It talks about how human behavior, emotions influence our financial decisions. It is one of the reasons why the Efficient Market Hypothesis(E.M.H) doesn’t hold true.
It does critique E.M.H and provides two strong points -
If the market is really efficient with all the info priced in then what’s the point for any investor to do some work getting new info or numbers when everything is already priced in ?
Also, if the market is really efficient with all the info priced in then how come George Soros’, Jim Simons’ and Warren Buffets of the world have made billions of dollars?
It gives a good glimpse on how the concept of “money” has not been around forever and is relatively recent on an evolutionary scale. So the idea of losing money generates similar emotions as “fight or flight” in case of a physical attack.
Using advanced technologies such as fMRI it has been found that similar centers in the brain are activated when there are prospects of making/losing money.
Humans are not rational beings and are influenced by emotions of fear, panic and pleasure and thus that is what makes them take irrational decisions in the context of money.
Concept of probability matching with the help of an experiment:
Consider the game Psychic Hotline. Either letter A or B will be shown on the screen. If you get it right +$1 else -$1.
After a few rounds, the participants observe that A appears more often than B. Say 75% of the times it is A, and B appears 25% times.
So the optimal strategy is to always pick A.
But people try to mix it up which is called “Probability Matching” and that is sub-optimal thus reducing the earnings to only 62.5% times.
- It is definitely worth pondering that our DNA is 97% similar to an orangutan but the 3% difference is big enough to keep us on different sides of the fence.
- Emotion isn't the source of irrationality. The author's proposition is that we wrongly conclude that emotions are the reason for our irrational actions when infact they are the reason of rationality.
- The author reminds us that although there were so many attempts to draw inspiration from Physics to apply to Economics - it is infact more similar to Biology. Both are equally complicated fields.
- The author puts forward a new theory to beat the E.M.H. He talks of Adaptive Market Hypothesis.
This theory is about revolving around heuristics. It blends in the concept of "bounded rationality" too. A very good example of this is how we may have 10 shirts, 10 pants, 5 ties and 5 jackets. We don't try out every single of them every day before going to work. Because in our minds already have a heuristic/idea about which shirt will shirt well enough with a pant. - Also, going by the word "adaptive" we continue to adapt and learn from our experiences and surroundings (dressing appropriately is an example - while going to a function we don't try out running shorts - adapting and cutting down our choices. This is another example of bounded rationality).
Monday, June 15, 2020
Lockdown Reading - Adaptive Markets
Saturday, June 6, 2020
Covid Bonds
The World Health Organization declared Covid-19 as a global pandemic on March 11, 2020. The virus still is out floating around and the economic impact of everyone staying indoors is unfolding. While it is the right decision for everyone to stay indoors, and slow the spread, it has definitely brought the wheel of the economic cycle to a grinding halt. This is something that has never happened before and there is no playbook to follow. Re-starting the economic cycle will require some innovative, ingenious ways.
Revenues for governments at the state level via taxes (sales tax etc) have almost dried up due to a sharp fall in economic activity. This has not only put at risk lots of government run programmes and schemes but also put severe strain on the exchequer.
In a lot of ways, the current scenario draws similarities with WWII except this time the enemy is a microbe. Taking a leaf out of the history book - “War Bonds” were issued during WWII so as to finance the U.S government’s involvement. Over 85 million Americans bought those war bonds, and by 1946, it had raised over $185 billion dollars which translates to $2.4 trillion in present day terms.
The same route can be adopted by the government. to finance its efforts to manufacture PPE, fund more clinical trials and studies for drugs to cure Covid-19 and when a cure or vaccine is found these bonds can help finance its large scale manufacture and distribution to every corner of the country. These bonds can range from a maturity period of 20-30 years, be tax-free and provide an interest rate of 3-4%.
In the current climate everyone is feeling the sting of the lockdown and even though social interactions have dropped to zero, the urge to help one another is at a peak. I’m sure such “Covid 19 bonds” will receive a very warm response from investors, hedge funds and even small households. This is not inherently a new concept - European Union is already considering it. India can move ahead and show the world how to cleverly manage its finances, care for its people and not let its institutions starve for much needed funds.