Behavioural Finance - taking over the center of the financial universe

"You must completely abstain from teaching or discussing this doctrine. You may not defend it - you must leave it completely, the opinion that the sun stands still at the center of the world and the earth moves around it".

The message must have been clear in itself, but was only underscored by the fact that it was delivered by Cardinal Robert Bellarmine who, besides being one of the Catholic Church's most respected theologians, also was the front man of The Order of the Dominicans and, by extension of this, also The Holy Inquisition. To drive home the point the letter that Bellarmine gave to Gallilei on this day the 26th of February 1616 was also signed by Pope Paul V himself.

Saint Robert Bellarmine - not a man you'd want to piss of in the early 1600's

- Cardinal Robert Bellarmine - not a man you'd want to piss off in the early 1600's. (picture by the courtesy of wikipedia)

The letter was a reaction to Gallilei's publication of Siderus Nuncius in 1610, loosely transalted to "The Messenger from the stars", which was a small booklet listing a number of observations he'd made with his newly invented telescope (optics was as hot in the 1600's as nanotech is today). More specifically the letter was a reaction to Gallilei's claim that the planet Venus almost undoubtedly was circling around the Sun, because this put him dangerously close to defending the heliocentric - and without a doubt heretical - view presented by Copernicus in the mid 1500's.

Why Care ?

I think most people laugh a little at the apparent naivety of ages past and just shrug away the Catholic Church's defence of the 2000+ years old geocentric view handed down to them all the way back from Aristotle and Ptolemy. Surely our belief in God can handle a little rearranging of the physical universe?

This misses the point that the Catholic Church, by extension of the necessary literacy among its clergy in order to read scripture, at this point in history was a dual-purpose entity charged with both keeping the faith alive but also with running the sciences. All the sciences. In fact there was little separation between theology and science, simply because it up until this point in time had been a prerequisite to becoming a scientist that you were first a monk or priest. 

In this respect you can re-think the Bellarmine-letter to Gallilei as sort of a rejection from the peer review committee of the day and start to see that the claims of heresy mounted against him as sort of a "You are wrong. Because if you are right that means that all our data and work is wrong - and we don't want that".

Gallilei originally seceded the point, but couldn't keep his mouth shut, so he was trialled a decade later and died in house arrest. Poor soul. Then again: I bet most of you knew Gallilei before this email and precisely 0% of readers knew Cardinal Bellarmine. At least he got the fame.

Why wouldn't they give it up?

An often overlooked fact, however, is that the mathematical modelling of the heliocentric universe as it had been developed by the clergy was actually matching the observations quite well. First is the basic fact that the Sun obviously moves around the Earth - or rather: if you have no other objects to relate this to, no backdrop of immovable stars to measure against, the three claims:

  1. The Sun orbits the Earth
  2. The Earth orbits the Sun
  3. The Earth and the Sun orbit each other

... are all completely consistent with the observable facts, simply because they are indistinguishable from each other and - if you happen to live on Earth - it might be understood why option #1 is your default opinion. 

As observations of other stars, comets and planets were entered into the equation the geocentric modelling adapted: Interstellar objects move in ellipses not in perfectly round circles. And when the movements of planets was observed to be apparently 'wobbly' around this elliptical track it was introduced that God in his infinite wisdom had asked the bodies of the heavens to move in elliptical circles around its main track - a little like the tips of a boomerang also circle around the central line of the flight path of the boomerang itself.

Add a few more troublesome observations and a few centuries of fiddling with ever more complicated elliptical models and you can maybe get a sense of the discussion that preceded the letter to Gallilei:

"For as long as anyone can remember we've believed the Sun orbits the Earth and for just as long we've been able to reconcile observations of the heavens with this view. Granted, we do have a few anomalies that we haven't been able to integrate yet - such as the orbit of Venus - but should this cause us to abandon the whole system and all the predictive power it has?"

The structure of this question is about as core as it gets in science. Our hypotheses and modelling of existing data is never perfect. There are always anomalies. Persistent, pesky, inexplicable anomalies. And sometimes they are resolved by tweaking the existing basic hypothesis that governs the models and experimental setup you use - and sometimes you have to abandon everything and start afresh. 

Over my dead body - as you please!

But just when you do it, of course, is the crucial question. When is the evidence strong enough? When do we believe we can built a better modelling, based on this new governing hypothesis, than what we already have? Science is, after all, deriving its purpose both from providing answers and from being useful and giving us tools to change our world. 

And while usefulness and truth are strongly aligned in the long run, they can have serious departures in the short run - especially when a new and better understanding of the universe is trying to introduce itself.

Philosophers of science have been largely cynical on the point of when it's a good idea as they have noted that scientists literally would rather die than change their minds. Hence, scientific fields tend to change only at the pace of a generational shift in the stock of it's scientists. 

The process looks like this:

  1. Someone discovers something that is irreconcilable with the current theory.
  2. The establishment ridicules him
  3. Young scientists, however, are more open minded and start research in the new theory.
  4. The old scientists die - and without heirs to their flawed worldview their theories with them.
  5. The once young scientists are the new establishment

The scientific philosopher Thomas Kuhn called this a 'paradigm shift', but the notion wasn't new (Karl Popper had extensively described a very similar process 30 years earlier). I'll often think in terms of 'operating systems' as the core thesis or belief of how the world (or a part of it)

Finally the point: Economics is in the midst of a paradigm shift.

We have a similar situation in Economics and finance today. The core belief is that the economic system is akin to a physical system of objects and forces. The term 'equilibrium', that describes how supply and demand interact to create a market price for something is exactly a term borrowed from physics. And this is no coincidence: Adam Smith used Newtons mechanical model of the universe to model the market, and the transfer of terms (such as 'forces' and 'equilibrium' and the division into agents and directions) are heavily indebted to the mechanical view of the world. 

Messy human interactions and seeming irrationalities were reconciled with the overall theoretical framework of rational agents in a supply-demand universe by a combination of 1) utility theory that stated that preferences are personal and view-point dependent and 2) game theory that explained why rational agents might end up in irrational deadlocks as a response to the possible strategies of other agents. This is the economic equivalent of elliptical circles around boomerang tracks. 

A product of this world view is that markets are - indeed must be! - efficient. The current price is the expression of the forces at work - and since the forces are inherently rationally observing the world, then the price must incorporate the full measure of reality.

Then comes along Amos Tversky and Daniel Kahneman and explodes the most core scientific notions: just as Gallileo attacked the notion that the sun revolves around the earth Tversky and Kahneman attack the notion that people are inherently rational agents. 

Their preferences are inconsistent, change over time and are - illogically - heavily influenced by what other people prefer. Their decision processes are just basically flawed. Their judgement easily manipulated. And so on.  

The world view here is less one of mechanical forces meeting to balance each other out in perfect equilibria as it is a view of a messy, hot soup of relatively bright animals trying to pursue all sorts of goals from the more rational to the utterly insane.

 

So this is what I see out there

I see an old establishment of economics and finance being upended by a new theoretical framework. I see all sorts of challenges to the old tenets of the faith, big and small, and I see the contours of a new theory of human decision making and markets emerge. One that is more biological than mechanical. One that tries to embrace the fact that people are human beings with bodies, emotions - evolved to fit a world without stock picking and savings accounts. 

And I want to leave you with this question: what can we do about it? Maybe we don't want it to be true that we are not rational decision makers - but let's pretend for a moment that we believe it: then what can we do as investors to increase our chances? Should we try and be rational? If yes: how? And if now: then what?

Just give me the first thing that pops into your mind in the comments below.

Thank you for reading.

 

 

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