How confident should you be?
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.