The Sunday Times 22 October 2017
In America the law introducing compulsory wearing of seat belts was introduced in the 1960’s as the country was experiencing mounting casualties on public roads and highways. In 1975, an economist from the University of Chicago, Samuel Peltzman, published a very controversial article with a shocking conclusion; contrary to what was expected, the introduction of the law did not reduce the total number of deaths. There was a decline in driver deaths, but this was almost entirely offset by an increase in pedestrian deaths.
Once you tell people that cars are safer, they will drive faster and more recklessly. And this is exactly what happened. Car drivers adapted in an unproductive way, rendering the intended effect of the regulation redundant.
That there are consequences to regulations beyond what is expected gave rise to the so-called Peltzman effect; the tendency of people to react to regulations by adapting behaviour, offsetting some or all of the benefits of the regulation.
The most obvious lesson within this is the dangers of the failure to consider second order effects – to reflect and ask how people will respond to change.
The investment business and more broadly, the finance industry, often treats economics as some sort of hard science, like physics. Physics has immutable laws; for a given change you get a very predictable response. How an electron spins on its axis within a hydrogen atom can be predicted to within twelve decimal places of accuracy (yes I had to look this up).
Predicting how a driver responds to air bags and seat belts is inherently more difficult. Equally, finance is about people and the dynamic interactions of unpredictable things like culture, politics and the environment. Forecasts using decimal points have no place.
Thinking about first order effects is easy. Thinking about second or higher order effects is hard. But just because it’s harder, doesn’t mean one shouldn’t do it. As Warren Buffett advises, asking the “and then what?” question should not be limited to chess players. It should be adopted by investors as well.
The idea that investors don’t like risk has been at the very foundation of financial theory and practice for several decades. We are familiar with the term ‘risk/reward trade off’ and we all accept, at least intellectually, that there is no such thing as a free lunch.
When the goal is to reduce driving time, it seems rational that increased safety would induce motorists to drive with less care. In a brilliant new book by MIT finance professor Andrew Lo, he argues that from a financial perspective this is consistent with basic portfolio theory: if an asset’s risk declines but its expected return remains unchanged, investors should invest more money into it, other things remaining the same.
But what if safety improvements are perceived to be more effective than they are? Then individuals may end up taking more risk than they intended to, simply because they feel safer.
Ironically, Thursday just gone was the 30th anniversary of the 1987 Wall Street crash which many believe to have been caused by portfolio insurance which purported to protect investors in a sell-off through the sale of futures. The seeds of its own destruction were embedded within the product and investors erroneously thought they were ‘safer’ than they were in reality.
Equally during the recent financial crisis; ratings agencies applied rankings to bonds that ultimately turned out to be completely false. The perception of risk differed entirely from the reality and when the tide went out, many investors were exposed.
It’s not that difficult to argue that financial bubbles from the past occur partly due to scores of people stuck in first-level thinking; the Internet will change the world, house prices never decline, China will grow forever. The simple refrain of first level thinking, translates into a simple action, usually with expensive consequences.
So where are we today? The level of volatility in the market is currently at all-time lows. Investors seem to be very complacent. A dose of second level thinking would be wise with reference to certain market segments (cryptocurrencies being one). With that in mind, I’d urge any would-be investor to consider the following:
Always be willing to see both sides of every argument or investment stance you take. You have to be willing to actively seek out opinions that are different than your own. Don’t judge your decisions based on the outcomes; judge them by the process you took to make them. And try not to be too confident in your own abilities. The market has a habit of making you humble (though sometimes this can take time).
Finally, much of the commentary you see in the financial press is full of first-level thinking, so acting upon it is dangerous to your wealth. Apart, of course, from the wise counsel served up in this column.
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Gary Connolly is Managing Director of iCubed, an investment consulting company providing investment support to financial advisors. He can be contacted at firstname.lastname@example.org or on twitter @gconno1. iCubed Training, Research and Consulting, trading as iCubed, is regulated by the Central Bank of Ireland.