of security analysts was conceived in Benjamin Graham’s course on security analysis that he taught at Columbia in the late 1920s. To debate the impact of this classic work, the organisers invited two speakers, Warren Buffett, a Graham student and an outstanding value investor, and Michael Jensen, a leader of the Efficient Markets Hypothesis, who had asserted few years earlier that there was “no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Markets Hypothesis.”

Jensen explained that extensive academic research had shown that analysis of publicly available data was almost worthless, at least as a means of outperforming the market. The great success of some practitioners of Graham’s principles, he argued, could be dismissed as luck. Jensen said, “If I survey a field of untalented analysts, all of whom are doing nothing but flipping coins, I expect to see some who have tossed two heads in a row and even some who have tossed ten heads in a row.”

Popularised by William Sharpe, the coin-flipping analogy has become a staple of MBA education. According to this analogy, if a million people flip a balanced coin, about 500000 will get a head and the balance a tail. Those who get a head continue the game and those who get a tail quit the game. In the second round about 250000 get a head.

In the third round about 125000 get a head. By the end of the tenth round nearly 975 people get a head. A straight run of 10 heads may persuade these people to believe that they have great skill in tossing coins. In reality, their success is due to chance not skill. Finance academics believe that the stock market works pretty much the same way: the chance factor will ensure that some investors will have a long streak of successes.

In response to the argument of academics that coin-flipping orangutans would achieve the same result as a bunch of successful investors, Buffett gave a fitting reply: “If you found that 40 per cent came from a particular zoo in Omaha, you could be pretty sure you were on to something. So you would probably go out and ask the zoo-keeper about what he’s feeding them, whether they have special exercises, what books they read, and who knows what else.”

Expressing admiration for Buffett, Michael Jensen said, “One of the things I came away from that was Warren Buffett was one of the smartest people I’ve ever met, and wise. He could play on my turf without making mistakes. It’s not by accident that he’s worth billions.”

Divergence between Market Prices and Fundamental Values

In their 1970 book Predictability of Stock Market, Clive Granger and Oskar Morgenstern provide a kind of alternate view of the efficient markets hypothesis. Both were big time economists. Clive Granger got the Nobel prize in economics in 2002 for unrelated work and Oscar Morgenstern was the co-author of Neumann- Morgenstern model for decision making under uncertainty, a model that dominated economics and finance.

They did not see the findings on efficient markets hypothesis in the same light as finance professors. They said that The Money Game authored by journalist George A.W. Goodman (Adam Smith) and not some academic journal article provided “probably the most perceptive account of stock market behaviour.”

In his book, Goodman devoted an entire chapter on random walk, but rejected it. Instead he argued, “that in the long run future earnings represent present value and that in the short run the dominant factor … was the elusive Australopithecus, the temper of the crowd.” Clive Granger and Oscar Morgenstern seemed to endorse this view. They wrote, “The random-walk hypothesis did not say that price changes are unpredictable: it says they are not predictable using (linear) combinations of previous price changes. It is conceivable that one could introduce other variables which did have some predictive values.”

More importantly, they argued that it was erroneous to believe that stock prices reflected intrinsic values, which according to them “are supposed to reflect fundamentals of their companies, such as capital equipment, inventories, unfilled orders, profits.” They went on to say, “Most of these items, and the values attached to them, will hardly fluctuate as fast and as far as stock prices do. It is a subterfuge going back at least to Adam Smith and David Ricardo to say that market prices will always oscillate around the true (equilibrium). But since no methods are developed to separate the oscillations from the basis, this is not an empirically testable assertion and it can be disregarded.”

Eugene Fama suggested that the EMH may be tested by seeing if stock price movements conformed to the dictates of a risk-return model like the CAPM.

This, however, is only a relative test. As Justin Fox wrote, “It might reveal whether stock price movements made sense in relation to each other and the overall market, but was no help in showing whether the overall market is correctly priced.”

Challenging the EMH, Robert Shiller, a Nobel laureate in economics, argued that the excessive volatility of stock prices could not be explained by fundamental factors. Devising, in effect, a non-event study, he looked at cases where prices moved but nothing of consequence happened

To argue that stock prices were right because it was hard to predict them was, according to Shiller, “one of the most remarkable errors in the history of economic thought. It is remarkable in the immediacy of its logical error and the sweep and implication of its consequences.”

Lawrence Summers, a Harvard professor, who later became the U.S. Treasury Secretary, was an ally of Shiller. He too, like Shiller, had a flair for combining advanced mathematics and provocative rhetoric. Summers said that it was an ‘idiot’s market, rather than a ‘rational market.’ He goaded Fisher Black, a luminary in the world of finance and a leading efficient marketer “How many finance professors are included in the Forbes 400? How many of the people who are there believe that the market is efficient?”

Persuaded, Black called Summers’ idiots as “noise traders.” In his 1985 presidential address to the American Finance Association, aptly titled “Noise”, Black said, “Noise makes financial markets possible, but also makes them imperfect.” Noise causes prices to diverge from intrinsic values and also makes it impossible to tell what those intrinsic values are. Proposing a diluted version of efficient market, Black said, “We might define an efficient market as one in which price is within a factor of 2 of value, i.e., the price is more than half of value and less than twice value …

By definition, I think all markets are efficient almost all of the time. ‘Almost all’ means at least 90%.” Commenting on this, Justin Fox wrote, “It was a loose, pragmatic, Ben Graham-ish definition, befitting a man who a year before had left MIT for a job at Goldman Sachs.” As Black observed, “Markets look lot less efficient from the banks of Hudson than the banks of Charles.”

Most finance professors ignored the Shiller–Summers attack against the efficient markets, but Robert Merton, a Nobel laureate in economics and Shiller’s classmate in graduate school defended the rational markets hypothesis. He argued that instead of asking the question “Why are stock prices so much more volatile than (measured) consumption, dividends, and replacement costs? Perhaps general economists will begin to ask questions like Why do (measured) consumption, dividends, and replacement costs exhibit so little volatility when compared with rational stock prices?”

nal stock prices?” However absurd it may appear, perhaps science works this way. As Thomas Kuhn put it in his insightful book The Structure of Scientific Revolutions, “Normal science… is predicated on the assumption that the scientific community knows what the world is like. Much of the community’s success of the enterprise derives from the community’s willingness to defend that assumption, if necessary at considerable cost.”

What was Eugene Fama, the father of EMH, doing as this controversy raged? After being a spectator for a while, he came back in a 1991 sequel in which he said, “EMH passed the acid test of scientific usefulness.” It was, however, different from saying that the market is perfectly rational or efficient.

According to Fama, the lesson from Shiller and Summers was “that irrational bubbles in stock prices are indistinguishable from rational time-varying expected returns. There was no way to be sure that the market was irrationally volatile or not.” Perhaps Fama, without repudiating the efficient market theory, shook its foundation in a way no one could have done.

Pervasiveness of Irrational Forces

In 1985, Andrei Shleifer, an MIT graduate student, thought that he had assembled convincing evidence against the efficient markets hypothesis. He discovered that, beginning September 1976 – Vanguard had launched the first retail index a month before that – the new stocks being added to the S&P 500 performed better than the rest of the market. Since nothing had changed about these businesses in terms of their intrinsic value, such things should not happen in an efficient market.

Shleifer presented his findings at the annual meeting of the American Finance Association. Myron Scholes, who was asked to critique the paper, said: “This paper reminds me of my rabbi back in Palo Alto. My rabbi, when he gives his sermon on Saturday, always begins with a little story about something that happened to his family back in the shtetl, and then he generalises from that little episode to some big moral about the whole world. That’s what this paper reminds me of. It’s rabbi economics.”

This criticism ringed like Merton Miller’s argument about the need to focus on “pervasive forces” and not anomalous quirks. Shleifer took the criticism seriously and began his quest for pervasive market forces that caused market irrationality.

Shleifer, a prolific researcher, had other interests as well. He published path- breaking articles on corporate governance, the economics of transition (from communism to market economies), and macro-economics. In 1999, he won the John Bates Clark Medal as the top American economist under forty.

Despite his forays into other areas, Shleifer continued his quest for an explanation which was more than ‘Rabbi economics.’ He was looking for “pervasive forces” rather anomalous quirks. And that pervasive force, according to Shleifer and his co-researcher Robert Vishny was the presence of “noise traders” and the “limits to arbitrage.”

The argument of behaviouralists rests on two key assumptions:

• Some investors—they call them noise traders—are not rational as their demand for risky assets is influenced by beliefs or sentiments that are not fully supported by fundamentals.
  
  
• Arbitrage operation by rational investors tends to be limited as there are risks associated with it.

Misleading Signals from the Market Forces

With enough evidence that stock prices can deviate significantly from their intrinsic value, the argument that financial markets should always set the priorities for corporations and for society lost some of its force.

Michael Jensen, a leading advocate of EMH, realised that overvaluation can trigger organisational forces that destroy value. Some conspicuous examples are Enron, WorldCom, and AOL. Enron and WorldCom struggled to meet expectations baked in their stock prices, manipulated their earnings, and self-destructed. Entertainment conglomerate Time Warner sold itself to a grossly overvalued Internet company, AOL, and destroyed nearly $50 billion of its value.

As Jensen wrote, “Like taking heroin, manning the helm of an overvalued company feels great at first. If you’re the CEO or CFO, you’re on TV, investors love you, your options are going through the roof, and the capital markets are wide open. But as heroin users learn, massive pain lies ahead.”

In order to mitigate the agency problem, Jensen had advocated the use of incentive compensation that aligned the interests of managers with shareholders. As the shareholder value principle spread across corporate America, executive salaries rose. CEO pay rose so sharply that it attracted criticism in the media and from politicians. Surprisingly, a group of scholars, who met at the University of Rochester, defended the rise in executive pay. They reached the consensus “that executive salaries are determined by the market, and that changes in compensation are strongly related to company performance.”

But when Jensen and Murphy subsequently analysed fifteen years of CEO pay at 250 big companies, they found to their dismay that there was no correlation between pay and performance. In a Harvard Business review article published in 1990, they wrote, “Is it any wonder then, that so many CEOs act like bureaucrats rather than the value–maximising entrepreneurs companies need to enhance their standing in world markets?” These were perhaps the most influential words written by Jensen. CEOs, shareholder activists, compensation consultants, corporate board members, and others agreed that CEOs should be paid for performance.

Incentive compensation in the form of stock options became quite pervasive. However, most of the stock options were poorly designed and had dysfunctional consequences. They rewarded managers for absolute performance, not relative performance; they vested too soon; they motivated managers to manage quarterly earnings to stimulate short-term price increases so that they could cash out their options.

Jensen, a champion of the notion that financial markets knew best and that financial-market-based incentives were a key to a more productive world, realised that the missing element in his models of corporate behaviour was integrity. As Justin Fox wrote about Jensen:“Now he was acknowledging that these incentives weren’t enough. If market participants failed to follow a particular non-market determined norm integrity markets wouldn’t work. The market couldn’t govern itself.”