The trader’s mindset and the psychology of underinvestment
Tim Harford and Chris Dillow have praised the psychological effects of gambling and playing the stock market. But this mindset has a dark side when it comes to innovation.
The trader’s mindset and the psychology of underinvestment
The brilliant Chris Dillow recently argued that having a flutter is good for your moral fibre. Specifically, Chris argued that betting, especially in that refined casino called the stock market, makes people less overconfident, and that this is good for them and for the world*.
I agree – but I can’t help thinking there’s a dark side to this too.
First, let’s look at Chris’s argument.
“Bets… or trades or investments… teach us an important lesson. Everyone who has made a decent number of them learns that however good is your research, theory and evidence, you'll often go wrong.”
To put it another way, extensive exposure to the stock market makes you realise that your best-laid plans may well go astray. And, the argument continues, this makes you a better person because it inoculates you against hubris.
What’s more, Chris argues, if you are someone with power or authority, your skepticism will make the world a better place because it protects others from the fall-out from your ideas going wrong. It’s harder to be the next Fred Goodwin when you’ve heard the flapping of the black swan’s wings.
This is certainly true, and very wise. But I can’t help thinking there’s also a deadening effect from this stockmarket-driven rationalism – and that this may explain some of the economic state we’re in these days.
The problem to my mind is that investing in public capital markets is an unusual activity. It's not like a lot of other economically significant decisions, and so the lessons it teaches may be less helpful than they appear.
When you buy a share, your decision to buy it will almost never affect its prospects. You’re a price-taker. Any glow of optimism you feel when placing you order is no-one’s problem but your own. (And to the extent that it makes you over-estimate the value of what you’re buying, optimism very much is a problem for you as an investor.) The market is bigger than most investors, and it cares no more about your mood than the ocean cares about the colour of a swimmer’s bathing suit.
But many economic decisions aren’t like this. Rather than dealing with a big market that doesn’t notice or care what you think, we often have to deal with other humans on a more micro scale – whether these are our colleagues, our customers or our business partners.
These guys make things more complex, because they react not just to what we do, but to our mood. And surprise, surprise, the mood that they respond best to is one of unreasonable optimism. Martin Seligman found that in most occupations, optimists do better than pessimists. This is not because they’re better judges of reality. Tali Sharot and Andreas Kappes recently did a fascinating literature review for Nesta (forthcoming) which shows much the same thing.
I say “unreasonable optimism” advisedly. Optimism is not a good trait if all you care about is being right. Psychologists have long noted that the people most likely to accurately predict the future are those with mild depression – a phenomenon of “depressive realism”**.
In financial markets, optimism is a handicap, a sucker’s trait. It makes you more likely to make bad bets, and gives you nothing in return. But in business, it’s a self-fulfilling prophecy.
And the benefits of optimism aren’t limited to the individual. Optimists are more likely to invest in innovative projects. Pessimists, being realistic, know that innovation rarely brings big rewards to the people who first invest in it, and that it’s much better to follow just behind the starry-eyed pioneers - and make all the serious money. After all, Steve Jobs had his billions, but Bill Gates his tens of billions.
If any of this is true, we should be much more ambivalent about activities that make us pessimistic. And we should be particularly skeptical of trends that made large numbers of our fellow citizens pessimistic.
If Chris is right and exposure to financial markets makes you soberer and more realistic, it seems plausible that thirty years of rewarding and glorifying traders, encouraging widespread share ownership, and generally financialising the economy might have had some general societal effects.
Nassim Taleb’s Fooled By Randomness is Exhibit A: the book (which I like very much, incidentally) argues that human cognitive biases are abundant and ruinous and displays a grumpy (depressive?) discontent with the world and an annoyance with humanity’s great schemes. It’s also evidenced with plenty of examples from Taleb’s own career as a trader.
As the pessimism of the trading floor has grown, we’ve seen a decline in something else – what we might call magnificence. By that I don’t mean opulence (by golly, we have enough of that).
I mean magnificence in its older sense of “doing great things”***. Businesses invest less (a point Chris himself has made), and when they do are widely thought to be short-termist****. Governments seem ever more constrained. Exceptions to this rule, like Elon Musk, seem like time travellers from a more rugged past.
If Chris is right that financial markets teach us skepticism, perhaps this is the psychological price we pay.
* Chris’s post was a response to an equally good article by Tim Harford, referring to a bet between Jonathan Portes and Andrew Lilico.
** I should note that many of these observations about optimism have been made – and made more eloquently – by Chris himself, for example here.
*** Credit for this goes to Jane Jacobs, via Chris Cook.
**** I think this is a different argument from the more familiar economic argument that financialisation hurts innovation (for example because it encourages managers to cut R&D to maintain stock prices as Richard Jones or Bill Lazonick have argued). What we’re talking about here is a psychological argument – a reason why exposure to financial markets might make a decision-maker less likely to take a foolish but societally beneficial punt on a new idea.
Afterthought: Of course there is one type of over-optimism that the financialisation of the economy positively encourages managers to indulge in: corporate takeovers. Like innovation investment, these often go badly for the protagonist. Unlike innovation investment, their spillovers are negative, not positive. Hmm.