Investors and policymakers are perfect… right?

Most economists and finance professionals believe that people are “rational.” Perfectly rational! This simple assumption leads to serious misunderstandings on the part of all of the various actors in the economy.

The assumption leads to the idea that information is equally available to everyone, that we all can interpret it properly, that it costs nothing, that we can get the information on a timely basis and that investors will use the information to invest in superior products and technologies.

The assumption also leads to the idea that policymakers will use it to craft economic policy that is supportive of growing employment, standards of living and productivity.

Due to this presumption of a rational world, we are expected to believe that lawmakers understand and read the laws they make, that there are no serious unintended consequences to those laws (because lawmakers and policymaking advisers are so smart and well-informed on the issues), that investors are able to forecast the impact of new laws on the future of the economy, that investors are very good at assessing potential risk and return using available information, and that investors therefore make good judgments about what investments such as houses, stocks, bonds and subprime mortgages are worth.

Sometimes things work out fine for a few years.

Lawmakers seem to enact desirable policies, investors seem to make smart choices and the economy grows. But things never work out forever. There are always excesses in the behaviors of the various actors, and eventually we always pay the consequences of these excesses.

All economic actors, whether they are lawmakers, policymakers, bankers or everyday investors, are prone to alternate periods of mania and panic.

Of course the theory that the world is filled with perfectly rational men and women is wrong. Not only wrong, but spectacularly and predictably wrong. This applies to experts and elites just as much as it applies to the average person.

Everyone is prone to heuristic biases and frame dependencies that preclude purely rational thought and action.

This is why even someone like Bill Gates feels less wealthy when the stock of Microsoft declines in value. Think about it. The price of his stock is down, yet he still owns and controls exactly the same company. If he still owns exactly the same thing, why should he feel less wealthy?

It takes awhile, but true students of the economy eventually realize that policy has consequence. Specifically, you get more of what you subsidize and you get less of what you penalize (either through tax or regulation).

It is important to know that the accompanying corollary that thoughtful students of economics usually associate with this idea is that good policy is simple, direct and understandable to almost everyone — whether or not they are experts.

Example 1: Cap and Trade
A proven way to get more efficient renewable energy would be to not tax any new kilowatt hours put into the nation’s power grid from renewable sources. Don’t tax the profits of such production for a period of 10, 20 or even 30 years.

We know that this tax policy would encourage an increase in renewable energy output.

The government doesn’t need to pick winners or losers and give them money or penalize them through regulation and increased taxes. The government just needs to specify the desired result and then reward that result.

The more direct the connection between the result and reward, the the quicker the result will be realized.

An example of how legislators get diverted from this direct path of action is the proposed Cap and Trade legislation. Cap and Trade legislation would have the effect of furthering government control of the energy sector.

The policy would not encourage the production of renewable energy. Rather it would penalize energy produced through traditional means, discourage general systemic economic activity and foster systemic employment loss (by increasing system-wide energy costs).

By acting through Cap and Trade legislation, the government would solidify its power over traditional energy production since through Cap and Trade the government would put itself in charge of how much traditional energy is produced.

Additionally the government would retain the power to grant exemptions to its own onerous bill (exemptions to Cap and Trade have been crafted by the roughly 1,000 lobbyists who have inserted thousands of these exemptions into the proposed legislation).

Management research has shown that organizations act to further their own existence first and foremost. Lawmakers and policymakers are no different.

Cap and Trade can only be viewed as rational if you see it as a means for politicians and the organs of government to enhance their power and continue their existence.

Remember, there is a simple and direct way to get increased economically feasible low-emission production of energy … don’t tax the fruits of renewable low-carbon energy output from the new technologies.

Example 2: Subprime Crisis
Are investment bankers really smart? Let’s turn to investment bankers and examine their imperfections as rational economic actors.

We know that investment bankers made a lot of money from packaging subprime mortgages, they’re supposed to be “really good” at their jobs, and they’re supposed to provide innovation and value to the investment environment.

In their role as intermediaries they are supposed to match up investors with appropriate and profitable investments. In the course of their work, the economy is supposed to benefit because of the investment bankers’ matching up of those who invest with worthy projects where the investment funds are needed.

Two problems diverted these professionals from successfully doing their jobs.

The first problem was a failure of the investment firms’ internal structural safeguards. Every investment bank has what is known as a “risk committee” (though the name may be different at each firm). It is the job of the risk committee to assess the risk in the firm’s various activities.

Usually risk committees are made up of senior firm members. In the case of the subprime crisis, the committees failed at their jobs. The committees failed to appreciate the actual risk of the subprime transactions.

In general, the risk committees committed a frame dependence that caused them to fail. They failed to correctly “frame” (i.e., describe the question of risk) regarding the nature of the risk in subprime pool products they were underwriting. This kind of error is called Mental Accounting. In the time before the crisis, the committees committed the error to excess.

Think of their failure in the following way: the committees asked the various bankers working on the subprime pool products if they “modeled the risk of the pools.” The committees were told that the answer was “yes.”

Then they were told what the result of the modeling was. On the basis of this information, the committees authorized more and more subprime pool organization and underwriting.

The questions that the committees should have asked the investment bankers were: “Do you know how risky the subprime assets are, and did you use that information to model the risk of the pools?” If they had asked these questions, the answers would have been “no” and “no.”

The risk committees failed to find out how risky subprime mortgage pools were in part because the investment bankers who were working on the pools had been deceived by several heuristic biases when designing the pools.

The second big reason for failure was that the investment bankers working on creating the pools fell prone to at least two heuristic biases. The most prominent of which were:

– They failed to forecast the range of possible outcomes in the subprime pools. This is called overconfidence.

– They concluded that stereotypical information about conventional mortgage products was useful in explaining the risk of an entirely different class of mortgage (i.e., the subprime mortgage).This heuristic bias is referred to as “representativeness.”

Finally all of the parties made the fundamental mistake of presuming that you can model uncertainty. This is definitely not true. Here are a few comments:

Risk should be thought of as the description of the expected outcome or sequence of possibilities that has been determined through statistical analysis.

For example, the average wind speed in the ocean 400 miles off of Gloucester, Massachusetts, on a given date is 20 mph. Uncertainty should be thought of as an outcome or sequence of outcomes that has occurred despite its remote probability. For example, on the same date as above, we go to a spot 400 miles off Gloucester, Massachusetts, and find ourselves in the middle of “The Perfect Storm” (wind speed 120 mph).

Seasoned investors know that bad things happen; seasoned investors usually believe that investment structures need to be flexible enough so that the investment vehicles can be adjusted to offer some response to improbable but disastrous events.

During the subprime crisis, the process of risk assessment and underwriting failed to consider the possibility of “The Perfect Storm,” and the men and women who packaged the subprime pools used the weather reports from southern California to forecast the weather in the north Atlantic.

A different lens
This paper, which first appeared in the November 2009 issue of the Walker Center Newsletter, is meant to get you to think about risk and return, benefit and cost and the inefficient way that people deal with this tradeoff. The state of today’s economy and investment environment has led investors and policy makers to extreme positions. It’s worth thinking about what they are doing in light of their susceptibility to both mania and panic.

Gary Gibbons, Ph.D.,a visiting professor of entrepreneurship at Thunderbird’s Walker Center for Global Entrepreneurship, is an expert in investing and corporate finance with extensive experience in portfolio management, securities valuation, financial modeling, and financial planning and evaluation in entrepreneurial firms.

[This article has been reproduced with permission from Knowledge Network, the online thought leadership platform for Thunderbird School of Global Management https://thunderbird.asu.edu/knowledge-network/]