The Hindu Business Line : Factor in those biases and quirks

In 1985, a 17-page paper was published in the Journal of Monetary Economics. The paper, titled “The Equity Premium — A Puzzle” was authored by Rajnish Mehra and Edward C. Prescott. It would go on to be one of the most cited papers in financial economic history. The premise of their work is rather interesting. Without going into the details, which are by no means boring, I will try to sort of compact Mehra & Prescott to a line or two.

3 explanations

It is common knowledge that in most economies the yield on equities is much higher than those on debt instruments. Mehra and Prescott spent six years in figuring out if the actual equity premium was reflective of economic realities. In other words, did equities deserve the premium they got over boring old risk-free bonds?

Their results suggested that this was not true. Equities were trading at much higher premiums than they should. Why do people trade equities at such high premiums?

Behavioural economics offers three popular explanations for this. A simple one is that there are inefficiencies in the market that cause lop-sided behaviour. (For instance, if it was really, really tough to buy and sell bonds, that itself could make equities a more valuable trading commodity with a premium.)

The other two explanations are worthy of a little chit chat. The first is that people tend to use heuristics, fancy word for ‘rules of thumb’, when making decisions. These rules are not entirely scientific. Instead they are often quick, instinctive responses honed over years of use. And some of these rules also lead to tricky little animals called cognitive biases.

Cognitive biases are deviations in your normal judgement due to certain prevailing situations. In other words, given certain situations, people go nuts and get all cranky.

Biases aplenty

Ignore everything else in this column if you want to. But make sure you fire up Google and read through the dozens of cognitive biases out there. Let’s try out a few, shall we?

How about endowment effect? If you are victim to this bias, then you will value something you currently own more than the actual market value for it. For instance, what about your coffee cup in the office? If I tried to buy it from you there is a good chance that you would expect to get paid more than market value for it.

Anyone with one of those bad bosses has surely experienced the pointy end of Information Bias. That’s when you are not ready to act till you have more information than you possibly need.

“Drop in a few slides on our competition strategy. And maybe a set on pricing policy. I think a couple on after-sales service will also be needed…”

“But sir… we haven’t been told what the product is yet…”

There is a laundry list of dozens of such biases, many of which can potentially affect our economic decision making ability. Throw in the inherent complexity of some economic scenarios (sub-prime mortgage losses?), a smattering of herd effects and inefficiencies in the market and you have the recipe for some pretty bizarre economics.

All about how you put it

After heuristics, the second pertinent element of behavioural economics is a simple case of framing. That’s when the same question put to a person in two different ways yields different responses.

(Ok, this one I know well. When you order pizza in the office you tend to look around and ask people “Anyone want a slice?” On the other hand, a simple rewording of that question drastically reduces slice pilferage: “No one wants any of my pizza, no?”)

So, on the one hand, the question itself can corrupt human response. And then the circumstances mess it up further. So really behavioural economics makes the whole thing look like a minefield of potential hazards, no? With bumbling homo sapiens just waiting to place a position on some credit derivative options and drive their bank into the ground? Thankfully good old market forces tend to stamp out eccentricities pretty soon. Irrationality is quickly shooed away by good common sense. Yet it is good to remember that within every human being out there is a set of biases and quirks lurking and biding their time to strike. So remember: Economic activity is subject to human risk. Please allow for behavioural goof-ups carefully before investing.

Have a good weekend everyone.

The writer, an alumnus of IIM-A, was a management consultant before quitting to work as a freelance writer, author and general handyman. He blogs at www.whatay.com

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