Seeking Alpha
Behavioral finance, growth, small-cap, fund holdings
Profile| Send Message|
( followers)  

Summary

  • Herbert Simon was a multi-talented social scientist whose achievements and contributions to behavioral economics are still yet to be fully realized.
  • The classical and neoclassical idea of homo economicus may have finally been put to rest by the failures leading into the Great Recession.
  • Three behavioral finance techniques are presented which could have a positive effect on investor portfolios and market understanding.

Few of you have likely ever heard of Herbert Simon. Don't blame yourself. The truth is, unless one is deeply entrenched in the historical relationship between politics, psychology, and economics, then this article likely represents your first exposure to the man. Despite his relative anonymity, the man was quite extraordinary. He was a beloved and renowned professor at Carnegie Mellon University, was the recipient of numerous prestigious awards, and is largely considered the "founding father of artificial intelligence." To label him a modern day "Renaissance Man" would be a gross understatement. He ventured into, and made valuable contributions towards, the fields of psychology, economics, computer science, sociology, political science, and predictive human cognition. His achievements, quite frankly, are far too long to list.

For the purposes of this article however, one must focus on his contributions to the fields of psychology and economics, as well as the constantly evolving offspring of the two; behavioral finance. In fact, it could be reasonably argued that Herbert Simon's theoretical premises regarding the relationship between administrative behavior and psychology, led to the creation of General Equilibrium Theory. It was this theory, General Equilibrium Theory, which essentially laid waste to the classical and neoclassical understanding of economics. It forever changed the universal understanding of econometrics, and became the foundation for which the field of behavioral economics has been built. Without Herbert Simon, our understanding of the relationship between psychology and market behavior would likely cease to exist.

The Death of Homo Economicus

For those of you unfamiliar with the term, homo economicus is representative of what the perfect investor would be in accordance with classical and neoclassical economic literature. It represents complete and unabated rationality. Homo economicus always succeeds in optimizing the intended benefit. Furthermore, it never fails to process, or put to use, all the information at his or her disposal in order to achieve the most decisive end result. Homo economicus is, in theory, investment perfection personified.

To us, in today's day and age, it likely sounds utterly ridiculous. However, the theory is not as dated as one may think. In fact, in Alan Greenspan's book The Map and the Territory, he openly concedes that the Great Recession came about largely by frequent and pragmatic errors made by economists and oversight committees to recognize the changing landscape of rationality in the markets. He admits that despite all the evidence to the contrary in front of them, that they continued to predict that investors would make the most rational decision available to them predicated on their long term best interest. In hindsight, it sounds like the entire Federal Reserve System was in a state of denial; however the truth is that conformist thinking generally reigns supreme in a group setting. Such was the case leading into the Great Recession.

It never should have happened. By 1955 Herbert Simon had declared, empirically and passionately, that homo economicus was an outdated and unrealistic component of financial theory. He presented unwavering evidence that decision making, problem solving, predictive behavior based in the uncertainty principal (thank you Werner Heisenberg), and modern game theory had all proven that universal market rationality could no longer dictate majority market behavior. One needed to better understand how investors reacted to market activity, and perhaps more importantly, why they reacted the way they did. Herbert Simon knew, half a century before the Great Recession, that if conventional economic theory went unchanged and unchallenged, that collapse of the system was inevitable.

Simon reiterated this fact in 1986, when he wrote in a published paper that;

"We need empirically valid theories of how businesses operate, of how investment decisions are actually made, and how the relationship between businesses and investors is one of cyclical interdependence. Until then, outdated theories which have outlasted their applicability will continue to dictate mass economic decisions."

And there it is, right there in front of you; a statement for the ages. Complete realism is utterly unattainable. Trying to control irrational markets fueled by abstractions such as greed, deceit, ambition, audacity, and desperation, by employing a belief system predicated on theoretical premises widely understood to be outdated, is simply foolish and irresponsible. Homo economicus has long been deceased, and it's time regulatory agencies and influential economists seek to validate more applicable theories in order to better serve global commerce, investor interest, and economic stability.

How This Helps You

As retail investors, fund managers, advisors, or analysts, the best way to put these developments and realizations to work for you is to employ the following three steps:

• Play the Game

• Fake It 'Till You Make It

• Embrace Your Inner Sociopath

At first glance those three steps likely seem out of context given the articles general theme and approach thus far. However, rest assured, these three steps, despite their unorthodox names, are right in line with the theories of Herbert Simon and the understanding of behavioral finance theory. They are simple, applicable, and capable of making a noteworthy impact on your portfolio.

First, let's examine step one; Play the Game.

Game Theory, as many of you are aware, is the study of strategic decision making. Most notably, it is the utilization of mathematical models in the understanding of conflict and cooperation among intelligent and rational decision makers. It is an exercise in behavioral predictability, and it is crucial in understanding why we make the decisions we do. While famous game theory applications such as "The Prisoners Dilemma" are taught ad nauseam at the university level, it is rarely applied to market psychology.

The Prisoners Dilemma is quite simple. It imagines two people, of the same criminal gang, being arrested on the same principal charge. The prisoners are then held in solitary confinement, away from one and other, with no means of communicating with each other. The police do not have enough evidence to convict the pair on the principal charge, and therefore intend to sentence both on a lesser charge which carries a lesser sentence. Simultaneously, the police offer each prisoner a deal. Each prisoner is given the choice between betraying their associate and testifying against them, confessing to the crime, or to cooperate alongside their associate and remain silent. If they both remain silent they will receive the lesser charge which carries a sentence of one year. If they both confess, they will each receive five years. If one betrays the other, the betrayer will walk away, and the convicted will serve 20 years. It is an exercise in predictive cooperation. In order to decide what action is best individually, one must predict accurately what the other will do. It's a painstaking exercise, and in an academic setting it often brings with it humorous results.

In the financial markets this application is a bit different. In this case, one must predict what other investors will do, however the investor does not know all the other investors personally. Therefore, it becomes an exercise in uncertainty. While it is possible, with enough data, to predict what the majority of people will do the majority of the time, it is impossible to predict what an individual will do all of the time. Therefore, one must determine what it is that the average person would be most likely to do in any given scenario. For example, do you ever wonder why terrible realty shows stay on television for multiple seasons? The answer is simple; because the majority of the viewing public for those shows, and thus the target audience, is comprised of women aged 18-34. Let's face it, the average 26 year old woman in modern day America is fascinated by nonsense. Hence, reality television reigns supreme. Don't get me wrong, every demographic, comprised of both men and women, has an absurdity or idiosyncrasy, but reality television seemed the best example. It best represents a clear cut decision being made predicated on the average and the majority. Many young female adults are exceptional, capable, and have never tuned into a single episode of reality television; but we are, again, focused on the average and the majority.

In the financial markets the same premise must be applied. An investor must determine what the average investor will decide to do, what the average executive would be inclined to act upon, and what the demographic is being engaged. For example, what kind of investor trades on biotechnology catalysts? Usually, catalyst trading is embraced by non-committal, fast paced, younger investors who are more concerned with quick profits than the impact of short term capital gains taxes. Thus, the average investor in such a climate will likely sell off immediately after a positive AdCom vote or FDA decision. They aren't there for growth and earnings. They are there to trade the catalyst. Hence, there is predictability to the sector regarding entry and exit points, volatility, and movement. This is behaviorally based. The same theory is applicable for high yield dividend stocks, large cap growth stocks, and even ETFs. If you know the type of investors who assume positions in the equity, you are more capable of determining how the stock price will react to different news and events based the behavioral tendencies of those investors. It is a game theory application, however while one player is always you (the investor), the other player is the average majority.

Let's now examine step two; Fake it 'Till You Make It.

This is a profoundly simple premise. I have always called it the "Invisible Client." This applies, primarily, to retail investors, since professional money managers and advisors already employ this method. This is about accountability and discipline, and it assists in managing risk.

The retail investor is often plagued with a difficult conundrum; when to take profits. It is an ongoing psychological battle. Human beings are designed to react, not respond. It is in our human make-up. We sell too early, we hold too long, we expect too much, and we plan for too little. We're instinctual beings, and on a primitive level we are challenged to taper instinct with deliberation. We want to believe, even when it is detrimental. Hope is innate, whereas cynicism is learned. It's a difficult lesson to absorb, and it is largely dictated by our individual experiences in life. What we must do to combat this behavior is to alter the paradigm.

Aside from credentials, experience, and capital position, do you know what the biggest difference is between fund managers and retail investors? The answer is that the fund managers have clients. They have someone to answer to. They have people to be accountable to. They have responsibilities outside of oneself. When one invests only their own money, they are subject to their imagination clouding their judgement. They start to think of things they could buy, schools they could send their kids to, and vacations they could take their spouses on. With every upward tick of the tape, their ambitions grow more extreme. It becomes a highly emotional experience. However, when one is responsible for other people's money the paradigm changes. Fund managers and investment advisors have to think about their careers, and worry about how they are perceived professionally. Will they be seen as responsible and successful, or negligent and incapable? That fear, that anxiety, that desire to be respected, acknowledged, and praised, that dramatically changes investment strategy. This is why fund managers are more likely to sell for marginal profits (as opposed to holding on for life altering profits), and why they sell strategic losses (as opposed to digging a deeper hole hoping desperately for a turnaround). The difference is the clients.

Hence, retail investors should employ the "Invisible Client" mechanism. Basically, it is nothing more than pretending you are investing someone else's money. It forces you to be more accountable to yourself by pretending to be accountable to others. You are, essentially, faking it. You are asking yourself, before every decision, what you would do if it was a client's money that had been entrusted to you. You are thinking like a fund manager, and your portfolio, over time, will thank you for it.

The final step is, of course, to Embrace Your Inner Sociopath.

Admittedly, this particular step has an ominously awkward name. However, it is appropriate. You see, developmental psychology is the study of how human beings, and their behavioral tendencies, change over time. This includes the process of decision making, problem solving, and moral understanding. It is, very much, a study of process. It is from this subject where the following statement can be accurately made; you're a reformed sociopath. I'm not making an accusation, and I am certainly not targeting any readers who may suffer from mental illness. Instead, I am stating a near scientific fact. If you were ever a teenager, then you were once, temporarily, a sociopath.

Most people need a reason to do something abhorrent to human decency. It is part of the reason why no evenhanded human being would ever call a soldier a murderer. A soldier goes to war to protect and preserve the greater good. A murderer kills to satisfy an urge, settle a score, or serve self-interest. There is a distinct difference. A teenager however profiles psychologically like the latter. They serve only self-interest, have yet to develop fully mature cognitive empathy, and are unable to recognize and respond to others feelings. They're in it for themselves. That is, almost by definition, a sociopath. Thus, you were once a sociopath, and can call upon that thought process once again.

So, why is this important? It's simple; because the market is a sociopath.

The market doesn't care if you make money. The market isn't troubled when you lose money. The market isn't on your side, and doesn't feel the need to make reparations for losses. It is affected by investor decisions, much in the same way investors are affected by its activity, but it has no vested interest in your personal welfare. We tend to forget this sometimes. We take a big loss, get that pit our stomachs, stand in front of the mirror only to see a failure staring back at us, and we think "it has to get better, I'm due. It will bounce back, it has to." The market doesn't have to do anything. History tells us that it is cyclical, but that has nothing to do with you. You take your money personal. The market just takes your money. It is not an equitable relationship in that regard.

Thus, to assist in your investment decisions, you must never take an investment outcome personal. If you make a significant gain it isn't because you "deserved it." It is because you worked hard, did your research, read the opportunity correctly, and forecasted shareholder behavior accurately. On the same token, if you take a substantial loss, it isn't because you "had it coming." It is simply because you read an opportunity incorrectly, and failed to respond accordingly. We've all been there; it happens. However, you are simply a tool of the market as an investor. Therefore, the market must be a tool of yours. The market is not an instrument of fate, nor is it a messenger of divine intervention. It is simply a resource. You should not strive to have a relationship with it, but rather you should strive to exploit it; just like your inner sociopath would want you to.

Conclusion

Herbert Simon was ahead of his time. He utilized the social sciences to predict economic trends, political directions, and scientific advancements. He was successful because he understood one baseline truth; that at the core of everything there are people. People develop technology. People lead commissions. People spend money. People direct companies. That was it. It's a comically simple truth, but it was put into action by an extraordinary man. As a result, his impact on the world was far greater than average.

As investors, and human beings, we want to employ ideas and processes that will advance our interests. Whether it is fundamental analysis, technical analysis, or classical theories, the objective is universal; we invest to make money. Behavioral economics can help in that process. Game theory can help you understand your investment to a deeper extent, as well as assist in ensuring that you more accurately predict forthcoming price trends. Employing the "Invisible Client" can protect you from allowing emotion to dictate your actions, and can minimize portfolio volatility by inspiring more responsible decisions. As to embracing your inner sociopath, well, I wouldn't suggest doing it in your social life, but as it pertains to the market, it's a capable tool. The market is a resource which we strive to calculate, predict, and exploit. It is nothing more. Treat it like such.

There is no perfect method. Investing is a personal experience which possesses the ability to tap into our most primitive tendencies and instincts. Success requires us to be rational in the face of irrationality, to be level headed in the presence of chaos, and to employ psychology in understanding econometrics. In many ways, it is unnatural. However, if you can strive to respond where you would usually react; can succeed in combating emotion with reason; and can apply behavioral probabilities to market predictability, then you may see better results from your portfolio. It may be easier for some (Herbert Simon), and harder for others (Alan Greenspan), but in the end the only way you will know if these methods can work for you is to give them a try. The markets are ever evolving, and as investors we must do the same.

Good luck to all.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: The Benefits Of Behavioral Finance, The Legacy Of Herbert Simon, And The Death Of Homo Economicus