Here's the burning issue I want everyone to understand about the economy and markets

Photo: Aaron P. Bernstein/ Getty Images.

In the late part of the last century I had a raging argument with a guy who truly believed the economic theories which said humans were utility-maximising automatons.

Armed with my new learnings about the work of Daniel Kahneman and Amos Tversky in what is now well understood be the underpinnings of behavioural economics and finance, I tried to point out to this fellow the flaws in his argument.

Sure, it was a wonk-fest. And when I mentioned that he probably believed that markets were efficient as well, he really got agitated and our discussion stepped up to a new level.

I was already leery of the idea that markets were efficient after spending almost a decade in them. But when I stumbled across Kahneman and Tversky’s cornerstone work, what they called “prospect theory”, in 1997 during my Master of Applied Finance, I was sold on the idea that human beings are often their own – and the market’s or economy’s – worst enemy.

What prospect theory essentially says is that our decision-making process drives different outcomes depending on how the question is framed or what the consequences of that decision might be.

For example, Kahneman and Tversky pointed out that gains and losses are valued differently by people. Throw in the way a question might be asked, the answer would be nudged by our inherent preference for gains and fear of losses.

It’s no understatement to say that the journey prospect theory started me on, and the more reading I did on the work of Kahneman and Tversky, and also from others of the behavioural school, professors like Richard Thaler, George Akerlof, and Robert Shiller to name but a few, were the most important lessons I have learnt in my career.

If I was to boil it down into a simple sentence I would say that behavioral economics and finance taught me we must have human interactions, emotions, psychology, behaviours and heuristics at the centerpiece of our understanding of, and outlook for, the economy and markets.

It’s a fundamental departure from the utility-maximising view of the way the economy and markets work. And while it doesn’t necessarily mean that all notions of market efficiency need be thrown out, it does mean a slavish devotion to them must be.

Why is this my burning issue?

Because if we put humans back at the centre of economies and markets we can understand the rise of Trump, why folks voted for Brexit, why negative rates seemed theoretically a good idea but have proved problematic in their efficacy once practiced.

If we put humans as the centrepiece of policy we can see why unfettered free markets lead to the self-interest of corporations and their managers predominating. In that context, we can see why labour’s share of income has fallen and inequality grown.

From a trading perspective, behavioural theories have helped me make a lot of money in the 15 or 16 years since I first stumbled upon Kahneman and Tversky’s theories. It neatly segued with my favourite Keynes quote likening the market to a beauty parade where the judges sought not to pick the prettiest contestant but rather pick the one the others thought prettiest.

If I could get into the mind of other traders and understand how they would frame market reactions and thus anticipate their moves, I could increase my profitability.

That’s something that Manoj Nerang is now seeking to automate at his $1 billion hedge fund. Recently Nerang told Business Insider’s Rachael Levy that the aim of his fund is “to make money by doing the same thing as the rest of the market, only doing it first before the rest of people commit their capital”.

He went on:

“…to me, the most fertile ground for building quant trading strategies that are profitable is by anticipating, is by orienting those strategies to have a very strong structural component that understands how human beings make decisions”

That’s an automated behavioural model.

What Kahneman and Tversky did, and how they did it, is neatly chronicled in Michael Lewis’s new book The Undoing Project. Earlier this week, Lewis sat down with Richard Feloni to discuss the pair.

Both the interview and the book are a must-read.

So too is an understanding of behavioural economics and finance if we want to understand our economy and markets and make better policy for the future.

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