Market Turmoil

On Capital Markets, Confidence Tricks, And Criminals

Wednesday, June 6th, 2012

The ascendency of behavioral economics over its “Classical” cousin is one of the more notable effects of the market turmoil of the last five years. Simple constructs like “Every marginal dollar has utility” have given way to more nuanced explanations that incorporate how human beings really make decisions about the tradeoffs between money and deeply held emotions and beliefs. But even with this realization, academia still seems to have a choke hold on the studies that expand our knowledge of this new discipline. Nic Colas, of ConvergEx, adds to the discipline’s canon with some examples of common street scams around the world. While the modern study of psychology and its interplay with economic choices is barely 100 years old, hustlers the world over have been perfecting their art for millennia. So if you’ve ever “Accidently” jostled someone into dropping their glasses or a bag of food, you can take comfort that you’re actually part of a long tradition of pragmatic field study in the topic of behavioral finance.

Nic Colas, ConvergEx: Taking It to the Streets

I have the good fortune to have been born and raised in Manhattan before it first became a largely gentrified and now extremely wealthy city. Back in the 1960s and 70s, people with money fled to the suburbs rather than subject their families to garbage strikes, dangerous subways, and crime-ridden streets. One advantage to this upbringing, however, was that you learned at an early age that “Street smarts” were a necessary part of a portfolio of urban-dwelling skills. And the first commandment of this rulebook is: “No one has any business talking to you on the streets of Gotham.” If they addressed you in any way other than (perhaps) “Hey, that bus mirror is going to hit you, idiot” they probably wanted to hustle you. And you learned that the guys with the soft-voiced anthem of “Smoke, smoke, smoke” were just peddling oregano they had lifted from the local pizzeria. But we digress…

What I find gratifying about these childhood lessons is that they were excellent training for the now-voguish topic of behavioral finance. The economic and financial meltdowns of the last five years – and the next five, most likely – have put many chinks in the armor of the “Classical” economics, with its claimed formulaic certainties and neatly drawn supply/demand graphs. Now, the study of how humans really make financial decisions, with all their biases, faults and even biological limitations, is the coin of the academic realm. Legions of grad students spend their time designing studies and experiments to show that humans make decisions that stray wildly from the “Optimal” solutions suggested by classical economics.

I would suggest, however, that you can witness a useful cross section of this up-and-coming academic discipline by just keeping an eye out for the myriad of scams run by con men and women on the streets of any major city. Further, the lessons of these scams should ring the proverbial bell for those market participants who want to understand the sources of many common investment pitfalls. The easiest way to expand on this thought is through several examples:

Example #1 – The Valuable Book. A man walks into a bar during the middle of the afternoon, long after the lunch rush but before the after-work crowd appears. He has a hardcover book with him, which he sets down at the bar. He orders a drink from the barkeep, and tells him that he needs to hit the ATM next door. He leaves the book behind to mark his spot.

A few minutes later, two well-dressed men enter the bar. The notice the book and ask the bartender if it his. He says it belongs to a fellow who is next door for a minute. The two men look through the book, and grow increasingly agitated. “This is a first edition of The Great Gatsby, with the original dust jacket!” That’s nice, says the bartender, how much is it worth? The well-dressed men respond, “At least $20,000. If they owner wants to sell it, let us know.” They hand the barkeep a card walk out.

The owner of the book walks back in. The bartender nonchalantly asks about the book. “Oh, it was my mother’s. She just passed away, poor dear.” The bartender professes a great admiration for Fitzgerald and says “Gee, I love old hardbacks – would you sell it?” After professing a reluctance to sell something so near and dear to old Mama, the man gives it up for $500.

The book turns out to be a fifth printing with a photoshopped cover. Real value: $1.75. The same scam has been run with violins and even mutts from the pound, all anchored around the same storyline.

The lesson: humans use a variety of heuristics – mental shortcuts, essentially – to make judgments. One of them is to rely on “Experts.” In this particular example, the wealth of television shows that feature experts revealing that someone’s old knickknack is really a hidden treasure also gives rise to a “Recency Effect” – recalling something you’ve seen in the near past and attributing more value to it.

Example #2 – The Broken Glasses. You are walking down the street, talking on the phone or listening to music. You think you are paying attention, but somehow you miss the person who is just removing their glasses. They fall to the ground and appear to shatter. You realize the wearer has a subtle but now-obvious mental challenge. They begin to cry and say their Mom is going to kill them for being so careless with their glasses. People around you begin to stare at you. One or two even stop to try to comfort the obviously distressed owner of the now-broken glasses. You feel like a jerk and hand over $100-200 to make up for your clumsiness and to show the bystanders that you aren’t actually jerk.

As you might guess, the glasses were never broken and the bystanders were accomplices meant to make sure you felt as guilty as possible. The whole scam takes 2-5 minutes from start to end and can be repeated – in different parts of town – 10/15 times in a day. I have seen it done at least a dozen times – usually to obviously affluent tourists in midtown Manhattan – with glasses or a bag of food from a takeout deli. It works every time. The only way out of this situation, which is the one I have personally used, is to claim that you have no money on you but that your cousin, who is a policeman at a nearby precinct, will lend you the cash. The con artists don’t especially want to walk into a police station and let the matter drop pretty quickly.

The lesson: social pressure is a powerful force in negotiations. You aren’t paying for the broken glasses. You are paying society to not think you are a careless jerk. This is a Harvard Business School case study-worthy example of “Know what business you are REALLY in.” The scam artist knows you are buying social standing.

Example #3 – Put Your Money with My Money. You are approached on the street by a man wearing clerical garb with a seemingly sad looking fellow in tow. The “Priest” explains that the other man has just been the victim of a robbery, and only has $5,000 in cash to his name. Leary of accepting help from anyone – he is a native of a country where the police are corrupt – he approached the “Cleric” looking for help getting to a local bank. They show you a paper back stuffed with $20s and $50s. Would you help by walking it across the street to a quite visible bank branch while the priest tries to hail a police car and convince the other man to explain what happened? Oh, and would you mind stuffing a few dollars into the bag as well, just to show that you are affluent enough to be trusted? When you drop your $100 into the sac, the switch occurs. You end up at the bank with a bag of paper, while the con men walk away with the real one.

The lesson: The term “Confidence Game” stems from the fact that the criminal appears to give you their confidence. Not that you give over yours. This act essentially makes you, the mark, pliable and open to suggestion. This is, I think, one of the most underexplored areas of behavioral finance. There are plenty of studies about the importance of trust, and there is even a “Trust Game” variant of the “Ultimatum Game” that is the bedrock of the discipline. See more here: http://wiki.dickinson.edu/index.php/Behavioral_Economics_and_Game_Theory). But the power to manipulate human action by “Giving” someone your confidence in the hopes of eliciting a response that is patently bad for them may fall beyond the walls of proper science.

I assume that the comparisons to recent events in the capital markets are fairly obvious, whether they be failed IPOs or the strategies used by weaker sovereign nations to negotiate with stronger ones. The point here is not to call out anyone as inherent ‘Criminal.’ There are plenty of laws – and diligent regulators – surrounding the capital markets, after all. Rather, the examples here are simply a lens that allows us to examine the nuances of human behavior with greater understanding. As the old saying goes,’The proper study of mankind is man.’ Even when it is a con man. And in the case of behavioral economics, perhaps especially so.

Tags: Ascendency, Behavioral Economics, Behavioral Finance, Capital Markets, Colas, Confidence Tricks, Convergex, Economic Choices, First Commandment, Good Fortune, Hustlers, Interplay, Market Turmoil, Smoke Smoke Smoke, Street Smarts, Study Of Psychology, Subways, Taking It To The Streets, Tradeoffs, Urban Dwelling
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What a Potential Greek Exit Means for Investors

Friday, June 1st, 2012

by Michelle Gibley, CFA, Director of International Research, Schwab Center for Financial Research

Key points

The risk of a Greek exit has increased, although the timing is uncertain.
In the meantime, we believe more market turmoil is likely, because most of the major tools to stem the crisis have political and legal barriers.
We prefer underweighting Europe at this time because the potential for downside risks has increased and there is the likelihood of high levels of ongoing volatility.

In national parliamentary elections on May 6^th, many Greeks swung their support away from mainstream parties and toward anti-austerity fringe parties, increasing the chance of an eventual Greek exit from the euro. This has led a lot of Schwab clients to ask some key questions—namely, if and when Greece could exit the euro, and what this would mean for investors. One word of caution before we start: It’s unusually difficult to predict a resolution to this crisis, given the number of different scenarios and political decisions involved. Here are some of the questions we’ve heard most frequently:

When would a potential Greek exit happen?

Because the May election didn’t give any party the majority of the parliament, and a coalition government failed to emerge, Greeks go back to the polls on June 17. This election could create the conditions for a fast exit if austerity measures to be implemented by June 30 are outright rejected. While Greece’s next quarterly bailout funding is due August 30, observers are concerned that Greece could run out of money as soon as July, as tax collection revenues are likely coming in below expected levels.

We believe an exit in the short-term is less likely because Europe doesn’t yet appear to have mechanisms in place to deal with the aftereffects, or contagion. A Greek exit could begin to infect other countries, threatening their ability to issue debt at reasonable rates and potentially pushing them closer to an eventual exit from the eurozone, and spark a flight of capital from banks in other peripheral countries. Measures to stem contagion will likely need approval—either parliamentary or by the general public—before they can be enacted. Therefore, Europe is likely to again kick the can down the road and buy time, even if a coalition of hard anti-austerity parties forms a government in Greece.

We believe the probability of a Greek exit increases as the year progresses and over the next several years. Greece is likely to need continual relaxation of bailout targets, which will become increasingly unpalatable to the electorate in financially stronger countries.

If Greece is small, why would a Greek exit matter?

We believe that markets are focused on Greece primarily because of the risk of contagion to Spain and Italy. While even last fall there was hope that Greece’s problems could be “ring-fenced,” or contained, the risk of contagion has become increasingly apparent.

Italian and Spanish bonds move somewhat in tandem

Italian and Spanish bonds move somewhat in tandem

Source: FactSet, iBoxx. As of May 29, 2012.

Spain’s problems are complicating the situation. In Spain, the fiscal deficit has been revised negatively and the health of its banking system has been deteriorating. The Spanish fiscal deterioration, combined with the inaction of the European Central Bank (ECB) at its April monetary policy meeting, helped to increase yields on the government debt of an entirely different country—Italy. Italian and Spanish government bonds continue to move somewhat in tandem, even though you could argue that Italy’s financial position is stronger than Spain’s.

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Tags: Austerity Measures, Bailout, Caution, Cfa, Coalition Government, Contagion, Downside Risks, Europe Need, Federal Reserve, Greeks, Legal Barriers, Likelihood, Major Tools, Market Turmoil, National Parliamentary Elections, Observers, Political Decisions, Scenarios, Schwab, Volatility
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Is Derating of Emerging Market Stocks Justified?

Sunday, October 23rd, 2011

The dividend yield of the iShares MSCI Emerging Markets Index Fund (EEM) recently moved above the dividend yield of the iShares S&P 500 Index Fund (IVV) for the first time since the 2008/2009 financial crisis.