By Jacob C. Maichel
Economists have a tendency to throw together models and talk about the decisions of rational actors inside of market places- but is that even possible? It is clear to some that aggregations of decisions reflect the best available knowledge, but is that actually true? Are there perhaps ways to allow for more rational decisions with government help?
Behavioral economics argues that people rarely make theoretically optimal decisions. In fact, they assert that individuals react more based on heuristics (shortcuts) than rational processes. Experiences aggregate to form heuristics, or biases according to behavioral economists; these heuristics, not economic signals, explain behavior in the marketplace.
Some of the most important biases I want to point out are:
Hindsight bias- A situation in which people put unrealistic belief in an event occurring because it has happened before. A classic example is seeing a shark attack on the news and fearing a similar situation when you travel to the beach (despite the statistical basis of that fear).
Overconfidence bias- The overconfidence bias is not only dangerous, but likely the most common. Those who suffer from this often think they know the markets better than most. They believe they have some system or knowledge that makes them immune to market forces. They highly overestimate their ability and/or knowledge.
Confirmation bias- This bias asserts that individuals collect, or recognize, only information which confirms their initial position; it causes a discounting of true information.
Optimism bias- The belief that everything will always have a good outcome.
Status Quo bias- Individuals have a preference for their present state, despite a change which would improve their state.
We experience these biases everyday in our lives without realizing it. It gets increasingly more dangerous when these biases begin to affect us in our investing strategies. I do not think it would be a stretch to argue that many of these biases are related to a lack of information available to the individual.
For example, regulation tends to impose transaction costs on industries which prevents the open entry and exit we would see in a free market. However, history argues that opinions of regulation should be approached with more nuance. For example, particular regulations in finance, which has an incredible amount of existing regulation, may actually benefit the consumers.
Let's look first to the Great Depression to help shed some light on the topic. Before the stock market crash of 1929, almost any investor was allowed to engage in margin trading. This meant that investors started to purchase very overpriced stocks at the advice of trusted "financial advisers". The average investor did not have the ability, or likely the desire, to monitor his investments. When things started going south in financial markets, the lack of knowledge became apparent.
I think particular banking and corporate disclosure regulations probably help us to overcome some of these biases by increasing the information available, or at minimum make better decisions. Admittedly there is a significant amount of regulations that are not needed, but some are undeniably beneficial. The Securities Act of 1933 and 1934 made the marketplace significantly more transparent. Investors got access to better information on the markets they were trading in and the companies they were investing in. With both of these Securities Acts came the creation of the Securities and Exchange Commission (SEC) which functioned as an authority in financial markets. The SEC also gave people the ability to file injunctions through them to prosecute negligent companies.
The overconfidence bias tricks us into thinking that with all this information, we can make the best decision. But, I think that it is better than the environment we had 90 years ago. Without reporting and transparency, it would be a result of luck to find any success in the market. Companies now must be even more particular with reporting and it is easier than ever to see how leveraged companies are. Leverage helps to indicate how much of the business is funded through debt rather than equity. Highly leveraged companies have to deal with large interest payments leading to decreased financial stability, possibly insolvency. While the overconfidence bias is not removed, investors are more likely to draw on relevant information as opposed to assuming it.
Banks are also safer than they have been historically, and more profitable since the repeal of Glass-Steagall. With the creation of reserve requirements and FDIC insurance, everyone was able to put more faith into the banking system. Even small town banks now can meet FDIC requirements and guarantee whole communities safety. I think this is vital for two reasons. First it encourages economic strength in rural areas by promoting savings within the community. Second, and perhaps more important, it offers a source of capital that is absent otherwise. Large branch banks have moved away from small business loans and instead opt for more attractive larger investments. You can see this phenomenon in the figure below from the FDIC:
The size of the average lender caused the massive consolidation of banks that we experienced in the past 15 years. Rural banks have loan officers that are part of the community, changing the social and economic incentives behind granting loans.
While these changes shifted the incentives within the banking system, some economists would argue it perverted the incentives. Their concerns are not without grounds, but I do believe that the additional regulations improved the existing environment. Good economics is comparative economics.
Once again, I admit, that I am not a fan of most regulation. I do, however, believe that there are some regulations that directly address behavioral flaws in investors. When viewing regulation maybe we should quit thinking about people as rational actors in economic models and perhaps rather think about what type of regulations may enhance our lives.
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