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a large proportion of people can be categorized as conditional cooperators, meaning that they are willing to cooperate if enough others do. People start out these games willing to give their fellow players the benefit of the doubt, but if cooperation rates are low, these conditional cooperators turn into free riders. However, cooperation can be maintained even in repeated games if players are given the opportunity to punish those who do not cooperate. As illustrated by the Punishment Game, described earlier, people are willing to spend some of their own money to teach a lesson to those who
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Economists need to adopt as nuanced a view of human nature as the farmers. Not everyone will free ride all the time, but some people are ready to pick your pocket if you are not careful.
The results clearly rejected this prediction. Of those who began with a lottery ticket, 82% decided to keep it, whereas of those who started out with the money, only 38% wanted to buy the ticket. This means that people are more likely to keep what they start with than to trade it, even when the initial allocations were done at random.
the endowment effect, if true, will reduce the volume of trade in a market. Those who start out with some object will tend to keep it, while those who don’t have such an object won’t be that keen to buy one.
As for whether rationality alone is “sufficient”—meaning that by itself, it alone can deliver important predictions—Arrow argued convincingly that rationality alone does not get you very much. To derive useful results, theorists have to add auxiliary assumptions, such as assuming that everyone has the same utility function, meaning the same tastes. This assumption is not only demonstrably false, but it immediately leads to all kinds of predictions that are inconsistent with the facts. We are not Econs and we are certainly not identical Econs.
I ended up deciding that my best strategy was to employ some humor. This can be risky, but I have found that if people are laughing, they tend to be more forgiving.
“I tend to view the study of behavioral extensions of these efficient market models as leading in a sense to the enhancement of the efficient market models. I could teach the efficient market models to my students with much more relish if I could describe them as extreme special cases before moving to the more realistic models.”
paradigms change only once experts believe there are a large number of anomalies that are not explained by the current paradigm.
“Discovery commences with the awareness of anomaly, i.e., with the recognition that nature has somehow violated the paradigm-induced expectations that govern normal science.”
First, people have a natural tendency to search for confirming rather than disconfirming evidence, as shown by the relative popularity of the 2 over the 3. This tendency is called the confirmation bias.
the first two columns were about “calendar” effects in the stock market. These results are just weird. Consider just a sample of them: Stocks tend to go up on Fridays and down on Mondays. January is a good month in which to hold stocks, particularly the early part of the month, and especially for the shares of small companies.
“firms” that elected to pay more than the minimum wage were rewarded with higher effort levels by their “workers.” This result supported the idea, initially proposed by George Akerlof, that employment contracts could be viewed partially as a gift exchange. The theory is that if the employer treats the worker well, in terms of pay and working conditions, that gift will be reciprocated with higher effort levels and lower turnover, thus making the payment of above-market wages economically profitable.
We are nice to people who treat us nicely and mean to people who treat us badly.
When the expert was thinking about the problem as a member of the project team, he was locked in the inside view—caught up in the optimism that comes with group endeavors—and did not bother thinking about what psychologists call “base rates,” that is, the average time for similar projects. When he put on his expert hat, thereby taking the outside view, he naturally thought of all the other projects he’d known and made a more accurate guess. If the outside view is fleshed out carefully and informed with appropriate baseline data, it will be far more reliable than the inside view.
In an organizational setting, the natural feeling of loss aversion can be exacerbated by the system of rewards and punishment. In many companies, creating a large gain will lead to modest rewards, while creating an equal-sized loss will get you fired. Under those terms, even a manager who starts out risk neutral, willing to take any bet that will make money on average, will become highly risk averse.
“Well, that means you have a problem,” I responded to the CEO. “Because you are not going to get twenty-three of these projects—you are only getting three. You must be doing something wrong, either by hiring wimpy managers who are unwilling to bear risks, or, more likely, by creating an incentive system in which taking this sort of a risk is not rewarded.”
Narrow framing prevents the CEO from getting the twenty-three projects he would like, and instead getting only three. When broadly considering the twenty-three projects as a portfolio, it is clear that the firm would find the collection of investments highly attractive, but when narrowly considering them one at a time, managers will be reluctant to bear the risk. The firm ends up taking on too little risk. One solution to this problem is to aggregate investments into a pool where they can be considered as a package.
But the cost of the experiment was tiny, compared to the size of the company. It just looked risky compared to the particular manager’s budget. In this example, narrow framing prevented innovation and experimentation, two essential ingredients in the long-term success of any organization.
In the economics literature, such failures are usually described in a way that implicitly puts the “blame” on the agent for taking decisions that fail to maximize the firm, and acting in their own self-interest instead.
Although this depiction is often apt, in many cases the real culprit is the boss, not the worker.
In order to get managers to be willing to take risks, it is necessary to create an environment in which those managers will be rewarded for decisions that were value-maximizing ex ante, that is, with information available at the time they were made, even if they turn out to lose money ex post.
The bottom line is that in many situations in which agents are making poor choices, the person who is misbehaving is often the principal, not the agent. The misbehavior is in failing to create an environment in which employees feel that they can take good risks and not be punished if the risks fail to pay off. I call these situations “dumb principal” problems.
The only way you can ever take 100 attractive bets is by first taking the first one, and it is only thinking about the bet in isolation that fools you into turning it down.
The same logic applies to investing in stocks and bonds. Recall that the equity premium puzzle asks why people would hold so many bonds if they expect the return on stocks to be 6% per year higher. Our answer was that they were taking too short-term a view of their investments. With a 6% edge in returns, over long periods of time such as twenty or thirty years, the chance of stocks doing worse than bonds is small, just like (though perhaps not as good odds as) the chance of losing money in Samuelson’s original 100-bet game.
For our Human subjects, the presentation of the data had a huge effect. The employees shown the annual rates of return chose to put 40% of their hypothetical portfolio in stocks, while those who looked at the long-term averages elected to put 90% of their money into stocks.
An implication of this analysis is that the more often people look at their portfolios, the less willing they will be to take on risk, because if you look more often, you will see more losses.
As predicted by myopic loss aversion, those who saw their results more often were more cautious. Those who saw their results eight times a year only put 41% of their money into stocks, while those who saw the results just once a year invested 70% in stocks.
The implication of our analysis is that the equity premium—or the required rate of return on stocks—is so high because investors look at their portfolios too often.
The higher the wage, the less drivers worked. Basic economics tells us that demand curves slope down and supply curves slope up. That is, the higher the wage, the more labor that is supplied. Here we were finding just the opposite result!
“Day-to-day fluctuations in the profits of existing investments, which are obviously of an ephemeral and non-significant character, tend to have an altogether excessive, and even an absurd, influence on the market.” To buttress his point, he noted the fact that shares of ice companies were higher in summer months when sales are higher. This fact is surprising because in an efficient market, stock prices reflect the long-run value of a company, a value that should not reflect the fact that is it warm in the summer and cold in the winter. A predictable seasonal pattern in stock prices like this
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Keynes was also skeptical that professional money managers would serve the role of the “smart money” that EMH defenders rely upon to keep markets efficient. Rather, he thought that the pros were more likely to ride a wave of irrational exuberance than to fight it. One reason is that it is risky to be a contrarian.
So what are all these managers really trying to do? They are trying to buy stocks that will go up in value—or, in other words, stocks that they think other investors will later decide should be worth more.
Buying a stock that the market does not fully appreciate today is fine, as long as the rest of the market comes around to your point of view sooner rather than later!
However, if you assume that some investors are overconfident, high trading volume emerges naturally. Jerry has no trouble doing the trade with Tom, because he thinks that he is smarter than Tom, and Tom thinks he’s smarter than Jerry. They happily trade, each feeling a twinge of guilt for taking advantage of his friend’s poor judgment.
If the P/E ratio is high, investors are paying a lot per dollar of earnings, and implicitly, a high P/E ratio is a forecast that earnings will grow quickly to justify the current high price. If earnings fail to grow as quickly as anticipated, the price of the stock will fall. Conversely, for a stock with a low price/earnings ratio, the market is forecasting that earnings will remain low or even fall. If earnings rebound, or even remain stable, the price of the stock will rise.
Implicitly, Graham was offering a kind of behavioral explanation for this finding. Cheap stocks were unpopular or out of favor, while expensive stocks were fashionable.
Werner and I thought that the same process might be at work in the stock market, too. Companies that are doing well for several years in a row gather an aura implying that they are a “good company,” and will continue to grow rapidly. On the other hand, companies that have been losers for several years become tagged as “bad companies” that can’t do anything right. Think of it as a form of stereotyping at the corporate level. If this corporate stereotyping is combined with the tendency to make forecasts that are too extreme, as in the sense of humor study, you have a situation that is ripe for
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The results strongly supported our hypothesis. We tested for overreaction in various ways, but as long as the period we looked back at to create the portfolios was long enough, say three years, then the Loser portfolio did better than the Winner portfolio. Much better.
Over the five-year period after we formed our portfolios, the Losers outperformed the market by about 30% while the Winners did worse than the market by about 10%.
in the tests we ran using Winner and Loser portfolios based on three-year “formation periods” and followed by three-year “test periods,” the average beta for the Winners was 1.37 and for the Losers was 1.03. So the Winners were actually riskier than the Losers.
By whatever measure one used, “value stocks” outperformed “growth stocks,” and to the consternation of EMH advocates, the value stocks were also less risky, as measured by beta.
in 1992 Fama and French began publishing a series of papers documenting that both value stocks and the stocks of small companies did indeed earn higher returns than predicted by the CAPM.
But Fama and French were forthright in conceding that they did not have any theory to explain why size and value should be risk factors. Unlike the capital asset pricing model, which was intended to be a normative theory of asset prices based on rational behavior by investors, there was no theoretical reason to believe that size and value should predict returns. Those factors were used because empirical research had shown them to matter.
In a nice twist of fate, profitability is another trait that Benjamin Graham looked for in judging the attractiveness of a firm as an investment.
It is hard to argue that the price at the close of trading on Thursday, October 15, and the price at the close of trading the following Monday—which was more than 25% lower—can both be rational measures of intrinsic value, given the absence of news.
The paper, titled “Stock Prices and Social Dynamics,” embraced the heretical idea that social phenomena might influence stock prices just as much as they do fashion trends.
Value stocks, either those with very low price/earnings ratios or extreme past losers, predictably outperform the market.
Does the same principle apply—that is, can you beat the market by buying stocks when they are relatively cheap and avoiding them when they are relatively expensive?
Since his warning came four years before the market peaked, he was wrong for a long time before he was right! This lack of precision means that the long-term price/earnings ratio is far from a sure-fire way to make money. Anyone who took Shiller’s advice in 1996 and bet heavily on the market falling would have gone broke before he had a chance to cash in.
