A couple of years ago, at my college reunion, alumni were treated to a series of lectures in many subjects. Among those we attended, my wife and I were fascinated by a presentation at the Yale School of Management – based on numerous studies sponsored by the University – which effectively repealed the notion of a marketplace governed by a rational person driving the pricing structure based on informed economic self-interest. OK, everyone should have known better simply based on the word “informed.”
Despite all of the market research, the analytics of experts, it seemed as if those who trade in the marketplace, particularly the non-expert day-traders, made their decisions under the assumption that with a little bit of reading, they could out-perform the marketplace. Statistics showed that, in fact, these non-expert day-traders trailed market averages with the reports of the occasional mega-success of one of their compatriots fueling their raging fires of overconfidence.
In fact, when Yale began making market predictions based on psychological factors, their estimates proved so much more accurate that the “rational economic man” predictions of professional analysts that the big financial institutions began absorbing the Yale predictors into their own analyses. The result? The professional analysts’ reports became more accurate, but the value of the psychological predictors was lost now that everyone was using the same formula.
But psychological variables still dominate the market-valuation process. One of the interesting economic iconoclasts to come around in the last few years is 46-year-old Malcolm Gladwell, a staff writer for The New Yorker since 1996 and best known as the author of the books The Tipping Point (2000), Blink (2005), and Outliers (2008). In a July 2009 article in The New Yorker, Gladwell examined the dominant theme that tried to explain the colossal failures of Wall Street that gave rise to our economic collapse. Popular notions of insufficient governmental regulation or incompetent analysis and decision-making were insufficient explanations to Gladwell. He felt there was a bigger cause: irrational and obvious overconfidence.
Is America, land of the free, home of the brave, where “cowboy” is a term of endearment, simply a culture that is too aggressive for its own good? But isn’t that what made America great? Perhaps the recent economic overconfidence (hubris) of a few was accelerated by the insecurities of the many (the sheep who followed out of fear that not following would have reflected their true ignorance). The November 6th theDeal.com excerpts this analysis from Gladwell’s July piece entitled Cocksure: Banks, battles, and the psychology of overconfidence. (Read Gladwell's piece here.)
Several years ago, a team headed by the psychologist Mark Fenton-O'Creevy created a computer program that mimicked the ups and downs of an index like the Dow, and recruited, as subjects, members of a highly paid profession. As the line moved across the screen, Fenton-O'Creevy asked his subjects to press a series of buttons, which, they were told, might or might not affect the course of the line. At the end of the session, they were asked to rate their effectiveness in moving the line upward. The buttons had no effect at all on the line. But many of the players were convinced that their manipulation of the buttons made the index go up and up. The world these people inhabited was competitive and stressful and complex. They had been given every reason to be confident in their own judgments. If they sat down next to you, with a tape recorder, it wouldn't take much for them to believe that they had you in the palm of their hand. They were traders at an investment bank.
TheDeal.com’s observation: “However, Gladwell also notes that overconfidence, particularly on Wall Street, can be an advantage since investment bankers borrow billions on the terms that they are able to pay it back. He cites Harvard biological anthropologist Richard Wrangham, who writes, ‘In conflicts involving mutual assessment, an exaggerated assessment of the probability of winning increases the probability of winning. Selection therefore favors this form of overconfidence.’”
And when you join this litany of psychological dysfunctions with hubris, the results can be staggering. As Goldman Sachs bankers soaked up their laden paychecks, bonus compensation and stock appreciation, their CEO, Lloyd Blankfein, justified his company to the London Times saying: “We help companies to grow by helping them to raise capital. Companies that grow create wealth. This, in turn, allows people to have jobs that create more growth and more wealth. We have a social purpose.”
Yeah, I’ve been keeping an eye on that job growth, Lloyd, 10.2% national unemployment (17.5% if you counter part-timers and those who’ve given up but still want full-time job) – nice work! The November 9th DailyFinance.com added: “[Blankfein] has put an unusual spin on the bank's activities. He says his firm is doing ‘God's work.’ This may seem like an audacious statement coming from a man whose company has been harshly criticized for planning to give many of its employees multi-million pay packages just a bit more than a year after the collapse of the credit markets.”
Hmmmm! Dekom on what needs to happen: When you have a bevy of overconfident, arrogant and overpaid cowboys holding the well-being of an entire nation in their sweating palms, you need to watch them like a hawk and corral their excesses with a vicious herd dog and the sounds of a strident whip! Crack! Snap! Grrrrrrrrrrrrrr!
I’m Peter Dekom, and I approve this message.