This post is a guest contribution by Rob Roy President of Atlantic Advisors Asset Management.
Beauty in the Details
The only way to teach economics in a semester or two is to simplify it beyond recognition. But the beauty of life is often in the details. And so in this letter we focus on the intangible and hard to measure but massive effects of human psychology in the markets. Bennet used to say that to be good at understanding markets you shouldn’t get an MBA with a finance concentration but instead should learn history, psychology, sociology and macroeconomics.
The concept of a rational human who makes economic decisions with a full set of data, and pursues enlightened self interest is personified by Homo Economicus1. It is just such a mythical economic figure that allows us to simplify our models of the economic world. The concept is enticing because it has a hint of emotion (self‐interest), but is a complete failure to describe reality because this emotion is masked by a false stability. In other words, there is no ability for homo economicus to adjust its emotions in a pendulum fashion from greed to fear and then back to greed again. But this pendulum of emotion is precisely what happens in markets that are comprised of real humans, not economic models of humans.
Two common market axioms that you may have heard are based on this very idea. “Buy from the fearful and sell to the greedy”, and “The crowd is always wrong at extremes” are useful because psychology is always important.
Changes in Behavior
Simple: When you were young and learning how to use a hammer, you swung with abandon at that nail until you hit your finger for the first time. Suddenly, your method of swinging the hammer changed and has remained changed even up to today.
Not as Simple: When you were young, you may have feared roller coasters. But then your friends liked them and so you tried them, and whadd’ya know? It was fun. But then maybe you started to get older and roller coasters started to make you feel queasy or your bones rattled too much and your neck hurt afterwards. You changed your behavior a few times, but now you probably have made up your mind whether you like‘em or not.
Complex: That string of condos that you flipped sure was sweet. It was a lot of fun making money without doing any real work. Thank goodness that the loss you took on the last one only wiped out all of your previous profits, and didn’t really put you under. Now how will you decide to take risk in the future? Are you chomping at the bit with all of these new “cheap” prices, or have you changed forever?
Changes in behavior typically occur after consequences are revealed and absorbed. The amount of change in behaviour and the permanence of the change is a function of the amount of pain felt and the length of the pain endured during the learning process. Trying to get us to go back to our previous behavior is nearly impossible if the consequences suffered are severe enough.
To me, this is one of the most pressing questions facing us in regard to our markets and how they will evolve in the next period. Will the consequences of our previous actions lead us to a changed behavior? Or will the government succeed in trying to get us to go back to our former practice of wild consumption?
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*Prior to joining Atlantic Advisors, Rob Roy was the Chief Investment Officer at Adventist Health System (AHS) from 1998 to 2007. While with AHS he was responsible for the development and management of a global portfolio containing both traditional and alternative exposure. During his tenure the portfolio grew from $600 million to over $2.5 billion while he led radical changes in the portfolio structure, investment policy, and board oversight committee.
Prior to AHS, Rob was a hedge fund risk manager, futures trader on the floor in Chicago, fixed income portfolio manager, municipal bond and derivatives trader, and a mutual fund accountant. Rob holds a BSBA in Finance from Suffolk University – Boston, and a MSc. in Financial Markets and Trading from Illinois Institute of Technology – Chicago.
