I recent read an excellent book on rationality and asset markets, entitled Rational Myopia: How Capital Markets Learn. When discussing a certain type of efficient market, the author (Kent Osband) makes the following observation:
Even though traders compete vigorously against each other and share no information other than the bids that determine price, the market behaves like an optimally unified rational learner. I call this the Invisible Mind theorem. . . .
However, capital markets are not fully Kelly-driven. Suppose my research suggests that the fair price is E, while the market consensus sets a fair price for F. Out of respect for the consensus, I might accord it a 1 – f chance of being correct. This shaves my bet to a fraction f of full Kelly, which if applied consistently is known as fractional Kelly. Fractional Kelly can be viewed as a type of herding. While the term is often used pejoratively to suggest that people are too dumb or lazy to think for themselves, it is hard to fault some deference to the wisdom of the crowd.
That got me thinking about the question of when we should defer to the crowd, and when we should think for ourselves. My strong support for the Efficient Market Hypothesis, and more broadly the wisdom of crowds, makes me a contrarian within the economics profession. I deny the existence of a bubble in the US housing market during 2006, or the NASDAQ in 2000. Is there something oxymoronic about being a contrarian believer in the wisdom of crowds? More broadly, when should we trust our own personal view and when should we trust the consensus view?
Imagine the US government holds an auction for offshore drilling rights in a section of ocean off the coast of Louisiana. Suppose you are one of ten companies bidding on the tract. How much should you bid? One answer would be to estimate the value of the drilling rights to your firm, and then bid that amount (or slightly less.) But you also know that your bid doesn’t matter unless you win the auction, in which case your bid—i.e., your estimate of the value of the tract—would be higher than for any other bidder. If you also believe in efficient markets, then conditional on winning the auction your firm is likely to overestimate the value of the drilling rights.
If oil firms are rational, they presumably factor in this “winner’s curse” and bid a fraction less than their estimate of the value of the drilling rights in order to offset the fact that if they win they will likely have overestimated the actual value. Perhaps they could look at previous actions and estimate the difference between the typical winning bid and the typical average bid.
In every single area of our lives we might want to assign a weight of f to our personal view of what is correct, and a weight of 1 – f to the consensus view. But how do we determine f? And how would this fraction vary between religious beliefs, political beliefs, scientific beliefs, estimates of asset values, and beliefs about economic policy issues? A good place to start is with a famous remark by G.K. Chesterton:
There exists in such a case a certain institution or law; let us say, for the sake of simplicity, a fence or gate erected across a road. The more modern type of reformer goes gaily up to it and says, “I don’t see the use of this; let us clear it away.” To which the more intelligent type of reformer will do well to answer: “If you don’t see the use of it, I certainly won’t let you clear it away. Go away and think. Then, when you can come back and tell me that you do see the use of it, I may allow you to destroy it.
Suppose I read an article by a contrarian scientist that rejects the theory of evolution. He raises some objections to evolution that seem quite persuasive to me. I cannot think of any objection to his argument. Should I accept the critique? According to Chesterton’s Fence reasoning, the answer is a resounding NO! Paradoxically, it would never be rational to accept this contrarian theory of the origin of species unless I could see what was wrong with it. After all, I know that roughly 99% of scientists support the theory of evolution, in some form. They presumably have reasons for rejecting these contrarian theories. So what are those reasons? If I don’t know, then I have no basis for accepting the heterodox scientist and rejecting the consensus. I’m merely an outsider, with no expertise in science.
People occasionally send me articles taking a contrarian stance on climate change. I’d be much more impressed if they also sent me an article explaining why mainstream climatologists reject that contrarian take, and then why the mainstream climatologist’s critique of the contrarians is wrong.
In contrast, I am an expert on a few areas of economics. When I take a contrarian stance on a particular topic—as with my opposition to FDIC—I try to make sure that I understand why my views are contrarian. Why do other economists disagree with me on FDIC? It is only because I believe that I do understand their objection, that is, I understand why the conventional view tends to favor government deposit insurance, that am I willing to take a contrarian view.
[When I attended the University of Chicago in the late 1970s, I felt that we understood mainstream economics better than mainstream economists understood Chicago School economics, for essentially the same reason that Canadians understand the US better than Americans understand Canada. We were in the minority. (I don’t know what the UC is like today.)]
Strictly speaking, one could argue that I should not say, “FDIC should be abolished”, rather I should say that I place a probability f that FDIC should be abolished and a probability 1 – f on the claim that the consensus in favor of FDIC is correct. I don’t do that because I assume that the intelligent reader already makes this mental adjustment. In my recent book entitled The Money Illusion, I wrestled with the question of why should readers accept my contrarian take on the Great Recession:
Also keep in mind that even if markets are efficient, it is only because each trader is willing to take a fresh, independent look at the situation and do his or her best to make accurate forecasts. Similarly, the market for ideas does tend toward efficiency in the long run, but only because intellectuals are willing to continually probe weaknesses in existing theories, and seek better ones. I view myself as just one tiny component of the wisdom of crowds, which means I can’t do my job if I blindly accept the conventional wisdom.
In a world where most intellectuals are arrogant, if I try to appear overly modest and humble then people will get a misleading impression of the strength of my argument, just as employers misjudge a person in a job interview that is modest about their abilities. At the same time, intellectuals should never appear more confident than they actually are. Let readers decide how to weight our views against those of the consensus. Readers will understand that I am a contrarian on the Great Recession (and on FDIC).
The wisdom of crowds can also be affected by motivated reasoning. It is possible that residents of Spain checked out all of the possible religions and just happened to (mostly) adopt Catholicism, whereas residents of nearby Morocco went through the same careful analysis and chose the Muslim religion. More likely, cultural factors played a role in both cases—people like to fit in with their neighbors. Motivated reasoning is also important in politics. Teachers prefer to believe that more spending on education isn’t just good for them personally, but is also good for society as a whole. Farmers feel that way about crop subsidies.
Some have even claimed that there is a sort of tribalism behind the surge in GameStop stock, which has become very popular among a certain internet subculture. Nonetheless, motivated reasoning is probably less of a factor in financial markets than in politics. Stocks soared when FDR devalued the dollar in 1933, even though many of the conservative financiers in the Wall Street subculture opposed FDR’s decision to abandon the gold standard.
Bryan Caplan’s BetOnIt approach to debate can be seen as a way to push people away from motivated reasoning, and toward their actual beliefs. Talk is cheap.
PS. While Osband’s book is full of thought-provoking ideas, be aware that it is also fairly technical in places.
READER COMMENTS
Phil H
Mar 11 2022 at 8:29pm
“In every single area of our lives we might want to assign a weight of f to our personal view of what is correct, and a weight of 1 – fto the consensus view.”
I bring a different view to this, one which values markets even higher, because I think they’re rarer than some writers here. One of Lemieux’s favourite topics, which I agree with, is that there is no such thing as the will of the people. It’s always a made-up claim by some motivated reasoner. I think that applies to most stuff. The wisdom of the crowd is not a thing that exists independently; it’s a thing that has to be distilled through a well-functioning market or other game. So your example of bids for a drilling plot would be a case in which the market has generated wisdom: a strong and open capital system plus fair auction rules should constitute a well-functioning market, and some outcome of that market (usually the final sale price) should represent a form of crowd wisdom. But when there is no effective market, as in cases like religion, no crowd wisdom exists.
Scott Sumner
Mar 11 2022 at 9:45pm
I think there’s a lot of truth in that. But I might not go quite that far. There’s no market for belief in evolution, but the scientific consensus is pretty clear. But yes, the market test is generally the most reliable.
Kevin Erdmann
Mar 11 2022 at 11:44pm
Great post.
I share much of your deference to efficient markets, though in my private investments, I have taken mostly tactical positions with extremely high expected excess returns. I have mostly been successful with that. Two ways that I square that is:
If you are going to try to out-gain the market, you better darn well respect it, and do all you can to find every use for the gate, and make allowances for the uses you missed.
I suspect that there is a reputational premium. At least this is where I think I have been able to take tactical gains in the types of out-of-favor industrials, etc. that I have typically found. Sometimes there is a regime shift where, say, a firm goes from being in doubt as a going concern to recovering and returning to form. There is a wide swath in that process where it is difficult to model the shift in a continuous way, and where taking a position expressing hope for gains carries a tremendous amount of reputational risk. Those gains are available, but it entails occasionally deep embarrassment, prinicipal-agent problems when selling it as a third party service, and other mental challenges. Stochastically, you are likely to lose your reputation eventually or you have to live a sad life in which reputation isn’t relevant and where you carry the scars of the embarrassing mistakes. (A good example is the Big Short character whose clients hated him even after he made them millions. And to add irony, I, even being sympathic, would argue he got lucky.)
Anyway, in a previous life I wrote about this kind of thing, following up on Scott’s insights in the post, if anyone is interested. My assertion: the idea that you should invest passively is not dependent on efficient markets.
https://www.idiosyncraticwhisk.com/2014/12/you-should-invest-passively-because.html
Scott Sumner
Mar 12 2022 at 12:19pm
Good comment.
john hare
Mar 12 2022 at 4:31am
As an inventor, one of the questions on one of my gadgets needs to be, “Why hasn’t someone done this?” Often it turns out that the particular idea requires a considerable shift in the way things are done that would have imposed a considerable cost on any that tried.
One current problem is that I have designed a small concrete house structure that my wife and I can build for cash. Base idea is for it to be F5 (261-318 mph winds)tornado proof so we can use the small house as a model to sell house additions that are storm safe. My classroom engineering (no degree) is over four decades back, but I have been working with concrete for all that time. I designed around simplicity of construction using experienced based conservative structural values. My problem has been finding a licensed engineer to check it out and do the blueprints that we can use for permitting.
After a half a dozen turned down even looking at the project I was getting angry and thinking poorly of their intelligence and ethics. Turns out that the reason they don’t want to do it is that most of them are making very good money stamping standard work that they can cut and paste with virtually no risk to themselves. “Trusses by others” and “Field verify” are just a couple of the common disclaimers. Building codes require engineered blueprints so they can make really good money having their draftsmen cut and paste to 30 year old code with a little drawing for particular projects.
I have a really good idea that the industry avoids. Finding out why they avoid it reveals a very high profit product once I get it into use. Had to go with an engineer starting his own firm and needing work to get it going at all.
Scott Sumner
Mar 12 2022 at 12:20pm
Interesting. I suppose that building regulations encourage conformity and discourage innovation.
Alan Goldhammer
Mar 12 2022 at 9:14am
While this was in general a very good post, the following is a huge misreading of Spanish history.
Islam spread rapidly across North Africa and into Europe via Spain. the Iberian peninsula was quickly conquered and it was dysfunction within the Islamic caliphate along with military action by the Christian states led to the downfall and unification of Spain as a Catholic state in 1492. The remaining practitioners of Islam were subject to the Inquisition just as the Jewish populace of Spain. The “possibility” that you allude to was not real.
Jon Murphy
Mar 12 2022 at 9:34am
Yes, that’s his point. There were factors, many many factors, beyond the wisdom of the crowd, to explain the divergent paths of Spain and Morocco.
Scott Sumner
Mar 12 2022 at 12:17pm
Not sure how your comment bears on my statement. Are you saying I’m wrong, and that current residents of these countries chose a religion as if choosing an item off a restaurant menu? You seem to attribute a meaning to my comment that wasn’t there. I am well aware of the history of that area.
Read my comment again. I am talking about current residents, not ancient history.
Jim Glass
Mar 12 2022 at 9:33pm
In every single area of our lives we might want to assign a weight of f to our personal view
I lived with a wife and three sons in a Manhattan apartment.
One of them would, say, turn on the toaster oven to preheat it to cook something a very special way (finicky, finicky!) and leave. Another would walk in, say “What idiot is trying to burn down the house?”, turn it off and leave. Then the first would come back and complain, “What idiot turned off my oven?” Yelling match ensues because both are now in “I’m right! You’re wrong!” mode. Sons and mother in close quarters may be easily triggered.
All of which could have been calmly avoided if #2 had asked “Is there a reason why this gate, er, oven is on?”, or #1 had asked “Did anyone have a decent reason for turning my oven off?”
Point is, being aware that there may be reasons for opinions different than one’s own can be a basic personality trait of everyday life, helping one get along more successfully with people and aiding success at every level, from minor daily interactions all the way up to religion and politics and investment decisions and all that big stuff. No conscious formal discount rate or Chesterton tale necessary.
Take economics. Summers and Krugman started out together, both superior academics. Now, 40 years later, post academia, Summers has been Treasury Secretary, Harvard’s President, etc., while Krugman’s been a to-his-choir newspaper columnist. I suspect because Summers has much more of this trait.
(OK, I may be totally unqualified to judge them personally, but I haven’t made a Krugman snark in ages, couldn’t resist. And he’s truly never been known for being modest about his own opinions.)
On a sounder note: I once saw Nobel-in-economics psychologist Daniel Kahneman get asked: “What’s the #1 cognitive mistake humans make?”
His answer was: “We all have opinions on countless subjects we know nothing about. That’s not the problem. The problem is, when challenged, we fight about them.”
Jim Glass
Mar 12 2022 at 9:35pm
Wow, I have to learn how to format comments here.
Knut P. Heen
Mar 14 2022 at 12:40pm
Robert Shiller is the contrarian. The view of Fama is the orthodoxy.
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