Wednesday, July 1, 2009
People Are Irrational - More Evidence
There are many problems with the theory, of course, but the one that has always stuck out for me is the whole idea of a rational agent because, frankly, people are nuts. We are not programmed to be purely rational. Although this seems obvious to most, an associate professor expressing this view anytime between 1970 and 2000 would have been smacked upside the head by his tenure review committee. Enjoy the rest of your career at East Nowhere Community College. It's still a dangerous viewpoint, but so much contrary evidence has rolled in that there are cracks in the monolith.
Which brings me to an interesting study of professional golfers by two professors at U. Penn. They analyzed golfers to see if they sank putts of equal length with differing rates of success depending on whether the putts were for birdies or pars. In theory, it shouldn't matter. A stroke is a stroke. "Par" and "birdie" are arbitrary assignations - they merely describe how you do on a hole.
1.6 million Tour putts were analyzed, and it turns out that pro golfers are 3% better at making par putts for par than for birdie. This adds up to about three strokes per tournament and some serious money. Interestingly, when confronted, few pro golfers doubted the findings. More interestingly, some said there was nothing they could do about it. The bias seems hardwired.
"You can't fool yourself," said Stuart Cink.
“Bogie aversion" has direct analogs in the investment world. For instance, it's a proven fact that people hate losing a dollar more than they like making a dollar. I myself feel this way, even though it makes no sense. Here's another one: lying on the street you find a pair of third row Springsteen tickets that are going on Ebay for $5000 apiece. Assuming you are a Springsteen fan, do you go to the concert or sell the tickets? Most would go to the concert. Would those same people pay $10,000 for the tickets? Not likely. This is also irrational behavior.
Then there’s the fact that two different people, given the exact same set of facts, will often do two totally different things. That means at least one isn’t a rational agent.
There are many, many such examples. As a result, markets will never be efficient. My own view is that they are mostly efficient most of the time, and terribly inefficient some of the time (e.g. lately).
Why does EMT persist? For one thing, it’s beautiful. When you follow it through its development from Markowitz to Sharpe to Tobin, with each economist adding new levels of elegance, you can’t help but admire the intellectual force behind the theory, and how neatly it seems to wrap the messy world of investing up into simple concepts. If this had been the fruits of my own intellectual efforts, I too would be reluctant to give up the ghost. The Nobel sitting in my study wouldn’t make it any easier, either. But the fact is, EMT is dead, as is a host of other market theories loosely banded together as Modern Portfolio Theory.
Nobels await those with better ideas, but they won’t be as beautiful, because they will need to explain the messiness of the human psyche.